Know what you own
In times of crisis and panic it always pays to really understand your portfolio. The great investor, Peter Lynch, put it perfectly: “know what you own, and know why you own it”.
In the last few days something extraordinary has taken place with the May contract of WTI Crude Oil. This is a futures contract: when an investor buys a futures contract it means they are obligated to purchase a barrel of crude oil at the stated date – in this case May – to be physically delivered. So you’re not buying oil directly, but you are obligated to do so at the agreed price when the date kicks in. The oil is then delivered physically.
Recently an Oil ETF (exchange traded fund) called USO (United States Oil Fund) starting receiving huge inflows at approximately $2 billion in 2020. Many investors assumed – incorrectly – that this ETF tracked the spot price of oil (the spot price is the current market price for immediate payment or delivery). In actual fact, USO was supposed to track the forward or front month contract. It did this by owning futures, and not the underlying commodity itself.
So, when the supply of oil flooded the market alongside the sheer drop in demand due to Coronavirus, there was nowhere to store the oil. Therefore, the May futures in oil producers were actually paying buyers to take the oil, at one point prices rising to almost $40 per barrel. In other words, that’s like paying the garbage man to take away your rubbish. And so, the situation became so absurd that WTI for May delivery on the futures exchange actually traded with a negative price:
The famous commodity investor Jim Rogers once said:
‘The price of a commodity will never go to zero. When you invest in commodities futures, you’re not buying a piece of paper that says you own an intangible piece of company that can go bankrupt.’
Perhaps what Jim Rogers says remains technically true, since what happened to negative oil prices was with the futures contract and not the spot price. But now we know that the future price of a commodity can go negative. USO owns approximately 25% of all futures contracts. It’s now very unclear what happens to the USO ETF. If months following May also turn negative, can the ETF itself also have a negative price? Will it be liquidated? What does this mean for the holders of the ETF? What about the discount versus the spot price – will that now ever be closed since losses have been realised on the May futures contract? And could this happen to other ETFs and futures contracts on other commodities?
Keep it simple, stupid
If this seems all very complicated then rest assured, it is. What happened this week was unprecedented, and the consequences are now very unclear. No-one know how this will pan out.
The aircraft engineer Kelly Johnson is assumed to have invented the acronym KISS, meaning Keep It Simple Stupid. For commodity investors it must now be clear that the plethora of financial “innovations” to “gain exposure” to an underlying asset are of dubious worth at best. If one wants to own something, then the best thing to do is actually own it. Not a futures contract, not an ETF, not a company that digs, mines, refines, or produces it. Just own the actual commodity. Owning a financial instrument that owns a commodity, or tracks it, or has exposure to it is absolutely nowhere near the same as owning the commodity outright yourself.
It is likely many of the USO buyers, who thought they held Oil, will lose a significant amount of their invested capital. For other commodities, including Gold, the best way to have exposure to it, is to own it. And the simplest way to do that, is Goldex.
Meanwhile, gold’s price has fallen back this week as investors take profit on the best performing asset class of 2020 amid continued turmoil on commodity and equity markets. The Comex market, which is the primary futures market for metals, saw gold for delivery in June fall by as much as $49.20 an ounce – or nearly 3% – before gaining back some of those losses. However, that hasn’t stopped Bank of America raising its 18-month price target for gold by a full $1,000 to $3,000 an ounce in a report titled: The Fed Can’t Print Gold.
BofA expects bullion to average $1,695 an ounce this year and $2,063 in 2021. The record of $1,921.17 was set in September 2011. Spot prices traded around $1,678 on Tuesday and are up 11% overall this year.
To be sure, a strong dollar, reduced financial market volatility, and lower jewellery demand in India and China could remain headwinds for gold, BofA said.
“But beyond traditional gold supply and demand fundamentals, financial repression is back on an extraordinary scale,” the report said.
Important disclaimer: this document is not an official research report and the views expressed in it are those of the authors. The authors are not registered research analysts and there is no assurance the trends mentioned will continue or that the forecasts discussed will be realised. Gold as a commodity is not a specified investment for the purpose of giving advice under the Financial Services and Markets Act 2000, therefore, this does not give rise to rights to claim compensation under the Financial Services Compensation Scheme.