Bankers and oil traders were perplexed on Wednesday as to why Deutsche Bank (NYSE:DB) decided late on Tuesday to shut down a popular oil investment product.
The bank cited a “regulatory event” to explain why it will redeem $425m in its PowerShares DB Crude Oil Double Long exchange traded notes (DXO), namely that the product pushed against the limits on crude oil holdings on the New York Mercantile Exchange.
But the exchange and the US commodities regulator did not acknowledge any event with regard to the fund leaving market participants to guess whether the storyline was more complicated.
Click for ARTICLE
- Alarm bells ring over scrapping of oil notes
- Javier Blas and Gregory Meyer
- Financial Times
- September 2, 2009
It’s not actually that mysterious. There are three main reasons why Deutsche Bank dumped DXO:
(1) Regulatory Heat: Because it’s double leveraged, the $425 million ETF has to hold $850 milllion in WTI crude oil contracts. At $68.50 per barrel that equates to 12.4 million barrels or 12,400 contracts. This is clearly a violation of Nymex’s 10,000 contract single month position accountability level. Of course one might ask “well why not go to ICE or expand into other months since the all months limit is 20,000 contracts.” Because, they probably know something we don’t know regarding how the CFTC might (a) set energy position limits and (b) make them apply in total across exchanges (NYMEX + ICE + OTC). One thing we do know is that double-leveraged ETFs of all kinds have gotten a great deal of regulatory scrutiny because they allow retail investors to take leveraged positions in their IRAs – something you’re not supposed to do.
(2) Litigation Threat: Retail investors buying the DXO (and oil ETFs like it) think that their investment is going to track the price of oil. But because these ETFs buy front month futures (not the actual commodity), and roll them each month, the largest component of the return investors receive is the “roll yield.” When the oil futures curve is in contango (upward sloping) then investors lose every month on the roll. In fact this year they have been losing their shirts on the roll. Anyone that buys and holds these ETFs with the idea that they’re hedging against inflation are going to get clobbered on this negative roll yield phenomenon. Just look at this chart (click to enlarge) which shows that while crude oil prices have risen from $46 to $68 (a 47% gain) , the DXO has only risen from $3.13 to $4.08 (a 30% gain). So rather than being up 94%, like one would expect from a double levered oil investment, this is up a measly 30% because 64% of the gain has been eaten up by negative roll yield! It will only be a matter of time before investors start suing the pants off Deutsche Bank and other oil ETF purveyors.
(3) DXO Makes Little Money: In all things Wall Street, the bottom line is the money. Deutsche Bank is dropping DXO primarily because they just aren’t making that much money. The best and easiest way to make money in this business is for people to be both long and short your ETF. When somebody shorts an ETF then it offsets an existing long and it become literally free money for the ETF company because they don’t have to buy any underlying securities or derivatives to hedge the long. They just collect the fees from both the long and short while one’s bet offsets the others (like bookies collecting the vigorish). In this case nobody is really shorting the DXO because it’s a retail product and overwhelmingly people want to be long DXO as an inflation hedge. So Deutsche Bank is having to carry the entire position in futures contracts. On top of that with aggregate position limits looming on the horizon and a maximum of 20,000 contracts as the current limit, they cannot grow this much beyond $685 million. Ideally they would like to see assets in the billions so it just becomes too much of a headache for them to keep it.
So Deutsche Bank is dropping DXO – mystery solved!