Overpricing Of The OIL ETF Presents An Arbitrage Opportunity

| About: iPath S&P (OIL)

Summary

OIL is still selling for 14% more than its published Indicative Value.

Investors can pocket this premium by shorting OIL and hedging with another oil ETP like USO.

ETF investors should pay attention to Indicative Values when trading.

On January 26, 2016, Grizzly Bear published an insightful article pointing out a 12% arbitrage opportunity from the mispricing of the iPath GSCI Crude Oil Trust (NYSEARCA:OIL). Since then, the opportunity has grown even larger - up to 31% on February 11, but has since started to shrink. One problem with exploiting mispricing in the market is that whatever factors caused the mispricing in the first place may get worse before the mispricing goes away. As of the close on February 12, 2016, OIL closed at $4.54 compared with its underlying value of $3.98, still a 14% premium.

Indeed, the discrepancies between the market price of OIL and its underlying value Barclays has put out a rare warning to investors to be careful when trading OIL.

Prior to September 2015, the price of the OIL ETN traded very close to its IV. From January through August, the average difference between OIL and OIL.IV was only 0.9% with a standard deviation of 1.3%. The following chart shows the recent price history of OIL and OIL.IV:

Source: Yahoo! Finance and ipathetn.com

Background: The iPath GSCI Crude Oil Trust Exchange Traded Note

The iPath GSCI Crude Oil Trust is an exchange-traded note (ETNs). ETNs are similar to but yet different from regular exchange-traded funds (ETFs) in that ETNs are unsecured debt instruments with payoffs linked to some index. Unlike an ETF, the ETN does not actually own an underlying portfolio. However, like an ETF it does trade on equity exchanges just like a stock.

OIL is issued by Barclays Bank PLC, and thus has all of the credit risk of Barclays. It matures on August 14, 2036 and pays no interest. The payoff at maturity is a function of the return on the S&P GSCI Crude Oil Total Return Index, less a fee of .75% per year. The S&P GSCI Crude Oil index is driven mostly by the near month West Texas Intermediate (WTI) crude oil contract.

Although the payoff on these notes is tied to the price of oil, this does not mean that Barclays is making long-term speculative bets on the price of oil. Instead, Barclays hedges the notes on its own.

Holders of OIL can redeem their ETNs (in lots of 50,000 ETNs) at any time at the current redemption value. This ability to redeem the notes prevents the price from dropping below the value of the shares. If the price did drop below the underlying value, arbitrageurs would buy the shares in the open market and redeem them for a quick profit. Indeed this type of arbitrage is what keeps ETF prices in line with their underlying portfolio values. ETF sponsors stand by to create or redeem ETF shares as the market dictates.

However, this process does not work in the other direction for OIL. While one can redeem the OIL ETNs, one can't demand that Barclays create new ones. One can't just hand Barclays some cash and walk away with new OIL ETNs at the announced daily value. As the notes are liabilities of Barclays, it is up to Barclays to decide whether or not to issue new OIL shares and at what price. The Wall Street Journal reports that Barclays has been trying to limit the issuance of new ETN notes and has imposed a fee of $.50 per share on new creations. More details on the OIL ETNs can be found in its prospectus.

Pay attention to Indicated Values (IVs)

One important factor that every investor should pay attention to is that the prices of exchange-traded products (ETPs) (including ETFs and ETNs) can and do deviate from the value of their underlying portfolios. Fortunately, ETP sponsors disseminate their estimates of the underlying value of the ETP portfolios at least every 15 seconds during the trading day. These estimates are called Indicative Values (IVs), although sometimes they are called Indicative Optimized Portfolio Values (IOPVs), Intraday Indicative Values (IIVs) and sometimes Intraday NAVs (iNAVs). Investors should check the IVs before trading to make sure that the ETF price is reflecting the current value of the underlying assets. If there is a discrepancy, investors should investigate carefully before trading.

One question that naturally arises with an IIV-based trading strategy is "How good is the IIV?" In the case of OIL, Barclays promises to redeem shares daily at a redemption value. As such, the daily redemption value is a pretty good estimate of the underlying value of the ETN. The IIV is an intraday estimate showing the impact of changes in market prices on the daily redemption value. Typically, but not always, the IV for an ETP is just the ticker symbol for the ETP with the suffix .IV. Thus, OIL.IV will bring up the IV for OIL.

IIVs can sometimes be hard to find. The IIV for OIL can be found on Yahoo with the ticker ^OIL-IV. On Interactive Brokers, it is OIL.IV as an index. If you have access to a Bloomberg terminal, the IIV can be found as OILIIV {Index} {go}.

Shorting costs

One problem with any long-short strategy is the cost of shorting. Indeed, many ETFs are hard to borrow. Fortunately, OIL is not as of this writing on the Reg SHO Threshold List of stocks with extended settlement fails. Interactive Brokers indicates that the stock can be borrowed for an annual fee of 1.34% as of this writing. Of course, borrowing costs can and do fluctuate, and there is always the possibility that a stock may become so hard to borrow that a buy-in occurs. Even though the stock is not too expensive to borrow, it is not one of the cheaper ones, so discount brokers may not bother to go to the effort to borrow the shares for you.

Here is a screen shot from Interactive Brokers showing recent borrowing costs:

Source: Interactive Brokers

Of course, there is always the risk that one may be bought in if shares can no longer be found to borrow, but this is unlikely with borrowing fees this low.

Hedging the price risk of crude oil with USO

While one might be tempted to just short OIL, one would then be taking on the price risk of crude oil. One can hedge the position by going long another crude oil ETP. ETFdb.com has a list of crude oil ETPs. The United States Oil Fund LP (NYSEARCA:USO), is a natural hedging vehicle in that it has the largest assets under management and average daily trading volume of the crude oil ETPs. USO also tracks the WTI contract, but with a slight difference. The USO rebalances daily, which means that over a long time period it may deviate from the index as with other daily rebalancing ETPs. However, this should not be a major problem as a short-term hedging tool. From 2006 through 2014, the daily returns of USO and OIL had a correlation of 99.5%. The correlation of the daily returns since the beginning of 2015 has been only 88.7% as OIL began to deviate from its IV. (Note that the IV for USO, unlike most ETPs, has its own ticker symbol UOI.)

USO is a K-1 LP

One word of caution, however. USO is a master limited partnership, and, as such, shareholders will receive a K-1 form for their share of the gains and losses of the fund instead of a 1099. This may complicate your tax situation. Traders who don't want K-1s can use futures or other oil related instruments to hedge.

Summary

The overpricing of OIL presents an easy-to-arbitrage profit opportunity. As Barclays appears to be reluctant to issue new OIL ETNs, the gap between the price of OIL and its underlying value will probably not go all the way to zero, but will continue to fluctuate. This will present future trading opportunities and suggests continued monitoring for when the gap gets particularly large.

Disclosure: I am/we are short OIL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also long USO. I may change this position at any time as the gap between OIL and OIL.IV fluctuates.