D-Day for the MacroShares Crude Oil ETFs

By Matthew Hougan

The way I figure it, today is D-day for the MacroShares crude oil ETFs.

[Correction: An earlier version of this article said that the last day of trading for the MacroShares would be June 26. It is actually June 25.]

The MacroShares, of course, are the unusual crude oil proxies launched by MacroShares LLC in November 2006. The funds - the MacroShares Up Oil Trust (AMEX: UCR) and MacroShares Down Oil Trust (AMEX: DCR) - are designed to track the price of crude oil.

Unlike traditional crude oil ETFs, the funds don't actually hold crude oil futures contracts. Instead, they are structured as pairs. When the price of oil goes up, assets are shifted from the Down Oil Trust to the Up Oil Trust, and vice versa. The funds work like a teeter-totter, with one rising as the other falls.

But of course, a teeter-totter can only rise so high or fall so far. The funds launched when the price of oil was about $60/barrel. If the price of oil doubles from that, the Up Oil Trust will take all the assets from the Down Oil Trust, which will be left with nothing.

Obviously, MacroMarkets can't allow that to happen. (What would happen if the price of oil more than doubled?) So the funds have a "termination trigger" built into their structure just shy of a doubling in price.

The prospectus says that the funds will terminate if "the Applicable Reference Price of Crude Oil rises to or above $111.00 ... for three (3) consecutive Price Determination Days."

The Applicable Reference Price of Crude Oil right now is tied to the June WTI Crude Oil contract, as traded on NYMEX. On Monday, it closed at $111.75. Yesterday, it closed at $113.30. So far today, it's trading north of $113.30. Assuming it stays above $111/barrel, the Macros will trigger their early termination trigger today and be liquidated.

If the trigger happens today, the last day of trading for the Macros will be June 25. Shareholders of record on June 30 will receive payouts based on the fund's NAV, with payments made on July 3.

(What happens if the price of oil keeps rising between now and June 25? I have no idea.)

Previously, MacroMarkets said it might seek approval from the SEC to launch a new set of oil Macros at a higher base price. Shareholders could not automatically roll into this new Macro without taking the distribution, due to IRS restrictions. But the new funds would be available for trading. MacroMarkets said it will make an announcement about future funds at the close of trading today, assuming the trigger happens.

(For in-depth coverage of how the Macros work, check out the article Jim and I wrote in the May/June issue of the Journal of Indexes.)

(Brad Zigler of HardAssetsInvestor.com has been covering the termination trigger better than anyone.)

But Wait ... It Gets More Interesting

The trigger event has short-term traders chomping at the bit.

At termination, shareholders will receive payout at NAV...which right now is WAY below the share price for DCR. Barron's first reported this anomaly on Sunday, and others have been moving into this trade. DCR is down more than 50% over the past five trading days, but still, the discrepancy exists.

At the close of trading on April 15, DCR closed at $4.12/share. Its NAV, however, was just $2.26/share. That's a potential $1.86/share (or 45%) arbitrage profit, just for shorting the fund. Ummm ... somebody get my broker on the phone.

Of course, that's not a recommendation to trade. There are lots of things that could go wrong: if oil's price falls today, SCR would not terminate and could go back to trading at a premium to NAV. In addition, oil's price could fall between now and June 30, which would drive up the NAV of DCR. There are probably more sophisticated ways to truly arb the difference---selling oil short by buying DCR long---but nothing is foolproof here.

Still, it's interesting.

For ETF Geeks Only

Why is DCR trading so far above its NAV?

Usually, ETFs trade very close to their net asset value. If not, arbitragers swoop in and exploit any discrepancies. For instance, if the share price of the SPDR S&P 500 ETF (AMEX: SPY) rises above the value of the S&P 500 index, arbitrageurs will buy up the stocks in the S&P 500 and trade them in for shares of SPY, and pocket the difference.

But the Macros have never tracked their NAV very well, often trading at huge premiums and discounts to NAV. Lots of people ... including MacroShares ... have tried to figure out why. The consensus is that the fund's paired trading mechanism makes arbitrage impossible. The Macros can only be created and redeemed in pairs --- if you create new shares of UCR, you also create new shares of DCR --- so there's no way to arbitrage the difference. As a result, the fund's share prices have traditionally deviated from the near-month futures contracts, which determine NAV.

Most people think that the market price of the Macros reflect long-term bets on where the price of oil is going in the future ... while the NAVs reflect where the price of the near-month referencee oil contract.

The termination event changes all that, bringing the market price of the Macros in line with the near-month contract. It collapses the time horizon, essentially forcing an arbitrage to occur.

Comments

[Gary Lucido]

I cover the behavior of these shares here in case you are interested. The short answer is that the gains and losses of the pair are capped once oil reaches 120. www.investingminds.com...

[Kevin Berk]

The reason DCR is trading above NAV even after "D-Day" is that it is basically a put option on NYMEX light sweet crude since you can't lose more than you put into DCR. If you do some quick math you will realize that DCR value equals the same percentage of the effective strike price ($120) as a July Put option with $96 strike price ($96 is likely where USO would trade if crude hit $120). July 96's is ~$9.30 = 9.7% of 96. 9.7% of 120 is 11.63. Divide that by 3 and voila = $3.88. DCR closed at $3.76. It is likely lower since it expires on June 25th instead of July 19. In fact it is a pretty decent alternative to a put since the liquidity has been pretty high.

[ManagingEditor]

Yes, indeed, the embedded option explains the price disparity as pointed ut in the Hard Assets Investors article "Accounting for MacroShares Premia/Discounts,"... hardassetsinvestor.com....

[pusn]

so this terminates trading on june 25th, and pays out to the DCR nav on the 25th, but if you have it on record on june 30th, you get paid out on that?

[eegorr]

The payout date is July 3rd.