- Leverage in a highly volatile environment presents lots of challenges.
- ERX, ERY, GUSH, and DRIP go from triple to double leveraged products.
- NRGU and NRGD continue to offer three times exposure to oil stock products.
- A dangerous game that is only appropriate for intraday or very short-term risk positions.
- A comparison of net assets, volumes and expense ratios as of April 30.
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In 2019 and early 2020, the energy sector in the equities market was a laggard. As stocks moved to new record peaks, energy-related companies did not participate in the rally. Moreover, when the price of crude oil climbed to the upside, the shares of oil companies and related energy businesses did not appreciate to the same extent. In hindsight, which is always twenty-twenty, the oil shares were sending an ominous signal. On April 20, 2020, the price of nearby crude oil futures on NYMEX fell to its lowest price in history when it traded to negative $40.32 per barrel.
Since oil futures began trading on NYMEX in the 1980s, the price had never traded below the 1986 bottom of $9.75 per barrel. In one day, on April 20, the price made a new low, fell through zero, and declined to below negative forty dollars per barrel. The move caused carnage for the oil companies, market participants with long positions, and many of the derivative products that were not created to withstand such a move. Since April 20, the most active oil ETF product, the United States Oil Fund (USO), has already undergone almost daily changes in the hedging structure that allows the product to fulfill its goal of replicating the price action in the NYMEX futures market.
The leveraged products that track the prices of energy-related shares have also undergone changes over the past weeks and months given the price action in the shares of energy companies. ERX and ERY, as well as GUSH and DRIP, were formerly triple leveraged products. Today, they provide only double leverage. The only triple-leveraged products in oil shares today are the MicroSectors US Big Oil Index 3X Leveraged ETN product (NRGU) and its bearish counterpart (NRGD). However, both of these highly geared products suffer from deficient levels of liquidity.
On April 23, in a piece on the dangers of ETF/ETN products in commodities, I warned that crude oil’s plunge on April 20 was a warning sign for all raw material markets. When it comes to oil-related equities, leveraged products magnify risk versus reward dynamics.
Leverage in a highly volatile environment presents lots of challenges
The advent of ETF and ETN products after the turn of this century increased liquidity in many commodity markets as they allow holders of standard equity accounts to invest and speculate in assets that were only available via the futures arena in the past. Perhaps the most successful ETF in the asset class has been the SPDR Gold Shares product (GLD), which began trading in 2004 and had net assets of $50.01 billion as of April 27. Three of the most active ETF products that hold 100% of their net assets in gold bullion include GLD, IAU, and BAR, had a combined net asset base of over $71 billion as of April 27. Following the successful launch of GLD, many other ETF and ETN products on commodities, stocks, indices, and other assets followed.
Some market participants hungry for leverage created another level of ETF and ETN instruments that magnify the percentage gains and losses in underlying assets. These leveraged ETFs use futures, swaps, options, and other derivatives that create the gearing. Since there is never any free lunch in markets, leveraged products carry more risk than unleveraged tools as they experience time decay that eats away at their value over time. The leveraged instruments are only appropriate for short-term trading positions in the underlying markets.
Crude oil has always been a challenge for the ETF and ETN market. The administrators and issuers do not hold the physical petroleum as they do in gold, so they must depend on futures contracts and other derivative instruments to replicate the price action in the futures market. The United States Crude Oil ETF (USO) has always been a challenge when it comes to following the price of the energy commodity on anything more than a short-term basis. The term structure of the crude oil market that swings back and forth from contango to backwardation or a future discount to a future premium present more than a challenge when it comes to rolling the contracts that replicate nearby price risks.
ERX, ERY, GUSH, and DRIP go from triple to double leveraged products
Crude oil had been a tough market throughout 2019, and the early part of 2020 as equities consistently lagged both the stock market and the price of crude oil. In a sign of how tough things are in the energy patch when it comes to values, trading and hedging leveraged products for the ETF/ETN administrations the Direxion Daily Energy Bull 3X Shares (NYSEARCA:ERX) and its bearish counterpart (ERY) quietly became the Direxion Daily Energy Bull and Bear 2X Shares recently. Both hold leveraged positions in some of the leading oil-related companies to replicate price action on the up and downside of the market in the shares.
At the same time, the Direxion Daily S&P Oil & Gas Exploration and Production Bull 3X Shares (GUSH) and its bearish counterpart (DRIP) morphed into the Direxion Daily S&P Oil & Gas Exploration and Production Bull and Bear 2X Shares products. The wild price action in energy futures markets and the related equities became too much to handle.
NRGU and NRGD continue to offer three times exposure to oil stock products
Two of the last triple leveraged products left standing these days in the oil equities are now the MicroSectors US Big Oil Index 3X Leveraged ETN product (NRGU) and its bearish counterpart (NRGO). The fund summary for NRGU states:
Source: Yahoo Finance
The fund summary for NRGD states:
Source: Yahoo Finance
The fund administrator for these triple leveraged oil share products also offers the double leveraged NRGO and NRGZ products.
A dangerous game that is only appropriate for intraday or very short-term risk positions
The price action in crude from early January 2020 to April 20 took the price of NYMEX futures dropped almost $106 per barrel from $65.65 to negative $40.32. Oil-related equities have been moving consistently lower since 2019 and picked up steam on the downside as the price of oil tanked. Leveraged instruments that magnify the percentage moves in the commodity and related equities became more than hair-raising. Last week, the most popular oil ETF product USO, with net assets of $2.35 billion, made another in a series of changes in structure to adapt to the volatile markets.
As the daily chart shows, the volatility in oil futures at over 305% on April 30 makes unleveraged ETFs hard to handle, and the leveraged ones have become a frightening rollercoaster of risk. The wide daily trading ranges in anything related to the oil market requires a highly disciplined approach to risk versus reward and a plan, including stops and profit targets. I would only use the leveraged products for intraday trades in the current environment.
A comparison of net assets, volumes and expense ratios as of April 30
The following chart compares the more established Direxion ERX/ERY and GUSH/DRIP products with RexShares NRGU/NRGD and NRGO/NGRZ products. I have not discussed any of the products with the administrators and invite them to comment on this piece or the information provided. Meanwhile, it appears that the net asset numbers for the NRGD and NRGZ products on Yahoo Finance do not match the trading volumes, so I put them in italics as they are dubious.
The Direxion products have been around for a long time and recently trimmed the leverage on the products mentioned above from three to only twice leveraged levels. The bottom four RexShares products suffer from limited liquidity, in the case of at least three of the four products, which likely makes bid-offer spreads wide during the trading day.
Crude oil stocks had been beaten down like redheaded stepchildren. There is a lot of price action in the shares these days, and the leveraged products only intensify the pain or pleasure for market participants. Action junkies looking to turbocharge risk can look at these products, but if April 20 taught us anything, it was to expect the unexpected when trading in markets where the unleveraged instruments are already a handful. ERX, with net assets of $146.3 million, remained the most liquidly traded turbocharged product in the group as of April 30.
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This article was written by
Andrew Hecht is a 35-year Wall Street veteran covering commodities and precious metals.He runs the investing group The Hecht Commodity Report, one of the most comprehensive commodities services available. It covers the market movements of 20 different commodities and provides bullish, bearish and neutral calls; directional trading recommendations, and actionable ideas for traders. Learn more.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.
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