Deutsche Bank, one of the largest issuers of commodity ETFs, has announced that it will liquidate its PowerShares DB Crude Oil Double Long Exchange Traded Notes (DXO), noting in a press release that “limitations imposed by the exchange on which Deutsche Bank manages the exposure of the Notes have resulted in a ‘regulatory event’…which has caused Deutsche Bank to redeem the notes.”
As part of the winding down process, within the next two weeks, DXO investors will receive the cash equivalent of the net asset value of their holdings in the ETN. As Morningstar’s Scott Burns notes, it is important to note that investors will be receiving the NAV of the note assets, rather than the market value. DXO, like other commodity exchange-traded products, has stopped issuing new shares in recent weeks, resulting in shares of the fund trading at a premium to NAV. “So if you bought this fund at a premium, you are out of luck unless you can sell it at the same premium,” notes Burns. Burns suggests that investors sell their holdings in DXO as soon as possible, but notes that most of DXO’s premium evaporated shortly after the announcement. In an extreme example of supply/demand imbalance for commodity funds, the U.S. Natural Gas was recently trading as high as 20% above its net asset value.
So what sunk DXO?
The fact that the Commodities Futures Trading Commission (CFTC) is expected to place position limits on commodity ETPs later this year certainly didn’t help. The fear in the ETF industry is that many funds are already over the position limits that will ultimately be imposed, and that such funds will be forced to liquidate a portion of their holdings to come into compliance.
Matt Hougan at IndexUniverse has an interesting theory on the drivers of the DXO liquidation. He proposes that exchanges are beginning to enforce rules that have been on the books for a long time, but have been overlooked up to this point. The New York Mercantile Exchange (NYMEX) has established “accountability limits” that essentially raise a red flag when a single firm accumulates a large enough portion of the futures market for a given commodity.
Since DXO effectively created a short position in oil for Deutsche Bank, it stands to reason that the issuer has used proceeds from share issuances to hedge its exposure to oil prices (i.e., taking a long position in futures contracts). Hougan reasons that Deutsche Bank regularly exceeded the accountability limits, but was never forced to reduce its positions in crude oil futures. “In the past, the exchange has looked the other way,” writes Hougan. “But it appears that is no longer the case. And in the current environment, it’s likely to stay this way in the future.”
Not A Leverage Issue
The news of the DXO liquidation came on the same day FINRA announced increased margin requirements for leveraged ETFs. Although DXO does offer 2x leverage on crude oil prices, this product resets its exposure on a monthly basis. Leveraged ETFs have been the subject of a separate controversy primarily due to misunderstandings surrounding the fact that they reset on a daily basis (see our Free Guide to Leveraged ETFs for a more thorough explanation). The leverage offered by DXO does however increase the size of the hedge that Deutsche Bank would be required to implement to perfectly offset its exposure.
In its efforts to curb speculative behavior in the markets for “commodities of finite supply” (essentially oil and gas funds), the CFTC has taken the first step towards restricting the universe of possible investors in the commodity markets. Prior to the introduction of ETPs that invested in natural resources in the early part of this decade, commodity investing was primarily reserved for large, sophisticated investors, such as hedge funds, multinational banks, and endowments.
The introduction of ETFs (and the development of their ETC cousins) brought commodity investing to the masses. But now it appears that this process is reversing, and commodity investing is in danger of becoming an elitist activity once again. In a recent Wall Street Journal article, John Hyland, chief investment officer for UNG and several other U.S. Commodity funds, noted that what the proposed regulations “[are] really saying is the only people who should be allowed to trade crude oil are oil companies and Morgan Stanley.”
Shares of DXO dropped more than 7% in trading Wednesday.
Disclosure: No positions at time of writing.