What Oil ETF Cash Flows Tell Us About Crude Prices

by on May 25, 2010 | ETFs Mentioned:

The saga now unfolding in Europe has dominated financial headlines in recent weeks, as equity markets around the world have taken their cues from the the latest developments in the streets of Athens and the German Bundestag. Europe’s debt crisis has overshadowed a perhaps even more unlikely development; crude oil prices slipped below $70 per barrel last week, and have now tumbled about $20 since the beginning of the month.

Crude prices have been battered by the perfect economic storm. Turmoil in Europe has investors worried about the drag on regional and even global growth in coming years; a prolonged economic downturn could sap a significant portion of oil demand from the markets. Meanwhile, the flight to safe havens has given a big boost to the U.S. dollar, which generally translates into lower commodity prices (otherwise, crude would become more expensive to international consumers). Finally, tame inflation figures–wholesale prices in the U.S. actually declined 0.1% in April–have eased concerns over the need to protect against a surge in CPI with exposure to natural resources.

The decline in oil prices is in the process of rippling throughout the global economy. Consumers may soon see lower prices at the pump (then again, they may not). Energy companies–and not just BP–are revising forecasts downwards. And issuers of oil ETFs, whose revenues depend directly on asset levels, are feeling the pinch. Right?

Not exactly. With oil prices plummeting–and the memory of $4 gas still fresh in the minds of many–it seems that investors have become increasingly anxious to gain exposure to crude. This has translated into a surge in interest in oil ETFs–as well as hundreds of millions of dollars in cash inflows. According to the National Stock Exchange, the United States Oil Fund (USO) finished April with $1.702 billion in assets. At the end of last week, the fund’s shares had lost almost 22% on the month, yet total assets were north of $2 billion. It’s the same story for the PowerShares DB Oil Fund (DBO), which finished April with $361 million. The fund has lost most than 20% in May, but finished last week with more than $406 million in assets, an increase of more than 12% over the previous month’s level.

Activity in the ProShares Ultra DJ-UBS Crude Oil (UCO) has been even more impressive; this leveraged ETF is down more than 35%, but assets are up almost 200% over last month.

Fools Rush In?

So why has the recent dip in crude prices caused a surge in oil ETF assets? The strategy of “buy low, sell high” may fall towards the simple end of the investment spectrum. But in times like these it is the simplest strategies that often prove to be most effective. Warren Buffett’s now-famous advice to be “greedy when others are fearful” echoes loud and clear in the current environment, as investors seek out assets that have been beaten down to an attractive entry point.

It’s not surprising that some investors are betting on crude oil prices following the recent slide. Judging by the creation activity occurring behind the scenes of the most popular oil ETFs, investors are making a monster wager on a recovery in crude oil prices in coming months.

UNG, Part Deux?

Of course some investors have seen this movie before, and recall that the ending wasn’t necessarily a happy one. As natural gas prices plunged throughout much of 2009, interest in the United States Natural Gas Fund (UNG) soared to an all time high. UNG ended up taking in more than $5.5 billion in cash in 2009, less than only three other exchange-traded products and nearly eight times beginning of year asset levels (see What’s Wrong With UNG?). But despite the obvious bullish sentiment among investors, UNG lost more than 50% of its value on the year, making it one of 2009′s worst performers (although it’s worth noting that contangoed futures markets also contributed to the loss).

There are, of course, two ways to interpret this trend. The oil bulls will point to the building momentum as a sign that an upward correction is inevitable. But on the flip side of the coin is a less optimistic scenario; if investors hadn’t been flocking into these futures-based commodity products in recent weeks, crude’s slide may have been much severe, indicating that prices are yet to bottom out.

Stay tuned. It will be interesting to see how this one plays out (sign up for our free ETF newsletter for more insights).

Disclosure: No positions at time of writing.