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When you run across something weird in the financial markets you have to ask yourself 3 questions:
- Is it real?
- Why does it exist? You need to understand this in order to know whether or not the weirdness will go away.
- How do I make money off of it?
Well, Jay brought something to our attention over the weekend that really got me thinking about these questions. The issue was first raised in this blog post on Thursday and then picked up in this one on Friday. Here's the deal: The MacroShares Down Crude Oil ETF (DCR) is an ETF that shorts the price of oil. But what's really, really, weird is that late last week it traded at an 80% premium to net asset value (tonight it closed at a 75% premium). That is simply unheard of in ETFs. ETFs have a structure that allows "authorized participants" to step in and buy or sell blocks of stock from/to the manager at the net asset value, which they can turn around and trade in the market, effectively driving down any premiums or discounts. So this shouldn't happen.
So I had to figure out what was going on. I started to research it and first convinced myself that, yes, this was real. Then I plowed through the MacroShares Web site and their 218 page prospectus. I'd like you to believe that I really read the whole prospectus but then you'd really think I was a nerd so I'll fess up that I merely searched for the key stuff. I came up with what I believe is the reason for this odd behavior. Now I think this is really fascinating but if you are not as fascinated with this sort of stuff as just making money off of it then you can skip four paragraphs down to the making money part.
The reason this premium exists is that DCR shares are created as one half of a pair of shares. The other half is the UCR shares, where the U stands for Up. There is a trust structure that basically obligates the UCR shareholders to transfer assets to the DCR shareholders to the extent that the price of oil moves down and vice versa. In other words the UCR shareholders are always on the other side of the deal. I think the attached diagram from the prospectus will clear this up.
Now, normally, a short fund would use futures to create the short position but there are ongoing costs with doing that. This alternative structure is actually pretty clever. The only problem is that apparently, at this point in time, retail investors are bearish on the price of oil. Consequently, the down shares were trading at a premium and the up shares were trading at an equal discount on a dollar basis. You will notice that the discount and premium of the two funds almost always offset each other on a dollar basis - more on this later. However, because of the different price levels of the two funds the percentages are different.
So what about the "authorized participants"? Why aren't they taking advantage of the situation like they are supposed to? Well, the problem is that they have to buy or sell shares in the two funds in a pair of 50,000 share blocks. If they want to take advantage of the DCR premium they could buy a pair of blocks at NAV and sell it in the open market. Only problem is that while they would get a premium on the DCR they would get a discount on the UCR and the two would pretty much offset. Furthermore, while they would probably drive down the premium they would also likely drive up the discount. Doesn't sound like a very promising strategy for them - unless the premium and discount are different. That's why they almost always offset each other. If they didn't offset each other there would be a profit opportunity for the authorized participants to either create or eliminate shares.
So what does this mean for you and me and how can we profit from it? First, if you want a short position in oil you shouldn't own the DCR. Your family shouldn't own it. Your friends shouldn't own it. It's a bad deal. The NAV of each share experiences the dollar price movement of 1/3 of a barrel of oil. If oil moves down by $3.00 per barrel then the NAV moves up by $1.00. Problem is that tonight the NAV is $8.67 but the shares closed at $15.04. So you can be right about oil prices moving down and the NAV could rise by $6.37 (if oil fell by ~$19/barrel) and you could make absolutely no money if the premium goes away - which I believe it ultimately has to. There is a better ways to bet on a price decline in oil. You could short the US Oil Fund (USO). It trades at NAV.
Second, if you are already long oil - e.g. you own USO - there is a cheaper way to be long. You can short the DCR because shorting a short fund makes you long. This is what I did. I already owned USO as part of my commodity diversification strategy and I replaced it with an equivalent amount of a short position in DCR. This way I will profit when the premium goes away, even if the price of oil doesn't change. Using tonight's closing values the replacement ratio is calculated as follows*: 1 USO share = 72.60/94.09 = .77 barrels of oil. 1 DCR share = -1/3 barrel of oil => 1 USO share = -2.31 DCR shares.
Third, if you want to remain neutral on oil you can simply short DCR and short USO in the proportions above. Your short position will cancel your short-short position and when the premium goes away you profit.
Oh, and you're probably wondering why does the premium have to go away? The reason is twofold. First, there is a tricky little clause in the trust agreement that created these shares. If the price of oil remains at or above $111 for 3 days in row (think that's possible?) there is a forced liquidation of the trust. This clause addresses a question I had - namely, what happens if the price of oil goes really high? Surely the DCR can't go negative. Hence, the need for a liquidation clause. And liquidation would occur at NAV less any unusual expenses. So instantly the premium and the discount would go away! Second, this premium is irrational and eventually rationality has to return. Either people will realize that there are better ways to take a short position or the asymmetry will go away as sentiment about the price of oil changes. A year ago DCR was trading at a discount!
* Don't trust my math here. Do it yourself. I executed my trade Monday morning and then later realized that I had made a logical error in computing the replacement ratio, which cost me a few hundred dollars and over an hour to straighten out. I didn't get this all straight in my head until this morning.
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| Gary | 03/13/2008 |
When analyzing this pair of stocks (UCR and DCR) it's important NOT to focus on the % premium but rather the dollar premium. There are a couple of reasons for that. First, the two shares have equal and opposite premiums that have been fairly stable at around $5 - 7 per share. But everyone focuses on the percentage which is misleading because as the price of oil goes up the value of the DCR shares go down and the % premium goes up. It's a non-issue because in reality what you should be focusing on is that when you buy a share of DCR you are short 1/3 of a barrel of oil - except currently you are shorting oil at the equivalent of a $15 discount.
I'm working on a new post for tomorrow that discusses the intricacies of the termination. |
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| x | 03/12/2008 |
Dear Mr. Gary,
Your analysis is detailed and the strategy sounds compelling. I did some simple math on my spread sheet. Athough Mr. Gary keeps saying the premium should go away, what I found is: the premium was 52% of NAV a month ago and today DCR is traded at $10 with a 160% premium! The premium actually goes along with the higher and higher crude oil price.
I really wonder what's going on here. Are DCR holders aware this fact: If oil is beyond $111 for three days this ETF will liquidated? They will lost all the premium. On the other hand, if the oil goes down, they are not likely gain as much as another 100% of NAV.
Maybe my second argument is debatable. Who knows. However I think it's not a favorable bet to hold DCR in today's circumstance -the oil price is over $109, the porbability that it goes higher than $111 is pretty high.
As you suggested, it is favorable to short DCR as long as you don't worry the premium would explode during that exciting three days. But again, who knows the market.
Mr. Gary, please let me know your thought about this fact of increasing premium. Thanks! |
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| Gary | 03/08/2008 |
| UCR and DCR do not employ futures. Their trust structure simply transfers gains and losses between the two funds. That's what makes it so brilliant...no contango or backwardation. |
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| Bruce | 02/25/2008 |
| Mike, where did you see that about being invested in futures set to expire in 19 years? The only thing I saw in the time frame was that there would be a final distribution in 2026 if a termination trigger hadn't been hit. Also, they are benchmarking themselves to front month (though we all know that benchmarks can mean nothing). |
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| Mike | 02/22/2008 |
| One key detail I think that is being missed here is that the other oil ETFs are long FRONT MONTH crude and therefore have a cost of rolling futures. UCR is long a barrel of crude 19 years from now. The premium or discount is simply a function of whether the crude oil curve is in contango or backwardation, and is not a valid measure of value - if you buy UCR rather than USO, you're simply betting that the 19-year barrel will go up more than the spot barrel (but the spot barrel also gains or loses with rolls of the futures underlying). That said, the structure is brilliant, and I am a strong supporter of the UCR/DCR concept - but people should understand the difference here! |
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| Bruce | 02/22/2008 |
| Please ignore last comment, don't know what I was thinking. Completely wrong. |
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| Bruce | 02/22/2008 |
| Gary, I was able to short USO through interactive brokers. Another alternative would be to go long USO and short DCR. |
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| Bruce | 02/22/2008 |
| Wow, great post. I looked into it and bit. Short 452 of USO at 77.56 and long 1101 of UCR at 26.77. One comment: the USO is invested in August futures, so be sure to use that to determine the ratio. Also, it is difficult to get a NAV estimate for the USO, but I assumed that since it is very liquid it must be pretty fairly priced. |
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| Jaime | 01/28/2008 |
| The whole subject seems to me a bit tricky. Seems to me one needs to know deeply theses types of funds to make sure you are doing the right trading at he right time. Any performance information on these funds, please? |
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| Gary | 11/22/2007 |
| I just discovered that it is currently impossible to short USO - apparently because of deliverability problems. As an alternative you can short OIL, which is an exchange traded note from Barclays. |
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