USOI: Earn A Fat Yield While Waiting For A Breakout/Breakdown

seekingalpha09-04

narvikk Recently, I updated my thoughts on the FT Cboe Vest Gold Strategy Target Income ETF (IGLD), noting that the IGLD ETF was an innovative way for yield-focused investors to gain exposure to gold ...

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In this article, I will analyze a similar fund, the ETRACS Crude Oil Shares Covered Call ETN (NASDAQ:USOI), that applies the covered-call strategy to oil commodities. Unlike the IGLD/GLD ETFs which hold physical gold bars in protected vaults, the USOI/USO ETFs are based on commodity futures and have significant tracking errors. When the futures curve is in contango, USO suffers significant 'roll-decay'. Currently, with the futures curve in backwardation, USO enjoys a 'roll-yield' which has boosted USOI's returns relative to spot oil prices. Stepping back, I believe oil is at a fundamental crossroads and caution should be exercised. On the one hand, geopolitical tensions in the Middle East and Ukraine continue to bolster oil prices. On the other, a slowing global economy is sapping oil demand. Commodity investors may be able to earn USOI's 'roll-yield' while they await the breakout/breakdown in the underlying commodity. I rate USOI a relative buy. Fund Overview The ETRACS Crude Oil Shares Covered Call ETN is an exchange-traded note (\"ETN\") offered by UBS AG. It offers investors exposure to the price return of the Credit Suisse Nasdaq WTI Crude Oil FLOWS 106 Index (\"Index\"), an index that tracks the investment performance of owning the United States Oil Fund, LP ETF (USO) while writing 6% out of the money (\"OTM\") call options in a \"covered call strategy\". Variable premiums received from the strategy are paid out to investors as cash distributions (Figure 1).   Figure 1 - USOI strategy overview (USOI prospectus) The USOI ETN is designed to generate monthly cash flows in exchange for giving up gains beyond the strike price of the written call options on the USO ETF. The USOI ETN's strategy does not protect investors from losses resulting from a decline in the price of the USO ETF beyond the call premiums received. The USOI ETN has $384 million in assets and charges a 0.85% expense ratio, compounded daily. A Note On ETN Risks Unlike exchange-traded funds (\"ETFs\") that own portfolios of securities, an ETN is an unsecured debt security issued by an investment bank (in the case of USOI, the issuer is UBS) that tracks an underlying index (the WTI Crude Oil FLOWS 106 Index) but trades on an exchange like a stock. Investors in the USOI ETN do not own the underlying commodities/securities; instead, they have struck a contractual obligation with the investment bank to receive the reference index's total returns less any accrued fees. In the event the security issuer goes bankrupt, investors in ETNs become unsecured creditors of the issuer. This default risk, while normally remote, almost became a reality in March 2023 as the original issuer of the USOI ETN, Credit Suisse, was pushed to the brink of bankruptcy before it was rescued by UBS. Returns Figure 2 shows the historical returns of the USOI ETN. USOI has delivered solid short-term total returns of 15.1% on a YTD basis and 3-year average annual returns of 13.5% to August 29, 2024. However, over longer time-frames, USOI's returns have been poor, with 5-year and since inception (\"SI\") average annual returns of -4.3% and -1.6% respectively.   Figure 2 - USOI historical returns (morningstar.com) Distribution In exchange for giving up the upside on the USO ETF, USOI investors receive an attractive monthly distribution, with a trailing 12-month distribution yield of 18.1% (Figure 3).   Figure 3 - USOI pays an attractive distribution yield (Seeking Alpha) Investors should note that USOI's distribution is variable and depends on the prevailing market price and volatility of the underlying USO ETF when the calls are written. Significant Slippage Against Crude Oil Investors studying the long-term performance of the USOI ETN and USO ETF would notice that the price action of the two funds does not track the price performance of the underlying commodity, WTI crude oil (Figure 4). Since USOI's inception, USOI has delivered -13.3% total returns compared to USO at -6.4% and spot WTI crude oil at 50.1%.   Figure 4 - USOI and USO has significant slippage vs. crude oil (Seeking Alpha) What investors need to understand is that unlike the GLD which holds gold bars in vaults, the USO ETF is a futures-based fund that obtains its crude oil exposure via the futures market (Figure 5).   Figure 5 - USO holdings (uscfinvestments.com) For example, in Figure 5 above, when the WTI October futures contract near expiry, the USO ETF will 'roll' into the November futures by selling the October futures and buying the November futures. When WTI crude oil futures are in contango, the USO ETF loses value by 'selling low, and buying high' (Figure 6).   Figure 6 - Illustrative contango chart (cmegroup.com) Conversely, if the oil futures curve is in backwardation, the USO ETF earns a 'roll yield', as it can sell the expiring October futures and buy cheaper November futures. For example, in the past 3 years, although spot crude oil has stayed roughly flat, the USO and USOI have generated handsome total returns from collecting this 'roll yield' (Figure 7).   Figure 7 - USOI and USO collected roll-yield in past 3 years (Seeking Alpha) Looking forward, the WTI crude oil futures curve is currently in backwardation, so the USO ETF and USOI ETN should continue to earn a 'roll yield' in the coming months (Figure 8).   Figure 8 - Current WTI futures curve (CME) Oil At A Crossroads Taking a step back, the crude oil market appears to be at a crossroads at the moment, with spot prices narrowing into a 'symmetrical triangle' pattern, with both a breakout and a breakdown possible (Figure 9).   Figure 9 - Oil narrowing into a symmetrical triangle pattern (Author created with price charts from stockcharts.com) On the positive side, geopolitical tensions from the continued war in Ukraine and simmering hostilities between Iran and Israel continue to provide support to oil prices. Furthermore, OPEC+ continues to manage the cartel's oil production and keep oil prices bid. On the negative side, weakening global growth, especially from China, has sapped oil demand. For example, China's manufacturing PMI, a measure of China's economic activity, recently fell to a 6-month low (Figure 10). This has caused Chinese oil imports to fall 2.9% YTD YoY to 10.9 mmboed.   Figure 10 - Chinese Manufacturing PMI (fxstreet.com) Overall, in my opinion, oil investors should stay nimble and adjust their oil positioning depending on whether bullish or bearish fundamentals prevail. By investing in the USOI ETN, investors may be able to collect the 'roll-yield' from the shape of the WTI futures curve plus premium income from selling call options while they await the resolution of the fundamental picture. Conclusion The USOI ETF applies a covered call strategy on the USO ETF, allowing investors to earn a high distribution yield from selling call options on USO. Unlike physical commodity-backed fund like the GLD, the USO is a futures-backed ETF with significant tracking error compared to spot commodity prices Currently, oil futures are in backwardation, which translates into a positive 'roll-yield' for USOI investors.  Stepping back, with oil prices consolidating in a symmetrical triangle pattern, caution is advised as the pattern can resolve with either a breakout or a breakdown, depending on whether bullish or bearish fundamentals prevail. For now, I believe USOI may be a relatively attractive investment option as it allows investors to earn a 'roll-yield' from the shape of the oil futures curve plus call premium income from selling call options while we await the resolution of oil's fundamental picture. I rate USOI a buy.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2464304318"}