When Oil Falls, These Funds Rise: The Strange World of Inverse Oil ETFs

The oil market has a tendency to act like desert weather. Weeks of calm were followed by a sudden outburst of violence. Prices climb toward triple digits, filling financial headlines with excitement, and then — sometimes just months later — the same barrel of crude sinks toward levels that make energy executives quietly uneasy. As one observes those fluctuations from the sidelines, it becomes clearer why the inverse oil ETF is a unique financial tool.

The concept seems a little out of date at first. Optimism is rewarded by most investments. When businesses are successful, stocks rise. Scarcity is rewarded by commodities. However, inverse oil ETFs are designed to counteract this tendency. When oil prices decline, they become more valuable. To put it another way, they make energy market pessimism a tradable tactic.

The workings of these funds are not immediately apparent from the outside. When a trader purchases a ticker symbol such as ProShares UltraShort Bloomberg Crude Oil (SCO) while seated in a bright office in Chicago or New York, a complex web of futures contracts and derivatives is hidden behind that straightforward transaction. The fund usually takes short positions in oil futures traded on the New York Mercantile Exchange rather than storing barrels of crude in a Texas warehouse.

Theoretically, the idea is simple. A basic inverse oil ETF seeks to increase by about the same amount if the price of West Texas Intermediate crude falls by 1% in a single day. It can seem almost counterintuitive to watch that happen during severe oil sell-offs. While oil headlines become gloomy and energy companies struggle, these funds steadily rise.

Some funds advance the concept. The goal of products such as PowerShares DB Crude Oil Double Short (DTO) is to deliver twice the inverse daily movement of oil prices. Thus, a 1% decline in crude could theoretically result in a 2% increase for investors. It’s a daring strategy, and in a metaphorical sense, one can almost feel the tension ingrained in it while standing on the trading floor. Rarely do leveraged bets act civilly.

These funds appear to provide investors with an easy way to voice their opinions about the oil market. A few years ago, traders flocked to inverse oil ETFs as crude prices started to decline. While oil stocks were glowing red on screens across brokerage platforms, some investors were discreetly celebrating minor gains in their inverse positions.

However, when one looks away from the charts, a different image emerges. The oil markets are chaotic. Monthly rolls of futures contracts frequently result in minor distortions. When one contract expires, another, sometimes at a different price, takes its place. The rolling futures process has the potential to improve or worsen the performance of the ETF.

An excellent illustration of a more straightforward structure is the United States Short Oil Fund (DNO). Instead of heavy leverage, it aims to mirror the daily inverse move of crude prices. The fund holds cash to satisfy margin requirements while maintaining short futures contracts. The plan seems clear on paper. In reality, market volatility frequently makes matters more difficult.

Perhaps the most common misconception about inverse oil ETFs is about time. They behave like long-term investments, according to many investors. It feels like a different reality. Because these funds reset every day, their performance may deviate from the anticipated inverse relationship over the course of weeks or months. The result is gradually changed by tiny daily adjustments that are compounded by erratic trading sessions.

One gets the impression that these products were intended for brief spikes in activity rather than patient investing when passing a row of trading desks during a volatile oil session, with screens flashing numbers and analysts discreetly modifying forecasts.

This has a psychological component as well. There is an emotional component to betting against oil. Oil has long been associated with industrial power, national identity, and geopolitics. Traders frequently convey a more comprehensive perspective on the world economy when they position themselves for declining energy prices.

However, the strategy remains uncertain. The price of oil can drastically change. Crude prices can rise in a matter of days due to a cold winter in the Northern Hemisphere, a conflict close to a shipping route, or an unexpected supply cut. Inverse oil ETFs move in the opposite direction at the same speed when that occurs.

During those times, it’s difficult to ignore how quickly enthusiasm can wane. Investors who had anticipated consistent returns now experience losses that seem almost mechanical. Conviction is rarely important to the market.

Nevertheless, these funds continue to garner attention in spite of the risks. The bet’s simplicity—oil down, fund up—seems to be appreciated by traders. That clarity has its own peculiar appeal in a market full of intricate strategies and opaque derivatives.

It’s still unclear if inverse oil ETFs will continue to be a specialized trading tool or develop into something more general. Investors will continue to search for ways to trade both sides of the barrel as long as oil prices fluctuate, as history indicates they will.