Cover Story July 22, 2010, 5:00PM EST

Amber Waves of Pain

(page 6 of 7)

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Hyland, 51, had never managed commodities before he joined U.S. Commodities in 2005. He had been in the investment business for 20 years—running portfolios and mutual funds—before he teamed up with U.S. Commodities CEO Nicholas Gerber. In 2006, as Gerber and Hyland were trying to win approval from the Securities & Exchange Commission for the U.S. Oil Fund, the fund's prospectus hit the desk of Dan McCabe, then CEO of Bear Hunter Structured Products, which was to be the fund's first market maker. McCabe recalls immediately spotting how traders would pick USO apart.

"Anybody who looked at it prior knew exactly what would happen," McCabe says. "From a trading side—and I spent most of my life trading—I would say, 'Wow, what a great opportunity.' "

After Hyland's oil and natural gas funds surged in 2008 and 2009, he found himself in the crosshairs of the Commodities Futures Trading Commission, which was holding hearings on energy speculation in the wake of $147-a-barrel oil. CFTC Chairman Gary Gensler began calling for limits on the number of energy contracts a single trader can hold. As Hyland's ETFs became poster children for the problem, Hyland became their most vocal advocate. At an ETF conference in Boca Raton, Fla., in January, he showed up with bottles of Merlot stamped with the company logo and the words "California Crude." The chances of pre-rolling his funds, he maintains, are "historically a 50-50 crapshoot"—a view many traders reject. His funds track daily moves in futures prices, he continues, because spot prices are impossible to capture unless you store fuel yourself. "I don't think the products are flawed," he says. "They do what they say they're supposed to do."

On Feb. 6, 2009—to cite one example—USO did what McCabe guessed it might. It gave traders an opportunity to profit at the expense of the fund's investors, McCabe says. With oil prices near their lowest in more than four years, long-term investors like Wolf had flocked to the fund; its monthly roll, taking place that day, had grown so large that it represented financial contracts for nearly 78 million barrels of oil, roughly four times the amount of oil the U.S. consumes in a single day. On Feb. 6, the price spread between expiring crude oil futures and those for the following month widened by $1.39 a barrel, or 30 percent, to $5.98. The price jump was so extreme that the CFTC announced an investigation within weeks, saying it "takes seriously issues surrounding price movements in our nation's vital energy markets."

In the midst of the price swing, according to an account released by the CFTC in April, a Morgan Stanley trader made a secret deal with a broker at UBS, acting on behalf of USO. Around noon, Morgan Stanley agreed to buy 33,110 of the fund's expiring March contracts and sell it April contracts, the CFTC said. The Morgan Stanley trader asked UBS to keep the trade quiet—a violation of New York Mercantile Exchange (Nymex) rules—until after the 2:30 p.m. close of trading that day.

The secret deal was breathtakingly large, equivalent to 12 percent of March futures on the Nymex. At the end of the day, USO and its investors lost because of the extreme contango: They could afford fewer of the more expensive April futures than they had in March, Forero says after analyzing Bloomberg data. Buying the same amount of oil would have cost $466 million more, he estimates. "You can either get screwed out of money or you can get screwed out of product," he says. "They had to pay more for effectively the same barrels."

The CFTC told the oil fund it may be held "vicariously liable" for UBS's actions, according to a March filing with the SEC. Hyland says he knew nothing about the deal. In April the CFTC ordered a $14 million civil fine for Morgan Stanley and $200,000 for UBS for failing to report the trade as required. The CFTC declined to explain how it arrived at the amounts or to disclose Morgan Stanley's profit. UBS declined comment. "Morgan Stanley fully cooperated with the CFTC and is pleased to have reached a resolution with our regulator," says company spokeswoman Jennifer Sala. "This matter concerned an isolated request by a former Morgan Stanley trader."