UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

xQuarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2017.

 

OR

 

¨Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from to .

 

Commission File Number: 001-34371

 

United States Short Oil Fund, LP

(Exact name of registrant as specified in its charter)

 

Delaware   20-2939256
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)

 

1999 Harrison Street, Suite 1530

Oakland, California 94612

(Address of principal executive offices) (Zip code)

 

(510) 522-9600

(Registrant’s telephone number, including area code)

 

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     x    Yes   ¨     No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     x    Yes   ¨     No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨   Accelerated filer ¨
         
Non-accelerated filer x (Do not check if a smaller reporting company) Smaller reporting company ¨
         
      Emerging growth company ¨

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided to Section 7(a)(2)(B) of the Securities Act. ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨    Yes   x     No

 

The registrant had 150,000 shares outstanding as of November 9, 2017.

 

 

 

   

 

 

UNITED STATES SHORT OIL FUND, LP

 

Table of Contents

 

  Page
   
Part I. FINANCIAL INFORMATION  
   
Item 1. Condensed Financial Statements. 1
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 16
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk. 33
   
Item 4. Controls and Procedures. 34
   
Part II. OTHER INFORMATION 34
   
Item 1. Legal Proceedings. 34
   
Item 1A. Risk Factors. 34
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. 34
   
Item 3. Defaults Upon Senior Securities. 35
   
Item 4. Mine Safety Disclosures. 35
   
Item 5. Other Information. 35
   
Item 6. Exhibits. 35

 

   

 

 

Part I. FINANCIAL INFORMATION

 

Item 1. Condensed Financial Statements.

 

Index to Condensed Financial Statements

 

Documents   Page
     
Condensed Statements of Financial Condition at September 30, 2017 (Unaudited) and December 31, 2016   2
     
Condensed Schedule of Investments (Unaudited) at September 30, 2017   3
     
Condensed Statements of Operations (Unaudited) for the three and nine months ended September 30, 2017 and 2016   5
     
Condensed Statement of Changes in Partners’ Capital (Unaudited) for the nine months ended September 30, 2017   6
     
Condensed Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2017 and 2016   7
     
Notes to Condensed Financial Statements for the period ended September 30, 2017 (Unaudited)   8

 

 1 

 

 

United States Short Oil Fund, LP

Condensed Statements of Financial Condition

At September 30, 2017 (Unaudited) and December 31, 2016

 

   September 30, 2017   December 31, 2016 
Assets          
Cash and cash equivalents (at cost $7,630,424 and $8,597,603, respectively) (Notes 2 and 5)  $7,630,424   $8,597,603 
Equity in trading accounts:          
Cash and cash equivalents (at cost $2,808,045 and $990,186, respectively)   2,808,045    990,186 
Unrealized gain (loss) on open commodity futures contracts   (529,760)   (329,150)
Receivable from General Partner (Note 3)   59,361    129,082 
Dividends receivable   2,159    821 
Interest receivable   1,409     
Directors' fees and insurance receivable   307    47 
           
Total assets  $9,971,945   $9,388,589 
           
Liabilities and Partners' Capital          
General Partner management fees payable (Note 3)  $5,084   $4,819 
Professional fees payable   62,101    87,923 
Brokerage commissions payable   702    942 
License fees payable   685    792 
           
Total liabilities   68,572    94,476 
           
Commitments and Contingencies  (Notes 3, 4 and 5)          
           
Partners' Capital          
General Partner        
Limited Partners   9,903,373    9,294,113 
Total Partners' Capital   9,903,373    9,294,113 
           
Total liabilities and partners' capital  $9,971,945   $9,388,589 
           
Limited Partners' shares outstanding   150,000    150,000 
Net asset value per share  $66.02   $61.96 
Market value per share  $66.17   $61.96 

 

See accompanying notes to condensed financial statements.

 

 2 

 

 

United States Short Oil Fund, LP

Condensed Schedule of Investments (Unaudited)

At September 30, 2017

 

   Notional
Amount
   Number of
Contracts
   Value/
Unrealized Gain
(Loss) on Open
Commodity
Contracts
   % of
Partners'
Capital
 
Open Futures Contracts - Short                    
United States Contracts                    
NYMEX WTI Crude Oil Futures CL November 2017 contracts, expiring October 2017*  $(9,390,880)   192   $(529,760)   (5.35)

 

      Principal
Amount
   Market
Value
    
Cash Equivalents                    
United States Treasury Obligations                    
U.S. Treasury Bills:                    
0.90%, 10/05/2017     $200,000   $199,980    2.02 
0.92%, 10/12/2017        200,000    199,944    2.02 
0.91%, 10/19/2017        200,000    199,909    2.02 
0.95%, 10/26/2017        200,000    199,868    2.02 
0.97%, 11/02/2017        200,000    199,828    2.02 
1.01%, 11/09/2017        200,000    199,782    2.02 
0.98%, 11/16/2017        200,000    199,750    2.01 
1.05%, 11/24/2017        200,000    199,687    2.01 
1.05%, 11/30/2017        100,000    99,826    1.01 
1.08%, 12/07/2017        300,000    299,403    3.02 
1.09%, 12/14/2017        200,000    199,556    2.01 
1.11%, 12/21/2017        100,000    99,753    1.01 
1.10%, 12/28/2017        100,000    99,732    1.01 
1.12%, 1/04/2018        100,000    99,706    1.01 
1.11%, 1/11/2018        100,000    99,687    1.01 
1.10%, 1/18/2018        200,000    199,340    2.01 
1.12%, 1/25/2018        200,000    199,281    2.01 
1.12%, 2/01/2018        200,000    199,238    2.01 
1.13%, 2/08/2018        100,000    99,594    1.00 
1.12%, 2/15/2018        200,000    199,155    2.01 
1.10%, 2/22/2018        200,000    199,128    2.01 
1.09%, 3/01/2018        200,000    199,090    2.01 
1.14%, 3/08/2018        200,000    199,006    2.01 
1.14%, 3/15/2018        200,000    198,964    2.01 
1.16%, 3/22/2018        200,000    198,901    2.01 
1.17%, 3/29/2018        200,000    198,846    2.01 
Total Treasury Obligations             4,686,954    47.32 

 

 3 

 

 

United States Short Oil Fund, LP

Condensed Schedule of Investments (Unaudited) (Continued)

At September 30, 2017

 

   Principal
Amount
   Market
 Value
   % of
 Partners'
 Capital
 
United States - Money Market Funds               
Fidelity Investments Money Market Funds - Government Portfolio  $1,000,000   $1,000,000    10.10 
Goldman Sachs Financial Square Funds - Government Fund - Class FS   1,000,000    1,000,000    10.10 
Morgan Stanley Institutional Liquidity Funds - Government Portfolio   1,000,000    1,000,000    10.10 
Total Money Market Funds        3,000,000    30.30 
Total Cash Equivalents       $7,686,954    77.62 

 

* Collateral amounted to $2,808,045 on open futures contracts.

 

See accompanying notes to condensed financial statements.

 

 4 

 

 

United States Short Oil Fund, LP

Condensed Statements of Operations (Unaudited)

For the three and nine months ended September 30, 2017 and 2016

 

   Three months ended
September 30, 2017
   Three months ended
September 30, 2016
   Nine months ended
September 30, 2017
   Nine months ended
September 30, 2016
 
Income                    
Gain (loss) on trading of commodity futures contracts:                    
Realized gain (loss) on closed futures contracts  $(784,566)  $765,560   $1,028,104   $(3,105,776)
Change in unrealized gain (loss) on open futures contracts   (415,820)   (693,270)   (200,610)   (1,092,854)
Realized gain (loss) on short-term investments               1,583 
Dividend income   6,730    737    14,688    4,820 
Interest income*   19,451    7,469    39,899    36,967 
ETF transaction fees           1,400    2,450 
                     
Total income (loss)   (1,174,205)   80,496    883,481    (4,152,810)
                     
Expenses                    
General Partner management fees (Note 3)   16,049    16,493    46,732    86,688 
Professional fees   15,912    28,455    52,093    72,385 
Brokerage commissions   5,493    6,794    16,284    45,434 
Directors' fees and insurance   525    506    1,499    2,928 
License fees   401    412    1,168    2,167 
                     
Total expenses   38,380    52,660    117,776    209,602 
                     
Expense waiver (Note 3)   (18,357)   (32,076)   (59,361)   (101,233)
                     
Net expenses   20,023    20,584    58,415    108,369 
                     
Net income (loss)  $(1,194,228)  $59,912   $825,066   $(4,261,179)
Net income (loss) per limited partnership share  $(7.96)  $0.40   $4.06   $(13.17)
Net income (loss) per weighted average limited partnership share  $(7.96)  $0.40   $5.46   $(17.85)
Weighted average limited partnership shares outstanding   150,000    150,000    151,099    238,686 

 

* Interest income does not exceed paid in kind of 5%.

 

See accompanying notes to condensed financial statements.

 

 5 

 

 

United States Short Oil Fund, LP

Condensed Statement of Changes in Partners' Capital (Unaudited)

For the nine months ended September 30, 2017

 

   General Partner   Limited Partners   Total 
             
Balances, at December 31, 2016  $   $9,294,113   $9,294,113 
Addition of 100,000 partnership shares       6,809,360    6,809,360 
Redemption of 100,000 partnership shares       (7,025,166)   (7,025,166)
Net income (loss)       825,066    825,066 
                
Balances, at September 30, 2017  $   $9,903,373   $9,903,373 
                
Net Asset Value Per Share:               
At December 31, 2016            $61.96 
At September 30, 2017            $66.02 

 

See accompanying notes to condensed financial statements.

 

 6 

 

 

United States Short Oil Fund, LP

Condensed Statements of Cash Flows (Unaudited)

For the nine months ended September 30, 2017 and 2016

 

   Nine months ended
September 30, 2017
   Nine months ended
September 30, 2016
 
Cash Flows from Operating Activities:          
Net income (loss)  $825,066   $(4,261,179)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:          
(Increase) decrease in commodity futures trading account - cash and cash equivalents   (1,817,859)   2,488,361 
Unrealized (gain) loss on open futures contracts   200,610    1,092,854 
(Increase) decrease in receivable from General Partner   69,721    8,701 
(Increase) decrease in dividends receivable   (1,338)   (441)
(Increase) decrease in interest receivable   (1,409)    
(Increase) decrease in directors' fees and insurance receivable   (260)   327 
Increase (decrease) in General Partner management fees payable   265    (6,669)
Increase (decrease) in professional fees payable   (25,822)   (16,769)
Increase (decrease) in brokerage commissions payable   (240)   (1,075)
Increase (decrease) in license fees payable   (107)   (119)
Net cash provided by (used in) operating activities   (751,373)   (696,009)
           
Cash Flows from Financing Activities:          
Addition of partnership shares   6,809,360    17,303,957 
Redemption of partnership shares   (7,025,166)   (27,204,899)
Net cash provided by (used in) financing activities   (215,806)   (9,900,942)
           
Net Increase (Decrease) in Cash and Cash Equivalents   (967,179)   (10,596,951)
           
Cash and Cash Equivalents, beginning of period   8,597,603    19,904,157 
Cash and Cash Equivalents, end of period  $7,630,424   $9,307,206 

 

See accompanying notes to condensed financial statements.

 

 7 

 

 

United States Short Oil Fund, LP

Notes to Condensed Financial Statements

For the period ended September 30, 2017 (Unaudited)

 

NOTE 1 — ORGANIZATION AND BUSINESS

 

The United States Short Oil Fund, LP (“DNO”) was organized as a limited partnership under the laws of the state of Delaware on June 30, 2008. DNO is a commodity pool that issues limited partnership shares (“shares”) that may be purchased and sold on the NYSE Arca, Inc. (the “NYSE Arca”). DNO will continue in perpetuity, unless terminated sooner upon the occurrence of one or more events as described in its Second Amended and Restated Agreement of Limited Partnership dated as of March 1, 2013 (the “LP Agreement”). The investment objective of DNO is for the daily changes in percentage terms of its shares’ per share net asset value (“NAV”) to inversely reflect the daily changes in percentage terms of the spot price of West Texas Intermediate (“WTI”) light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes in the price of the futures contract for WTI light, sweet crude oil traded on the New York Mercantile Exchange (the “NYMEX”) that is the near month contract to expire, except when the near month contract is within two weeks of expiration, in which case the futures contract will be the next month contract to expire (the “Benchmark Futures Contract”), plus interest earned on the Fund’s collateral holdings, less DNO’s expenses.

 

DNO’s investment objective is not for its NAV or market price of its shares to equal, in dollar terms, the inverse of the spot price of WTI light, sweet crude oil or any particular futures contract based on WTI light, sweet crude oil, nor is DNO’s investment objective for the percentage change in its NAV to reflect the inverse of the percentage change of the price of any particular futures contract as measured over a time period greater than one day.

 

United States Commodity Funds LLC (“USCF”), the general partner of DNO, believes that it is not practical to manage the portfolio to achieve such an investment goal when investing in short positions in Futures Contracts (as defined below) and Other Crude Oil-Related Investments (as defined below). DNO accomplishes its objective through investments in short positions in futures contracts for WTI light, sweet crude oil and other types of crude oil, diesel-heating oil, gasoline, natural gas and other petroleum-based fuels that are traded on the NYMEX, ICE Futures Exchange (“ICE Futures”) or other U.S. and foreign exchanges (collectively, “Futures Contracts”) and other oil-related investments such as cash-settled options on Futures Contracts, forward contracts for oil, cleared swap contracts and over-the-counter (“OTC”) transactions that are based on the price of crude oil, diesel-heating oil, gasoline, natural gas and other petroleum-based fuels, Futures Contracts and indices based on the foregoing (collectively, “Other Crude Oil-Related Investments”). As of September 30, 2017, DNO held short positions in 192 WTI Crude Oil Futures CL Contracts traded on the NYMEX and did not hold short positions on the ICE Futures.

 

DNO commenced investment operations on September 24, 2009 and has a fiscal year ending on December 31. USCF is responsible for the management of DNO. USCF is a member of the National Futures Association (the “NFA”) and became registered as a commodity pool operator with the Commodity Futures Trading Commission (the “CFTC”) effective December 1, 2005 and a swaps firm on August 8, 2013. USCF is also the general partner of the United States Oil Fund, LP (“USO”), the United States Natural Gas Fund, LP (“UNG”), the United States 12 Month Oil Fund, LP (“USL”), the United States Gasoline Fund, LP (“UGA”) and the United States Diesel-Heating Oil Fund, LP (“UHN”), which listed their limited partnership shares on the American Stock Exchange (the “AMEX”) under the ticker symbols “USO” on April 10, 2006, “UNG” on April 18, 2007, “USL” on December 6, 2007, “UGA” on February 26, 2008 and “UHN” on April 9, 2008, respectively. As a result of the acquisition of the AMEX by NYSE Euronext, each of USO’s, UNG’s, USL’s, UGA’s and UHN’s shares commenced trading on the NYSE Arca on November 25, 2008. USCF is also the general partner of the United States 12 Month Natural Gas Fund, LP (“UNL”) and the United States Brent Oil Fund, LP (“BNO”), which listed their limited partnership shares on the NYSE Arca under the ticker symbols “UNL” on November 18, 2009 and “BNO” on June 2, 2010, respectively. USCF is also the sponsor of the United States Commodity Index Fund (“USCI”), the United States Copper Index Fund (“CPER”), the United States Agriculture Index Fund (“USAG”) and the USCF Canadian Crude Oil Index Fund (“UCCO”), each a series of the United States Commodity Index Funds Trust. USCI, CPER and USAG listed their shares on the NYSE Arca under the ticker symbol “USCI” on August 10, 2010, “CPER” on November 15, 2011 and “USAG” on April 13, 2012, respectively. UCCO is currently in registration and has not commenced operations.

 

In addition, USCF is the sponsor of the USCF Funds Trust, a Delaware statutory trust, and each of its series, the REX S&P MLP Fund and the REX S&P MLP Inverse Fund, which are currently in registration and have not commenced operations (together, the “REX Funds”), and the United States 3x Oil Fund (“USOU”) and the United States 3x Short Oil Fund (“USOD”), which commenced operations on July 20, 2017.

 

All funds listed previously, other than UCCO and the REX Funds, are referred to collectively herein as the “Related Public Funds.”

 

DNO issues shares to certain authorized purchasers (“Authorized Participants”) by offering baskets consisting of 50,000 shares (“Creation Baskets”) through ALPS Distributors, Inc., as its marketing agent (the “Marketing Agent”). The purchase price for a Creation Basket is based upon the NAV of a share calculated shortly after the close of the core trading session on the NYSE Arca on the day the order to create the basket is properly received.

 

 8 

 

 

In addition, Authorized Participants pay DNO a $350 fee for each order placed to create one or more Creation Baskets or to redeem one or more baskets (“Redemption Baskets”), consisting of 50,000 shares. Shares may be purchased or sold on a nationally recognized securities exchange in smaller increments than a Creation Basket or Redemption Basket. Shares purchased or sold on a nationally recognized securities exchange are not purchased or sold at the per share NAV of DNO but rather at market prices quoted on such exchange.

 

In September 2009, DNO initially registered 25,000,000 shares on Form S-1 with the U.S. Securities and Exchange Commission (the “SEC”). On September 24, 2009, DNO listed its shares on the NYSE Arca under the ticker symbol “DNO”. On that day, DNO established its initial per share NAV by setting the price at $50 and issued 200,000 shares in exchange for $10,000,000. DNO also commenced investment operations on September 24, 2009, by taking short positions in Futures Contracts traded on the NYMEX based on WTI light, sweet crude oil. As of September 30, 2017, DNO had registered a total of 25,000,000 shares.

 

The accompanying unaudited condensed financial statements have been prepared in accordance with Rule 10-01 of Regulation S-X promulgated by the SEC and, therefore, do not include all information and footnote disclosure required under generally accepted accounting principles in the United States of America (“U.S. GAAP”). The financial information included herein is unaudited; however, such financial information reflects all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of USCF, necessary for the fair presentation of the condensed financial statements for the interim period.

 

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The financial statements have been prepared in conformity with U.S. GAAP as detailed in the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification. DNO is an investment company and follows the accounting and reporting guidance in FASB Topic 946.

 

Revenue Recognition

 

Commodity futures contracts, forward contracts, physical commodities and related options are recorded on the trade date. All such transactions are recorded on the identified cost basis and marked to market daily. Unrealized gains or losses on open contracts are reflected in the condensed statements of financial condition and represent the difference between the original contract amount and the market value (as determined by exchange settlement prices for futures contracts and related options and cash dealer prices at a predetermined time for forward contracts, physical commodities, and their related options) as of the last business day of the year or as of the last date of the condensed financial statements. Changes in the unrealized gains or losses between periods are reflected in the condensed statements of operations. DNO earns income on funds held at the custodian or futures commission merchant (“FCM”) at prevailing market rates earned on such investments.

 

Brokerage Commissions

 

Brokerage commissions on all open commodity futures contracts are accrued on a full-turn basis.

 

Income Taxes

 

DNO is not subject to federal income taxes; each partner reports his/her allocable share of income, gain, loss deductions or credits on his/her own income tax return.

 

In accordance with U.S. GAAP, DNO is required to determine whether a tax position is more likely than not to be sustained upon examination by the applicable taxing authority, including resolution of any tax related appeals or litigation processes, based on the technical merits of the position. DNO files an income tax return in the U.S. federal jurisdiction, and may file income tax returns in various U.S. states. DNO is not subject to income tax return examinations by major taxing authorities for years before 2014. The tax benefit recognized is measured as the largest amount of benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. De-recognition of a tax benefit previously recognized results in DNO recording a tax liability that reduces net assets. However, DNO’s conclusions regarding this policy may be subject to review and adjustment at a later date based on factors including, but not limited to, on-going analysis of and changes to tax laws, regulations and interpretations thereof. DNO recognizes interest accrued related to unrecognized tax benefits and penalties related to unrecognized tax benefits in income tax fees payable, if assessed. No interest expense or penalties have been recognized as of and for the period ended September 30, 2017.

 

 9 

 

 

Creations and Redemptions

 

Authorized Participants may purchase Creation Baskets or redeem Redemption Baskets only in blocks of 50,000 shares at a price equal to the NAV of the shares calculated shortly after the close of the core trading session on the NYSE Arca on the day the order is placed.

 

DNO receives or pays the proceeds from shares sold or redeemed within three business days after the trade date of the purchase or redemption. The amounts due from Authorized Participants are reflected in DNO’s condensed statements of financial condition as receivable for shares sold, and amounts payable to Authorized Participants upon redemption are reflected as payable for shares redeemed.

 

Authorized Participants pay DNO a transaction fee of $350 for each order placed to create one or more Creation Baskets or to redeem one or more Redemption Baskets.

 

Partnership Capital and Allocation of Partnership Income and Losses

 

Profit or loss shall be allocated among the partners of DNO in proportion to the number of shares each partner holds as of the close of each month. USCF may revise, alter or otherwise modify this method of allocation as described in the LP Agreement.

 

Calculation of Per Share NAV

 

DNO’s per share NAV is calculated on each NYSE Arca trading day by taking the current market value of its total assets, subtracting any liabilities and dividing that amount by the total number of shares outstanding. DNO uses the closing price for the contracts on the relevant exchange on that day to determine the value of contracts held on such exchange.

 

Net Income (Loss) Per Share

 

Net income (loss) per share is the difference between the per share NAV at the beginning of each period and at the end of each period. The weighted average number of shares outstanding was computed for purposes of disclosing net income (loss) per weighted average share. The weighted average shares are equal to the number of shares outstanding at the end of the period, adjusted proportionately for shares added and redeemed based on the amount of time the shares were outstanding during such period. There were no shares held by USCF at September 30, 2017.

 

Offering Costs

 

Offering costs incurred in connection with the registration of additional shares after the initial registration of shares are borne by DNO. These costs include registration fees paid to regulatory agencies and all legal, accounting, printing and other expenses associated with such offerings. These costs are accounted for as a deferred charge and thereafter amortized to expense over twelve months on a straight-line basis or a shorter period if warranted.

 

Cash Equivalents

 

Cash equivalents include money market funds and overnight deposits or time deposits with original maturity dates of six months or less.

 

Reclassification

 

Certain amounts in the accompanying condensed financial statements were reclassified to conform to the current presentation.

 

Use of Estimates

 

The preparation of condensed financial statements in conformity with U.S. GAAP requires USCF to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed financial statements, and the reported amounts of the revenue and expenses during the reporting period. Actual results may differ from those estimates and assumptions.

 

 10 

 

 

NOTE 3 — FEES PAID BY THE FUND AND RELATED PARTY TRANSACTIONS

 

USCF Management Fee

 

Under the LP Agreement, USCF is responsible for investing the assets of DNO in accordance with the objectives and policies of DNO. In addition, USCF has arranged for one or more third parties to provide administrative, custody, accounting, transfer agency and other necessary services to DNO. For these services, DNO is contractually obligated to pay USCF a fee, which is paid monthly, equal to 0.60% per annum of average daily total net assets.

 

Ongoing Registration Fees and Other Offering Expenses

 

DNO pays all costs and expenses associated with the ongoing registration of its shares subsequent to the initial offering. These costs include registration or other fees paid to regulatory agencies in connection with the offer and sale of shares, and all legal, accounting, printing and other expenses associated with such offer and sale. For the nine months ended September 30, 2017 and 2016, DNO did not incur registration fees and other offering expenses.

 

Independent Directors’ and Officers’ Expenses

 

DNO is responsible for paying its portion of the directors’ and officers’ liability insurance for DNO and the Related Public Funds and the fees and expenses of the independent directors who also serve as audit committee members of DNO and the Related Public Funds. DNO shares the fees and expenses on a pro rata basis with each Related Public Fund, as described above, based on the relative assets of each Related Public Fund computed on a daily basis. These fees and expenses for the year ending December 31, 2017 are estimated to be a total of $1,500 for DNO and, in the aggregate for DNO and the Related Public Funds, $539,350.

 

Licensing Fees

 

As discussed in Note 4 below, DNO entered into a licensing agreement with the NYMEX on May 22, 2009, as amended on October 20, 2011. Pursuant to the agreement, DNO and the Related Public Funds, other than BNO, USCI, CPER and USAG, pay a licensing fee that is equal to 0.015% on all net assets. During the nine months ended September 30, 2017 and 2016, DNO incurred $1,168 and $2,167, respectively, under this arrangement.

 

Investor Tax Reporting Cost

 

The fees and expenses associated with DNO’s audit expenses and tax accounting and reporting requirements are paid by DNO. These costs are estimated to be $70,000 for the year ending December 31, 2017. Tax reporting costs fluctuate between years due to the number of shareholders during any given year.

 

Other Expenses and Fees and Expense Waivers

 

In addition to the fees described above, DNO pays all brokerage fees and other expenses in connection with the operation of DNO, excluding costs and expenses paid by USCF as outlined in Note 4 – Contracts and Agreements below. USCF has voluntarily agreed to pay certain expenses typically borne by DNO, to the extent that such expenses exceed 0.15% of DNO’s NAV, on an annualized basis. USCF has no obligation to continue such payments into subsequent periods. For the nine months ended September 30, 2017, USCF waived $59,361 of DNO’s expenses. This voluntary expense waiver is in addition to those amounts USCF is contractually obligated to pay as described in Note 4 – Contracts and Agreements.

 

NOTE 4 — CONTRACTS AND AGREEMENTS

 

Marketing Agent Agreement

 

DNO is party to a marketing agent agreement, dated as of June 8, 2009, as amended from time to time, with the Marketing Agent and USCF, whereby the Marketing Agent provides certain marketing services for DNO as outlined in the agreement. The fee of the Marketing Agent, which is borne by USCF, is equal to 0.06% on DNO’s assets up to $3 billion and 0.04% on DNO’s assets in excess of $3 billion. In no event may the aggregate compensation paid to the Marketing Agent and any affiliate of USCF for distribution-related services exceed 10% of the gross proceeds of DNO’s offering.

 

The above fee does not include website construction and development, which are also borne by USCF.

 11 

 

 

Brown Brothers Harriman & Co. Agreements

 

DNO is also party to a custodian agreement, dated October 7, 2008, as amended from time to time, with Brown Brothers Harriman & Co. (“BBH&Co.”) and USCF, whereby BBH&Co. holds investments on behalf of DNO. USCF pays the fees of the custodian, which are determined by the parties from time to time. In addition, DNO is party to an administrative agency agreement, dated October 7, 2008, as amended from time to time, with USCF and BBH&Co., whereby BBH&Co. acts as the administrative agent, transfer agent and registrar for DNO. USCF also pays the fees of BBH&Co. for its services under such agreement and such fees are determined by the parties from time to time.

 

Currently, USCF pays BBH&Co. for its services, in the foregoing capacities, a minimum amount of $75,000 annually for its custody, fund accounting and fund administration services rendered to DNO and each of the Related Public Funds, as well as a $20,000 annual fee for its transfer agency services. In addition, USCF pays BBH&Co. an asset-based charge of (a) 0.06% for the first $500 million of the Related Public Funds’ combined net assets, (b) 0.0465% for the Related Public Funds’ combined net assets greater than $500 million but less than $1 billion, and (c) 0.035% once the Related Public Funds’ combined net assets exceed $1 billion. The annual minimum amount will not apply if the asset-based charge for all accounts in the aggregate exceeds $75,000. USCF also pays BBH&Co. transaction fees ranging from $7 to $15 per transaction.

 

Brokerage and Futures Commission Merchant Agreements

 

On October 8, 2013, DNO entered into a brokerage agreement with RBC Capital Markets, LLC (“RBC Capital” or “RBC”) to serve as DNO’s FCM effective October 10, 2013. The agreement with RBC requires it to provide services to DNO in connection with the purchase and sale of Futures Contracts and Other Crude Oil-Related Investments that may be purchased and sold by or through RBC Capital for DNO’s account. In accordance with the agreement, RBC Capital charges DNO commissions of approximately $7 to $8 per round-turn trade, including applicable exchange and NFA fees for Futures Contracts and options on Futures Contracts. Such fees include those incurred when purchasing Futures Contracts and options on Futures Contracts when DNO issues shares as a result of a Creation Basket, as well as fees incurred when selling Futures Contracts and options on Futures Contracts when DNO redeems shares as a result of a Redemption Basket. Such fees are also incurred when Futures Contracts and options on Futures Contracts are purchased or redeemed for the purpose of rebalancing the portfolio. DNO also incurs commissions to brokers for the purchase and sale of Futures Contracts, Other Crude Oil-Related Investments or short-term obligations of the United States of two years or less (“Treasuries”). 

 

   For the nine months
ended September 30,
2017
   For the nine months
ended September 30,
2016
 
Total commissions accrued to brokers  $16,284   $45,434 
Total commissions as an annualized percentage of average total net assets   0.21%   0.31%
Commissions accrued as a result of rebalancing  $15,281   $44,628 
Percentage of commissions accrued as a result of rebalancing   93.84%   98.23%
Commissions accrued as a result of creation and redemption activity  $1,003   $806 
Percentage of commissions accrued as a result of creation and redemption activity   6.16%   1.77%

 

The decrease in the total commissions accrued to brokers by DNO for the nine months ended September 30, 2017, as compared to the nine months ended September 30, 2016, was a result of a lower number of futures contracts being held and trade.

 

NYMEX Licensing Agreement

 

DNO and the NYMEX entered into a licensing agreement on May 22, 2009, as amended on October 20, 2011, whereby DNO was granted a non-exclusive license to use certain of the NYMEX’s settlement prices and service marks. Under the licensing agreement, DNO and the Related Public Funds, other than BNO, USCI, CPER and USAG, pay the NYMEX an asset-based fee for the license, the terms of which are described in Note 3. DNO expressly disclaims any association with the NYMEX or endorsement of DNO by the NYMEX and acknowledges that “NYMEX” and “New York Mercantile Exchange” are registered trademarks of the NYMEX. 

 

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NOTE 5 — FINANCIAL INSTRUMENTS, OFF-BALANCE SHEET RISKS AND CONTINGENCIES

 

DNO may engage in the trading of futures contracts, options on futures contracts, cleared swaps and OTC swaps (collectively, “derivatives”). DNO is exposed to both market risk, which is the risk arising from changes in the market value of the contracts, and credit risk, which is the risk of failure by another party to perform according to the terms of a contract.

DNO may enter into futures contracts, options on futures contracts and swaps to gain exposure to changes in the value of an underlying commodity. A futures contract obligates the seller to deliver (and the purchaser to accept) the future delivery of a specified quantity and type of a commodity at a specified time and place. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The contractual obligations of a buyer or seller may generally be satisfied by taking or making physical delivery of the underlying commodity or by making an offsetting sale or purchase of an identical futures contract on the same or linked exchange before the designated date of delivery. Cleared swaps are agreements that are eligible to be cleared by a clearinghouse, e.g., ICE Clear Europe, and provide the efficiencies and benefits that centralized clearing on an exchange offers to traders of futures contracts, including credit risk intermediation and the ability to offset positions initiated with different counterparties.

 

The purchase and sale of futures contracts, options on futures contracts and cleared swaps require margin deposits with an FCM. Additional deposits may be necessary for any loss on contract value. The Commodity Exchange Act requires an FCM to segregate all customer transactions and assets from the FCM’s proprietary activities.

 

Futures contracts, options on futures contracts and cleared swaps involve, to varying degrees, elements of market risk (specifically commodity price risk) and exposure to loss in excess of the amount of variation margin. The face or contract amounts reflect the extent of the total exposure DNO has in the particular classes of instruments. Additional risks associated with the use of futures contracts are an imperfect correlation between movements in the price of the futures contracts and the market value of the underlying securities and the possibility of an illiquid market for a futures contract. Buying and selling options on futures contracts exposes investors to the risks of purchasing or selling futures contracts.

 

All of the futures contracts held by DNO through September 30, 2017 were exchange-traded. The risks associated with exchange-traded contracts are generally perceived to be less than those associated with OTC swaps since, in OTC swaps, a party must rely solely on the credit of its respective individual counterparties. However, in the future, if DNO were to enter into non-exchange traded contracts, it would be subject to the credit risk associated with counterparty non-performance. The credit risk from counterparty non-performance associated with such instruments is the net unrealized gain, if any, on the transaction. DNO has credit risk under its futures contracts since the sole counterparty to all domestic and foreign futures contracts is the clearinghouse for the exchange on which the relevant contracts are traded. In addition, DNO bears the risk of financial failure by the clearing broker.

 

DNO’s cash and other property, such as Treasuries, deposited with an FCM are considered commingled with all other customer funds, subject to the FCM’s segregation requirements. In the event of an FCM’s insolvency, recovery may be limited to a pro rata share of segregated funds available. It is possible that the recovered amount could be less than the total of cash and other property deposited. The insolvency of an FCM could result in the complete loss of DNO’s assets posted with that FCM; however, the majority of DNO’s assets are held in investments in Treasuries, cash and/or cash equivalents with DNO’s custodian and would not be impacted by the insolvency of an FCM. The failure or insolvency of DNO’s custodian, however, could result in a substantial loss of DNO’s assets.

 

USCF invests a portion of DNO’s cash in money market funds that seek to maintain a stable per share NAV. DNO is exposed to any risk of loss associated with an investment in such money market funds. As of September 30, 2017 and December 31, 2016, DNO held investments in money market funds in the amounts of $3,000,000 and $3,000,000, respectively. DNO also holds cash deposits with its custodian. Pursuant to a written agreement with BBH&Co., uninvested overnight cash balances are swept to offshore branches of U.S. regulated and domiciled banks located in Toronto, Canada; London, United Kingdom; Grand Cayman, Cayman Islands; and Nassau, Bahamas; which are subject to U.S. regulation and regulatory oversight. As of September 30, 2017 and December 31, 2016, DNO held cash deposits and investments in Treasuries in the amounts of $7,438,469 and $6,587,789, respectively, with the custodian and FCM. Some or all of these amounts may be subject to loss should DNO’s custodian and/or FCM cease operations.

 

For derivatives, risks arise from changes in the market value of the contracts. Theoretically, DNO is exposed to market risk equal to the value of futures contracts purchased and unlimited liability on such contracts sold short. As both a buyer and a seller of options, DNO pays or receives a premium at the outset and then bears the risk of unfavorable changes in the price of the contract underlying the option.

 

DNO’s policy is to continuously monitor its exposure to market and counterparty risk through the use of a variety of financial, position and credit exposure reporting controls and procedures. In addition, DNO has a policy of requiring review of the credit standing of each broker or counterparty with which it conducts business.

 

The financial instruments held by DNO are reported in its condensed statements of financial condition at market or fair value, or at carrying amounts that approximate fair value, because of their highly liquid nature and short-term maturity.

 

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NOTE 6 — FINANCIAL HIGHLIGHTS

 

The following table presents per share performance data and other supplemental financial data for the nine months ended September 30, 2017 and 2016 for the shareholders. This information has been derived from information presented in the condensed financial statements.

 

   For the nine months ended
September 30, 2017
(Unaudited)
   For the nine months ended
September 30, 2016
(Unaudited)
 
Per Share Operating Performance:          
Net asset value, beginning of period  $61.96   $81.25 
Total income (loss)   4.45    (12.72)
Net expenses   (0.39)   (0.45)
Net increase (decrease) in net asset value   4.06    (13.17)
Net asset value, end of period  $66.02   $68.08 
           
Total Return   6.55%   (16.21)%
           
Ratios to Average Net Assets          
Total income (loss)   8.48%   (21.52)%
Management fees*   0.60%   0.60%
Total expenses excluding management fees*   0.91%   0.85%
Expenses waived*   (0.76)%   (0.70)%
Net expenses excluding management fees*   0.15%   0.15%
Net income (loss)   7.92%   (22.08)%

 

*Annualized.

 

Total returns are calculated based on the change in value during the period. An individual shareholder’s total return and ratio may vary from the above total returns and ratios based on the timing of contributions to and withdrawals from DNO.

 

NOTE 7 — FAIR VALUE OF FINANCIAL INSTRUMENTS

 

DNO values its investments in accordance with Accounting Standards Codification 820 – Fair Value Measurements and Disclosures (“ASC 820”). ASC 820 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. The changes to past practice resulting from the application of ASC 820 relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurement. ASC 820 establishes a fair value hierarchy that distinguishes between: (1) market participant assumptions developed based on market data obtained from sources independent of DNO (observable inputs) and (2) DNO’s own assumptions about market participant assumptions developed based on the best information available under the circumstances (unobservable inputs). The three levels defined by the ASC 820 hierarchy are as follows:

 

Level I – Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

 

Level II – Inputs other than quoted prices included within Level I that are observable for the asset or liability, either directly or indirectly. Level II assets include the following: quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).

 

Level III – Unobservable pricing input at the measurement date for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available.

 

In some instances, the inputs used to measure fair value might fall within different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest input level that is significant to the fair value measurement in its entirety.

 

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The following table summarizes the valuation of DNO’s securities at September 30, 2017 using the fair value hierarchy:

 

At September 30, 2017  Total   Level I   Level II   Level III 
Short-Term Investments  $7,686,954   $7,686,954   $   $ 
Exchange-Traded Futures Contracts                    
United States Contracts   (529,760)   (529,760)        

 

During the nine months ended September 30, 2017, there were no transfers between Level I and Level II.

 

The following table summarizes the valuation of DNO’s securities at December 31, 2016 using the fair value hierarchy:

 

At December 31, 2016  Total   Level I   Level II   Level III 
Short-Term Investments  $6,794,517   $6,794,517   $   $ 
Exchange-Traded Futures Contracts                    
United States Contracts   (329,150)   (329,150)        

 

During the year ended December 31, 2016, there were no transfers between Level I and Level II.

 

Effective January 1, 2009, DNO adopted the provisions of Accounting Standards Codification 815 — Derivatives and Hedging, which require presentation of qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts and gains and losses on derivatives.

 

Fair Value of Derivative Instruments

 

Derivatives not
Accounted for
as Hedging
Instruments
  Condensed
Statements of
Financial
Condition Location
  Fair Value
At September 30,
2017
   Fair Value
At December 31,
2016
 
Futures - Commodity Contracts  Assets  $(529,760)  $(329,150)

 

The Effect of Derivative Instruments on the Condensed Statements of Operations

 

      For the nine months ended
September 30, 2017
   For the nine months ended
September 30, 2016
 
Derivatives not
Accounted for
as Hedging
Instruments
  Location of
Gain (Loss)
on Derivatives
Recognized in
Income
  Realized
Gain (Loss)
on Derivatives
Recognized in
Income
   Change in
Unrealized
Gain (Loss) on
Derivatives
Recognized in
Income
   Realized
Gain (Loss)
on Derivatives
Recognized in
Income
   Change in
Unrealized
Gain (Loss) on
Derivatives
Recognized in
Income
 
Futures - Commodity Contracts  Realized gain (loss) on
closed futures contracts
  $1,028,104        $(3,105,776)     
                        
   Change in unrealized
gain (loss) on open
contracts
       $(200,610)       $(1,092,854)

 

NOTE 8 — SUBSEQUENT EVENTS

 

DNO has performed an evaluation of subsequent events through the date the condensed financial statements were issued. This evaluation did not result in any subsequent events that necessitated disclosures and/or adjustments.

 

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion should be read in conjunction with the condensed financial statements and the notes thereto of the United States Short Oil Fund, LP (“DNO”) included elsewhere in this quarterly report on Form 10-Q.

 

Forward-Looking Information

 

This quarterly report on Form 10-Q, including this “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements regarding the plans and objectives of management for future operations. This information may involve known and unknown risks, uncertainties and other factors that may cause DNO’s actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by any forward-looking statements. Forward-looking statements, which involve assumptions and describe DNO’s future plans, strategies and expectations, are generally identifiable by use of the words “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “believe,” “intend” or “project,” the negative of these words, other variations on these words or comparable terminology. These forward-looking statements are based on assumptions that may be incorrect, and DNO cannot assure investors that the projections included in these forward-looking statements will come to pass. DNO’s actual results could differ materially from those expressed or implied by the forward-looking statements as a result of various factors.

 

DNO has based the forward-looking statements included in this quarterly report on Form 10-Q on information available to it on the date of this quarterly report on Form 10-Q, and DNO assumes no obligation to update any such forward-looking statements. Although DNO undertakes no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, investors are advised to consult any additional disclosures that DNO may make directly to them or through reports that DNO in the future files with the U.S. Securities and Exchange Commission (the “SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.

 

Introduction

 

DNO, a Delaware limited partnership, is a commodity pool that issues shares that may be purchased and sold on the NYSE Arca, Inc. (the “NYSE Arca”). The investment objective of DNO is for the daily changes, in percentage terms, of its shares’ per share net asset value (“NAV”) to inversely reflect the daily changes, in percentage terms, of the spot price of West Texas Intermediate (“WTI”) light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes, in the price of a specified short-term futures contract on WTI light, sweet crude oil traded on the New York Mercantile Exchange (the “NYMEX”) that is the near month contract to expire, except when the near month contract is within two weeks of expiration, in which case it will be measured by the futures contract that is the next month contract to expire (the “Benchmark Futures Contract”), plus interest earned on DNO’s collateral holdings, less DNO’s expenses. “Near month contract” means the next contract traded on the NYMEX due to expire. “Next month contract” means the first contract traded on the NYMEX due to expire after the near month contract.

 

DNO’s investment objective is not for its NAV or market price of shares to equal, in dollar terms, the inverse of the spot price of WTI light, sweet crude oil or any particular futures contract based on WTI light, sweet crude oil, nor is DNO’s investment objective for the percentage change in its NAV to reflect the inverse of the percentage change of the price of any particular futures contract as measured over a time period greater than one day. The general partner of DNO, United States Commodity Funds LLC (“USCF”), believes that it is not practical to manage the portfolio to achieve such an investment goal when investing in short positions in Futures Contracts (as defined below) and Other Crude Oil-Related Investments (as defined below).

 

DNO invests in short positions in futures contracts for crude oil, diesel-heating oil, gasoline, natural gas and other petroleum-based fuels that are traded on the NYMEX, ICE Futures Exchange (“ICE Futures”) or other U.S. and foreign exchanges (collectively, “Futures Contracts”). DNO may take short positions in other crude oil-related investments such as cash-settled options on Futures Contracts, forward contracts for crude oil, cleared swap contracts and over-the-counter (“OTC”) swaps that are based on the price of crude oil and other petroleum-based fuels, Futures Contracts and indices based on the foregoing (collectively, “Other Crude Oil-Related Investments”). For convenience and unless otherwise specified, Futures Contracts and Other Crude Oil-Related Investments collectively are referred to as “Crude Oil Interests” in this quarterly report on Form 10-Q.

 

USCF believes that market arbitrage opportunities will cause daily changes in DNO’s share price on the NYSE Arca on a percentage basis to closely track daily changes in DNO’s per share NAV on a percentage basis. USCF further believes that daily changes in prices of the Benchmark Futures Contract have historically closely tracked the daily changes in the spot prices of WTI light, sweet crude oil. USCF believes that the net effect of these relationships will be that the daily changes in the price of DNO’s shares on the NYSE Arca on a percentage basis will closely track the inverse of the daily changes in the spot price of a barrel of WTI light, sweet crude oil on a percentage basis, plus interest earned on DNO’s collateral holdings, less DNO’s expenses.

 

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DNO seeks to achieve its investment objective by investing so that the average daily percentage change in DNO’s NAV for any period of 30 successive valuation days will be within plus/minus ten percent (10%) of the inverse of the average daily percentage change in the price of the Benchmark Futures Contract over the same period.

 

To achieve its investment objective, DNO anticipates that it will need to maintain “short” positions in the Futures Contracts and Other Crude-Oil Related Investments in which it invests. A short position is one in which DNO will have sold the Futures Contract or Other Crude-Oil Related Investment and must buy it back or otherwise close out the position in the future. As a result, a drop in the market value of the Crude Oil Interest would lead to a potential gain for DNO, while an increase in the market value of the Crude Oil Interest would lead to a potential loss for DNO. Typically, a short position will produce a result that is the inverse of buying the Futures Contract or Other Crude-Oil Related Investment (an approach referred to as being “long” the investment). USCF expects the daily performance of DNO to generally be inverse to the daily performance of the United States Oil Fund, LP (“USO”), another commodity pool managed by USCF, which seeks to have the daily changes in percentage terms of its shares’ per share NAV track the daily changes in percentage terms of the spot price of light, sweet crude oil as traded in the United States.

 

Regulatory Disclosure

 

Requirement to File New Registration Statement. As previously reported, on March 21, 2016, United States Commodity Fund LLC (“USCF”), the general partner of United States Short Oil Fund, LP (the “Fund”), filed a Form 8-K to announce that it suspended the ability of the Authorized Participants to purchase new Creation Baskets under the Fund’s registration statement on Form S-1 that first became effective on January 17, 2013 (file no. 333-185962) (the “Prior Registration Statement”). The Prior Registration Statement had last been declared effective on May 1, 2015 and at all times included a prospectus that complied with the requirements of Section 10 of the Securities Act of 1933 (the “Securities Act”) and Form S-1. However, the Fund did not file a new registration statement prior to January 17, 2016, the date of expiration of the three-year period following the date the Prior Registration Statement was initially declared effective as required pursuant to Rule 415(a)(5).

 

On March 22, 2016, the Fund filed a new registration statement registering additional shares under the Securities Act on Form S-1 (file no. 333-210297) (the “New Registration Statement”) with the SEC and the National Futures Association (“NFA”). The NFA approved the prospectus for use on May 12 and on May 13, 2016, the SEC declared the Fund’s New Registration Statement effective allowing the Fund to resume offering Creation Baskets to its Authorized Participants.

 

Accountability Levels, Position Limits and Price Fluctuation Limits. Designated contract markets, such as the NYMEX and ICE Futures, have established accountability levels and position limits on the maximum net long or net short futures contracts in commodity interests that any person or group of persons under common trading control (other than as a hedge, which an investment by DNO is not) may hold, own or control. These levels and position limits apply to the futures contracts that DNO invests in to meet its investment objective. In addition to accountability levels and position limits, the NYMEX and ICE Futures also set daily price fluctuation limits on futures contracts. The daily price fluctuation limit establishes the maximum amount that the price of a futures contract may vary either up or down from the previous day’s settlement price. Once the daily price fluctuation limit has been reached in a particular futures contract, no trades may be made at a price beyond that limit.

 

The accountability levels for the Benchmark Futures Contract and other Futures Contracts traded on U.S.-based futures exchanges, such as the NYMEX, are not a fixed ceiling, but rather a threshold above which the NYMEX may exercise greater scrutiny and control over an investor’s positions. The current accountability level for investments for any one-month in the Benchmark Futures Contract is 10,000 net contracts. In addition, the NYMEX imposes an accountability level for all months of 20,000 net futures contracts for investments in futures contracts for light, sweet crude oil. In addition, the ICE Futures maintains the same accountability levels, position limits and monitoring authority for its light, sweet crude oil contract as the NYMEX. If DNO and the Related Public Funds exceed these accountability levels for investments in the futures contract for light, sweet crude oil, the NYMEX and ICE Futures will monitor DNO’s and the Related Public Funds’ exposure and may ask for further information on their activities including the total size of all positions, investment and trading strategy, and the extent of liquidity resources of DNO and the Related Public Funds. If deemed necessary by the NYMEX and/or ICE Futures, DNO could be ordered to reduce its Crude Oil Futures CL contracts to below the 10,000 single month and/or 20,000 all month accountability level. As of September 30, 2017, DNO held short positions in 192 WTI Crude Oil Futures CL Contracts traded on the NYMEX and DNO did not hold short positions on the ICE Futures Contracts. For the nine months ended September 30, 2017, DNO did not exceed accountability levels on the NYMEX or ICE Futures, however, the aggregated total of the Related Public Funds did exceed the accountability levels. No action was taken by the NYMEX and DNO did not reduce the number of Futures Contracts held as a result.

 

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Position limits differ from accountability levels in that they represent fixed limits on the maximum number of futures contracts that any person may hold and cannot allow such limits to be exceeded without express CFTC authority to do so. In addition to accountability levels and position limits that may apply at any time, the NYMEX and the ICE Futures impose position limits on contracts held in the last few days of trading in the near month contract to expire. It is unlikely that DNO will run up against such position limits because DNO’s investment strategy is to close out its positions and “roll” from the near month contract to expire to the next month contract beginning two weeks from expiration of the contract. For the nine months ended September 30, 2017, DNO did not exceed any position limits imposed by the NYMEX and ICE Futures.

 

The regulation of commodity interest trading in the United States and other countries is an evolving area of the law. The various statements made in this summary are subject to modification by legislative action and changes in the rules and regulations of the SEC, Financial Industry Regulatory Authority (“FINRA”), CFTC, NFA, the futures exchanges, clearing organizations and other regulatory bodies.

 

Futures Contracts and Position Limits

 

The CFTC is generally prohibited by statute from regulating trading on non-U.S. futures exchanges and markets. The CFTC, however, has adopted regulations relating to the marketing of non-U.S. futures contracts in the United States. These regulations permit certain contracts on non-U.S. exchanges to be offered and sold in the United States.

 

The CFTC has proposed to adopt limits on speculative positions in 25 physical commodity futures and option contracts as well as swaps that are economically equivalent to such contracts in the agriculture, energy and metals markets (the “Position Limit Rules”). The Position Limit Rules would, among other things: identify which contracts are subject to speculative position limits; set thresholds that restrict the size of speculative positions that a person may hold in the spot month, other individual months, and all months combined; create an exemption for positions that constitute bona fide hedging transactions; impose responsibilities on designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) to establish position limits or, in some cases, position accountability rules; and apply to both futures and swaps across four relevant venues: OTC, DCMs, SEFs as well as certain non-U.S. located platforms. The CFTC’s first attempt at finalizing the Position Limit Rules, in 2011, was successfully challenged by market participants in 2012 and, since then, the CFTC has re-proposed them and solicited comments from market participants multiple times. At this time, it is unclear how the Position Limit Rules may affect DNO, but the effect may be substantial and adverse. By way of example, the Position Limit Rules may negatively impact the ability of DNO to meet its investment objectives through limits that may inhibit USCF’s ability to sell additional Creation Baskets of DNO.

 

Until such time as the Position Limit Rules are adopted, the regulatory architecture in effect prior to the adoption of the Position Limit Rules will govern transactions in commodities and related derivatives (collectively, “Referenced Contracts”). Under that system, the CFTC enforces federal limits on speculation in nine agricultural products (e.g., corn, wheat and soy), while futures exchanges establish and enforce position limits and accountability levels for other agricultural and certain energy products (e.g., oil and natural gas). As a result, DNO may be limited with respect to the size of its investments in any commodities subject to these limits.

 

Under existing and recently adopted CFTC regulations, for the purpose of position limits, a market participant is generally required, subject to certain narrow exceptions, to aggregate all positions for which that participant controls the trading decisions with all positions for which the participant has a 10 percent or greater ownership interest in an account or position, as well as the positions of two or more persons acting pursuant to an express or implied agreement or understanding with that participant (the “Aggregation Rules”). The Aggregation Rules will also apply with respect to the Position Limit Rules if and when such Position Limit Rules are adopted.

 

“Swap” Transactions

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) imposes regulatory requirements on certain “swap” transactions that DNO is authorized to engage in that may ultimately impact the ability of DNO to meet its investment objective. The term “swap” is broadly defined to include various types of OTC derivatives, including swaps and options.

 

CFTC regulations require that certain transactions ultimately falling within the definition of “swap” be executed on organized exchanges or “swap execution facilities” and cleared through regulated clearing organizations (“CCPs”). “Clearing” refers to the process by which a trade that is bilaterally executed by two parties is submitted to a CCP, via a clearing member (i.e., an “FCM”), and replaced by two mirror swaps, with the CCP becoming the counterparty to both of the initial parties to the swap. CCPs have several layers of protection against default including margin, member capital contributions and FCM guarantees of their customers’ transactions with the CCP. FCMs also pre-qualify the counterparties to all swaps that are sent to the CCP from a credit perspective, setting limits for each counterparty and collecting initial and variation margin daily from each counterparty for changes in the value of cleared swaps. The margin collected from both parties to the swap protects against credit risk in the event a counterparty defaults. The initial and variation margin requirements are set by and held for the benefit of the CCP. Additional initial margin may be required and held by the FCM, due to its guarantees of its customers’ trades with the CCP.

 

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Current rules and regulations require enhanced customer protections, risk management programs, internal monitoring and controls, capital and liquidity standards, customer disclosures and auditing and examination programs for FCMs. The rules are intended to afford greater assurances to market participants that customer segregated funds and secured amounts are protected, customers are provided with appropriate notice of the risks of futures trading and of the FCMs with which they may choose to do business, FCMs are monitoring and managing risks in a robust manner, the capital and liquidity of FCMs are strengthened to safeguard the continued operations and the auditing and examination programs of the CFTC and the self-regulatory organizations are monitoring the activities of FCMs in a thorough manner.

 

Certain index-based credit default swaps and interest rate swaps are subject to mandatory clearing. If DNO enters into index-based credit default swaps or interest rate swaps that are subject to mandatory clearing, DNO will be required to centrally clear those swaps.

 

To the extent that a swap is required to be cleared, it must also be executed on a SEF or DCM if it is designated as “made available to trade” by a SEF or DCM. “Made available to trade” refers to the regulatory process by which the SEF or DCM execution requirement is implemented by the CFTC. To date, only certain of the index-based credit default swaps and interest rate swaps that are required to be cleared are made available to trade on a SEF. If DNO enters into index-based credit default swaps or interest rate swaps that are subject to mandatory clearing, DNO will be required to execute those swaps on a SEF if they are designated as made available to trade. In order to execute swaps on a SEF, DNO will have to be a member of a SEF or it may access the SEF through an intermediary. Members of a SEF are subject to additional requirements under CFTC regulations and are subject to the rules and jurisdiction of the relevant SEF.

 

Swaps that are not required to be cleared and executed on a SEF but that are executed bilaterally are also subject to various requirements pursuant to CFTC regulations, including, among others, reporting and recordkeeping requirements and, depending on the status of the counterparties, trading documentation requirements and dispute resolution requirements. In addition, U.S. regulators have adopted rules to impose initial and variation margin requirements that will apply to swap dealers and major swap participants and their counterparties. If DNO engages in non-cleared swap transactions it will be subject to some or all of the requirements of the margin rules, which include a requirement that swap dealers and major swap participants collect variation margin daily, beginning in March 2017, and, potentially initial margin, beginning in September 2020.

 

Derivatives Regulations in Non-U.S. Jurisdictions

 

In addition to U.S. laws and regulations, DNO may be subject to non-U.S. derivatives laws and regulations if it engages in futures and/or swaps transactions with non-U.S. persons. For example, DNO may be impacted by European laws and regulations to the extent that it engages in futures transactions on European exchanges or derivatives transactions with European entities. Other jurisdictions impose requirements applicable to futures and derivatives that are similar to those imposed by the U.S., including position limits, margin, clearing and trade execution requirements.

 

Money Market Reform

 

The SEC adopted Rule 2a-7 under the Investment Company Act of 1940, which became effective in 2016, to reform money market funds (“MMFs”). While the new rule applies only to MMFs, it may indirectly affect institutional investors such as DNO. A portion of DNO’s assets that are not used for margin or collateral in the Futures Contracts currently are invested in government MMFs. DNO does not hold any non-government MMFs and, particularly in light of recent changes to the rule governing the operation of MMFs, does not anticipate investing in any non-government MMFs. However, if DNO invests in other types of MMFs besides government MMFs in the future, DNO could be negatively impacted by investing in an MMF that does not maintain a stable $1.00 net asset value or that has the potential to impose redemption fees and gates (temporary suspension of redemptions).

 

Price Movements

 

Crude oil futures prices were volatile during the nine months ended September 30, 2017. The price of the Benchmark Futures Contract started the period at $53.720 per barrel. It hit a peak on February 23, 2017 at a price of $54.450 per barrel. The low of the period was on June 21, 2017 when the price dropped to $42.530 per barrel. The period ended with the Benchmark Futures Contract at $51.670 per barrel, a decrease of approximately (3.82)% over the period. DNO’s per share NAV began the period at $61.96 and ended the period at $66.02 on September 30, 2017, an increase of approximately 6.55% over the period. DNO’s per share NAV reached its high for the period on June 21, 2017 at $80.19 and reached its low for the period on January 6, 2017 at $61.58. Since DNO’s investment objective is to track the inverse of the daily changes in the price of the Benchmark Futures Contract, the increase in DNO’s per share NAV reflects the inverse of the decrease in the price of the Benchmark Futures Contract. The Benchmark Futures Contract prices listed above began with the February 2017 contract and ended with the November 2017 Contracts. The decrease of approximately (3.82)% on the Benchmark Futures Contract listed above is a hypothetical return only and could not actually be achieved by an investor holding Futures Contracts. An investment in Futures Contracts would need to be rolled forward during the time period described in order to simulate such a result. Furthermore, the change in the nominal price of these differing Futures Contracts, measured from the start of the period to the end of the period, does not represent the actual benchmark results that DNO seeks to track, which are more fully described below in the section titled “Tracking DNO’s Benchmark.

 

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During the nine months ended September 30, 2017, the crude oil futures market was in a state of contango, meaning that the price of the near month crude Oil Futures Contract was lower than the price of the next month crude Oil Futures Contract, and contracts further away from expiration. (On days when the market is in backwardation, the price of the near month crude Oil Futures Contract is typically higher than the price of the next month crude Oil Futures Contract or contracts further away from expiration.) For a discussion of the impact of backwardation and contango on total returns, see “Term Structure of Crude Oil Prices and the Impact on Total Returns” below.

 

Valuation of Futures Contracts and the Computation of the Per Share NAV

 

The per share NAV of DNO’s shares is calculated once each NYSE Arca trading day. The per share NAV for a particular trading day is released after 4:00 p.m. New York time. Trading during the core trading session on the NYSE Arca typically closes at 4:00 p.m. New York time. DNO’s administrator uses the NYMEX closing price (determined at the earlier of the close of the NYMEX or 2:30 p.m. New York time) for the contracts held on the NYMEX, but calculates or determines the value of all other DNO investments, including ICE Futures contracts or other futures contracts, as of the earlier of the close of the NYSE Arca or 4:00 p.m. New York time.

 

Results of Operations and the Crude Oil Market

 

Results of Operations. On September 24, 2009, DNO listed its shares on the NYSE Arca under the ticker symbol “DNO.” On that day, DNO established its initial offering price at $50.00 per share and issued 200,000 shares to the initial Authorized Participant in exchange for $10,000,000 in cash.

 

Since its initial offering of 25,000,000 shares, DNO has not registered any subsequent offerings of its shares. As of September 30, 2017, DNO had issued 4,150,000 shares, 150,000 of which were outstanding. As of September 30, 2017, there were 20,850,000 shares registered but not yet issued.

 

More shares may have been issued by DNO than are outstanding due to the redemption of shares. Unlike funds that are registered under the Investment Company Act of 1940, as amended, shares that have been redeemed by DNO cannot be resold by DNO. As a result, DNO contemplates that additional offerings of its shares will be registered with the SEC in the future in anticipation of additional issuances and redemptions.

 

As of September 30, 2017, DNO had the following Authorized Participants: BNP Paribas Prime Brokerage, Inc., BNP Paribas Securities Corp., Citadel Securities LLC, Citigroup Global Markets Inc., Credit Suisse Securities USA LLC, Deutsche Bank Securities Inc., Goldman Sachs & Company, JP Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., Morgan Stanley & Company LLC, Nomura Securities International Inc., RBC Capital Markets LLC, SG Americas Securities LLC, UBS Securities LLC and Virtu Financial BD LLC.

 

For the Nine Months Ended September 30, 2017 Compared to the Nine Months Ended September 30, 2016

 

   For the nine
months ended
September 30, 2017
   For the nine
months ended
September 30, 2016
 
Average daily total net assets  $10,413,397   $19,299,119 
Dividend and interest income earned on Treasuries, cash and/or cash equivalents  $54,587   $41,787 
Annualized approximate yield based on average daily total net assets   0.70%   0.29%
Management fee  $46,732   $86,688 
Total fees and other expenses excluding management fees  $71,044   $122,914 
Fees and expenses related to the registration or offering of additional shares  $   $ 
Total amount of the expense waiver  $59,361   $101,233 
Expenses before allowance for the expense waiver  $117,776   $209,602 
Expenses after allowance for the expense waiver  $58,415   $108,369 
Total commissions accrued to brokers  $16,284   $45,434 
Total commissions as annualized percentage of average total net assets   0.21%   0.31%
Commissions accrued as a result of rebalancing  $15,281   $44,628 
Percentage of commissions accrued as a result of rebalancing   93.84%   98.23%
Commissions accrued as a result of creation and redemption activity  $1,003   $806 
Percentage of commissions accrued as a result of creation and redemption activity   6.16%   1.77%

 

Portfolio Expenses. DNO’s expenses consist of investment management fees, brokerage fees and commissions, certain offering costs, licensing fees, the fees and expenses of the independent directors of USCF and expenses relating to tax accounting and reporting requirements. The management fee that DNO pays to USCF is calculated as a percentage of the total net assets of DNO. The fee is accrued daily and paid monthly.

 

Average interest rates earned on short-term investments held by DNO, including cash, cash equivalents and Treasuries, were higher during the nine months ended September 30, 2017, compared to the nine months ended September 30, 2016. As a result, the amount of income earned by DNO as a percentage of average daily total net assets was higher during the nine months ended September 30, 2017, compared to the nine months ended September 30, 2016.

 

The decrease in total fees and expenses excluding management fees for the nine months ended September 30, 2017, compared to the nine months ended September 30, 2016, was lower due to a decrease in certain operating expenses during the nine months ended September 30, 2017.

 

The decrease in the total commissions accrued to brokers by DNO for the nine months ended September 30, 2017, as compared to the nine months ended September 30, 2016, was a result of a lower number of futures contracts being held and traded.

 

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For the Three Months Ended September 30, 2017 Compared to the Three Months Ended September 30, 2016

 

   For the three
months ended
September 30, 2017
   For the three
months ended
September 30, 2016
 
Average daily total net assets  $10,611,915   $10,935,221 
Dividend and interest income earned on Treasuries, cash and/or cash equivalents  $26,181   $8,206 
Annualized approximate yield based on average daily total net assets   0.98%   0.30%
Management fee  $16,049   $16,493 
Total fees and other expenses excluding management fees  $22,331   $36,167 
Fees and expenses related to the registration or offering of additional shares  $   $ 
Total amount of the expense waiver  $18,357   $32,076 
Expenses before allowance for the expense waiver  $38,380   $52,660 
Expenses after allowance for the expense waiver  $20,023   $20,584 
Total commissions accrued to brokers  $5,493   $6,794 
Total commissions as annualized percentage of average total net assets   0.21%   0.25%
Commissions accrued as a result of rebalancing  $5,493   $6,794 
Percentage of commissions accrued as a result of rebalancing   100.00%   100.00%
Commissions accrued as a result of creation and redemption activity  $   $ 
Percentage of commissions accrued as a result of creation and redemption activity   %   %

 

Portfolio Expenses. DNO’s expenses consist of investment management fees, brokerage fees and commissions, certain offering costs, licensing fees, the fees and expenses of the independent directors of USCF and expenses relating to tax accounting and reporting requirements. The management fee that DNO pays to USCF is calculated as a percentage of the total net assets of DNO. The fee is accrued daily and paid monthly.

 

Average interest rates earned on short-term investments held by DNO, including cash, cash equivalents and Treasuries, were higher during the three months ended September 30, 2017, compared to the three months ended September 30, 2016. As a result, the amount of income earned by DNO as a percentage of average daily total net assets was higher during the three months ended September 30, 2017, compared to the three months ended September 30, 2016.

 

The decrease in total fees and expenses excluding management fees for the three months ended September 30, 2017, compared to the three months ended September 30, 2016, was lower due to a decrease in certain operating expenses during the three months ended September 30, 2017.

 

The decrease in the total commissions accrued to brokers by DNO for the three months ended September 30, 2017, as compared to the three months ended September 30, 2016, was a result of a lower number of futures contracts being held and traded.

 

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Tracking DNO’s Benchmark

 

USCF seeks to manage DNO’s portfolio such that changes in its average daily per share NAV, on a percentage basis, closely inversely track the daily changes in the average price of the Benchmark Futures Contract, also on a percentage basis. Specifically, USCF seeks to manage the portfolio such that over any rolling period of 30-valuation days, the average daily change in DNO’s per share NAV is within a range of (90)% to (110)% ((0.9) to (1.1)) of the average daily change in the price of the Benchmark Futures Contract. As an example, if the average daily movement of the price of the Benchmark Futures Contract for a particular 30-valuation day time period was 0.5% per day, USCF would attempt to manage the portfolio such that the average daily movement of the per share NAV during that same time period fell between (0.45)% and (0.55)% (i.e., between (0.9) and (1.1) of the benchmark’s results). DNO’s portfolio management goals do not include trying to make the nominal price of DNO’s per share NAV equal to the inverse of the nominal price of the current Benchmark Futures Contract or the inverse of the spot price for WTI light, sweet crude oil. USCF believes that it is not practical to manage the portfolio to achieve such an investment goal when investing in short positions in Futures Contracts.

 

For the 30-valuation days ended September 30, 2017, the inverse of the simple average daily change in the Benchmark Futures Contract was (0.2771)%, while the simple average daily change in the per share NAV of DNO over the same time period was (0.2763)%. The average daily difference was 0.0008% (or 0.08 basis points, where 1 basis point equals 1/100 of 1%). As a percentage of the inverse of the daily movement of the Benchmark Futures Contract, the average error in daily tracking by the per share NAV was 0.1268%, meaning that over this time period DNO’s tracking error was within the plus or minus 10% range established as its benchmark tracking goal.

 

Since the commencement of the offering of DNO’s shares to the public on September 24, 2009 to September 30, 2017, the inverse of the simple average daily change in the Benchmark Futures Contract was 0.0375%, while the simple average daily change in the per share NAV of DNO over the same time period was 0.0345%. The average daily difference was (0.0030)% (or (0.30) basis points, where 1 basis point equals 1/100 of 1%). As a percentage of the inverse of the daily movement of the Benchmark Futures Contract, the average error in daily tracking by the per share NAV was (0.8695)%, meaning that over this time period DNO’s tracking error was within the plus or minus 10% range established as its benchmark tracking goal. The following two graphs demonstrate the correlation between the changes in DNO’s NAV and the changes in the Benchmark Futures Contract. The first graph exhibits the daily changes for the last 30 valuation days ended September 30, 2017. The second graph measures monthly changes from September 30, 2012 through September 30, 2017.

 

 

 

*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

 

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*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

 

An alternative tracking measurement of the return performance of DNO versus the inverse of the return of its Benchmark Futures Contract can be calculated by comparing the actual return of DNO, measured by changes in its per share NAV, versus the expected changes in its per share NAV under the assumption that DNO’s returns had been exactly the same as inverse to the daily changes in its Benchmark Futures Contract.

 

For the nine months ended September 30, 2017, the actual total return of DNO as measured by changes in its per share NAV was 6.55%. This is based on an initial per share NAV of $61.96 as of December 31, 2016 and an ending per share NAV as of September 30, 2017 of $66.02. During this time period, DNO made no distributions to its shareholders. However, if DNO’s daily changes in its per share NAV had instead exactly inversely tracked the changes in the daily total return of the Benchmark Futures Contract, DNO would have had an estimated per share NAV of $66.06 as of September 30, 2017, for a total return over the relevant time period of 6.62%. The difference between the actual per share NAV total return of DNO of 6.55% and the expected total return based on the inverse of changes in the daily return of the Benchmark Futures Contract of 6.62% was an error over the time period of (0.07)%, which is to say that DNO’s actual total return underperformed the inverse of the benchmark result. DNO incurs expenses primarily composed of the management fee, brokerage commissions for the buying and selling of futures contracts, and other expenses. The impact of these expenses tends to cause daily changes in the per share NAV of DNO to track slightly lower than the inverse of the daily changes in the price of the Benchmark Futures Contract.

 

By comparison, for the nine months ended September 30, 2016, the actual total return of DNO as measured by changes in its per share NAV was (16.21)%. This was based on an initial per share NAV of $81.25 as of December 31, 2015 and an ending per share NAV as of September 30, 2016 of $68.08. During this time period, DNO made no distributions to its shareholders. However, if DNO’s daily changes in its per share NAV had instead exactly inversely tracked the changes in the daily total return of the Benchmark Futures Contract, DNO would have had an estimated per share NAV of $68.25 as of September 30, 2016, for a total return over the relevant time period of (16.00)%. The difference between the actual per share NAV total return of DNO of (16.21)% and the expected total return based on the inverse of changes in the daily return of the Benchmark Futures Contract of (16.00)% was an error over the time period of (0.21)%, which is to say that DNO’s actual total return underperformed the inverse of the benchmark result by that percentage. DNO incurred expenses primarily composed of the management fee, brokerage commissions for the buying and selling of futures contracts, and other expenses. The impact of these expenses tended to cause daily changes in the per share NAV of DNO to track slightly lower than the inverse of daily changes in the price of the Benchmark Futures Contract.

 

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There are currently three factors that have impacted or are most likely to impact DNO’s ability to accurately inversely track its Benchmark Futures Contract.

 

First, DNO may buy or sell its holdings in the then current Benchmark Futures Contract at a price other than the closing settlement price of that contract on the day during which DNO executes the trade. In that case, DNO may pay a price that is higher, or lower, than that of the Benchmark Futures Contract, which could cause the changes in the daily per share NAV of DNO to either be too high or too low relative to the inverse of the daily changes in the Benchmark Futures Contract. During the nine months ended September 30, 2017, USCF attempted to minimize the effect of these transactions by seeking to execute its purchase or sale of the Benchmark Futures Contract at, or as close as possible to, the end of the day settlement price. However, it may not always be possible for DNO to obtain the closing settlement price and there is no assurance that failure to obtain the closing settlement price in the future will not adversely impact DNO’s attempt to inversely track the Benchmark Futures Contract over time.

 

Second, DNO incurs expenses primarily composed of the management fee, brokerage commissions for the buying and selling of futures contracts, and other expenses. The impact of these expenses tends to cause daily changes in the per share NAV of DNO to track slightly lower than the inverse of daily changes in the price of the Benchmark Futures Contract. At the same time, DNO earns dividend and interest income on its cash, cash equivalents and Treasuries. DNO is not required to distribute any portion of its income to its shareholders and did not make any distributions to shareholders during the nine months ended September 30, 2017. Interest payments, and any other income, were retained within the portfolio and added to DNO’s NAV. When this income exceeds the level of DNO’s expenses for its management fee, brokerage commissions and other expenses (including ongoing registration fees, licensing fees and the fees and expenses of the independent directors of USCF), DNO will realize a net yield that will tend to cause daily changes in the per share NAV of DNO to track slightly higher than the inverse of daily changes in the Benchmark Futures Contract. If short-term interest rates rise above the current levels, the level of deviation created by the yield would decrease. Conversely, if short-term interest rates were to decline, the amount of error created by the yield would increase. When short-term yields drop to a level lower than the combined expenses of the management fee and the brokerage commissions, then the tracking error becomes a negative number and would tend to cause the daily returns of the per share NAV to underperform the inverse of the daily returns of the Benchmark Futures Contract. USCF anticipates that interest rates will continue to remain at historical lows and, therefore, it is anticipated that fees and expenses paid by DNO will continue to be higher than interest earned by DNO. As such, USCF anticipates that DNO will continue to underperform its benchmark until such a time when interest earned at least equals or exceeds the fees and expenses paid by DNO.

 

Third, DNO may hold Other Crude Oil-Related Investments in its portfolio that may fail to closely track the inverse of the Benchmark Futures Contract’s total return movements. In that case, the error in tracking the inverse of the Benchmark Futures Contract could result in daily changes in the per share NAV of DNO that are either too high, or too low, relative to the inverse of the daily changes in the Benchmark Futures Contract. During the nine months ended September 30, 2017, DNO did not hold any Other Crude Oil-Related Investments. If DNO increases in size, and due to its obligations to comply with regulatory limits, DNO may invest in Other Crude Oil-Related Investments which may have the effect of increasing transaction related expenses and may result in increased tracking error.

 

Term Structure of Crude Oil Futures Prices and the Impact on Total Returns. Several factors determine the total return from investing in futures contracts. One factor arises from “rolling” futures contracts that will expire at the end of the current month (the “near” or “front” month contract) forward each month prior to expiration. For a strategy that entails holding the near month contract, the price relationship between that futures contract and the next month futures contract will impact returns. For example, if the price of the near month futures contract is higher than the next futures month contract (a situation referred to as “backwardation”), then absent any other change, the price of a next month futures contract tends to rise in value as it becomes the near month futures contract and approaches expiration. Conversely, if the price of a near month futures contract is lower than the next month futures contract (a situation referred to as “contango”), then absent any other change, the price of a next month futures contract tends to decline in value as it becomes the near month futures contract and approaches expiration.

 

As an example, assume that the price of crude oil for immediate delivery, is $50 per barrel, and the value of a position in the near month futures contract is also $50. Over time, the price of crude oil will fluctuate based on a number of market factors, including demand for oil relative to supply. The value of the near month futures contract will likewise fluctuate in reaction to a number of market factors. If an investor seeks to maintain a position in a near month futures contract and not take delivery of physical barrels of crude oil, the investor must sell the current near month futures contract as it approaches expiration and invest in the next month futures contract. In order to continue holding a position in the current near month futures contract, this “roll” forward of the futures contract must be executed every month.

 

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Contango and backwardation are natural market forces that have impacted the total return on an investment in DNO’s shares during the past year relative to a hypothetical direct investment in crude oil. In the future, it is likely that the relationship between the market price of DNO’s shares and changes in the spot prices of light, sweet crude oil will continue to be impacted by contango and backwardation. It is important to note that this comparison ignores the potential costs associated with physically owning and storing crude oil, which could be substantial.

 

If the futures market is in backwardation, e.g., when the price of the near month futures contract is higher than the price of the next month futures contract, the investor would buy a next month futures contract for a lower price than the current near month futures contract. Assuming the price of the next month futures contract was $49 per barrel, or 2% cheaper than the $50 near month futures contract, then, hypothetically, and assuming no other changes (e.g., to either prevailing crude oil prices or the price relationship between the spot price, the near month contract and the next month contract, and, ignoring the impact of commission costs and the income earned on cash and/or cash equivalents), the value of the $49 next month futures contract would rise to $50 as it approaches expiration. In this example, the value of an investment in the next month futures contract would tend to outperform the spot price of crude oil. As a result, it would be possible for the new near month futures contract to rise 12% while the spot price of crude oil may have risen a lower amount, e.g., only 10%. Similarly, the spot price of crude oil could have fallen 10% while the value of an investment in the futures contract might have fallen another amount, e.g., only 8%. Over time, if backwardation remained constant, this difference between the spot price and the futures contract price would continue to increase.

 

If the futures market is in contango, an investor would be buying a next month futures contract for a higher price than the current near month futures contract. Again, assuming the near month futures contract is $50 per barrel, the price of the next month futures contract might be $51 per barrel, or 2% more expensive than the front month futures contract. Hypothetically, and assuming no other changes, the value of the $51 next month futures contract would fall to $50 as it approaches expiration. In this example, the value of an investment in the second month would tend to underperform the spot price of crude oil. As a result, it would be possible for the new near month futures contract to rise only 10% while the spot price of crude oil may have risen a higher amount, e.g., 12%. Similarly, the spot price of crude oil could have fallen 10% while the value of an investment in the second month futures contract might have fallen another amount, e.g., 12%. Over time, if contango remained constant, this difference between the spot price and the futures contract price would continue to increase.

 

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The chart below compares the daily price of the near month crude oil futures contract to the price of 13th month crude oil futures contract (i.e., a contract one year forward) over the last 10 years. When the price of the near month futures contract is higher than the price of the 13th month futures contract, the market would be described as being in backwardation. When the price of the near month futures contract is lower than the 13th month futures contract, the market would be described as being in contango. Although the price of the near month futures contract and the price of the 13th month futures contract tend to move together, it can be seen that at times the near month futures contract prices are higher than the 13th month futures contract prices (backwardation), and at other times, the near month futures contract prices are lower than the 13th month futures contract prices (contango).

 

 

 

*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

 

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An alternative way to view the same data is to subtract the dollar price of the 13th month crude oil futures contract from the dollar price of the near month crude oil futures contract, as shown in the chart below. When the difference is positive, the market is in backwardation. When the difference is negative, the market is in contango. The crude oil market spent time in both backwardation and contango during the last ten years.

 

 

 

*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

 

An investment in a portfolio that owned only the near month crude oil futures contract would likely produce a different result than an investment in a portfolio that owned an equal number of each of the near 12 months’ of crude oil futures contracts. Generally speaking, when the crude oil futures market is in backwardation, a portfolio of only the near month crude oil futures contract may tend to have a higher total return than a portfolio of 12 months’ of the crude oil futures contract. Conversely, if the crude oil futures market was in contango, the portfolio containing only 12 months’ of crude oil futures contracts may tend to outperform the portfolio holding only the near month crude oil futures contract.

 

 27 

 

 

Historically, the crude oil futures markets have experienced periods of contango and backwardation, with backwardation being in place roughly as often as contango since oil futures trading, started in 1982. Following the global financial crisis in the fourth quarter of 2008, the crude oil market moved into contango and remained in contango for a period of several years. During parts of 2009, the level of contango was unusually steep as a combination of slack U.S. and global demand for crude oil and issues involving the physical transportation and storage of crude oil at Cushing, Oklahoma, the primary pricing point for oil traded in the U.S., led to unusually high inventories of crude oil. A combination of improved transportation and storage capacity, along with growing demand for crude oil globally, moderated the inventory build-up and led to reduced levels of contango by 2011. However, at the end of November 2014, global crude oil inventories grew rapidly after the Organization of Petroleum Exporting Countries’ (“OPEC”) decided to defend its market share against U.S. shale-oil producers, resulting in another period during which the crude oil market remained primarily in contango, sometimes steep contango. This period of contango continued through December 31, 2016. In addition, the crude oil markets are expected to remain in contango until U.S. and global oil inventories decline significantly. If OPEC’s recent cuts in oil production have their intended effect on the crude oil market then such a decline may occur in 2017.

 

Periods of contango or backwardation do not materially impact DNO’s investment objective of having the daily percentage changes in its per share NAV inversely track the daily percentage changes in the price of the Benchmark Futures Contract since the impact of backwardation and contango tend to equally impact the daily percentage changes in price of both DNO’s shares and the Benchmark Futures Contract. It is impossible to predict with any degree of certainty whether backwardation or contango will occur in the future. It is likely that both conditions will occur during different periods.

 

Crude Oil Market. During the nine months ended September 30, 2017, crude oil prices have traded in a range between $43 to $53 as U.S. production growth threatened to overwhelm the impact of OPEC supply cuts. Prices rose during the third quarter as U.S. and global inventories declined. U.S. storage fell faster than the normal seasonal pace and dropped below prior-year inventory levels for the first time since 2014. U.S. production ramped up steadily throughout the year, returning to record levels last seen during summer 2015. However, production and rig count growth both appeared to level off towards the end of the quarter and may represent caution on the part of producers. Temporary disruptions also occurred as a result of hurricane Harvey. Looking ahead, expected demand growth appears strong while OPEC has stated it is prepared to take any action necessary to perpetuate the current trend towards a balanced market. Should global demand growth forecasts fail to be realized, or if OPEC is unable to counter growing U.S. production, there is a meaningful possibility that crude prices could fall again. On the other hand, increasing global tensions and the possibility of any number of conflicts escalating could lead to price shocks to the upside.

 

Crude Oil Price Movements in Comparison to Other Energy Commodities and Investment Categories. USCF believes that investors frequently measure the degree to which prices or total returns of one investment or asset class move up or down in value in concert with another investment or asset class. Statistically, such a measure is usually done by measuring the correlation of the price movements of the two different investments or asset classes over some period of time. The correlation is scaled between 1 and -1, where 1 indicates that the two investment options move up or down in price or value together, known as “positive correlation,” and -1 indicates that they move in completely opposite directions, known as “negative correlation.” A correlation of 0 would mean that the movements of the two are neither positively nor negatively correlated, known as “non-correlation.” That is, the investment options sometimes move up and down together and other times move in opposite directions.

 

 28 

 

 

For the ten-year time period between September 30, 2007 and September 30, 2017, the table below compares the monthly movements of crude oil prices versus the monthly movements of the prices of several other energy commodities, such as natural gas, diesel-heating oil, and unleaded gasoline, as well as several major non-commodity investment asset classes, such as large cap U.S. equities, U.S. government bonds and global equities. It can be seen that over this particular time period, the movement of crude oil on a monthly basis exhibited strong correlation with unleaded gasoline and diesel-heating oil, moderate correlation with the movements of large cap U.S. equities and global equities, limited correlation with natural gas, and limited negative correlation with U.S. government bonds.

 

          U.S.                                
          Gov’t.                                
          Bonds                                
    Large     (EFFAS     Global                          
    Cap U.S.     U.S.     Equities                          
    Equities     Gov’t.     (FTSE           Diesel-              
Correlation Matrix   (S&P     Bond     World     Unleaded     Heating     Natural     Crude  
September 30, 2007 – September 30, 2017*   500)     Index)     Index)     Gasoline     Oil     Gas     Oil  
Large Cap U.S. Equities (S&P 500)     1.000       (0.287 )      0.965       0.446       0.436       0.083       0.464  
U.S. Gov’t. Bonds (EFFAS U.S. Gov’t. Bond Index)             1.000       (0.257 )      (0.349 )      (0.331 )      (0.041 )      (0.390 )
Global Equities (FTSE World Index)                     1.000       0.484       0.476       0.121       0.514  
Unleaded Gasoline                             1.000       0.729       0.154       0.700  
Diesel-Heating Oil                                     1.000       0.258       0.805  
Natural Gas                                             1.000       0.263  
Crude Oil                                                     1.000  

 

Source: Bloomberg, NYMEX

 

*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

 

The table below covers a more recent, but much shorter, range of dates than the above table. Over the one year period ended September 30, 2017, movements of crude oil displayed strong correlation with large cap U.S. equites and diesel-heating oil, moderate correlation with movements of global equities, and limited negative to little correlation with movements with U.S. Government bonds, unleaded gasoline and natural gas.

 

          U.S.                                
          Gov’t.                                
          Bonds                                
    Large     (EFFAS     Global                          
    Cap U.S.     U.S.     Equities                          
    Equities     Gov’t.     (FTSE           Diesel-              
Correlation Matrix   (S&P     Bond     World     Unleaded     Heating     Natural     Crude  
12 Months ended September 30, 2017*   500)     Index)     Index)     Gasoline     Oil     Gas     Oil  
Large Cap U.S. Equities (S&P 500)     1.000       (0.229 )      0.768       (0.150 )     0.326       (0.331 )     0.620  
U.S. Gov’t. Bonds (EFFAS U.S. Gov’t. Bond Index)             1.000       0.288       0.319       (0.103 )      (0.271 )      (0.393)  
Global Equities (FTSE World Index)                     1.000       (0.124 )     0.223       (0.516 )      0.515  
Unleaded Gasoline                             1.000       0.497       0.408       (0.212 ) 
Diesel-Heating Oil                                     1.000       0.185       0.676  
Natural Gas                                             1.000       (0.119 )
Crude Oil                                                     1.000  

 

Source: Bloomberg, NYMEX

 

*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

 

 29 

 

 

Investors are cautioned that the historical price relationships between crude oil and various other energy commodities, as well as other investment asset classes, as measured by correlation may not be reliable predictors of future price movements and correlation results. The results pictured above would have been different if a different range of dates had been selected. USCF believes that crude oil has historically not demonstrated a strong correlation with equities or bonds over long periods of time. However, USCF also believes that in the future it is possible that crude oil could have long-term correlation results that indicate prices of crude oil more closely track the movements of equities or bonds. In addition, USCF believes that, when measured over time periods shorter than ten years, there will always be some periods where the correlation of crude oil to equities and bonds will be either more strongly positively correlated or more strongly negatively correlated than the long-term historical results suggest.

 

The correlations between crude oil, natural gas, diesel-heating oil and gasoline are relevant because USCF endeavors to invest DNO’s assets in Futures Contracts and Other Crude Oil-Related Investments so that daily changes in percentage terms in DNO’s per share NAV correlate as closely as possible with the inverse of the daily changes in percentage terms in the price of the Benchmark Futures Contract. If certain other fuel-based commodity futures contracts do not closely correlate with the Benchmark Futures Contract, then their use could lead to greater tracking error. As noted above, USCF also believes that the changes in percentage terms in the price of the Benchmark Futures Contract will closely correlate with changes in percentage terms in the inverse of the spot price of WTI light, sweet crude oil.

 

Critical Accounting Policies

 

Preparation of the condensed financial statements and related disclosures in compliance with accounting principles generally accepted in the United States of America requires the application of appropriate accounting rules and guidance, as well as the use of estimates. DNO’s application of these policies involves judgments and actual results may differ from the estimates used.

 

USCF has evaluated the nature and types of estimates that it makes in preparing DNO’s condensed financial statements and related disclosures and has determined that the valuation of its investments, which are not traded on a United States or internationally recognized futures exchange (such as forward contracts and OTC swaps) involves a critical accounting policy. The values which are used by DNO for its Futures Contracts are provided by its commodity broker who uses market prices when available, while OTC swaps are valued based on the present value of estimated future cash flows that would be received from or paid to a third party in settlement of these derivative contracts prior to their delivery date and valued on a daily basis. In addition, DNO estimates interest and dividend income on a daily basis using prevailing rates earned on its cash and cash equivalents. These estimates are adjusted to the actual amount received on a monthly basis and the difference, if any, is not considered material.

 

Liquidity and Capital Resources

 

DNO has not made, and does not anticipate making, use of borrowings or other lines of credit to meet its obligations. DNO has met, and it is anticipated that DNO will continue to meet, its liquidity needs in the normal course of business from the proceeds of the sale of its investments, or from the Treasuries, cash and/or cash equivalents that it intends to hold at all times. DNO’s liquidity needs include: redeeming shares, providing margin deposits for its existing Futures Contracts or the purchase of additional Futures Contracts and posting collateral for its OTC swaps, if applicable, and, except as noted below, payment of its expenses, summarized below under “Contractual Obligations.”

 

DNO currently generates cash primarily from: (i) the sale of baskets consisting of 50,000 shares (“Creation Baskets”) and (ii) income earned on Treasuries, cash and/or cash equivalents. DNO has allocated substantially all of its net assets to trading in Crude Oil Interests. DNO invests in Crude Oil Interests to the fullest extent possible without being leveraged or unable to satisfy its current or potential margin or collateral obligations with respect to its investments in Futures Contracts and Other Crude Oil-Related Investments. A significant portion of DNO’s NAV is held in cash and cash equivalents that are used as margin and as collateral for its trading in Crude Oil Interests. The balance of the assets is held in DNO’s account at its custodian bank and in investments in Treasuries at the FCM. Income received from DNO’s investments in money market funds and Treasuries is paid to DNO. During the nine months ended September 30, 2017, DNO’s expenses exceeded the income DNO earned and the cash earned from the sale of Creation Baskets and the redemption of Redemption Baskets. During the nine months ended September 30, 2017, DNO used other assets to pay expenses, which could cause a decrease in DNO’s NAV over time. To the extent expenses exceed income, DNO’s NAV will be negatively impacted.

 

DNO’s investments in Crude Oil Interests may be subject to periods of illiquidity because of market conditions, regulatory considerations and other reasons. For example, most commodity exchanges limit the fluctuations in futures contracts prices during a single day by regulations referred to as “daily limits.” During a single day, no trades may be executed at prices beyond the daily limit. Once the price of a futures contract has increased or decreased by an amount equal to the daily limit, positions in the contracts can neither be taken nor liquidated unless the traders are willing to effect trades at or within the specified daily limit. Such market conditions could prevent DNO from promptly liquidating its positions in Futures Contracts. During the nine months ended September 30, 2017, DNO did not purchase or liquidate any of its positions while daily limits were in effect; however, DNO cannot predict whether such an event may occur in the future.

 

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Since the initial offering of DNO, all payments with respect to DNO’s expenses were paid by USCF. DNO does not have an obligation or intention to refund such payments by USCF. USCF is under no obligation to pay DNO’s current or future expenses. Since the initial offering of shares, DNO has been responsible for expenses relating to: (i) management fees, (ii) brokerage fees and commissions, (iii) licensing fees for the use of intellectual property, (iv) ongoing registration expenses in connection with offers and sales of its shares subsequent to the initial offering, (v) other expenses, including tax reporting costs, (vi) fees and expenses of the independent directors of USCF and (vii) other extraordinary expenses not in the ordinary course of business, while USCF has been responsible for expenses relating to the fees of DNO’s Marketing Agent, Administrator and Custodian and registration expenses relating to the initial offering of shares. If USCF and DNO are unsuccessful in raising sufficient funds to cover these respective expenses or in locating any other source of funding, DNO will terminate and investors may lose all or part of their investment.

 

Market Risk

 

Trading in Futures Contracts and Other Crude Oil-Related Investments, such as forwards, involves DNO entering into contractual commitments to purchase or sell crude oil at a specified date in the future. The aggregate market value of the contracts will significantly exceed DNO’s future cash requirements since DNO intends to close out its open positions prior to settlement. As a result, DNO is generally only subject to the risk of loss arising from the change in value of the contracts. DNO considers the “fair value” of its derivative instruments to be the unrealized gain or loss on the contracts. The market risk associated with DNO’s commitments to purchase oil is limited to the aggregate market value of the contracts held. However, should DNO enter into a contractual commitment to sell oil, it would be required to make delivery of the oil at the contract price, repurchase the contract at prevailing prices or settle in cash. Since there are no limits on the future price of oil, the market risk to DNO could be unlimited.

 

DNO’s exposure to market risk depends on a number of factors, including the markets for oil, the volatility of interest rates and foreign exchange rates, the liquidity of the Futures Contracts and Other Crude Oil-Related Investments markets and the relationships among the contracts held by DNO. Drastic market occurrences could ultimately lead to the loss of all or substantially all of an investor’s capital.

 

Credit Risk

 

When DNO enters into Futures Contracts and Other Crude Oil-Related Investments, it is exposed to the credit risk that the counterparty will not be able to meet its obligations. The counterparty for the Futures Contracts traded on the NYMEX and on most other futures exchanges is the clearinghouse associated with the particular exchange. In general, in addition to margin required to be posted by the clearinghouse in connection with cleared trades, clearinghouses are backed by their members who may be required to share in the financial burden resulting from the nonperformance of one of their members and, therefore, this additional member support should significantly reduce credit risk. DNO is not currently a member of any clearinghouse. Some foreign exchanges are not backed by their clearinghouse members but may be backed by a consortium of banks or other financial institutions. There can be no assurance that any counterparty, clearinghouse, or their members or their financial backers will satisfy their obligations to DNO in such circumstances.

 

USCF attempts to manage the credit risk of DNO by following various trading limitations and policies. In particular, DNO generally posts margin and/or holds liquid assets that are approximately equal to the market value of its obligations to counterparties under the Futures Contracts and Other Crude Oil-Related Investments it holds. USCF has implemented procedures that include, but are not limited to, executing and clearing trades only with creditworthy parties and/or requiring the posting of collateral or margin by such parties for the benefit of DNO to limit its credit exposure. An FCM, when acting on behalf of DNO in accepting orders to purchase or sell Futures Contracts on United States exchanges, is required by CFTC regulations to separately account for and segregate as belonging to DNO, all assets of DNO relating to domestic Futures Contracts trading. These FCMs are not allowed to commingle DNO’s assets with their other assets. In addition, the CFTC requires commodity brokers to hold in a secure account DNO’s assets related to foreign Futures Contracts trading.

 

In the future, DNO may purchase OTC swaps, see “Item 3. Quantitative and Qualitative Disclosures About Market Risk” in this quarterly report on Form 10-Q for a discussion of OTC swaps.

 

As of September 30, 2017, DNO held cash deposits and investments in Treasuries and money market funds in the amount of $10,438,469 with the custodian and FCM. Some or all of these amounts held by a custodian or an FCM, as applicable, may be subject to loss should DNO’s custodian or FCM, as applicable, cease operations.

 

 31 

 

 

Off Balance Sheet Financing

 

As of September 30, 2017, DNO had no loan guarantee, credit support or other off-balance sheet arrangements of any kind other than agreements entered into in the normal course of business, which may include indemnification provisions relating to certain risks that service providers undertake in performing services which are in the best interests of DNO. While DNO’s exposure under these indemnification provisions cannot be estimated, they are not expected to have a material impact on DNO’s financial position.

 

European Sovereign Debt

 

DNO had no direct exposure to European sovereign debt as of September 30, 2017 and has no direct exposure to European sovereign debt as of the filing of this quarterly report on Form 10-Q.

 

Redemption Basket Obligation

 

In order to meet its investment objective and pay its contractual obligations described below, DNO requires liquidity to redeem shares, which redemptions must be in blocks of 50,000 shares called “Redemption Baskets.” DNO has to date satisfied this obligation by paying from the cash or cash equivalents it holds or through the sale of its Treasuries in an amount proportionate to the number of shares being redeemed.

 

Contractual Obligations

 

DNO’s primary contractual obligations are with USCF. In return for its services, USCF is entitled to a management fee calculated daily and paid monthly as a fixed percentage of DNO’s NAV, currently 0.60% of NAV on its average daily total net assets.

 

USCF agreed to pay the start-up costs associated with the formation of DNO, primarily its legal, accounting and other costs in connection with USCF’s registration with the CFTC as a CPO and the registration and listing of DNO and its shares with the SEC, FINRA and NYSE Arca (formerly, AMEX), respectively. However, since DNO’s initial offering of shares, offering costs incurred in connection with registering and listing additional shares of DNO have been directly borne on an ongoing basis by DNO, and not by USCF.

 

USCF pays the fees of the Marketing Agent and the fees of BBH&Co., as well as BBH&Co.’s fees for performing administrative services, including those in connection with the preparation of DNO’s condensed financial statements and its SEC, NFA and CFTC reports. USCF and DNO have also entered into a licensing agreement with the NYMEX pursuant to which DNO and the Related Public Funds, managed by USCF, other than BNO, USCI, CPER and USAG, pay a licensing fee to the NYMEX. DNO also pays the fees and expenses associated with its tax accounting and reporting requirements. USCF has voluntarily agreed to pay certain expenses typically borne by DNO to the extent that such expenses exceed 0.15% (15 basis points) of DNO’s NAV, on an annualized basis. USCF has no obligation to continue such payments into subsequent periods. This voluntary expense waiver is in addition to those amounts USCF is contractually obligated to pay as described in Note 4 in Item 1 of this quarterly report on Form 10-Q.

 

In addition to USCF’s management fee, DNO pays its brokerage fees (including fees to an FCM), OTC dealer spreads, any licensing fees for the use of intellectual property, and, subsequent to the initial offering, registration and other fees paid to the SEC, FINRA, or other regulatory agencies in connection with the offer and sale of shares, as well as legal, printing, accounting and other expenses associated therewith, and extraordinary expenses. The latter are expenses not incurred in the ordinary course of DNO’s business, including expenses relating to the indemnification of any person against liabilities and obligations to the extent permitted by law and under the LP Agreement, the bringing or defending of actions in law or in equity or otherwise conducting litigation and incurring legal expenses and the settlement of claims and litigation. Commission payments to an FCM are on a contract-by-contract, or round turn, basis. DNO also pays a portion of the fees and expenses of the independent directors of USCF. See Note 3 to the Notes to Condensed Financial Statements (Unaudited) in Item 1 of this quarterly report on Form 10-Q.

 

The parties cannot anticipate the amount of payments that will be required under these arrangements for future periods, as DNO’s per share NAVs and trading levels to meet its investment objective will not be known until a future date. These agreements are effective for a specific term agreed upon by the parties with an option to renew, or, in some cases, are in effect for the duration of DNO’s existence. Either party may terminate these agreements earlier for certain reasons described in the agreements.

 

As of September 30, 2017, DNO’s portfolio consisted of 192 short positions in WTI Crude Oil Futures CL Contracts traded on the NYMEX. As of September 30, 2017, DNO did not hold short positions on the ICE Futures. For a list of DNO’s current holdings, please see DNO’s website at www.uscfinvestments.com.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

Commodity Price Risk.

 

DNO is exposed to commodity price risk. In particular, DNO is exposed to crude oil price risk through its holdings of Futures Contracts together with any other derivatives in which it may invest, which are discussed below. As a result, fluctuations in the value of Futures Contracts that DNO holds in its portfolio, as described in “Contractual Obligations” under “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” above, are expected to directly affect the value of DNO’s shares.

 

OTC Contract Risk

 

Currently, OTC transactions are subject to changing regulation.

 

DNO may purchase OTC Oil Interests such as forward contracts or swap or spot contracts. Unlike most exchange-traded futures contracts or exchange-traded options on such futures, each party to an OTC swap bears the credit risk that the other party may not be able to perform its obligations under its contract.

 

DNO may enter into certain transactions where an OTC component is exchanged for a corresponding futures contract (“Exchange for Related Position” or “EFRP” transactions). In the most common type of EFRP transaction entered into by DNO, the OTC component is the purchase or sale of one or more baskets of DNO shares. These EFRP transactions may expose DNO to counterparty risk during the interim period between the execution of the OTC component and the exchange for a corresponding futures contract. Generally, the counterparty risk from the EFRP transaction will exist only on the day of execution.

 

Swap transactions, like other financial transactions, involve a variety of significant risks. The specific risks presented by a particular swap transaction necessarily depend upon the terms and circumstances of the transaction. In general, however, all swap transactions involve some combination of market risk, credit risk, counterparty credit risk, funding risk, liquidity risk and operational risk.

 

Highly customized swap transactions in particular may increase liquidity risk, which may result in a suspension of redemptions. Highly leveraged transactions may experience substantial gains or losses in value as a result of relatively small changes in the value or level of an underlying or related market factor.

 

In evaluating the risks and contractual obligations associated with a particular swap transaction, it is important to consider that a swap transaction may be modified or terminated only by mutual consent of the original parties and subject to agreement on individually negotiated terms. Therefore, it may not be possible for USCF to modify, terminate or offset DNO’s obligations or its exposure to the risks associated with a transaction prior to its scheduled termination date.

 

To reduce the credit risk that arises in connection with such contracts, DNO will generally enter into an agreement with each counterparty based on the Master Agreement published by the International Swaps and Derivatives Association that provides for the netting of its overall exposure to its counterparty, if the counterparty is unable to meet its obligations to DNO due to the occurrence of a specified event, such as the insolvency of the counterparty.

 

USCF assesses or reviews, as appropriate, the creditworthiness of each potential or existing counterparty to an OTC swap pursuant to guidelines approved by USCF’s board of directors (the “Board”). Furthermore, USCF on behalf of DNO only enters into OTC swaps with counterparties who are, or are affiliates of, (a) banks regulated by a United States federal bank regulator, (b) broker-dealers regulated by the SEC, (c) insurance companies domiciled in the United States, or (d) producers, users or traders of energy, whether or not regulated by the CFTC. Any entity acting as a counterparty shall be regulated in either the United States or the United Kingdom unless otherwise approved by the Board after consultation with its legal counsel. Existing counterparties are also reviewed periodically by USCF. DNO will also require that the counterparty be highly rated and/or provide collateral or other credit support. Even if collateral is used to reduce counterparty credit risk, sudden changes in the value of OTC transactions may leave a party open to financial risk due to a counterparty default since the collateral held may not cover a party’s exposure on the transaction in such situations.

 

In general, valuing OTC derivatives is less certain than valuing actively traded financial instruments such as exchange-traded futures contracts and securities or cleared swaps because the price and terms on which such OTC derivatives are entered into or can be terminated are individually negotiated, and those prices and terms may not reflect the best price or terms available from other sources. In addition, while market makers and dealers generally quote indicative prices or terms for entering into or terminating OTC swaps, they typically are not contractually obligated to do so, particularly if they are not a party to the transaction. As a result, it may be difficult to obtain an independent value for an outstanding OTC derivatives transaction.

 

During the nine months reporting period ended September 30, 2017, DNO limited its OTC activities to EFRP transactions.

 

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DNO anticipates that the use of Other Crude Oil-Related Investments together with its investments in Futures Contracts will produce price and total return results that closely track the investment goals of DNO. However, there can be no assurance of this. OTC swaps may result in higher transaction-related expenses than the brokerage commissions paid in connection with the purchase of Futures Contracts, which may impact DNO’s ability to successfully track the Benchmark Futures Contract.

 

Item 4.Controls and Procedures.

  

Disclosure Controls and Procedures

 

DNO maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in DNO’s periodic reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time period specified in the SEC’s rules and forms.

 

The duly appointed officers of USCF, including its chief executive officer and chief financial officer, who perform functions equivalent to those of a principal executive officer and principal financial officer of DNO if DNO had any officers, have evaluated the effectiveness of DNO’s disclosure controls and procedures and have concluded that the disclosure controls and procedures of DNO have been effective as of the end of the period covered by this quarterly report on Form 10-Q.

 

Change in Internal Control Over Financial Reporting

 

There were no changes in DNO’s internal control over financial reporting during DNO’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, DNO’s internal control over financial reporting.

 

Part II. OTHER INFORMATION

 

Item 1.Legal Proceedings.

 

Not applicable.

 

Item 1A. Risk Factors.

 

There have been no material changes to the risk factors previously disclosed in DNO’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016, filed on March 24, 2017.

 

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds.

 

  (a) None.

 

  (b) Not applicable.

 

  (c) DNO does not purchase shares directly from its shareholders. In connection with its redemption of baskets held by Authorized Participants, DNO did not have any redemptions during the third quarter of the year ended December 31, 2017. The following table summarizes the redemptions by Authorized Participants during the three months ended September 30, 2017:

 

Issuer Purchases of Equity Securities

 

Period  Total
Number of
Shares
Redeemed
   Average Price Per
Share
 
7/1/17 to 7/31/17       NA 
8/1/17 to 8/31/17       NA 
9/1/17 to 9/30/17       NA 
Total         

 

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  Item 3. Defaults Upon Senior Securities.

 

Not applicable.

 

  Item 4. Mine Safety Disclosures.

 

Not applicable.

 

  Item 5. Other Information.

 

Not applicable.

 

  Item 6. Exhibits.

 

Listed below are the exhibits, which are filed as part of this quarterly report on Form 10-Q (according to the number assigned to them in Item 601 of Regulation S-K):

 

Exhibit Number   Description of Document
31.1(1)   Certification by Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2(1)   Certification by Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1(1)   Certification by Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2(1)   Certification by Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS   XBRL Instance Document.
101.SCH   XBRL Taxonomy Extension Schema.
101.CAL   XBRL Taxonomy Extension Calculation Linkbase.
101.DEF   XBRL Taxonomy Extension Definition Linkbase.
101.LAB   XBRL Taxonomy Extension Label Linkbase.
101.PRE   XBRL Taxonomy Extension Presentation Linkbase.

 

(1)Filed herewith.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

United States Short Oil Fund, LP (Registrant)

By: United States Commodity Funds LLC, its general partner

 

By: /s/ John P. Love  
  John P. Love  
  President and Chief Executive Officer  
  (Principal executive officer)  

 

Date: November 13, 2017  
   
By: /s/ Stuart P. Crumbaugh  
  Stuart P. Crumbaugh  
  Chief Financial Officer  
  (Principal financial and accounting officer)  

 

Date: November 13, 2017

 

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