Item 1.
Business.
What is USDHO?
The United States Diesel-Heating Oil Fund,
LP (formerly, the United States Heating Oil Fund, LP) (“USDHO”) is a Delaware limited partnership organized on April 12,
2007. USDHO maintains its main business office at 1999 Harrison Street, Suite 1530, Oakland, California 94612. USDHO is a commodity
pool that issues limited partnership interests (“units”) traded on the NYSE Arca, Inc. (the “NYSE Arca”). It
operates pursuant to the terms of the Second Amended and Restated Agreement of Limited Partnership dated as of March
1, 2013 (as amended from time to time, the “LP Agreement”), which grants full management control to its general partner,
United States Commodity Funds LLC (“USCF”).
Prior to August 1, 2012, USDHO was known
as United States Heating Oil Fund, LP. USCF believes that, historically, the heating oil futures contract has been used by both
industry and financial participants as a way to hedge or invest in exposure to diesel fuel due to the close physical similarities
between the two products. The New York Mercantile Exchange (the “NYMEX”) announced in April 2012 changes to the physical
specifications of the heating oil contract which involves the reduction in the allowable amount of sulfur in heating oil down to
the levels found in diesel fuel. In doing so, the NYMEX specifically referenced the desire to make the heating oil contract a “……dual-use
price benchmark for both the heating oil and on-road diesel markets.” Aside from the change of the name and designated CUSIP
number effective August 1, 2012, no other change was made to the Fund.
The investment objective of USDHO is for
the daily changes in percentage terms of its units’ per unit net asset value (“NAV”) to reflect the daily changes
in percentage terms of the spot price of heating oil (also known as No. 2 fuel oil) for delivery to the New York harbor, as
measured by the daily changes in the price of the futures contract for heating oil traded on 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”), less USDHO’s
expenses. It is not the intent of USDHO to be operated in a fashion such that the per unit NAV will equal, in dollar terms,
the spot price of heating oil or any particular futures contract based on heating oil. It is not the intent of USDHO to be operated
in a fashion such that its per unit NAV will reflect the percentage change of the price of any particular futures contract as measured
over a time period greater than one day. USCF believes that it is not practical to manage the portfolio to achieve such an investment
goal when investing in Futures Contracts (as defined below) and Other Heating Oil Related Investments (as defined below). USDHO’s
units began trading on April 9, 2008. USCF is the general partner of USDHO and is responsible for the management of USDHO.
Who is USCF?
USCF is a single member limited liability
company that was formed in the state of Delaware on May 10, 2005. Prior to June 13, 2008, USCF was known as Victoria
Bay Asset Management, LLC. It maintains its main business office at 1999 Harrison Street, Suite 1530, Oakland, California
94612. USCF is a wholly owned subsidiary of Wainwright Holdings, Inc., a Delaware corporation (“Wainwright”). Mr. Nicholas
Gerber (discussed below) controls Wainwright by virtue of his ownership of Wainwright’s shares. Wainwright is a holding
company that previously owned an insurance company organized under Bermuda law (which has been liquidated) and a registered investment
adviser firm named Ameristock Corporation, which has been distributed to the Wainwright shareholders. USCF is a member of
the National Futures Association (the “NFA”) and registered as a commodity pool operator (“CPO”) with the
Commodity Futures Trading Commission (the “CFTC”) on December 1, 2005.
USCF also serves as general partner or
sponsor of the United States Oil Fund, LP (“USOF”), United States Natural Gas Fund, LP (“USNG”), the United
States 12 Month Oil Fund, LP (“US12OF”), the United States Gasoline Fund, LP (“UGA”), the United States
Short Oil Fund, LP (“USSO”), the United States 12 Month Natural Gas Fund, LP (“US12NG”), the United States
Brent Oil Fund, LP (“USBO”), the United States Commodity Index Fund (“USCI”), the United States Copper
Index Fund (“CPER”), the United States Agriculture Index Fund (“USAG”) and the United States Metals Index
Fund (“USMI”). USOF, USNG, US12OF, UGA, USSO, US12NG, USBO, USCI, CPER, USAG and USMI are actively operating funds
and all are listed on the NYSE Arca. All funds listed previously are referred to collectively as the “Related Public Funds.”
The Related Public Funds are subject to reporting requirements under the Securities Exchange Act of 1934, as amended (the “Exchange
Act”). For more information about each of the Related Public Funds, investors in USDHO may call 1.800.920.0259 or visit www.unitedstatescommodityfunds.com
or the SEC’s website at www.sec.gov.
USCF has also filed registration statements
to register units of the United States Sugar Fund (“USSF”), the United States Natural Gas Double Inverse Fund (“UNGD”),
the United States Gasoil Fund (“USGO”) and the United States Asian Commodities Basket Fund (“UAC”), each
of which is a series of the United States Commodity Funds Trust I and the US Golden Currency Fund (“HARD”), a series
of the United States Currency Funds Trust. USSF, UNGD, USGO, UAC and HARD are currently not available to the public, as such funds
are still in the process of review by various regulatory agencies which have regulatory authority over USCF and such funds. UAC
has been declared effective by the regulatory agencies which have regulatory authority over USCF and UAC, but at the time of filing
of this annual report on Form 10-K, UAC has not been made available to the public.
USCF is required to evaluate the credit
risk of USDHO to the futures commission merchant (“FCM”), oversee the purchase and sale of USDHO’s units by certain
authorized purchasers (“Authorized Purchasers”), review daily positions and margin requirements of USDHO and manage
USDHO’s investments. USCF also pays the fees of ALPS Distributors, Inc., which serves as the marketing agent for USDHO (the
“Marketing Agent”), and Brown Brothers Harriman & Co. (“BBH&Co.”), which serves as the administrator
(the “Administrator”) and the custodian (the “Custodian”) for USDHO.
Limited partners have no right to elect
USCF as the general partner on an annual or any other continuing basis. If USCF voluntarily withdraws as general partner, however,
the holders of a majority of USDHO’s outstanding units (excluding for purposes of such determination units owned, if any, by
the withdrawing USCF and its affiliates) may elect its successor. USCF may not be removed as general partner except upon approval
by the affirmative vote of the holders of at least 66 and 2/3 percent of USDHO’s outstanding units (excluding units owned,
if any, by USCF and its affiliates), subject to the satisfaction of certain conditions set forth in the LP Agreement.
The business and affairs of USCF are managed
by a board of directors (the “Board”), which is comprised of three management directors (the “Management Directors”),
some of whom are also its executive officers, and three independent directors who meet the independent director requirements established
by the NYSE Arca Equities Rules and the Sarbanes-Oxley Act of 2002. The Management Directors have the authority to manage USCF
pursuant to its LLC Agreement, as amended from time to time. Through its Management Directors, USCF manages the day-to-day operations
of USDHO. The Board has an audit committee which is made up of the three independent directors (Peter M. Robinson, Gordon L. Ellis
and Malcolm R. Fobes III). For additional information relating to the audit committee, please see
“Item 10. Directors,
Executive Officers and Corporate Governance – Audit Committee”
in this annual report on Form 10-K.
How Does USDHO Operate?
An investment in the units provides a means
for diversifying an investor’s portfolio or hedging exposure to changes in diesel-heating oil prices. An investment
in the units allows both retail and institutional investors to easily gain this exposure to the diesel-heating oil market in a
transparent, cost-effective manner.
The net assets of USDHO consist primarily
of investments in futures contracts for diesel-heating oil, but may also consist of investments in futures contracts for crude
oil, gasoline, natural gas and other petroleum-based fuels that are traded on the NYMEX, ICE Futures or other U.S. and foreign
exchanges (collectively, “Futures Contracts”), and to a lesser extent, in order to comply with regulatory requirements
or in view of market conditions, in other diesel-heating oil-related investments such as cash-settled options on Futures Contracts,
forward contracts for diesel-heating oil, cleared swap contracts and non-exchange traded (“over-the-counter”) transactions
that are based on the price of diesel-heating oil, crude oil and other petroleum-based fuels, Futures Contracts and indices based
on the foregoing (collectively, “Other Diesel-Heating Oil-Related Investments”). Market conditions that USCF currently
anticipates could cause USDHO to invest in Other Diesel-Heating Oil-Related Investments include those allowing USDHO to obtain
greater liquidity or to execute transactions with more favorable pricing. For convenience and unless otherwise specified, Futures
Contracts and Other Diesel-Heating Oil-Related Investments collectively are referred to as “Diesel-Heating Oil Interests”
in this annual report on Form 10-K. USDHO invests substantially the entire amount of its assets in Futures Contracts while
supporting such investments by holding the amounts of its margin, collateral and other requirements relating to these obligations
in short-term obligations of the United States of two years or less (“Treasuries”), cash and cash equivalents. The
daily holdings of USDHO are available on USDHO’s website at www.unitedstatesdieselheatingoilfund.com.
The investment objective of USDHO is for
the daily changes in percentage terms of its units’ per unit NAV to reflect the daily changes in percentage terms of the
spot price of heating oil, for delivery to the New York harbor (also known as No. 2 fuel), as measured by the daily changes
in the price of the futures contract for heating oil, traded on 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”), less USDHO’s expenses. It is not the intent
of USDHO to be operated in a fashion such that the per unit NAV will equal, in dollar terms, the spot price of heating oil or any
particular futures contract based on heating oil. It is not the intent of USDHO to be operated in a fashion such that its per unit
NAV will reflect the percentage change of the price of any particular futures contract as measured over a time period greater than
one day. USDHO may invest in interests other than the Benchmark Futures Contract to comply with accountability levels and position
limits. For a detailed discussion of accountability levels and position limits, see
“Item 1. Business – What are
Futures Contracts?”
below in this annual report on Form 10-K.
USCF employs a “neutral” investment
strategy in order to track changes in the price of the Benchmark Futures Contract regardless of whether the price goes
up or goes down. USDHO’s “neutral” investment strategy is designed to permit investors generally to purchase
and sell USDHO’s units for the purpose of investing indirectly in diesel-heating oil in a cost-effective manner, and/or to
permit participants in the diesel-heating oil or other industries to hedge the risk of losses in their diesel-heating oil-related
transactions. Accordingly, depending on the investment objective of an individual investor, the risks generally associated
with investing in diesel-heating oil and/or the risks involved in hedging may exist. In addition, an investment in USDHO involves
the risk that the changes in the price of USDHO’s units will not accurately track the changes in the Benchmark Futures Contract,
and that changes in the Benchmark Futures Contract will not closely correlate with changes in the spot prices of diesel-heating
oil.
The Benchmark Futures Contract is changed
from the near month contract to expire to the next month contract to expire during one day each month. On that day, USCF closes
or sells USDHO’s Diesel-Heating Oil Interests and also reinvests or “rolls” in new Diesel-Heating Oil Interests.
The anticipated monthly dates on which
the Benchmark Futures Contract will be changed and USDHO’s Diesel-Heating Oil Interests will be “rolled” in 2012
are posted on USDHO’s website at www.unitedstatesdieselheatingoilfund.com, and are subject to change without notice.
USDHO’s total portfolio composition
is disclosed on its website each business day that the NYSE Arca is open for trading. The website disclosure of portfolio
holdings is made daily and includes, as applicable, the name and value of each diesel-heating oil interest, the specific types
of Other Diesel-Heating Oil-Related Investments and characteristics of such Other Diesel-Heating Oil-Related Investments, the name
and value of each Treasury and cash equivalent, and the amount of cash held in USDHO’s portfolio. USDHO’s website
is publicly accessible at no charge. USDHO’s assets used for margin and collateral are held in segregated accounts pursuant
to the Commodity Exchange Act (the “CEA”) and CFTC regulations.
Effective February 29, 2012, the units issued
by USDHO may only be purchased by Authorized Purchasers and only in blocks of 50,000 units called Creation Baskets. The
amount of the purchase payment for a Creation Basket is equal to the aggregate NAV of the units in the Creation Basket. Similarly,
only Authorized Purchasers may redeem units and only in blocks of 50,000 units called Redemption Baskets. Prior to February 29,
2012, Authorized Purchasers could only purchase or redeem units in blocks of 100,000 units. The amount of the redemption proceeds
for a Redemption Basket is equal to the aggregate NAV of units in the Redemption Basket. The purchase price for Creation Baskets
and the redemption price for Redemption Baskets are the actual NAV calculated at the end of the business day when a request for
a purchase or redemption is received by USDHO. The NYSE Arca publishes an approximate per unit NAV intra-day based on the prior
day’s per unit NAV and the current price of the Benchmark Futures Contract, but the price of Creation Baskets and Redemption
Baskets is determined based on the actual per unit NAV calculated at the end of the day.
While USDHO issues units only in Creation
Baskets, units are listed on the NYSE Arca and investors may purchase and sell units at market prices like any listed security.
What is USDHO’s Investment Strategy?
In managing USDHO’s assets, USCF
does not use a technical trading system that issues buy and sell orders. USCF instead employs a quantitative methodology whereby
each time a Creation Basket is sold, USCF purchases Diesel-Heating Oil Interests, such as the Benchmark Futures Contract, that
have an aggregate market value that approximates the amount of Treasuries and/or cash received upon the issuance of the Creation
Basket.
By remaining invested as fully as possible
in Futures Contracts or Other Diesel-Heating Oil-Related Investments, USCF believes that the daily changes in percentage terms
in USDHO’s per unit NAV will continue to closely track the daily changes in percentage terms in the price of the Benchmark
Futures Contract. USCF believes that certain arbitrage opportunities result in the price of the units traded on the NYSE Arca
closely tracking the per unit NAV of USDHO. Additionally, Benchmark Futures Contracts traded on the NYMEX have closely tracked
the daily spot price of heating oil for delivery to the New York harbor. Based on these expected interrelationships, USCF
believes that the changes in the price of USDHO’s units traded on the NYSE Arca have closely tracked and will continue to
closely track the daily changes in the spot price of heating oil. For performance data relating to USDHO’s ability to
track its benchmark, see
“Item 7. Management’s Discussion and Analysis of Financial Condition and Results of
Operations – Tracking USDHO’s Benchmark”
in this annual report on Form 10-K.
USCF endeavors to place USDHO’s trades
in Futures Contracts and Other Diesel-Heating Oil-Related Investments and otherwise manage USDHO’s investments so that “A”
will be within plus/minus 10 percent of “B”, where:
|
•
|
A is the average daily change in USDHO’s per unit NAV for any period of 30 successive valuation days;
i.e
., any
NYSE Arca trading day as of which USDHO calculates its per unit NAV; and
|
|
•
|
B is the average daily percentage change in the price of the Benchmark Futures Contract over the same period.
|
USCF believes that market arbitrage opportunities
will cause the daily changes in USDHO’s unit price on the NYSE Arca to closely track the daily changes in USDHO’s per
unit NAV. USCF believes that the net effect of these two expected relationships and the relationships described above between
USDHO’s per unit NAV and the Benchmark Futures Contract, will be that the daily changes in the price of USDHO’s units
on the NYSE Arca will closely track, in percentage terms, the daily changes in the spot price of a gallon of diesel-heating oil,
less USCF’s expenses. For performance data relating to USDHO’s ability to track its benchmark, see
“Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations – Tracking USDHO’s Benchmark”
in this annual report on Form 10-K.
The specific Futures Contracts purchased
depend on various factors, including a judgment by USCF as to the appropriate diversification of USDHO’s investments in futures
contracts with respect to the month of expiration, and the prevailing price volatility of particular contracts. While USCF has
made significant investments in NYMEX Futures Contracts, for various reasons, including the ability to enter into the precise amount
of exposure to the diesel-heating oil market, position limits or other regulatory requirements limiting USDHO’s holdings,
and market conditions, it may invest in Futures Contracts traded on other exchanges or invest in Other Diesel-Heating Oil-Related
Investments. To the extent that USDHO invests in Other Diesel-Heating Oil-Related Investments, it would prioritize investments
in contracts and instruments that are economically equivalent to the Benchmark Futures Contract, including cleared swaps that satisfy
such criteria, and then, to a lesser extent, it would invest in other types of cleared swaps and other contracts, instruments and
non-cleared swaps, such as swaps in the over-the-counter market. If USDHO is required by law or regulation, or by one of its regulators,
including a futures exchange, to reduce its position in the Futures Contract to the applicable position limit or to a specified
accountability level or if market conditions dictate it would be more appropriate to invest in Other Diesel-Heating Oil-Related
Investments, a substantial portion of USDHO’s assets could be invested in accordance with such priority in Other Diesel-Heating
Oil-Related Investments that are intended to replicate the return on the Benchmark Futures Contract. As USDHO’s assets reach
higher levels, it is more likely to exceed position limits, accountability levels or other regulatory limits and, as a result,
it is more likely that it will invest in accordance with such priority in Other Diesel-Heating Oil-Related Investments at such
higher levels. In addition, market conditions that USCF currently anticipates could cause USDHO to invest in Other Diesel-Heating
Oil-Related Investments include those allowing USDHO to obtain greater liquidity or to execute transactions with more favorable
pricing. See
“Item 1. Business – Regulation”
in this annual report on Form 10-K for a discussion of the
potential impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) on USDHO’s
ability to invest in over-the-counter transactions and cleared swaps.
USCF may not be able to fully invest USDHO’s
assets in Futures Contracts having an aggregate notional amount exactly equal to USDHO’s NAV. For example, as standardized
contracts, the Futures Contracts are for a specified amount of a particular commodity, and USDHO’s NAV and the proceeds from
the sale of a Creation Basket are unlikely to be an exact multiple of the amounts of those contracts. As a result, in such circumstances,
USDHO may be better able to achieve the exact amount of exposure to changes in price of the Benchmark Futures Contract through
the use of Other Diesel-Heating Oil-Related Investments, such as over-the-counter contracts that have better correlation with changes
in price of the Benchmark Futures Contract.
USDHO anticipates that to the extent it
invests in Futures Contracts other than diesel-heating oil contracts (such as futures contracts for crude oil, natural gas,
and other petroleum-based fuels) and Other Diesel-Heating Oil-Related Investments, it will enter into various non-exchange-traded
derivative contracts to hedge the short-term price movements of such Futures Contracts and Other Diesel-Heating Oil-Related Investments
against the current Benchmark Futures Contract.
USCF does not anticipate letting USDHO’s
Futures Contracts expire and taking delivery of the underlying commodity. Instead, USCF closes existing positions,
e.g.
,
when it changes the Benchmark Futures Contract or Other Diesel-Heating Oil-Related Investments or it otherwise determines it would
be appropriate to do so and reinvests the proceeds in new Futures Contracts or Other Diesel-Heating Oil-Related Investments. Positions
may also be closed out to meet orders for Redemption Baskets and in such case proceeds for such baskets will not be reinvested.
What is the Diesel-Heating Oil
Market and the Petroleum-Based Fuel Market?
USDHO may purchase Futures Contracts traded
on the NYMEX that are based on diesel-heating oil. The ICE Futures also offers a heating oil futures contract which trades
in units of 42,000 U.S. gallons (1,000 barrels). The heating oil futures contract is cash settled against the prevailing market
price for heating oil delivered to the New York harbor. It may also purchase contracts on other exchanges, including the ICE
Futures, the Singapore Exchange and the Dubai Mercantile Exchange.
Changes
to the NYMEX Heating Oil Contract.
The heating oil contract offered by NYMEX was
the first energy commodity futures contract listed in the United States in 1978, predating similar contracts on crude oil, natural
gas, and gasoline by a number of years. Heating oil is physically similar to diesel fuel with the primary physical difference historically
being the amount of allowable sulfur permitted in heating oil versus the lower levels of sulfur permitted in diesel fuel. Despite
this physical difference, the similarities between the two distilled products was such that physical producers or users of diesel
fuel, as well as financial investors, have traditionally used the heating oil contract to hedge or speculate on diesel fuel prices.
In recent years several diesel-specific contracts have been listed on US futures exchanges. However, none of these contracts have
seen much use as the diesel market continued to make use of the heating oil contract, which provided greater liquidity. At the
same time, several states in the US Northeast have proposed new standards for heating oil that would require heating oil to contain
lower levels of sulfur. These new levels of permitted sulfur will have the effect of removing the single largest physical difference
between heating oil and diesel fuel.
On April 11, 2012, NYMEX
announced that they would be phasing in new physical specifications for the existing heating oil futures contract that will mandate
lower sulfur levels. The new standards apply to any heating oil that is physically delivered to satisfy NYMEX contracts. The new
specifications will govern such deliveries starting in May 2013. In announcing these changes, NYMEX specifically referenced the
desire to bring the contract in line with the standards for diesel fuel. NYMEX stated:
These revisions
to our benchmark heating oil contract are reflective of customer feedback and our desire to help market participants make a smooth
transition to new lower-sulfur diesel standards for heating oil ahead of changes in environmental regulations in the Northeastern
U.S.
Following the
transition to lower sulfur specifications, the Heating Oil contract will serve as a dual-use price benchmark for both the heating
oil and on-road diesel markets. It will also more closely match diesel specifications in international markets, including the European
ultra-low sulfur diesel market.
Although NYMEX has made
clear their desire to encourage the use of the heating oil futures contracts as a proxy for the diesel fuel market as well, USCF
is not aware of any current plans on the part of the NYMEX to rename the heating oil contract to reflect this dual-use.
As stated,
USCF believes that historically the wholesale price of heating oil and of diesel fuel have closely tracked each other. Only in
the last few years was a low-sulfur diesel-specific futures contract listed for trading in the United States. As mentioned, such
contracts have so far failed to attract substantial use and USCF believes most market participants continue to use the more liquid
heating oil contract for their hedging and investment needs. However, the price movements of the diesel contracts can be compared
to the price movements of heating oil contracts over the last four years. The chart below measures the daily price of the front
month heating oil futures contract on the NYMEX versus the daily price of the front month low sulfur
diesel
contract on the NYMEX. Investors are cautioned that neither contract represents retail prices for either fuel. The heating oil
contract represents wholesale prices in the New York region while the diesel contract represents wholesale prices in the Gulf Coast
region.
USCF estimates that the
price movements of the two contracts over this four year period have had a correlation of over .90. As a result, USCF believes
that the NYMEX heating oil futures contract will continue to be used by the marketplace as a contract to hedge or invest in both
heating oil and diesel fuel.
Diesel-Heating Oil.
Diesel-heating
oil, also known as No. 2 fuel oil, accounts for 25% of the yield of a barrel of crude oil, the second largest “cut”
from oil after gasoline. The heating oil futures contract listed and traded on the NYMEX trades in units of 42,000 gallons (1,000
barrels) and is based on delivery in the New York harbor, the principal cash market center. The ICE Futures also offers a Heating
Oil Futures Contract which trades in units of 42,000 U.S. gallons (1,000 barrels). The Heating Oil Futures Contract is cash-settled
against the prevailing market price for heating oil delivered to the New York Harbor.
Light, Sweet Crude Oil.
Crude oil
is the world’s most actively traded commodity. The futures contracts for light, sweet crude oil that are traded on the
NYMEX are the world’s most liquid forum for crude oil trading, as well as the world’s largest volume futures contract
trading on a physical commodity. Due to the liquidity and price transparency of oil futures contracts, they are used as a
principal international pricing benchmark. The futures contracts for light, sweet crude oil trade on the NYMEX in units of
1,000 U.S. barrels (42,000 gallons) and, if not closed out before maturity, will result in delivery of oil to Cushing, Oklahoma,
which is also accessible to the international spot markets by two major interstate petroleum pipeline systems. In Europe,
Brent crude oil is the standard for futures contracts and is primarily traded on the ICE Futures. Brent crude oil is the price
reference for two-thirds of the world’s traded oil. The ICE Brent Futures is a deliverable contract with an option to cash
settle which trades in units of 1,000 barrels (42,000 U.S. gallons). The ICE Futures also offers a WTI crude oil futures contract
which trades in units of 1,000 barrels. The WTI crude oil futures contract is cash settled against the prevailing market price
for U.S. light sweet crude oil.
Demand for petroleum products by consumers,
as well as agricultural, manufacturing and transportation industries, determines demand for crude oil by refiners. Since the precursors
of product demand are linked to economic activity, crude oil demand will tend to reflect economic conditions. However, other factors
such as weather also influence product and crude oil demand.
Crude oil supply is determined by both
economic and political factors. Oil prices (along with drilling costs, availability of attractive prospects for drilling, taxes
and technology, among other factors) determine exploration and development spending, which influence output capacity with a lag.
In the short run, production decisions by the Organization of Petroleum Exporting Countries (“OPEC”) also affect supply
and prices. Oil export embargoes and the current conflict in the Middle East represent other routes through which political developments
move the market. It is not possible to predict the aggregate effect of all or any combination of these factors. The price of crude
oil has historically been volatile.
Gasoline.
Gasoline is the largest
single volume refined product sold in the U.S. and accounts for almost half of national oil consumption. The gasoline futures contract
listed and traded on the NYMEX trades in units of 42,000 gallons (1,000 barrels) and is based on delivery at petroleum products
terminals in the New York harbor, the major East Coast trading center for imports and domestic shipments from refineries in the
New York harbor area or from the Gulf Coast refining centers. The price of gasoline has historically been volatile.
Natural Gas.
Natural gas accounts
for almost a quarter of U.S. energy consumption. The natural gas futures contract listed and traded on the NYMEX trades in units
of 10,000 million British thermal units and is based on delivery at the Henry Hub in Louisiana, the nexus of 16 intra- and
interstate natural gas pipeline systems that draw supplies from the region’s prolific gas deposits. The pipelines serve markets
throughout the U.S. East Coast, the Gulf Coast, the Midwest, and up to the Canadian border. The price of natural gas has historically
been volatile.
What are Futures Contracts?
Futures Contracts are agreements between
two parties. One party agrees to buy a commodity such as diesel-heating oil from the other party at a later date at a price and
quantity agreed-upon when the contract is made. Futures Contracts are traded on futures exchanges, including the NYMEX. For
example, the Benchmark Futures Contract is traded on the NYMEX in units of 42,000 gallons (1,000 barrels). Futures Contracts traded
on the NYMEX are priced by floor brokers and other exchange members both through an “open outcry” of offers to purchase
or sell the contracts and through an electronic, screen-based system that determines the price by matching electronically offers
to purchase and sell. Additional risks of investing in Futures Contracts are included in
“Item 1A. Risk Factors”
in this annual report on Form 10-K.
Impact of Accountability Levels, Position
Limits and Price Fluctuation Limits
. Futures contracts include typical and significant characteristics. Most significantly,
the CFTC and U.S. designated contract markets such as the NYMEX 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 USDHO is not) may hold, own or control. The net position is the difference
between an individual or firm’s open long contracts and open short contracts in any one commodity. In addition, most
U.S.-based futures exchanges, such as the NYMEX, limit the daily price fluctuation for futures contracts. Currently,
the ICE Futures imposes position and accountability limits that are similar to those imposed by U.S.-based futures exchanges and
also limits the maximum daily price fluctuation, while some other non-U.S. futures exchanges have not adopted such limits.
The accountability levels for the Benchmark
Futures Contract and other Futures Contracts traded on 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
any one-month in the Benchmark Futures Contract is 5,000 net contracts. In addition, the NYMEX imposes an accountability level
for all months of 7,000 net futures contracts for investments in futures contracts for heating oil. In addition, the ICE Futures
maintains the same accountability levels, position limits and monitoring authority for its heating oil contracts as the NYMEX.
If USDHO and the Related Public Funds exceed these accountability levels for investments in the futures contract for diesel-heating
oil, the NYMEX and ICE Futures will monitor USDHO’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 USDHO and the Related Public Funds. If deemed necessary by the NYMEX and/or ICE Futures, USDHO cold
be ordered to reduced its aggregate position back to the accountability level. USDHO did not exceed accountability levels
of the NYMEX or ICE Futures during the year ended December 31, 2012. As of December 31, 2012, USDHO held 53 Heating Oil Futures
HO Contracts traded on the NYMEX and did not hold any Futures Contracts traded on the ICE Futures.
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 USDHO will run up against such position limits because USDHO’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 year ended December 31, 2012, USDHO did not exceed any position limits
imposed by NYMEX and ICE Futures.
In late 2011, the CFTC adopted rules that
impose new position limits on Reference Contracts (as defined below) involving 28 energy, metals and agricultural commodities (the
“Position Limit Rules”). The Position Limit Rules were scheduled to become effective on October 12, 2012. However,
on September 28, 2012, the United States District Court for the District of Columbia vacated these regulations on the basis of
ambiguities in the provisions of the CEA (as modified by the Dodd-Frank Act) upon which the regulations were based. In its September
28th decision, the court remanded the Position Limit Rules to the CFTC with instructions to use its expertise and experience to
resolve the ambiguities in the statute. On November 15, 2012, the CFTC indicated that it will move forward with an appeal of the
District Court’s decision to vacate the Position Limit Rules. At this time, it is not possible to predict how the CFTC’s
appeal could affect USDHO, but it may be substantial and adverse. Furthermore, until such time as the appeal is resolved or, if
applicable revisions to the Position Limit Rules are proposed and adopted, the regulatory architecture in effect prior to the enactment
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 agricultural products (e.g., corn, wheat and soy), while
futures exchanges enforce accountability levels for agricultural and certain energy products (e.g., oil and natural gas). As a
result, USDHO may be limited with respect to the size of its investments in any commodities subject to these limits. Finally, subject
to certain narrow exceptions, the vacated Position Limit Rules would have required the aggregation, for purposes of the position
limits, of all positions in the 28 Referenced Contracts held by a single entity and its affiliates, regardless of whether such
position existed on U.S. futures exchanges, non-U.S. futures exchanges, in cleared swaps or in over-the-counter swaps. The CFTC
is presently considering new aggregation rules, under a rulemaking proposal that is distinct from the Position Limit Rules. At
this time, it is unclear how any modified aggregation rules may affect USDHO, but it may be substantial and adverse. By way of
example, the aggregation rules in combination with any potential revised Position Limit Rules may negatively impact the ability
of USDHO to meet its investment objectives through limits that may inhibit USCF’s ability to sell additional Creation Baskets
of USDHO.
Furthermore, until such time as the appeal
is resolved or, if applicable revisions to the Position Limit Rules are proposed and adopted, the regulatory architecture in effect
prior to the enactment 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 agricultural products
(e.g., corn, wheat and soy), while futures exchanges enforce accountability levels for agricultural and certain energy products
(e.g., oil and natural gas). As a result, USDHO may be limited with respect to the size of its investments in any commodities subject
to these limits. Finally, subject to certain narrow exceptions, the vacated Position Limit Rules would have required the aggregation,
for purposes of the position limits, of all positions in the 28 Referenced Contracts held by a single entity and its affiliates,
regardless of whether such position existed on U.S. futures exchanges, non-U.S. futures exchanges, in cleared swaps or in over-the-counter
swaps. The CFTC is presently considering new aggregation rules, under a rulemaking proposal that is distinct from the Position
Limit Rules. At this time, it is unclear how any modified aggregation rules may affect USDHO, but it may be substantial and adverse.
By way of example, the aggregation rules in combination with any potential revised Position Limit Rules may negatively impact the
ability of USDHO to meet its investment objectives through limits that may inhibit USCF’s ability to sell additional Creation
Baskets of USDHO.
Price Volatility
. The price volatility
of Futures Contracts generally has been historically greater than that for traditional securities such as stocks and bonds. Price
volatility often is greater day-to-day as opposed to intra-day. Futures Contracts tend to be more volatile than stocks and
bonds because price movements for diesel-heating oil are more currently and directly influenced by economic factors for which current
data is available and are traded by diesel-heating oil futures traders throughout the day. Because USDHO invests a significant
portion of its assets in Futures Contracts, the assets of USDHO, and therefore the prices of USDHO units, may be subject to
greater volatility than traditional securities.
Marking-to-Market Futures Positions
. Futures
Contracts are marked to market at the end of each trading day and the margin required with respect to such contracts is adjusted
accordingly. This process of marking-to-market is designed to prevent losses from accumulating in any futures account. Therefore,
if USDHO’s futures positions have declined in value, USDHO may be required to post “variation margin” to cover
this decline. Alternatively, if USDHO’s futures positions have increased in value, this increase will be credited to
USDHO’s account.
Why Does USDHO Purchase and Sell Futures
Contracts?
USDHO’s investment objective is for
the daily changes in percentage terms of its units’ per unit NAV to reflect the daily changes in percentage terms of the
Benchmark Futures Contract, less USDHO’s expenses. USDHO invests primarily in Futures Contracts. USDHO seeks to
have its aggregate NAV approximate at all times the aggregate market value of the Futures Contracts and Other Diesel-Heating
Oil-Related Investments it holds.
In connection with investing in Futures
Contracts and Other Diesel-Heating Oil-Related Investments, USDHO holds Treasuries, cash and/or cash equivalents that serve
as segregated assets supporting USDHO’s positions in Futures Contracts and Other Diesel-Heating Oil-Related Investments. For
example, the purchase of a Futures Contract with a stated value of $10 million would not require USDHO to pay $10 million upon
entering into the contract; rather, only a margin deposit, generally of 5% to 30% of the stated value of the Futures Contract,
would be required. To secure its Futures Contract obligations, USDHO would deposit the required margin with the
FCM and would separately hold, through its Custodian or FCM, Treasuries, cash and/or cash equivalents in an amount equal
to the balance of the current market value of the contract, which at the contract’s inception would be $10 million minus
the amount of the margin deposit, or $9.5 million (assuming a 5% margin).
As a result of the foregoing, typically
5% to 30% of USDHO’s assets are held as margin in segregated accounts with a FCM. In addition to the Treasuries
and cash it posts with the FCM for the Futures Contracts it owns, USDHO may hold, through the Custodian, Treasuries, cash and/or
cash equivalents that can be posted as additional margin or as other collateral to support its over-the-counter contracts. USDHO
earns income from the Treasuries and/or cash equivalents that it purchases, and on the cash it holds through the Custodian or FCM. USDHO
anticipates that the earned income will increase the NAV and limited partners’ capital contribution accounts. USDHO
reinvests the earned income, holds it in cash, or uses it to pay its expenses. If USDHO reinvests the earned income, it makes
investments that are consistent with its investment objective.
What are the Trading Policies of USDHO?
Liquidity
USDHO invests only in Futures Contracts
and Other Diesel-Heating Oil-Related Investments that, in the opinion of USCF, are traded in sufficient volume to permit the ready
taking and liquidation of positions in these financial interests and Other Diesel-Heating Oil-Related Investments that, in the
opinion of USCF, may be readily liquidated with the original counterparty or through a third party assuming the position of USDHO.
Spot Commodities
While the Futures Contracts traded on the
NYMEX can be physically settled, USDHO does not intend to take or make physical delivery. USDHO may from time to time trade
in Other Diesel-Heating Oil-Related Investments, including contracts based on the spot price of diesel-heating oil.
Leverage
USCF endeavors to have the value of USDHO’s
Treasuries, cash and cash equivalents, whether held by USDHO or posted as margin or other collateral, at all times approximate
the aggregate market value of its obligations under its Futures Contracts and Other Diesel-Heating Oil-Related Investments. Commodity
pools’ trading positions in futures contracts or other related investments are typically required to be secured by the deposit
of margin funds that represent only a small percentage of a futures contract’s (or other commodity interest’s) entire
market value. While USCF has not and does not intend to leverage USDHO’s assets, it is not prohibited from doing so under
the LP Agreement.
Borrowings
Borrowings are not used by USDHO unless
USDHO is required to borrow money in the event of physical delivery, if USDHO trades in cash commodities, or for short-term needs
created by unexpected redemptions.
Over-the-Counter Derivatives (Including
Spreads and Straddles)
In addition to Futures Contracts, there
are also a number of listed options on the Futures Contracts on the principal futures exchanges. These contracts offer investors
and hedgers another set of financial vehicles to use in managing exposure to the diesel-heating oil market. Consequently,
USDHO may purchase options on Futures Contracts on these exchanges in pursuing its investment objective.
In addition to the Futures Contracts and
options on the Futures Contracts, there also exists an active non-exchange-traded market in derivatives tied to diesel-heating
oil. These derivatives transactions (also known as over-the-counter contracts) are usually entered into between two parties
in private contracts. Unlike most of the exchange-traded Futures Contracts or exchange-traded options on the Futures Contracts,
each party to such contract bears the credit risk of the other party,
i.e
., the risk that the other party may not be able
to perform its obligations under its contract.
To reduce the credit risk that arises in
connection with such contracts, USDHO will generally enter into an agreement with each counterparty based on the Master Agreement
published by the International Swaps and Derivatives Association, Inc. (“ISDA”) that provides for the netting of its
overall exposure to its counterparty.
USCF assesses or reviews, as appropriate,
the creditworthiness of each potential or existing counterparty to an over-the-counter contract pursuant to guidelines approved
by USCF’s Board.
USDHO may employ spreads or straddles in
its trading to mitigate the differences in its investment portfolio and its goal of tracking the price of the Benchmark Futures
Contract. USDHO would use a spread when it chooses to take simultaneous long and short positions in futures written on the
same underlying asset, but with different delivery months.
USDHO has not employed any hedging methods
since all of its investments have been made over an exchange. Therefore, USDHO has not been exposed to counterparty risk.
Pyramiding
USDHO has not and will not employ the technique,
commonly known as pyramiding, in which the speculator uses unrealized profits on existing positions as variation margin for the
purchase or sale of additional positions in the same or another commodity interest.
Who are the Service Providers?
In its capacity as the Custodian for USDHO, BBH&Co.
may hold USDHO’s Treasuries, cash and/or cash equivalents pursuant to a custodial agreement. BBH&Co. is
also the registrar and transfer agent for the units. In addition, in its capacity as Administrator for USDHO, BBH&Co. performs
certain administrative and accounting services for USDHO and prepares certain SEC, NFA and CFTC reports on behalf of USDHO. USCF
pays BBH&Co.’s fees for these services.
BBH&Co.’s principal business
address is 50 Milk Street, Boston, MA 02109-3661. BBH&Co., a private bank founded in 1818, is neither a publicly held
company nor insured by the Federal Deposit Insurance Corporation. BBH&Co. is authorized to conduct a commercial banking business
in accordance with the provisions of Article IV of the New York State Banking Law, New York Banking Law §§160–181,
and is subject to regulation, supervision, and examination by the New York State - Department of Financial Services. BBH&Co.
is also licensed to conduct a commercial banking business by the Commonwealths of Massachusetts and Pennsylvania and is subject
to supervision and examination by the banking supervisors of those states.
USDHO also employs ALPS Distributors,
Inc. as the Marketing Agent. USCF pays the Marketing Agent an annual fee. In no event may the aggregate compensation
paid to the Marketing Agent and any affiliate of USCF for distribution-related services in connection with the offering of units
exceed ten percent (10%) of the gross proceeds of the offering.
ALPS’s principal business address
is 1290 Broadway, Suite 1100, Denver, CO 80203. ALPS is the marketing agent for USDHO. ALPS is a broker-dealer registered
with the Financial Industry Regulatory Authority (“FINRA”) and a member of the Securities Investor Protection
Corporation.
UBS Securities LLC (“UBS Securities”)
is USDHO’s FCM. USDHO and UBS have entered into an Institutional Futures Client Account Agreement. This agreement requires
UBS Securities to provide services to USDHO in connection with the purchase and sale of Diesel-Heating Oil Interests that may be
purchased or sold by or through UBS Securities for USDHO’s account. USDHO pays UBS Securities’ commissions for
executing and clearing trades on behalf of USDHO.
UBS Securities’ principal business
address is 677 Washington Blvd, Stamford, CT 06901. UBS Securities is a futures clearing broker for USDHO. UBS Securities is registered
in the U.S. with FINRA as a broker-dealer and with the CFTC as a FCM. UBS Securities is a member of various U.S. futures and securities
exchanges.
UBS is and has been a defendant in numerous
legal proceedings, including actions brought by regulatory organizations and government agencies, relating to its securities and
commodities business that allege various violations of federal and state securities laws. UBS AG, the ultimate parent company to
UBS Securities, files annual reports and quarterly reports to the SEC in which it discloses material information about matters
involving but not limited to, UBS Securities, including information about any material litigation or regulatory investigations
(https://www.ubs.com/global/en/about_ubs/investor_relations/quarterly_reporting/2011.html). Actions with respect to UBS Securities’
FCM business are publicly available on the website of the National Futures Association (http://www.nfa.futures.org/).
On June 27, 2007, the Securities Division
of the Secretary of the Commonwealth of Massachusetts (“Massachusetts Securities Division”) filed an administrative
complaint (the “Complaint”) and notice of adjudicatory proceeding against UBS Securities, captioned In The Matter of
UBS Securities, LLC, Docket No. E-2007-0049, which alleged that UBS Securities violated the Massachusetts Uniform Securities Act
(the “Act”) and related regulations by providing the advisers for certain hedge funds with gifts and gratuities in
the form of below market office rents, personal loans with below market interest rates, event tickets, and other perks, in order
to induce those hedge fund advisers to increase or retain their level of prime brokerage fees paid to UBS Securities. On November 22,
2010, UBS Securities entered into a Consent Order and Settlement with the Massachusetts Securities Division, pursuant to which
UBS Securities agreed to implementing a disclosure policy and retaining an independent consultant to monitor the policy. UBS Securities
also paid a $100,000 fine.
In the summer of 2008, the Massachusetts
Securities Division, Texas State Securities Board, and the New York Attorney General (“NYAG”) all brought actions against
UBS and UBS Financial Services, Inc. (“UBS Financial”), alleging violations of various state law anti-fraud provisions
in connection with the marketing and sale of auction rate securities.
On August 8, 2008, UBS Securities
and UBS Financial Services reached agreements with the SEC, the NYAG, the Massachusetts Securities Division and other state regulatory
agencies represented by the North American Securities Administrators Association (“NASAA”) to restore liquidity to
all remaining client’s holdings of auction rate securities by June 30, 2012. On October 2, 2008, UBS Securities
and UBS Financial entered into a final consent agreement with the Massachusetts Securities Division settling all allegations in
the Massachusetts Securities Division’s administrative proceeding against UBS Securities and UBS Financial with regards to
the auction rate securities matter. On December 11, 2008, UBS Securities and UBS Financial executed an Assurance of Discontinuance
in the auction rate securities settlement with the NYAG. On the same day, UBS Securities and UBS Financial finalized settlements
with the SEC. UBS Securities and UBS Financial paid penalties of $75 million to NYAG and an additional $75 million to be apportioned
among the participating NASAA states. In March 2010, UBS Securities and UBS Financial and NASAA agreed on final settlement terms,
pursuant to which, UBS Securities and UBS Financial agreed to provide client liquidity up to an additional $200 million.
On August 14, 2008 the New Hampshire
Bureau of Securities Regulation (the “Bureau”) filed an administrative action against UBS Securities relating to a
student loan issuer, the New Hampshire Higher Education Loan Corp. (“NHHELCO”). The complaint alleged fraudulent and
unethical conduct in violation of New Hampshire state statutes. On April 14, 2010, UBS Securities entered into a Consent Order
resolving all of the Bureau’s claims. UBS Securities paid $750,000 to the Bureau for all costs associated with the Bureau’s
investigation. UBS Securities entered a separate civil settlement with NHHELCO and provided a total financial benefit of $20 million
to NHHELCO.
On April 29, 2010, the CFTC issued
an order with respect to UBS Securities and levied a fine of $200,000. The Order stated that on February 6, 2009, UBS Securities’
employee broker aided and abetted UBS Securities’ customer’s concealment of material facts from the NYMEX in violation
of Section 9(a)(4) of the CEA, 7 U.S.C. § 13(a)(4) (2006). Pursuant to NYMEX Rules, a block trade must be reported to
NYMEX “within five minutes of the time of execution” consistent with the requirements of NYMEX Rule 6.21C(A)(6). Although
the block trade in question was executed earlier in the day, UBS Securities’ employee broker aided and abetted its customer’s
concealment of facts when, in response to the customer’s request to delay reporting the trade until after the close of trading,
UBS Securities’ employee did not report the trade until after the close. Because the employee broker undertook his actions
within the scope of his employment, pursuant to Section 2(a)(1)(B) of the CEA, 7 U.S.C. § 2(a)(1)(B) (2006), and Commission
Regulation 1.2, 17 C.F.R. § 1.2 (2009), UBS Securities is liable for the employee broker’s aiding and abetting of its
customer’s violation of Section 9(a)(4) of the CEA. The fine has been paid and the matter is now closed.
UBS Securities will act only as clearing
broker for USDHO and as such will be paid commissions for executing and clearing trades on behalf of USDHO. UBS Securities
has not passed upon the adequacy or accuracy of this annual report on Form 10-K. UBS Securities neither will act in any supervisory
capacity with respect to USCF nor participate in the management of USCF or USDHO.
UBS Securities is not affiliated with USDHO
or USCF. Therefore, USDHO does not believe that USDHO has any conflicts of interest with UBS Securities or their trading principals
arising from their acting as USDHO’s FCM.
Currently, USCF does not employ commodity
trading advisors for trading of USDHO contracts. USCF currently does, however, employ a trading advisor for USCI, CPER, USAG
and USMI, SummerHaven Investment Management, LLC (“SummerHaven”). If, in the future, USCF does employ commodity
trading advisors for USDHO, it will choose each advisor based on arm’s-length negotiations and will consider the advisor’s
experience, fees and reputation.
Fees of USDHO
Fees and Compensation Arrangements
with USCF and Non-Affiliated Service Providers
(1)
Service Provider
|
|
Compensation Paid by USCF
|
BBH&Co., Custodian and Administrator
|
|
Minimum amount of $75,000 annually for its custody, fund accounting and fund administration services rendered to all funds, as well as a $20,000 annual fee for its transfer agency services. In addition, an asset-based charge of (a) 0.06% for the first $500 million of USDHO’s and the Related Public Funds’ combined net assets, (b) 0.0465% for USDHO’s and the Related Public Funds’ combined net assets greater than $500 million but less than $1 billion, and (c) 0.035% once USDHO’s and the Related Public Funds’ combined net assets exceed $1 billion.
(2)
|
|
|
ALPS Distributors, Inc., Marketing Agent
|
|
0.06% on USDHO’s assets up to $3 billion; and 0.04% on USDHO’s assets in excess of $3 billion.
|
|
(1)
|
USCF pays this compensation.
|
|
(2)
|
The annual minimum amount will not apply if the asset-based charge for all accounts in the aggregate exceeds $75,000. USCF
also will pay transaction charge fees to BBH&Co., ranging from $7 to $15 per transaction for the funds.
|
Compensation to USCF
USDHO is contractually obligated to pay
USCF a management fee based on 0.60% per annum on its average net assets. Fees are calculated on a daily basis (accrued at
1/365 of the applicable percentage of NAV on that day) and paid on a monthly basis. Total net assets are calculated by taking the
current market value of USDHO’s total assets and subtracting any liabilities.
Fees and Compensation Arrangements between USDHO and Non-Affiliated
Service Providers
(3)
Service Provider
|
|
Compensation Paid by USDHO
|
|
|
UBS Securities LLC, Futures
Commission Merchant
|
|
Approximately $3.50 per buy or sell;
charges may vary
|
|
|
|
(3)
|
USDHO pays this compensation.
|
New York Mercantile Exchange Licensing Fee
(4)
Assets
|
|
Licensing Fee
|
|
Prior to October 19, 2011
:
|
|
|
|
|
First $1,000,000,000
|
|
|
0.04% of NAV
|
|
After the first $1,000,000,000
|
|
|
0.02% of NAV
|
|
On and after October 20, 2011
:
|
|
|
0.015% on all net assets
|
|
(4)
|
Fees are calculated on a daily basis (accrued at 1/365 of the applicable percentage of NAV on that day) and paid on a monthly basis. USDHO is responsible for its pro rata share of the assets held by USDHO and the Related Public Funds, other than USBO, USCI, CPER, USAG and USMI.
|
Expenses Paid or Accrued by USDHO through December 31,
2012 in dollar terms:
Expenses:
|
|
Amount in Dollar Terms
|
|
Amount Paid or Accrued to USCF:
|
|
$
|
278,181
|
|
Amount Paid or Accrued in Portfolio Brokerage Commissions:
|
|
$
|
39,162
|
|
Other Amounts Paid or Accrued
(5)
:
|
|
$
|
803,811
|
|
Total Expenses Paid or Accrued:
|
|
$
|
1,121,154
|
|
Expenses Waived
(6)
:
|
|
$
|
(702,252
|
)
|
Total Expenses Paid or Accrued Including Expenses Waived
(6)
:
|
|
$
|
418,902
|
|
(5)
|
Includes expenses relating to the registration of additional units, legal fees, auditing fees, printing expenses, licensing fees, tax reporting fees, prepaid insurance expenses and miscellaneous expenses and fees and expenses paid to the independent directors of USCF.
|
(6)
|
USCF has voluntarily agreed to pay certain expenses typically borne by USDHO, to the extent that such expenses exceeded 0.15% (15 basis points) of USDHO’s NAV, on an annualized basis, through at least June 30, 2013. USCF has no obligation to continue such payments into subsequent periods.
|
Expenses Paid or Accrued by USDHO through December 31,
2012 as a Percentage of Average Daily Net Assets:
Expenses:
|
|
Amount as a Percentage of
Average Daily Net Assets
|
Amount Paid or Accrued to USCF:
|
|
0.60% annualized
|
Amount Paid or Accrued in Portfolio Brokerage Commissions:
|
|
0.08% annualized
|
Other Amounts Paid or Accrued
(7)
:
|
|
1.73% annualized
|
Total Expenses Paid or Accrued:
|
|
2.41% annualized
|
Expenses Waived
(8)
:
|
|
(1.51)% annualized
|
Total Expenses Paid or Accrued Including Expenses Waived
(8)
:
|
|
0.90% annualized
|
(7)
|
Includes expenses relating to the registration of additional units, legal fees, auditing fees, printing expenses, licensing fees, tax reporting fees, prepaid insurance expenses and miscellaneous expenses and fees and expenses paid to the independent directors of USCF.
|
(8)
|
USCF has voluntarily agreed to pay certain expenses typically borne by USDHO, to the extent that such expenses exceeded 0.15% (15 basis points) of USDHO’s NAV, on an annualized basis, through at least June 30, 2013. USCF has no obligation to continue such payments into subsequent periods.
|
Other Fees
. USDHO also
pays the fees and expenses associated with its tax accounting and reporting requirements. These fees were approximately $50,000
for the fiscal year ended December 31, 2012. In addition, USDHO is responsible for paying its portion of the directors’
and officers’ liability insurance for USDHO and the Related Public Funds and the fees and expenses of the independent directors
who also serve as audit committee members of USDHO and the Related Public Funds organized as limited partnerships and, as of July 8,
2011, those Related Public Funds organized as a series of a Delaware statutory trust. USDHO 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 ended December 31, 2012 were $540,586 for USDHO and the Related
Public Funds. USDHO’s portion of such fees and expenses for the year ended December 31, 2012 was $1,514.
Form of Units
Registered Form
. Units
are issued in registered form in accordance with the LP Agreement. The Administrator has been appointed registrar and transfer
agent for the purpose of transferring units in certificated form. The Administrator keeps a record of all limited partners
and holders of the units in certificated form in the registry (the “Register”). USCF recognizes transfers of units
in certificated form only if done in accordance with the LP Agreement. The beneficial interests in such units are held in
book-entry form through participants and/or accountholders in the Depository Trust Company (“DTC”).
Book Entry
. Individual certificates
are not issued for the units. Instead, units are represented by one or more global certificates, which are deposited by the Administrator
with DTC and registered in the name of Cede & Co., as nominee for DTC. The global certificates evidence all
of the units outstanding at any time. Unitholders are limited to: (1) participants in DTC such as banks, brokers, dealers
and trust companies (“DTC Participants”), (2) those who maintain, either directly or indirectly, a custodial relationship
with a DTC Participant (“Indirect Participants”), and (3) those banks, brokers, dealers, trust companies and others
who hold interests in the units through DTC Participants or Indirect Participants, in each case who satisfy the requirements for
transfers of units. DTC Participants acting on behalf of investors holding units through such participants’ accounts
in DTC will follow the delivery practice applicable to securities eligible for DTC’s Same-Day Funds Settlement System. Units
are credited to DTC Participants’ securities accounts following confirmation of receipt of payment.
DTC
. DTC has advised USDHO
as follows: It is a limited purpose trust company organized under the laws of the State of New York and is a member of the Federal
Reserve System, a “clearing corporation” within the meaning of the New York Uniform Commercial Code and a “clearing
agency” registered pursuant to the provisions of Section 17A of the Exchange Act. DTC holds securities for DTC Participants
and facilitates the clearance and settlement of transactions between DTC Participants through electronic book-entry changes in
accounts of DTC Participants.
Calculating Per Unit NAV
USDHO’s per unit NAV is calculated
by:
|
•
|
Taking the current market value of its total assets;
|
|
•
|
Subtracting any liabilities; and
|
|
•
|
Dividing that total by the total number of outstanding units.
|
The Administrator calculates the per unit
NAV of USDHO once each NYSE Arca trading day. The per unit 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. The
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 Futures Contracts traded on the NYMEX, but calculates or determines the value of all other USDHO investments (including Futures
Contracts not traded on the NYMEX, Other Diesel-Heating Oil-Related Investments and Treasuries), using market quotations, if available,
or other information customarily used to determine the fair value of such investments as of the earlier of the close of the NYSE
Arca or 4:00 p.m. New York time, in accordance with the current Administrative Agency Agreement among BBH&Co., USDHO and USCF.
“Other information” customarily used in determining fair value includes information consisting of market data in the
relevant market supplied by one or more third parties including, without limitation, relevant rates, prices, yields, yield curves,
volatilities, spreads, correlations or other market data in the relevant market; or information of the types described above from
internal sources if that information is of the same type used by USDHO in the regular course of its business for the valuation
of similar transactions. The information may include costs of funding, to the extent costs of funding are not and would not be
a component of the other information being utilized. Third parties supplying quotations or market data may include, without limitation,
dealers in the relevant markets, end-users of the relevant product, information vendors, brokers and other sources of market information.
In addition, in order to provide updated
information relating to USDHO for use by investors and market professionals, the NYSE Arca calculates and disseminates throughout
the core trading session on each trading day an updated indicative fund value. The indicative fund value is calculated by
using the prior day’s closing per unit NAV of USDHO as a base and updating that value throughout the trading day to reflect
changes in the most recently reported trade price for the active Futures Contracts on the NYMEX. The prices reported for those
Futures Contract months are adjusted based on the prior day’s spread differential between settlement values for the relevant
contract and the spot month contract. In the event that the spot month contract is also the Benchmark Futures Contract, the
last sale price for that contract is not adjusted. The indicative fund value unit basis disseminated during NYSE Arca core
trading session hours should not be viewed as an actual real time update of the per unit NAV, because the per unit NAV is calculated
only once at the end of each trading day based upon the relevant end of day values of USDHO’s investments.
The indicative fund value is disseminated
on a per unit basis every 15 seconds during regular NYSE Arca core trading session hours of 9:30 a.m. New York time to 4:00 p.m.
New York time. The normal trading hours of the NYMEX are 10:00 a.m. New York time to 2:30 p.m. New York time. This means
that there is a gap in time at the beginning and the end of each day during which USDHO’s units are traded on the NYSE Arca,
but real-time NYMEX trading prices for Futures Contracts traded on the NYMEX are not available. During such gaps in time the
indicative fund value will be calculated based on the end of day price of such Futures Contracts from the NYMEX immediately preceding
trading session. In addition, other Futures Contracts, Other Diesel-Heating Oil Related Investments and Treasuries held by USDHO
will be valued by the Administrator, using rates and points received from client-approved third party vendors (such as Reuters
and WM Company) and advisor quotes. These investments will not be included in the indicative fund value.
The NYSE Arca disseminates the indicative
fund value through the facilities of CTA/CQ High Speed Lines. In addition, the indicative fund value is published on the NYSE
Arca’s website and is available through on-line information services such as Bloomberg and Reuters.
Dissemination of the indicative fund value
provides additional information that is not otherwise available to the public and is useful to investors and market professionals
in connection with the trading of USDHO’s units on the NYSE Arca. Investors and market professionals are able throughout
the trading day to compare the market price of USDHO and the indicative fund value. If the market price of USDHO’s units
diverges significantly from the indicative fund value, market professionals will have an incentive to execute arbitrage trades. For
example, if USDHO appears to be trading at a discount compared to the indicative fund value, a market professional could buy USDHO’s
units on the NYSE Arca and sell short Futures Contracts. Such arbitrage trades can tighten the tracking between the market
price of USDHO and the indicative fund value and thus can be beneficial to all market participants.
Creation and Redemption of Units
USDHO creates and redeems units from time
to time, but only in one or more Creation Baskets or Redemption Baskets. The creation and redemption of baskets are only made
in exchange for delivery to USDHO or the distribution by USDHO of the amount of Treasuries and any cash represented by the baskets
being created or redeemed, the amount of which is based on the combined NAV of the number of units included in the baskets being
created or redeemed determined after 4:00 p.m. New York time on the day the order to create or redeem baskets is properly received.
Authorized Purchasers are the only persons
that may place orders to create and redeem baskets. Authorized Purchasers must be (1) registered broker-dealers or other securities
market participants, such as banks and other financial institutions, that are not required to register as broker-dealers to engage
in securities transactions as described below, and (2) DTC Participants. To become an Authorized Purchaser, a person must
enter into an Authorized Purchaser Agreement with USCF on behalf of USDHO. The Authorized Purchaser Agreement provides the procedures
for the creation and redemption of baskets and for the delivery of the Treasuries and any cash required for such creations and
redemptions. The Authorized Purchaser Agreement and the related procedures attached thereto may be amended by USDHO, without the
consent of any limited partner or unitholder or Authorized Purchaser. From July 1, 2011 through December 31, 2012 (and
continuing at least through May 1, 2013), the applicable transaction fee paid by Authorized Purchasers is $350 to USDHO for
each order they place to create or redeem one or more baskets; prior to July 1, 2011, this fee was $1,000. Authorized Purchasers
who make deposits with USDHO in exchange for baskets receive no fees, commissions or other form of compensation or inducement of
any kind from either USDHO or USCF, and no such person will have any obligation or responsibility to USCF or USDHO to effect any
sale or resale of units. As of December 31, 2012, 12 Authorized Purchasers had entered into agreements with USCF on behalf
of USDHO. During the year ended December 31, 2012, USDHO did not issue any Creation Basket and redeemed 2 Redemption Baskets.
Certain Authorized Purchasers are expected
to be capable of participating directly in the physical diesel-heating oil market and the diesel-heating oil futures market. In
some cases, Authorized Purchasers or their affiliates may from time to time buy diesel-heating oil or sell diesel-heating oil or
Diesel-Heating Oil Interests and may profit in these instances. USCF believes that the size and operation of the diesel-heating
oil market make it unlikely that an Authorized Purchaser’s direct activities in the diesel-heating oil or securities markets
will significantly affect the price of diesel-heating oil, Diesel-Heating Oil Interests, or the price of the units.
Each Authorized Purchaser is required to
be registered as a broker-dealer under the Exchange Act and is a member in good standing with FINRA, or exempt from being or otherwise
not required to be registered as a broker-dealer or a member of FINRA, and qualified to act as a broker or dealer in the states
or other jurisdictions where the nature of its business so requires. Certain Authorized Purchasers may also be regulated under
federal and state banking laws and regulations. Each Authorized Purchaser has its own set of rules and procedures, internal
controls and information barriers as it determines is appropriate in light of its own regulatory regime.
Under the Authorized Purchaser Agreement,
USCF has agreed to indemnify the Authorized Purchasers against certain liabilities, including liabilities under the Securities
Act of 1933, as amended (the “Securities Act”), and to contribute to the payments the Authorized Purchasers may be
required to make in respect of those liabilities.
The following description of the procedures
for the creation and redemption of baskets is only a summary and an investor should refer to the relevant provisions of the LP
Agreement and the form of Authorized Purchaser Agreement for more detail, each of which is incorporated by reference into this
annual report on Form 10-K.
Creation Procedures
On any business day, an Authorized Purchaser
may place an order with the Marketing Agent to create one or more baskets. For purposes of processing purchase and redemption
orders, a “business day” means any day other than a day when any of the NYSE Arca, the NYMEX or the NYSE is closed
for regular trading. Purchase orders must be placed by 12:00 p.m. New York time or the close of regular trading on the NYSE
Arca, whichever is earlier. The day on which the Marketing Agent receives a valid purchase order is referred to as the purchase
order date.
By placing a purchase order, an Authorized
Purchaser agrees to deposit Treasuries, cash, or a combination of Treasuries and cash, as described below. Prior to the
delivery of baskets for a purchase order, the Authorized Purchaser must also have wired to the Custodian the non-refundable transaction
fee due for the purchase order. Authorized Purchasers may not withdraw a creation request.
The manner by which creations are made
is dictated by the terms of the Authorized Purchaser Agreement. By placing a purchase order, an Authorized Purchaser agrees to:
(1) deposit Treasuries, cash, or a combination of Treasuries and cash with the Custodian, and (2) if required by USCF
in its sole discretion, enter into or arrange for a block trade, an exchange for physical or exchange for swap, or any other over-the-counter
energy transaction (through itself or a designated acceptable broker) with USDHO for the purchase of a number and type of futures
contracts at the closing settlement price for such contracts on the purchase order date. If an Authorized Purchaser fails to consummate
(1) and (2), the order shall be cancelled. The number and type of contracts specified shall be determined by USCF, in its
sole discretion, to meet USDHO’s investment objective and shall be purchased as a result of the Authorized Purchaser’s
purchase of units.
Determination of Required Deposits
The total deposit required to create each
basket (“Creation Basket Deposit”) is the amount of Treasuries and/or cash that is in the same proportion to the total
assets of USDHO (net of estimated accrued but unpaid fees, expenses and other liabilities) on the purchase order date as the number
of units to be created under the purchase order is in proportion to the total number of units outstanding on the purchase order
dates. USCF determines, directly in its sole discretion or in consultation with the Administrator, the requirements for Treasuries
and the amount of cash, including the maximum permitted remaining maturity of a Treasury and proportions of Treasury and cash that
may be included in deposits to create baskets. The Marketing Agent will publish such requirements at the beginning of each
business day. The amount of cash deposit required is the difference between the aggregate market value of the Treasuries required
to be included in a Creation Basket Deposit as of 4:00 p.m. New York time on the date the order to purchase is properly received
and the total required deposit.
Delivery of Required Deposits
An Authorized Purchaser who places a purchase
order is responsible for transferring to USDHO’s account with the Custodian the required amount of Treasuries and cash by
the end of the third business day following the purchase order date. Upon receipt of the deposit amount, the Administrator
directs DTC to credit the number of baskets ordered to the Authorized Purchaser’s DTC account on the third business day following
the purchase order date. The expense and risk of delivery and ownership of Treasuries until such Treasuries have been received
by the Custodian on behalf of USDHO shall be borne solely by the Authorized Purchaser.
Because orders to purchase baskets must
be placed by 12:00 p.m., New York time, but the total payment required to create a basket during the continuous offering period
will not be determined until after 4:00 p.m. New York time on the date the purchase order is received, Authorized Purchasers will
not know the total amount of the payment required to create a basket at the time they submit an irrevocable purchase order for
the basket. USDHO’s per unit NAV and the total amount of the payment required to create a basket could rise or fall
substantially between the time an irrevocable purchase order is submitted and the time the amount of the purchase price in respect
thereof is determined.
Rejection of Purchase Orders
USCF acting by itself or through the Marketing
Agent shall have the absolute right but no obligation to reject a purchase order or a Creation Basket Deposit if:
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it determines that the investment alternative available to USDHO at that time will not enable it to meet its investment objective;
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it determines that the purchase order or the Creation Basket Deposit is not in proper form;
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it believes that the purchase order or the Creation Basket Deposit would have adverse tax consequences to USDHO, the limited partners or its unitholders;
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the acceptance or receipt of the Creation Basket Deposit would, in the opinion of counsel to USCF, be unlawful; or
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circumstances outside the control of USCF, Marketing Agent or Custodian make it, for all practical purposes, not feasible to process creations of baskets.
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None of USCF, the Marketing Agent or the
Custodian will be liable for the rejection of any purchase order or Creation Basket Deposit.
Redemption Procedures
The procedures by which an Authorized Purchaser
can redeem one or more baskets mirror the procedures for the creation of baskets. On any business day, an Authorized Purchaser
may place an order with the Marketing Agent to redeem one or more baskets. Redemption orders must be placed by 12:00 p.m.
New York time or the close of regular trading on the NYSE Arca, whichever is earlier. A redemption order so received will
be effective on the date it is received in satisfactory form by the Marketing Agent. The redemption procedures allow Authorized
Purchasers to redeem baskets and do not entitle an individual unitholder to redeem any units in an amount less than a Redemption
Basket, or to redeem baskets other than through an Authorized Purchaser.
By placing a redemption order, an Authorized
Purchaser agrees to deliver the baskets to be redeemed through DTC’s book-entry system to USDHO, as described below. Prior
to the delivery of the redemption distribution for a redemption order, the Authorized Purchaser must also have wired to USDHO’s
account at the Custodian the non-refundable transaction fee due for the redemption order. An Authorized Purchaser may not withdraw
a redemption order.
The manner by which redemptions are made
is dictated by the terms of the Authorized Purchaser Agreement. By placing a redemption order, an Authorized Purchaser agrees to
(1) deliver the Redemption Basket to be redeemed through DTC’s book-entry system to USDHO’s account with the Custodian
not later than 3:00 p.m. New York time on the third business day following the effective date of the redemption order (“Redemption
Distribution Date”), and (2) if required by USCF in its sole discretion, enter into or arrange for a block trade, an
exchange for physical or exchange for swap, or any other over-the-counter energy transaction (through itself or a designated acceptable
broker) with USDHO for the sale of a number and type of futures contracts at the closing settlement price for such contracts on
the Redemption Order Date. If an Authorized Purchaser fails to consummate (1) and (2) above, the order shall be cancelled.
The number and type of contracts specified shall be determined by USCF, in its sole discretion, to meet USDHO’s investment
objective and shall be sold as a result of the Authorized Purchaser’s sale of units.
Determination of Redemption Distribution
The redemption distribution from USDHO
consists of a transfer to the redeeming Authorized Purchaser of an amount of Treasuries and/or cash that is in the same proportion
to the total assets of USDHO (net of estimated accrued but unpaid fees, expenses and other liabilities) on the date the order to
redeem is properly received as the number of units to be redeemed under the redemption order is in proportion to the total number
of units outstanding on the date the order is received. USCF, directly or in consultation with the Administrator, determines
the requirements for Treasuries and the amounts of cash, including the maximum permitted remaining maturity of a Treasury, and
the proportions of Treasuries and cash that may be included in distributions to redeem baskets. The Marketing Agent will publish
an estimate of the redemption distribution per basket as of the beginning of each business day.
Delivery of Redemption Distribution
The redemption distribution due from USDHO
will be delivered to the Authorized Purchaser by 3:00 p.m. New York time on the third business day following the redemption order
date if, by 3:00 p.m. New York time on such third business day, USDHO’s DTC account has been credited with the baskets to
be redeemed. If USDHO’s DTC account has not been credited with all of the baskets to be redeemed by such time, the redemption
distribution will be delivered to the extent of whole baskets received. Any remainder of the redemption distribution will
be delivered on the next business day to the extent of remaining whole baskets received if USDHO receives the fee applicable to
the extension of the redemption distribution date which USCF may, from time to time, determine and the remaining baskets to be
redeemed are credited to USDHO’s DTC account by 3:00 p.m. New York time on such next business day. Any further outstanding
amount of the redemption order shall be cancelled. Pursuant to information from USCF, the Custodian will also be authorized
to deliver the redemption distribution notwithstanding that the baskets to be redeemed are not credited to USDHO’s DTC account
by 3:00 p.m. New York time on the third business day following the redemption order date if the Authorized Purchaser has collateralized
its obligation to deliver the baskets through DTC’s book entry-system on such terms as USCF may from time to time determine.
Suspension or Rejection of Redemption
Orders
USCF may, in its discretion, suspend the
right of redemption, or postpone the redemption settlement date: (1) for any period during which the NYSE Arca or the NYMEX
is closed other than customary weekend or holiday closings, or trading on the NYSE Arca or the NYMEX is suspended or restricted,
(2) for any period during which an emergency exists as a result of which delivery, disposal or evaluation of Treasuries is
not reasonably practicable, or (3) for such other period as USCF determines to be necessary for the protection of the limited
partners or unitholders. For example, USCF may determine that it is necessary to suspend redemptions to allow for the orderly
liquidation of USDHO’s assets at an appropriate value to fund a redemption. If USCF has difficulty liquidating its positions,
e.g
., because of a market disruption event in the futures markets, a suspension of trading by the exchange where the futures
contracts are listed or an unanticipated delay in the liquidation of a position in an over-the-counter contract, it may be appropriate
to suspend redemptions until such time as such circumstances are rectified. None of USCF, the Marketing Agent, the Administrator,
or the Custodian will be liable to any person or in any way for any loss or damages that may result from any such suspension or
postponement.
Redemption orders must be made in whole
baskets. USCF will reject a redemption order if the order is not in proper form as described in the Authorized Purchaser Agreement
or if the fulfillment of the order, in the opinion of its counsel, might be unlawful. USCF may also reject a redemption order
if the number of units being redeemed would reduce the remaining outstanding units to 100,000 units (
i.e
., two baskets)
or less.
Creation and Redemption Transaction
Fee
To compensate USDHO for its expenses in
connection with the creation and redemption of baskets, an Authorized Purchaser is required to pay a transaction fee to USDHO per
order to create or redeem baskets, regardless of the number of baskets in such order. From July 1, 2011 through December 31,
2012 (and continuing at least through May 1, 2013), the applicable transaction fee paid by Authorized Purchasers is $350 to
USDHO for each order they place to create or redeem one or more baskets; prior to July 1, 2011, this fee was $1,000. The transaction
fee may be reduced, increased or otherwise changed by USCF. USCF shall notify DTC of any change in the transaction fee and will
not implement any increase in the fee for the redemption of baskets until 30 days after the date of the notice.
Tax Responsibility
Authorized Purchasers are responsible for
any transfer tax, sales or use tax, stamp tax, recording tax, value added tax or similar tax or governmental charge applicable
to the creation or redemption of baskets, regardless of whether or not such tax or charge is imposed directly on the Authorized
Purchaser, and agree to indemnify USCF and USDHO if they are required by law to pay any such tax, together with any applicable
penalties, additions to tax and interest thereon.
Secondary Market Transactions
As noted, USDHO creates and redeems units
from time to time, but only in one or more Creation Baskets or Redemption Baskets. The creation and redemption of baskets
are only made in exchange for delivery to USDHO or the distribution by USDHO of the amount of Treasuries and cash represented by
the baskets being created or redeemed, the amount of which will be based on the aggregate NAV of the number of units included in
the baskets being created or redeemed determined on the day the order to create or redeem baskets is properly received.
As discussed above, Authorized Purchasers
are the only persons that may place orders to create and redeem baskets. Authorized Purchasers must be registered broker-dealers
or other securities market participants, such as banks and other financial institutions that are not required to register as broker-dealers
to engage in securities transactions. An Authorized Purchaser is under no obligation to create or redeem baskets, and an Authorized
Purchaser is under no obligation to offer to the public units of any baskets it does create. Authorized Purchasers that do
offer to the public units from the baskets they create will do so at per-unit offering prices that are expected to reflect, among
other factors, the trading price of the units on the NYSE Arca, the NAV of USDHO at the time the Authorized Purchaser purchased
the Creation Baskets and the per unit NAV of the units at the time of the offer of the units to the public, the supply of
and demand for units at the time of sale, and the liquidity of the Futures Contract market and the market for Other Diesel-Heating
Oil-Related Investments. The prices of units offered by Authorized Purchasers are expected to fall between USDHO’s per
unit NAV and the trading price of the units on the NYSE Arca at the time of sale. Units initially comprising the same basket
but offered by Authorized Purchasers to the public at different times may have different offering prices. An order for one or more
baskets may be placed by an Authorized Purchaser on behalf of multiple clients. Authorized Purchasers who make deposits with USDHO
in exchange for baskets receive no fees, commissions or other form of compensation or inducement of any kind from either USDHO
or USCF, and no such person has any obligation or responsibility to USCF or USDHO to effect any sale or resale of units. Units
trade in the secondary market on the NYSE Arca. Units may trade in the secondary market at prices that are lower or higher
relative to their per unit NAV. The amount of the discount or premium in the trading price relative to the per unit NAV may
be influenced by various factors, including the number of investors who seek to purchase or sell units in the secondary market
and the liquidity of the Futures Contracts market and the market for Other Diesel-Heating Oil-Related Investments. While the
units trade during the core trading session on the NYSE Arca until 4:00 p.m. New York time, liquidity in the market for Futures
Contracts and Other Diesel-Heating Oil-Related Investments may be reduced after the close of the NYMEX at 2:30 p.m. New York time. As
a result, during this time, trading spreads, and the resulting premium or discount, on the units may widen.
Investments
USCF causes USDHO to transfer the proceeds
from the sale of Creation Baskets to the Custodian or other custodian for trading activities. USCF will invest USDHO’s assets
in Futures Contracts and Other Diesel-Heating Oil-Related Investments and investments in Treasuries, cash and/or cash equivalents. When
USDHO purchases a Futures Contract and certain exchange-traded Other Diesel-Heating Oil-Related Investments, USDHO is required
to deposit 5% to 30% with the selling FCM on behalf of the exchange a portion of the value of the contract or other interest as
security to ensure payment for the obligation under Diesel-Heating Oil Interests at maturity. This deposit is known as initial
margin. Counterparties in transactions in over-the-counter Diesel-Heating Oil Interests will generally impose similar collateral
requirements on USDHO. USCF will invest the assets that remain after margin and collateral are posted in Treasuries, cash and/or
cash equivalents subject to these margin and collateral requirements. USCF has sole authority to determine the percentage of assets
that are:
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held on deposit with the FCM or other custodian
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used for other investments, and
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held in bank accounts to pay current obligations and as reserves.
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Ongoing margin and collateral payments
will generally be required for both exchange-traded and over-the-counter Diesel-Heating Oil Interests based on changes in the value
of the Diesel-Heating Oil Interests. Furthermore, ongoing collateral requirements with respect to over-the-counter Diesel-Heating
Oil Interests are negotiated by the parties, and may be affected by overall market volatility, volatility of the underlying commodity
or index, the ability of the counterparty to hedge its exposure under a Diesel-Heating Oil Interest, and each party’s creditworthiness.
In light of the differing requirements for initial payments under exchange-traded and over-the-counter Diesel-Heating Oil Interests
and the fluctuating nature of ongoing margin and collateral payments, it is not possible to estimate what portion of USDHO’s
assets will be posted as margin or collateral at any given time. The Treasuries, cash and cash equivalents held by USDHO will constitute
reserves that will be available to meet ongoing margin and collateral requirements. All interest income will be used for USDHO’s
benefit.
A FCM, counterparty, government agency
or commodity exchange could increase margin or collateral requirements applicable to USDHO to hold trading positions at any time. Moreover,
margin is merely a security deposit and has no bearing on the profit or loss potential for any positions held.
The assets of USDHO posted as margin for
Futures Contracts are held in segregated accounts pursuant to the CEA and CFTC regulations.
The Commodity Interest Markets
General
The CEA governs the regulation of
commodity interest transactions, markets and intermediaries. The CEA provides for varying degrees of regulation of commodity
interest transactions depending upon: (1) the type of instrument being traded (
e.g
., contracts for future delivery,
options, swaps or spot contracts), (2) the type of commodity underlying the instrument (distinctions are made between instruments
based on agricultural commodities, energy and metals commodities and financial commodities), (3) the nature of the parties
to the transaction (retail, eligible contract participant, or eligible commercial entity), (4) whether the transaction is
entered into on a principal-to-principal or intermediated basis, (5) the type of market on which the transaction occurs, and
(6) whether the transaction is subject to clearing through a clearing organization.
The offer and sale of units of USDHO, as
well as units of each of the Related Public Funds, is registered under the Securities Act. USDHO and the Related Public Funds are
subject to the requirements of the Securities Act, the Exchange Act and the rules and regulations adopted thereunder as administered
by the Securities and Exchange Commission (the “SEC”). Firms’ participation in the distribution of units are
regulated as described above, as well as by the self regulatory association, FINRA.
Futures Contracts
A futures contract is a standardized contract
traded on, or subject to the rules of, an exchange that calls for the future delivery of a specified quantity and type of a commodity
at a specified time and place. Futures contracts are traded on a wide variety of commodities, including agricultural products,
bonds, stock indices, interest rates, currencies, energy and metals. The size and terms of futures contracts on a particular
commodity are identical and are not subject to any negotiation, other than with respect to price and the number of contracts traded
between the buyer and seller.
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. The
difference between the price at which the futures contract is purchased or sold and the price paid for the offsetting sale or purchase,
after allowance for brokerage commissions, constitutes the profit or loss to the trader. Some futures contracts, such as stock
index contracts, settle in cash (reflecting the difference between the contract purchase/sale price and the contract settlement
price) rather than by delivery of the underlying commodity.
In market terminology, a trader who purchases
a futures contract is long in the market and a trader who sells a futures contract is short in the market. Before a trader
closes out his long or short position by an offsetting sale or purchase, his outstanding contracts are known as open trades or
open positions. The aggregate amount of open positions held by traders in a particular contract is referred to as the open
interest in such contract.
Forward Contracts
A forward contract is a contractual obligation
to purchase or sell a specified quantity of a commodity at or before a specified date in the future at a specified price and, therefore,
is economically similar to a futures contract. Unlike futures contracts, however, forward contracts are typically traded in
the over-the-counter markets and are not standardized contracts. Forward contracts for a given commodity are generally available
for various amounts and maturities and are subject to individual negotiation between the parties involved. Moreover, generally
there is no direct means of offsetting or closing out a forward contract by taking an offsetting position as one would a futures
contract on a U.S. exchange. If a trader desires to close out a forward contract position, he generally will establish an
opposite position in the contract but will settle and recognize the profit or loss on both positions simultaneously on the delivery
date. Thus, unlike in the futures contract market where a trader who has offset positions will recognize profit or loss immediately,
in the forward market a trader with a position that has been offset at a profit will generally not receive such profit until the
delivery date, and likewise a trader with a position that has been offset at a loss will generally not have to pay money until
the delivery date. In recent years, however, the terms of forward contracts have become more standardized, and in some instances
such contracts now provide a right of offset or cash settlement as an alternative to making or taking delivery of the underlying
commodity.
In general, the CFTC does not regulate
the interbank and forward foreign currency markets with respect to transactions in contracts between certain sophisticated counterparties
such as USDHO or between certain regulated institutions and retail investors. Although U.S. banks are regulated in various ways
by the Federal Reserve Board, the Comptroller of the Currency and other U.S. federal and state banking officials, banking authorities
do not regulate the forward markets to the same extent that the swap markets will be regulated by the CFTC once the Dodd-Frank
Act is fully implemented. At a minimum, over-the-counter currency forwards, options and swaps will be subject to heightened recordkeeping,
reporting and business conduct standards.
On November 16, 2012, the Secretary of
the Treasury issued a final determination that exempts both foreign exchange swaps and foreign exchange forwards from the definition
of “swap” and, by extension, additional regulatory requirements (such as clearing and margin). The final determination
does not extend to other foreign exchange derivatives, such as foreign exchange options, currency swaps, and non-deliverable forwards.
While the U.S. government does not currently
impose any restrictions on the movements of currencies, it could choose to do so. The imposition or relaxation of exchange controls
in various jurisdictions could significantly affect the market for that and other jurisdictions’ currencies. Trading in the
interbank market also exposes USDHO to a risk of default since failure of a bank with which USDHO had entered into a forward contract
would likely result in a default and thus possibly substantial losses to USDHO.
Options on Futures Contracts
Options on futures contracts are standardized
contracts traded on an exchange. An option on a futures contract gives the buyer of the option the right, but not the obligation,
to take a position at a specified price (the striking, strike, or exercise price) in the underlying futures contract or underlying
interest. The buyer of a call option acquires the right, but not the obligation, to purchase or take a long position in the
underlying interest, and the buyer of a put option acquires the right, but not the obligation, to sell or take a short position
in the underlying interest.
The seller, or writer, of an option is
obligated to take a position in the underlying interest at a specified price opposite to the option buyer if the option is exercised. The
seller of a call option must stand ready to take a short position in the underlying interest at the strike price if the buyer should
exercise the option. The seller of a put option, on the other hand, must stand ready to take a long position in the underlying
interest at the strike price.
A call option is said to be in-the-money
if the strike price is below current market levels and out-of-the-money if the strike price is above current market levels. Conversely,
a put option is said to be in-the-money if the strike price is above the current market levels and out-of-the-money if the strike
price is below current market levels.
Options have limited life spans, usually
tied to the delivery or settlement date of the underlying interest. Some options, however, expire significantly in advance
of such date. The purchase price of an option is referred to as its premium, which consists of its intrinsic value (which
is related to the underlying market value) plus its time value. As an option nears its expiration date, the time value shrinks
and the market and intrinsic values move into parity. An option that is out-of-the-money and not offset by the time it expires
becomes worthless. On certain exchanges, in-the-money options are automatically exercised on their expiration date, but on
others unexercised options simply become worthless after their expiration date.
Regardless of how much the market swings,
the most an option buyer can lose is the option premium. The option buyer deposits his premium with his broker, and the money
goes to the option seller. Option sellers, on the other hand, face risks similar to participants in the futures markets. For
example, since the seller of a call option is assigned a short futures position if the option is exercised, his risk is the same
as someone who initially sold a futures contract. Because no one can predict exactly how the market will move, the option
seller posts margin to demonstrate his ability to meet any potential contractual obligations.
Options on Forward Contracts or Commodities
Options on forward contracts or commodities
operate in a manner similar to options on futures contracts. An option on a forward contract or commodity gives the buyer
of the option the right, but not the obligation, to take a position at a specified price in the underlying forward contract or
commodity. However, unlike options on futures contracts, options on forward contracts or on commodities are individually negotiated
contracts between counterparties and are typically traded in the over-the-counter market. Therefore, options on forward contracts
and physical commodities possess many of the same characteristics of forward contracts with respect to offsetting positions and
credit risk that are described above.
Swap Contracts
Swap transactions generally involve contracts
between two parties to exchange a stream of payments computed by reference to a notional amount and the price of the asset that
is the subject of the swap. Swap contracts are principally traded off-exchange, although certain swap contracts are also being
traded in electronic trading facilities and cleared through clearing organizations.
Swaps are usually entered into on a net
basis, that is, the two payment streams are netted out in a cash settlement on the payment date or dates specified in the agreement,
with the parties receiving or paying, as the case may be, only the net amount of the two payments. Swaps do not generally
involve the delivery of underlying assets or principal. Accordingly, the risk of loss with respect to swaps is generally limited
to the net amount of payments that the party is contractually obligated to make. In some swap transactions one or both parties
may require collateral deposits from the counterparty to support that counterparty’s obligation under the swap agreement. If
the counterparty to such a swap defaults, the risk of loss consists of the net amount of payments that the party is contractually
entitled to receive less any collateral deposits it is holding.
Some swap transactions are cleared through
central counterparties. These transactions, known as cleared swaps, involve two counterparties first agreeing to the terms
of a swap transaction, then submitting the transaction to a clearing house that acts as the central counterparty. Once accepted
by the clearing house, the original swap transaction is novated and the central counterparty becomes the counterparty to a trade
with each of the original parties based upon the trade terms determined in the original transaction. In this manner each individual
swap counterparty reduces its risk of loss due to counterparty nonperformance because the clearing house acts as the counterparty
to each transaction.
“Swap” Transactions
The Dodd-Frank Act imposes new regulatory
requirements on certain “swap” transactions that USDHO is authorized to engage in that may ultimately impact the ability
of USDHO to meet its investment objective. On August 13, 2012, the CFTC and the SEC published joint final rules defining the terms
“swap” and “security- based swap.” The term “swap” is broadly defined to include various types
of over-the-counter derivatives, including swaps and options. The effective date of these final rules was October 12, 2012.
The Dodd-Frank Act requires 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 (which are referred to in the Dodd-Frank Act
as “derivative clearing organizations” (“DCOs”)), if the CFTC mandates the central clearing of a particular
contract. On November 28, 2012, the CFTC issued its final clearing determination requiring that certain credit default swaps and
interest rate swaps be cleared by registered DCOs. This is the CFTC’s first clearing determination under the Dodd-Frank
Act and became effective on February 11, 2013. On March 11, 2013, “swap dealers,” “major swap participants,”
and certain active funds will be required to clear certain credit default swaps and interest rate swaps. Determination on other
types of swaps are expected in the future, and, when finalized, could require USDHO to centrally clear certain over-the-counter
instruments presently entered into and settled on a bi-lateral basis. If a swap is required to be cleared, the initial margin
will be set by the clearing organization, subject to certain regulatory requirements and guidelines. Initial and variation margin
requirements for swap dealers and major swap participants who enter into uncleared swaps and capital requirements for swap dealers
and major swap participants who enter into both cleared and uncleared trades will be set by the CFTC, the SEC or the applicable
“Prudential Regulator.” On May 23, 2012, the CFTC published final regulations, which became effective as of July 23,
2012, to determine which entities will be regulated as “swap dealers” and “major swap participants” and
thus have to comply with these capital and margin requirements (as well as a multitude of other requirements under the Dodd-Frank
Act). Most of the requirements imposed became effective on October 12, 2012, when additional final rules defining the terms “swap,”
“security-based swap,” and “mixed swap” became effective. However, on October 11, 2012 and October 12,
2012, the CFTC issued several no-action letters and interpretive guidance which delayed much of the implementation of the requirements
from October 12, 2012 until December 31, 2012. Increased regulation of, and the imposition of additional costs on, swap transactions
could have an adverse effect on USDHO by, for example, reducing the size of and therefore liquidity in the derivatives market,
increasing transaction costs and decreasing the ability to customize derivative transactions.
On February 7, 2012, the CFTC published
a rule requiring each FCM and DCO to segregate cleared swaps and related collateral posted by a customer of the FCM from the assets
of the FCM or DCO, although such property can be commingled with the property of other cleared swaps customers of the FCM or DCO.
This rule addresses losses incurred by a DCO in a so-called “double default” scenario in which a customer of an FCM
defaults in its obligations to the FCM and the FCM, in turn, defaults in its obligations to the DCO. Under this scenario, the DCO
can only access the collateral attributable to other customers of the DCO whose cleared swap positions are in a loss position following
the primary customer’s default. This rule became effective on November 8, 2012. Some market participants have expressed concern
that the requirements of this segregation rule may result in higher initial margins or higher fees. USDHO does not anticipate any
impact to their operations in order to meet the requirements of the new rule.
Additionally, the CFTC published rules
on February 17, 2012 and April 3, 2012 that require “swap dealers” and “major swap participants” to: 1)
adhere to business conduct standards, 2) implement policies and procedures to ensure compliance with the CEA and 3) maintain records
of such compliance. These new requirements may impact the documentation requirements for both cleared and non-cleared swaps and
cause swap dealers and major swap participants to face increased compliance costs that, in turn, may be passed along to counterparties
(such as USDHO) in the form of higher fees and expenses that related to trading swaps.
On February 24, 2012, the CFTC amended
certain disclosure obligations to require that the operator of a commodity pool that invests in swaps include standardized swap
risk disclosures in the pool’s disclosure documents by December 31, 2012.
On December 5, 2012, the CFTC’s Division
of Market Oversight issued a letter providing swap dealers with time-limited no-action relief from swap data reporting obligations
with respect to equity swaps, foreign exchange swaps and other commodity swaps. For these asset classes, the letter provides swap
dealers with reporting relief (i) with respect to real-time price reporting and regular swap reporting (under Part 43 and Part
45 of the CFTC’s regulations, respectively), until February 28, 2013, and (ii) historical swap reporting requirements (under
Part 46 of the CFTC’s regulations) until March 30, 2013.
On December 21, 2012, the CFTC’s
Division of Market Oversight issued two letters providing certain swap dealers with time-limited no-action relief from some swap
data reporting obligations. One letter provides relief from reporting requirements for branches of swap dealers located in emerging
markets who encounter technical difficulties in complying with the reporting rules. The letter also provides that swap dealers
may delay reporting compliance for certain complex and exotic swaps until April 30, 2013.
Under a second letter, all swap dealers
have until April 10, 2013 to report certain information about their counterparties, including: status as a major swap participant,
a financial entity, a U.S. person or a commercial end-user.
On December 18, 2012, the CFTC deferred
the compliance date for many of the Dodd-Frank Act’s external business conduct standards from December 31, 2012 to May 1,
2013, and for some requirements to July 1, 2013, providing swap dealers an additional four to six months from the original compliance
date.
Regulation
Futures exchanges in the United States
are subject to varying degrees of regulation under the CEA depending on whether such exchange is a designated contract market,
exempt board of trade or electronic trading facility. Clearing organizations are also subject to the CEA and the rules and regulations
adopted thereunder and administered by the CFTC. The CFTC is the governmental agency charged with responsibility for regulation
of futures exchanges and commodity interest trading conducted on those exchanges. The CFTC’s function is to implement
the CEA’s objectives of preventing price manipulation and excessive speculation and promoting orderly and efficient commodity
interest markets. In addition, the various exchanges and clearing organizations themselves exercise regulatory and supervisory
authority over their member firms.
The CFTC also regulates the activities
of “commodity trading advisors” and “commodity pool operators” and the CFTC has adopted regulations with
respect to certain of such persons’ activities. Pursuant to its authority, the CFTC requires a CPO, such as USCF, to keep
accurate, current and orderly records with respect to each pool it operates. The CFTC may suspend, modify or terminate the registration
of any registrant for failure to comply with CFTC rules or regulations. Suspension, restriction or termination of USCF’s
registration as a CPO would prevent it, until such time (if any) as such registration were to be reinstated, from managing, and
might result in the termination of, USDHO or the Related Public Funds.
The CEA also gives the states certain powers
to enforce its provisions and the regulations of the CFTC.
Under certain circumstances, the CEA grants
unitholders the right to institute a reparations proceeding before the CFTC against USCF (as a registered commodity pool operator),
as well as those of their respective employees who are required to be registered under the CEA. Unitholders may also be able to
maintain a private right of action for certain violations of the CEA.
Pursuant to authority in the CEA, the NFA
has been formed and registered with the CFTC as a registered futures association. The NFA is the only self regulatory association
for commodities professionals other than the exchanges. As such, the NFA promulgates rules governing the conduct of commodity professionals
and disciplines those professionals that do not comply with such standards. The CFTC has delegated to the NFA responsibility for
the registration of commodity pool operation. USCF is a member of the NFA. As a member of the NFA, USCF is subject to NFA standards
relating to fair trade practices, financial condition, and consumer protection. The CFTC is prohibited by statute from regulating
trading on foreign commodity exchanges and markets.
The CEA requires all FCMs, such as USDHO’s
clearing brokers, to meet and maintain specified fitness and financial requirements, to segregate customer funds from proprietary
funds and account separately for all customers’ funds and positions, and to maintain specified books and records open to
inspection by the staff of the CFTC. The CFTC has similar authority over introducing brokers, or persons who solicit or accept
orders for commodity interest trades but who do not accept margin deposits for the execution of trades. The CEA authorizes
the CFTC to regulate trading by FCMs and by their officers and directors, permits the CFTC to require action by exchanges in the
event of market emergencies, and establishes an administrative procedure under which customers may institute complaints for damages
arising from alleged violations of the CEA. The CEA also gives the states powers to enforce its provisions and the regulations
of the CFTC.
The regulations of the CFTC and the NFA
prohibit any representation by a person registered with the CFTC or by any member of the NFA, that registration with the CFTC,
or membership in the NFA, in any respect indicates that the CFTC or the NFA, as the case may be, has approved or endorsed that
person or that person’s trading program or objectives. The registrations and memberships of the parties described in
this summary must not be considered as constituting any such approval or endorsement. Likewise, no futures exchange has given
or will give any similar approval or endorsement.
On November 14, 2012, the CFTC proposed
new regulations that would 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 proposed 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. The final regulations have not yet been adopted.
USDHO’s investors are afforded prescribed
rights for reparations under the CEA against USCF (as a registered commodity pool operator), as well as its respective employees
who are required to be registered under the CEA. Investors may also be able to maintain a private right of action for violations
of the CEA. The CFTC has adopted rules implementing the reparation provisions of the CEA, which provide that any person may file
a complaint for a reparations award with the CFTC for violation of the CEA against a floor broker or a FCM, introducing broker,
commodity trading advisor, CPO, and their respective associated persons.
The regulation of commodity interest trading
in the United States and other countries is an evolving area of the law, as exemplified by the various discussions of the Dodd-Frank
Act. The various statements made in this summary are subject to modification by legislative action and changes in the rules and
regulations of the CFTC, the NFA, the futures exchanges, clearing organizations and other regulatory bodies.
Futures Contracts and Position Limits
The CFTC is 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 traded on non-U.S. exchanges to
be offered and sold in the United States.
In October 2011, the CFTC finalized rules
that establish position limits with respect to 28 physical delivery commodity futures and options contracts, as well as to forward
contracts that are economically equivalent to such contracts (the “Position Limit Rules”). The Position Limit Rules
were scheduled to become effective on October 12, 2012. However, on September 28, 2012, the United States District Court for the
District of Columbia vacated these regulations on the basis of ambiguities in the provisions of the Commodity Exchange Act (as
modified by the Dodd-Frank Act) upon which the regulations were based. In its September 28th decision, the court remanded the Position
Limit Rules to the CFTC with instructions to use its expertise and experience to resolve the ambiguities in the statute. On November
15, 2012, the CFTC indicated that it will move forward with an appeal of the District Court’s decision to vacate the Position
Limit Rules. At this time, it is not possible to predict how the CFTC’s appeal could affect USDHO, but it may be substantial
and adverse. Furthermore, until such time as the appeal is resolved or, if applicable revisions to the Position Limit Rules are
proposed and adopted, the regulatory architecture in effect prior to the enactment of the Position Limit Rules will govern transactions
in commodities and related derivatives. As a result, USDHO may be limited with respect to the size of its investments in any commodities
subject to these limits. Finally, subject to certain narrow exceptions, the vacated Position Limit Rules would have required the
aggregation, for purposes of the position limits, of all positions in the 28 Referenced Contracts held by a single entity and its
affiliates, regardless of whether such position existed on U.S. futures exchanges, non-U.S. futures exchanges, in cleared swaps
or in over-the-counter swaps. The CFTC is presently considering new aggregation rules, under a rulemaking proposal that is distinct
from the Position Limit Rules. At this time, it is unclear how any modified aggregation rules may affect USDHO, but it may be substantial
and adverse. By way of example, the aggregation rules in combination with any potential revised Position Limit Rules may negatively
impact the ability of USDHO to meet its investment objectives through limits that may inhibit USCF’s ability to sell additional
Creation Baskets of USDHO.
Based on its current understanding of the
final position limit regulations, USCF does not anticipate significant negative impact on the ability of USDHO to achieve its investment
objective.
Commodity Margin
Original or initial margin is the minimum
amount of funds that must be deposited by a commodity interest trader with the trader’s broker to initiate and maintain an
open position in futures contracts. Maintenance margin is the amount (generally less than the original margin) to which a
trader’s account may decline before he must deliver additional margin. A margin deposit is like a cash performance bond. It
helps assure the trader’s performance of the futures contracts that he or she purchases or sells. Futures contracts
are customarily bought and sold on initial margin that represents a very small percentage (ranging upward from less than 5%) of
the aggregate purchase or sales price of the contract. Because of such low margin requirements, price fluctuations occurring
in the futures markets may create profits and losses that, in relation to the amount invested, are greater than are customary in
other forms of investment or speculation. As discussed below, adverse price changes in the futures contract may result in
margin requirements that greatly exceed the initial margin. In addition, the amount of margin required in connection with
a particular futures contract is set from time to time by the exchange on which the contract is traded and may be modified from
time to time by the exchange during the term of the contract.
Brokerage firms, such as USDHO’s
clearing brokers, carrying accounts for traders in commodity interest contracts may not accept lower, and generally require higher,
amounts of margin as a matter of policy to further protect themselves. The clearing brokers require USDHO to make margin deposits
equal to exchange minimum levels for all commodity interest contracts. This requirement may be altered from time to time in
the clearing brokers’ discretion.
Regulators have not yet finalized the Dodd-Frank
rules regarding initial margin levels for over-the-counter derivatives. It is possible that such levels may be higher than those
for futures contracts. Also, initial margin requirements for non-cleared swaps will be subject to higher margin requirements than
cleared swaps. And, under pending rule proposals, USDHO may be required to post, but not be entitled to receive, initial and variation
margin in respect of non-cleared swaps. Until such time as the regulators finalize these margin rules, trading in the over-the-counter
markets where no clearing facility is provided generally will not require margin per se. Rather, it will involve the extension
of credit between counterparties that is secured by transfers of credit support and/or independent amounts. Credit support is transferred
between counterparties in respect of the open over-the-counter derivatives entered into between them, while independent amounts
are fixed amounts posted by one or both counterparties at the execution of a particular over-the-counter transaction.
When a trader purchases an option, there
is no margin requirement; however, the option premium must be paid in full. When a trader sells an option, on the other hand,
he or she is required to deposit margin in an amount determined by the margin requirements established for the underlying interest
and, in addition, an amount substantially equal to the current premium for the option. The margin requirements imposed on
the selling of options, although adjusted to reflect the probability that out-of-the-money options will not be exercised, can in
fact be higher than those imposed in dealing in the futures markets directly. Complicated margin requirements apply to spreads
and conversions, which are complex trading strategies in which a trader acquires a mixture of options positions and positions in
the underlying interest.
Margin requirements are computed each day
by a trader’s clearing broker. When the market value of a particular open commodity interest position changes to a point
where the margin on deposit does not satisfy maintenance margin requirements, a margin call is made by the broker. If the
margin call is not met within a reasonable time, the broker may close out the trader’s position. With respect to USDHO’s
trading, USDHO (and not its investors personally) is subject to margin calls.
Finally, many major U.S. exchanges have
passed certain cross margining arrangements involving procedures pursuant to which the futures and options positions held in an
account would, in the case of some accounts, be aggregated and margin requirements would be assessed on a portfolio basis, measuring
the total risk of the combined positions.
SEC Reports
USDHO makes available, free of charge,
on its website, its annual reports on Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K and amendments
to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable
after these forms are filed with, or furnished to, the SEC. These reports are also available from the SEC though its website
at: www.sec.gov.
CFTC Reports
USDHO also makes available its monthly
reports and its annual reports required to be prepared and filed with the NFA under the CFTC regulations.
Intellectual Property
USCF owns trademark registrations for UNITED
STATES HEATING OIL FUND (U.S. Reg. No. 3490750) for “fund investment services in the field of heating oil futures contracts,
cash-settled options on heating oil futures contracts, forward contracts for heating oil, over-the-counter transactions based on
the price of heating oil, and indices based on the foregoing,” in use since April 8, 2008, UHN UNITED STATES HEATING
OIL FUND, LP (and House Design) (U.S. Reg. No. 3638986) for “investment services in the field of heating oil futures
contracts and other heating oil related investments,” in use since April 8, 2008 and UHN UNITED STATES DIESEL-HEATING
OIL FUND, LP (and Flame Design), S.N. 85703821 in use since August 15, 2012. USDHO relies upon these trademarks through which
it markets its services and strives to build and maintain brand recognition in the market and among current and potential investors. So
long as USDHO continues to use these trademarks to identify its services, without challenge from any third party, and properly
maintains and renews the trademark registrations under applicable laws, rules and regulations, it will continue to have indefinite
protection for these trademarks under current laws, rules and regulations. USCF has been granted two patents Nos. 7,739,186
and 8,019,675, for systems and methods for an exchange traded fund (ETF) that tracks the price of one or more commodities.
The risk factors should be read in connection
with the other information included in this annual report on Form 10-K, including Management’s Discussion and Analysis of
Financial Condition and Results of Operations and USDHO’s financial statements and the related notes.
Risks Associated With Investing Directly
or Indirectly in Diesel-Heating Oil
Investing in Diesel-Heating Oil Interests
subjects USDHO to the risks of the diesel-heating oil industry and this could result in large fluctuations in the price of USDHO’s
units.
USDHO is subject to the risks and hazards
of the diesel-heating oil industry because it invests in Diesel-Heating Oil Interests. The risks and hazards that are inherent
in the diesel-heating oil industry may cause the price of diesel-heating oil to widely fluctuate. If the changes in percentage
terms of USDHO’s units accurately track the changes in percentage terms of the Benchmark Futures Contract or the spot price
of diesel-heating oil, then the price of its units may also fluctuate. The exploration for crude oil, the raw material used
in the production of diesel-heating oil, and production of diesel-heating oil are uncertain processes with many risks. The
cost of drilling, completing and operating wells for crude oil is often uncertain, and a number of factors can delay or prevent
drilling operations or production of diesel-heating oil, including:
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unexpected drilling conditions;
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pressure or irregularities in formations;
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equipment failures or repairs;
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fires or other accidents;
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adverse weather conditions;
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pipeline ruptures, spills or other supply disruptions; and
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shortages or delays in the availability of drilling rigs and the delivery of equipment.
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Diesel-Heating Oil transmission,
distribution, gathering, and processing activities involve numerous risks that may affect the price of diesel-heating oil.
There are a variety of hazards inherent
in diesel-heating oil transmission, distribution, gathering, and processing, such as leaks, explosions, pollution, release of toxic
substances, adverse weather conditions (such as hurricanes and flooding), pipeline failure, abnormal pressures, uncontrollable
flows of diesel-heating oil, scheduled and unscheduled maintenance, physical damage to the gathering or transportation system,
and other hazards which could affect the price of diesel-heating oil. To the extent these hazards limit the supply or delivery
of diesel-heating oil, diesel-heating oil prices will increase.
The price of diesel-heating oil fluctuates
on a seasonal basis and this would result in fluctuations in the price of USDHO’s units.
Diesel-heating oil prices fluctuate seasonally. For
example, in some parts of the United States and other markets, the diesel-heating oil demand for power peaks during the cold winter
months, with market prices peaking at that time. As a result, in the future, the overall price of diesel-heating oil may fluctuate
substantially on a seasonal basis, which may make consecutive period to period comparisons less relevant. Cold weather increases
demand and prices follow. Extremely cold and hazardous weather can make energy transportation more difficult, as oil trucks may
have to wait for roads to be plowed and oil barges may be delayed due to frozen rivers and harbors.
Changes in the political climate
could have negative consequences for diesel-heating oil prices.
Uprise in the Middle East, including civil
war in Syria and uprise in Egypt could put diesel-heating oil exports in jeopardy. As global markets continue to react to various
crises and uprises, such unrests in general could impact the production, supply and cost of diesel-heating oil.
Limitations on ability to develop
additional sources of diesel-heating oil could impact future prices
In the past, a supply disruption in one
area of the world was softened by the ability of major oil-producing nations to increase output to make up the difference. At
this time, some of that spare reserve capacity has been absorbed by increased demand.
Daily changes in USDHO’s per
unit NAV may not correlate with daily changes in the price of the Benchmark Futures Contract. If this were to occur, investors
may not be able to effectively use USDHO as a way to hedge against diesel-heating oil-related losses or as a way to indirectly
invest in diesel-heating oil.
USCF endeavors to invest USDHO’s
assets as fully as possible in Futures Contracts and Other Diesel-Heating Oil-Related Investments so that the daily changes in
percentage terms of the per unit NAV closely correlate with the daily changes in percentage terms in the price of the Benchmark
Futures Contract. However, daily changes in USDHO’s per unit NAV may not correlate with the daily changes in the price
of the Benchmark Futures Contract for several reasons as set forth below:
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USDHO: (i) may not be able to buy/sell the exact amount of Futures Contracts and Other Diesel-Heating Oil-Related Investments to have a perfect correlation with the per unit NAV; (ii) may not always be able to buy and sell Futures Contracts or Other Diesel-Heating Oil-Related Investments at the market price; and (iii) is required to pay fees, including brokerage fees and the management fee, which will have an effect on the correlation.
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Short-term supply and demand for diesel-heating oil may cause the changes in the market price of the Benchmark Futures Contract to vary from the changes in USDHO’s per unit NAV if USDHO has fully invested in Futures Contracts that do not reflect such supply and demand and it is unable to replace such contracts with Futures Contracts that do reflect such supply and demand.
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USDHO sells and buys only as many Futures Contracts and Other Diesel-Heating Oil-Related Investments that it can to get the daily changes in percentage terms of the per unit NAV as close as possible to the daily changes in percentage terms in the price of the Benchmark Futures Contract. The remainder of its assets are invested in Treasuries, cash and/or cash equivalents and are used to satisfy initial margin and additional margin requirements, if any, and to otherwise support its investments in Diesel-Heating Oil Interests. Investments in Treasuries, cash and/or cash equivalents, both directly and as margin, provide rates of return that vary from changes in the price of the Benchmark Futures Contract.
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Because USDHO incurs certain expenses in connection with its investment activities, and holds most of its assets in more liquid short-term securities for margin and other liquidity purposes and for redemptions that may be necessary on an ongoing basis, USCF is generally not able to fully invest USDHO’s assets in Futures Contracts or Other Diesel-Heating Oil-Related Investments and there cannot be perfect correlation between changes in USDHO’s per unit NAV and changes in the price of the Benchmark Futures Contract.
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As USDHO grows, there may be more or less correlation. For example, if USDHO only has enough money to buy three Futures Contracts and it needs to buy four contracts to track the price of diesel-heating oil, then the correlation will be lower, but if it buys 20,000 Futures Contracts and it needs to buy 20,001 contracts, then the correlation will be higher. At certain asset levels, USDHO may be limited in its ability to purchase the Benchmark Futures Contract or other Futures Contracts due to accountability levels imposed by the relevant exchanges. To the extent that USDHO invests in these other Futures Contracts or other Diesel-Heating Oil-Related Investments, the correlation with the Benchmark Futures Contract may be lower. If USDHO is required to invest in other Futures Contracts and Other Diesel-Heating Oil-Related Investments that are less correlated with the Benchmark Futures Contract, USDHO would likely invest in over-the-counter contracts to increase the level of correlation of USDHO’s assets. Over-the-counter contracts entail certain risks described below under “Over-the-Counter Contract Risk.”
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USDHO may not be able to buy the exact number of Futures Contracts and Other Diesel-Heating Oil-Related Investments to have a perfect correlation with the Benchmark Futures Contract if the purchase price of Futures Contracts required to be fully invested in such contracts is higher than the proceeds received for the sale of a Creation Basket on the day the basket was sold. In such case, USDHO could not invest the entire proceeds from the purchase of the Creation Basket in such futures contracts (for example, assume USDHO receives $5,000,000 for the sale of a Creation Basket and assume that the price of a Futures Contract for diesel-heating oil is $105,000 based on a price of $2.50 per gallon, then USDHO could only invest in 47 Futures Contracts with an aggregate value of $4,935,000). USDHO would be required to invest a percentage of the proceeds in cash, Treasuries or other liquid securities to be deposited as margin with the FCM through which the contracts were purchased. The remainder of the purchase price for the Creation Basket would remain invested in Treasuries, cash and/or cash equivalents or other liquid securities as determined by USCF from time to time based on factors such as potential calls for margin or anticipated redemptions. If the trading market for Futures Contracts is suspended or closed, USDHO may not be able to purchase these investments at the last reported price.
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If daily changes in USDHO’s per unit
NAV do not correlate with daily changes in the price of the Benchmark Futures Contract, then investing in USDHO may not be an effective
way to hedge against diesel-heating oil-related losses or indirectly invest in diesel-heating oil.
The Benchmark Futures Contract may
not correlate with the spot price of diesel-heating oil and this could cause changes in the price of the units to substantially
vary from the changes in the spot price of diesel-heating oil. If this were to occur, then investors may not be able to effectively
use USDHO as a way to hedge against diesel-heating oil-related losses or as a way to indirectly invest in diesel-heating oil. In
addition, the price relationship between the near month contract and the next month contract that compose the Benchmark Futures
Contract will vary and may impact both the total return over time of USDHO’s per unit NAV, as well as the degree to which
its total return tracks other diesel-heating oil price indices’ total returns.
When using the Benchmark Futures Contract
as a strategy to track the spot price of diesel-heating oil, at best the correlation between changes in prices of such Diesel-Heating
Oil Interests and the spot price of diesel-heating oil can be only approximate. The degree of imperfection of correlation
depends upon circumstances such as variations in the speculative diesel-heating oil market, supply of and demand for such Diesel-Heating
Oil Interests and technical influences in oil futures trading. If there is a weak correlation between the Diesel-Heating Oil
Interests and the spot price of diesel-heating oil, then even in situations where there is also tracking among the price of
units, the per unit NAV of such units and Diesel-Heating Oil Interests, the price of units may not accurately track the spot price
of diesel-heating oil and investors may not be able to effectively use USDHO as a way to hedge the risk of losses in their
diesel-heating oil-related transactions or as a way to indirectly invest in diesel-heating oil.
Backwardation and contango may increase
USDHO’s tracking error and/or negatively impact total return.
The design of USDHO’s Benchmark Futures
Contract is such that every month it begins by using the near month contract to expire until the near month contract is within
two weeks of expiration, when it transitions to the next month contract to expire. In the event of a diesel-heating oil futures
market where near month contracts trade at a higher price than next month to expire contracts, a situation described as “backwardation”
in the futures market, then absent the impact of the overall movement in diesel-heating oil prices the value of the benchmark contract
would tend to rise as it approaches expiration. As a result, the total return of the Benchmark Futures Contract would tend
to track higher. Conversely, in the event of a diesel-heating oil futures market where near month contracts trade at a lower
price than next month contracts, a situation described as “contango” in the futures market, then absent the impact
of the overall movement in diesel-heating oil prices the value of the benchmark contract would tend to decline as it approaches
expiration. As a result the total return of the Benchmark Futures Contract would tend to track lower. When compared to
total return of other price indices, such as the spot price of diesel-heating oil, the impact of backwardation and contango may
lead the total return of USDHO’s per unit NAV to vary significantly. In the event of a prolonged period of contango,
and absent the impact of rising or falling diesel-heating oil prices, this could have a significant negative impact on USDHO’s
per unit NAV and total return. See
“Item 7. Management’s Discussion and Analysis of Financial Condition and Results
of Operations”
in this annual report on Form 10-K for a discussion of the potential effects of contango and backwardation.
USDHO may experience a loss if it
is required to sell Treasuries at a price lower than the price at which they were acquired.
The value of Treasuries generally moves
inversely with movements in interest rates. If USDHO is required to sell Treasuries at a price lower than the price at which
they were acquired, USDHO will experience a loss. This loss may adversely impact the price of the units and may decrease the
correlation among the price of units, the NAV of units, the price of the Benchmark Futures Contract and Other Diesel-Heating Oil-Related
Investments, and the spot price of diesel-heating oil.
Certain of USDHO’s investments
could be illiquid which could cause large losses to investors at any time or from time to time.
USDHO may not always be able to liquidate
its positions in its investments at the desired price. It is difficult to execute a trade at a specific price when there is
a relatively small volume of buy and sell orders in a market. A market disruption, such as a foreign government taking political
actions that disrupt the market in its currency, its diesel-heating oil production or exports, or in another major export, can
also make it difficult to liquidate a position. Alternatively, limits imposed by futures exchanges or other regulatory organizations,
such as accountability levels, position limits and daily price fluctuation limits, may contribute to a lack of liquidity with respect
to some commodity interests.
Unexpected market illiquidity may cause
major losses to investors at any time or from time to time. In addition, USDHO has not and does not intend at this time to
establish a credit facility, which would provide an additional source of liquidity and instead relies only on the Treasuries, cash
and/or cash equivalents that it holds. The anticipated large value of the positions in Futures Contracts that USCF will acquire
or enter into for USDHO increases the risk of illiquidity. The Other Diesel-Heating Oil-Related Investments that USDHO invests
in, such as negotiated over-the-counter contracts, may have a greater likelihood of being illiquid since they are contracts between
two parties that take into account not only market risk, but also the relative credit, tax, and settlement risks under such contracts. Such
contracts also have limited transferability that results from such risks and from the contract’s express limitations.
Because both Futures Contracts and Other
Diesel-Heating Oil-Related Investments may be illiquid, USDHO’s Diesel-Heating Oil Interests may be more difficult to liquidate
at favorable prices in periods of illiquid markets and losses may be incurred during the period in which positions are being liquidated.
If the nature of hedgers and speculators
in futures markets has shifted such that diesel-heating oil purchasers are the predominant hedgers in the market, USDHO might have
to reinvest at higher futures prices or choose Other Diesel-Heating Oil-Related Investments.
The changing nature of the hedgers and
speculators in the diesel-heating oil market influences whether futures prices are above or below the expected future spot price. In
order to induce speculators to take the corresponding long side of the same futures contract, diesel-heating oil producers must
generally be willing to sell futures contracts at prices that are below expected future spot prices. Conversely, if the predominant
hedgers in the futures market are the purchasers of the diesel-heating oil who purchase futures contracts to hedge against a rise
in prices, then speculators will only take the short side of the futures contract if the futures price is greater than the expected
future spot price of diesel-heating oil. This can have significant implications for USDHO when it is time to reinvest the
proceeds from a maturing Futures Contract into a new Futures Contract.
While USDHO does not intend to take
physical delivery of diesel-heating oil under its Futures Contracts, physical delivery under such contracts impacts the value of
the contracts.
While it is not the current intention of
USDHO to take physical delivery of diesel-heating oil under any of its Futures Contracts, futures contracts are not required to
be cash-settled and it is possible to take delivery under some of these contracts. Storage costs associated with purchasing diesel-heating
oil could result in costs and other liabilities that could impact the value of Futures Contracts or Other Diesel-Heating Oil-Related
Investments. Storage costs include the time value of money invested in diesel-heating oil as a physical commodity plus the
actual costs of storing the diesel-heating oil less any benefits from ownership of diesel-heating oil that are not obtained by
the holder of a futures contract. In general, Futures Contracts have a one-month delay for contract delivery and the back
month (the back month is any future delivery month other than the spot month) includes storage costs. To the extent that these
storage costs change for diesel-heating oil while USDHO holds Futures Contracts or Other Diesel-Heating Oil-Related Investments,
the value of the Futures Contracts or Other Diesel-Heating Oil-Related Investments, and therefore USDHO’s NAV, may change
as well.
Regulation of the commodity interests
and energy markets is extensive and constantly changing; future regulatory developments are impossible to predict but may significantly
and adversely affect USDHO.
The futures markets are subject to comprehensive
statutes, regulations, and margin requirements. In addition, the CFTC and the exchanges are authorized to take extraordinary
actions in the event of a market emergency, including, for example, the retroactive implementation of speculative position limits
or higher margin requirements, the establishment of daily price limits and the suspension of trading.
The regulation of commodity interest transactions
in the United States is a rapidly changing area of law and is subject to ongoing modification by governmental and judicial action. Considerable
regulatory attention has been focused on non-traditional investment pools that are publicly distributed in the United States. In
addition, various national governments outside of the United States have expressed concern regarding the disruptive effects of
speculative trading in the energy markets and the need to regulate the derivatives markets in general. The effect of any future
regulatory change on USDHO is impossible to predict, but it could be substantial and adverse.
For a more detailed discussion of the regulations
to be imposed by the CFTC and the SEC and the potential impacts thereof on USDHO, please see
“Item 1. Business –
Regulation”
in this annual report on Form 10-K.
Investing in USDHO for purposes of
hedging may be subject to several risks including the possibility of losing the benefit of favorable market movement.
Participants in the diesel-heating oil
or in other industries may use USDHO as a vehicle to hedge the risk of losses in their diesel-heating oil-related transactions. There
are several risks in connection with using USDHO as a hedging device. While hedging can provide protection against an adverse
movement in market prices, it can also preclude a hedger’s opportunity to benefit from a favorable market movement. In
a hedging transaction, the hedger may be concerned that the hedged item will increase in price, but must recognize the risk that
the price may instead decline and if this happens he will have lost his opportunity to profit from the change in price because
the hedging transaction will result in a loss rather than a gain. Thus, the hedger foregoes the opportunity to profit from
favorable price movements.
An investment in USDHO may provide
little or no diversification benefits. Thus, in a declining market, USDHO may have no gains to offset losses from other investments,
and an investor may suffer losses on an investment in USDHO while incurring losses with respect to other asset classes.
Historically, Futures Contracts and Other
Diesel-Heating Oil-Related Investments have generally been non-correlated to the performance of other asset classes such as stocks
and bonds. Non-correlation means that there is a low statistically valid relationship between the performance of futures and
other commodity interest transactions, on the one hand, and stocks or bonds, on the other hand. However, there can be no assurance
that such non-correlation will continue during future periods. If, contrary to historic patterns, USDHO’s performance
were to move in the same general direction as the financial markets, investors will obtain little or no diversification benefits
from an investment in the units. In such a case, USDHO may have no gains to offset losses from other investments, and investors
may suffer losses on their investment in USDHO at the same time they incur losses with respect to other investments.
Variables such as drought, floods, weather,
embargoes, tariffs and other political events may have a larger impact on diesel-heating oil prices and diesel-heating oil-linked
instruments, including Futures Contracts and Other Diesel-Heating Oil-Related Investments, than on traditional securities. These
additional variables may create additional investment risks that subject USDHO’s investments to greater volatility than investments
in traditional securities.
Non-correlation should not be confused
with negative correlation, where the performance of two asset classes would be opposite of each other. There is no historic
evidence that the spot price of diesel-heating oil and prices of other financial assets, such as stocks and bonds, are negatively
correlated. In the absence of negative correlation, USDHO cannot be expected to be automatically profitable during unfavorable
periods for the stock market, or vice versa.
USDHO’s Operating Risks
USDHO is not a registered investment
company so unitholders do not have the protections of the 1940 Act.
USDHO is not an investment company subject
to the 1940 Act. Accordingly, investors do not have the protections afforded by that statute which, for example, requires
investment companies to have a majority of disinterested directors and regulates the relationship between the investment company
and its investment manager.
USCF is leanly staffed and relies
heavily on key personnel to manage trading activities.
In managing and directing the day-to-day
activities and affairs of USDHO, USCF relies heavily on Messrs. Howard Mah and John Hyland. If Messrs. Mah or Hyland
were to leave or be unable to carry out their present responsibilities, it may have an adverse effect on the management of USDHO. Furthermore,
Messrs. Mah and Hyland are currently involved in the management of the Related Public Funds. USCF has also filed registration
statements to register units of USSF, UNGD, USGO and UAC, each a series of the United States Commodity Funds Trust I, and HARD,
a series of the United States Currency Funds Trust. Mr. Mah is also employed by Ameristock Corporation, a registered investment
adviser that until January 11, 2013, managed a public mutual fund. On January 11, 2013, Ameristock Mutual Fund, Inc. was reorganized
with and into the Drexel Hamilton Centre American Equity Fund, a series of the Drexel Hamilton Mutual Funds. Drexel Hamilton Mutual
Funds and its advisor, Drexel Hamilton Investment Partners, are not affiliated with USCF. After the consummation of the reorganization
and liquidation, the Ameristock Corporation maintained its non-advisory assets. It is estimated that Mr. Mah will spend approximately
98% of his time on USDHO and Related Public Fund matters. Mr. Hyland will spend approximately 100% of his time on USDHO and
Related Public Fund matters. To the extent that USCF establishes additional funds, even greater demands will be placed on
Messrs. Mah and Hyland, as well as the other officers of USCF and its Board.
Accountability levels, position limits,
and daily price fluctuation limits set by the exchanges have the potential to cause a tracking error, which could cause the price
of units to substantially vary from the price of the Benchmark Futures Contract and prevent investors from being able to effectively
use USDHO as a way to hedge against diesel-heating oil-related losses or as a way to indirectly invest in diesel-heating oil.
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 USDHO is not) may hold, own or control. 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.
In late 2011, the CFTC adopted rules that
impose new position limits on Referenced Contracts involving 28 energy, metals and agricultural commodities (the “Position
Limit Rules”). The Position Limit Rules were scheduled to become effective on October 12, 2012. However, on September 28,
2012, the United States District Court for the District of Columbia vacated these regulations on the basis of ambiguities in the
provisions of the CEA (as modified by the Dodd-Frank Act) upon which the regulations were based. In its September 28th decision,
the court remanded the Position Limit Rules to the CFTC with instructions to use its expertise and experience to resolve the ambiguities
in the statute. On November 15, 2012, the CFTC indicated that it will move forward with an appeal of the District Court’s
decision to vacate the Position Limit Rules. At this time, it is not possible to predict how the CFTC’s appeal could affect
USDHO, but it may be substantial and adverse. Furthermore, until such time as the appeal is resolved or, if applicable revisions
to the Position Limit Rules are proposed and adopted, the regulatory architecture in effect prior to the enactment of the Position
Limit Rules will govern transactions in commodities and related derivatives. Under that system, the CFTC enforces federal limits
on speculation in agricultural products (e.g., corn, wheat and soy), while futures exchanges enforce accountability levels for
agricultural and certain energy products (e.g., oil and natural gas). As a result, USDHO may be limited with respect to the size
of its investments in any commodities subject to these limits. Finally, subject to certain narrow exceptions, the vacated Position
Limit Rules would have required the aggregation, for purposes of the position limits, of all positions in the 28 Referenced Contracts
held by a single entity and its affiliates, regardless of whether such position existed on U.S. futures exchanges, non-U.S. futures
exchanges, in cleared swaps or in over-the-counter swaps. The CFTC is presently considering new aggregation rules, under a rulemaking
proposal that is distinct from the Position Limit Rules. At this time, it is unclear how any modified aggregation rules may affect
USDHO, but it may be substantial and adverse. By way of example, the aggregation rules in combination with any potential revised
Position Limit Rules may negatively impact the ability of USDHO to meet its investment objectives through limits that may inhibit
USCF’s ability to sell additional Creation Baskets of USDHO.
All of these limits may potentially cause
a tracking error between the price of the units and the price of the Benchmark Futures Contract. This may in turn prevent
investors from being able to effectively use USDHO as a way to hedge against diesel-heating oil-related losses or as a way to indirectly
invest in diesel-heating oil.
USDHO has not limited the size of its offering
and is committed to utilizing substantially all of its proceeds to purchase Futures Contracts and Other Diesel-Heating Oil-Related
Investments. If USDHO encounters accountability levels, position limits, or price fluctuation limits for Futures Contracts
on the NYMEX or ICE Futures, it may then, if permitted under applicable regulatory requirements, purchase Futures Contracts on
other exchanges that trade listed diesel-heating oil futures. In addition, if USDHO exceeds accountability levels on either
the NYMEX or ICE Futures and is required by such exchanges to reduce its holdings, such reduction could potentially cause a tracking
error between the price of the units and the price of the Benchmark Futures Contract.
To the extent that USCF uses spreads
and straddles as part of its trading strategy, there is the risk that the per unit NAV may not closely track the changes in the
Benchmark Futures Contract.
If USCF were to utilize a spread or straddle
position and the spread performed differently than expected, the results could impact USDHO’s tracking error. This could
affect USDHO’s investment objective of having its per unit NAV closely track the changes in the Benchmark Futures Contract. Additionally,
a loss on a spread position would negatively impact USDHO’s absolute return. For a more detailed discussion regarding spreads
and straddles, please see
“Item 1. Business – Spreads and Straddles”
in this annual report on Form 10-K.
USDHO and USCF may have conflicts
of interest, which may permit them to favor their own interests to the detriment of unitholders.
USDHO and USCF may have inherent conflicts
to the extent USCF attempts to maintain USDHO’s asset size in order to preserve its fee income and this may not always be
consistent with USDHO’s objective of having the value of its units’ per unit NAV track the changes in the Benchmark
Futures Contract. USCF’s officers, directors and employees do not devote their time exclusively to USDHO. These
persons are directors, officers or employees of other entities that may compete with USDHO for their services. They could
have a conflict between their responsibilities to USDHO and to those other entities.
In addition, USCF’s principals, officers,
directors or employees may trade futures and related contracts for their own account. A conflict of interest may exist if
their trades are in the same markets and at the same time as USDHO trades using the clearing broker to be used by USDHO. A
potential conflict also may occur if USCF’s principals, officers, directors or employees trade their accounts more aggressively
or take positions in their accounts which are opposite, or ahead of, the positions taken by USDHO.
USCF has sole current authority to manage
the investments and operations of USDHO, and this may allow it to act in a way that furthers its own interests which may create
a conflict with the best interests of investors. Limited partners have limited voting control, which will limit the ability to
influence matters such as amendment of the LP Agreement, change in USDHO’s basic investment policy, dissolution of this fund,
or the sale or distribution of USDHO’s assets.
USCF serves as the general partner to each
of USDHO, USOF, USNG, US12OF, UGA, USSO, US12NG and USBO and the sponsor for USCI, CPER, USAG and USMI, and will serve as the sponsor
for USSF, UNGD, USGO, UAC and HARD if such funds offer their securities to the public or begin operations. USCF may have a
conflict to the extent that its trading decisions for USDHO may be influenced by the effect they would have on the other funds
it manages. These trading decisions may be influenced since USCF also serves as the general partner or sponsor for all of
the funds and is required to meet all of the funds’ investment objectives as well as USDHO’s. If USCF believes
that a trading decision it made on behalf of USDHO might (i) impede its other funds from reaching their investment objectives,
or (ii) improve the likelihood of meeting its other funds’ objectives, then USCF may choose to change its trading decision
for USDHO, which could either impede or improve the opportunity for USDHO to meet its investment objective. In addition, USCF
is required to indemnify the officers and directors of its other funds if the need for indemnification arises. This potential
indemnification will cause USCF’s assets to decrease. If USCF’s other sources of income are not sufficient to
compensate for the indemnification, then USCF may terminate and investors could lose their investment.
Unitholders may only vote on the
removal of USCF and limited partners have only limited voting rights. Unitholders and limited partners will not participate
in the management of USDHO and do not control USCF so they will not have influence over basic matters that affect USDHO. In addition,
USDHO could terminate at any time and cause the liquidation and potential loss of an investor’s investment and could upset
the overall maturity and timing of an investor’s investment portfolio.
Limited partners will have limited voting
rights with respect to USDHO’s affairs. Unitholders must apply to become limited partners, and unitholders that have not
applied to become limited partners have no voting rights, other than to remove USCF as the general partner of USDHO. Even
then, unitholders may remove USCF only if 66 2/3% of the unitholders elect to do so. Unitholders and limited partners will
not be permitted to participate in the management or control of USDHO or the conduct of its business. Unitholders and limited
partners must therefore rely upon the duties and judgment of USCF to manage USDHO’s affairs.
USDHO may terminate at any time, regardless
of whether USDHO has incurred losses, subject to the terms of the LP Agreement. In particular, unforeseen circumstances, including
the death, adjudication of incompetence, bankruptcy, dissolution, or removal of USCF as the general partner of USDHO could cause
USDHO to terminate unless a majority interest of the limited partners within 90 days of the event elects to continue the partnership
and appoints a successor general partner, or the affirmative vote of a majority in interest of the limited partners subject to
certain conditions. However, no level of losses will require USCF to terminate USDHO. USDHO’s termination would
cause the liquidation and potential loss of an investor’s investment. Termination could also negatively affect the overall
maturity and timing of an investor’s investment portfolio.
USCF may manage a large amount of
assets and this could affect USDHO’s ability to trade profitably.
Increases in assets under management may
affect trading decisions. In general, USCF does not intend to limit the amount of assets of USDHO that it may manage. The more
assets USCF manages, the more difficult it may be for it to trade profitably because of the difficulty of trading larger positions
without adversely affecting prices and performance and of managing risk associated with larger positions.
Limited partners may have limited
liability in certain circumstances, including potentially having liability for the return of wrongful distributions.
Under Delaware law, a limited partner might
be held liable for USDHO’s obligations as if it were a general partner if the limited partner participates in the control
of the partnership’s business and the persons who transact business with the partnership think the limited partner is the
general partner.
A limited partner will not be liable for
assessments in addition to its initial capital investment in any of USDHO’s capital securities representing units. However,
a limited partner may be required to repay to USDHO any amounts wrongfully returned or distributed to it under some circumstances. Under
Delaware law, USDHO may not make a distribution to limited partners if the distribution causes USDHO’s liabilities (other
than liabilities to partners on account of their partnership interests and nonrecourse liabilities) to exceed the fair value of
USDHO’s assets. Delaware law provides that a limited partner who receives such a distribution and knew at the time of the
distribution that the distribution violated the law will be liable to the limited partnership for the amount of the distribution
for three years from the date of the distribution.
With adequate notice, a limited partner
may be required to withdraw from the partnership for any reason.
If USCF gives at least fifteen (15) days’
written notice to a limited partner, then USCF may for any reason, in its sole discretion, require any such limited partner to
withdraw entirely from the partnership or to withdraw a portion of its partner capital account. USCF may require withdrawal
even in situations where the limited partner has complied completely with the provisions of the LP Agreement.
USDHO does not expect to make cash
distributions.
USDHO has not previously made any cash
distributions and intends to re-invest any realized gains in additional Diesel-Heating Oil Interests rather than distributing cash
to limited partners. Therefore, unlike mutual funds, commodity pools or other investment pools that actively manage their
investments in an attempt to realize income and gains from their investing activities and distribute such income and gains to their
investors, USDHO generally does not expect to distribute cash to limited partners. An investor should not invest in USDHO
if it will need cash distributions from USDHO to pay taxes on its share of income and gains of USDHO, if any, or for any other
reason. Although USDHO does not intend to make cash distributions, the income earned from its investments held directly or
posted as margin may reach levels that merit distribution,
e.g
., at levels where such income is not necessary to support
its underlying investments in Diesel-Heating Oil Interests and investors adversely react to being taxed on such income without
receiving distributions that could be used to pay such tax. If this income becomes significant then cash distributions may
be made.
There is a risk that USDHO will not
earn trading gains sufficient to compensate for the fees and expenses that it must pay and as such USDHO may not earn any profit.
USDHO pays brokerage charges of approximately
0.07% of average total net assets based on FCM fees of $3.50 per buy or sell, management fees of 0.60% of NAV on its average total
net assets, and over-the-counter spreads and extraordinary expenses (
e.g.,
subsequent offering expenses, other expenses
not in the ordinary course of business, including the indemnification of any person against liabilities and obligations to the
extent permitted by law and required under the LP Agreement and under agreements entered into by USCF on USDHO’s behalf and
the bringing and defending of actions at law or in equity and otherwise engaging in the conduct of litigation and the incurring
of legal expenses and the settlement of claims and litigation) that cannot be quantified.
These fees and expenses must be paid in
all cases regardless of whether USDHO’s activities are profitable. Accordingly, USDHO must earn trading gains sufficient
to compensate for these fees and expenses before it can earn any profit.
If offerings of the units do not
raise sufficient funds to pay USDHO’s future expenses and no other source of funding of expenses is found, USDHO may be forced
to terminate and investors may lose all or part of their investment.
Prior to the offering of units that commenced
on April 9, 2008, all of USDHO’s expenses were funded by USCF and its affiliates. These payments by USCF and its
affiliates were designed to allow USDHO the ability to commence the public offering of its units. USDHO now directly
pays certain of these fees and expenses. USCF will continue to pay other fees and expenses, as set forth in the LP Agreement. If
USCF and USDHO are unable to raise sufficient funds to cover their expenses or locate any other source of funding, USDHO may be
forced to terminate and investors may lose all or part of their investment.
USDHO may incur higher fees and expenses
upon renewing existing or entering into new contractual relationships.
The clearing arrangements between the clearing
brokers and USDHO generally are terminable by the clearing brokers once the clearing broker has given USDHO notice. Upon termination,
USCF may be required to renegotiate or make other arrangements for obtaining similar services if USDHO intends to continue trading
in Futures Contracts or Other Diesel-Heating Oil-Related Investments at its present level of capacity. The services of any
clearing broker may not be available, or even if available, these services may not be available on the terms as favorable as those
of the expired or terminated clearing arrangements.
USDHO may miss certain trading opportunities
because it will not receive the benefit of the expertise of independent trading advisors.
USCF does not employ trading advisors for
USDHO; however, it reserves the right to employ them in the future. The only advisor to USDHO is USCF. A lack of independent
trading advisors may be disadvantageous to USDHO because it will not receive the benefit of a trading advisor’s expertise.
An unanticipated number of redemption
requests during a short period of time could have an adverse effect on the NAV of USDHO.
If a substantial number of requests for
redemption of Redemption Baskets are received by USDHO during a relatively short period of time, USDHO may not be able to satisfy
the requests from USDHO’s assets not committed to trading. As a consequence, it could be necessary to liquidate positions
in USDHO’s trading positions before the time that the trading strategies would otherwise dictate liquidation.
The financial markets are currently
in a slow period of recovery and the financial markets are still relatively fragile.
Since 2008, the financial markets have
experienced very difficult conditions and volatility as well as significant adverse trends. The conditions in these markets
have resulted in a decrease in availability of corporate credit and liquidity and have led indirectly to the insolvency, closure
or acquisition of a number of major financial institutions and have contributed to further consolidation within the financial services
industry. In addition, the Administration and Congress have periodically been reaching impasses in passing a fiscal budget
which could create long-term concerns regarding the credit of the United States and interest earned, as well as the United States
Government’s ability to pay its obligations to holders of Treasuries. If low interest rates on Treasuries continues or if
USDHO is not able to redeem its investments in Treasuries prior to maturity and the U.S. Government cannot pay its obligations,
USDHO would be negatively impacted. In addition, USDHO might also be negatively impacted by its use of money market mutual funds
to the extent those funds might themselves be using Treasuries. Although the financial markets saw signs of recovery beginning
in late 2010 and 2011, economic growth in 2012 was slow and the financial markets are still fragile. A poor financial recovery
could adversely affect the financial condition and results of operations of USDHO’s service providers and Authorized Purchasers,
which would impact the ability of USCF to achieve USDHO’s investment objective.
The failure or bankruptcy of a clearing
broker or USDHO’s Custodian could result in a substantial loss of USDHO’s assets and could impair USDHO in its ability
to execute trades.
Under CFTC regulations, a clearing broker
maintains customers’ assets in a bulk segregated account. If a clearing broker fails to do so, or even if the customers’
funds are segregated by the clearing broker but the clearing broker is unable to satisfy a substantial deficit in a customer account,
the clearing broker’s other customers may be subject to risk of a substantial loss of their funds in the event of that clearing
broker’s bankruptcy. In that event, the clearing broker’s customers, such as USDHO, are entitled to recover, even
in respect of property specifically traceable to them, only a proportional share of all property available for distribution to
all of that clearing broker’s customers. The bankruptcy of a clearing broker could result in the complete loss of USDHO’s
assets posted with the clearing broker; though the majority of USDHO’s assets are held in Treasuries, cash and/or cash equivalents
with the Custodian and would not be impacted by the bankruptcy of a clearing broker. USDHO also may be subject to the risk
of the failure of, or delay in performance by, any exchanges and markets and their clearing organizations, if any, on which commodity
interest contracts are traded.
In addition, to the extent USDHO’s
clearing broker is required to post USDHO’s assets as margin to a clearinghouse, the margin will be maintained in an omnibus
account containing the margin of all the clearing broker’s customers. If USDHO’s clearing broker defaults to a
clearinghouse because of a default by one of the clearing broker’s other customers or otherwise, then the clearinghouse can
look to all of the margin in the omnibus account, including margin posted by USDHO and any other non-defaulting customers of the
clearing broker to satisfy the obligations of the clearing broker.
From time to time, the clearing brokers
may be subject to legal or regulatory proceedings in the ordinary course of their business. A clearing broker’s involvement
in costly or time-consuming legal proceedings may divert financial resources or personnel away from the clearing broker’s
trading operations, which could impair the clearing broker’s ability to successfully execute and clear USDHO’s trades.
In addition, the majority of USDHO’s
assets are held in Treasuries, cash and/or cash equivalents with the Custodian. The insolvency of the Custodian could result
in a complete loss of USDHO’s assets held by that Custodian, which, at any given time, would likely comprise a substantial
portion of USDHO’s total assets.
Third parties may infringe upon or
otherwise violate intellectual property rights or assert that USCF has infringed or otherwise violated their intellectual property
rights, which may result in significant costs and diverted attention.
Third parties may utilize USDHO’s
intellectual property or technology, including the use of its business methods, trademarks and trading program software, without
permission. USCF has a patent for USDHO’s business method and has registered its trademarks. USDHO does not currently
have any proprietary software. However, if it obtains proprietary software in the future, then any unauthorized use of USDHO’s
proprietary software and other technology could also adversely affect its competitive advantage. USDHO may not have adequate
resources to implement procedures for monitoring unauthorized uses of its patents, trademarks, proprietary software and other technology. Also,
third parties may independently develop business methods, trademarks or proprietary software and other technology similar to that
of USCF or claim that USCF has violated their intellectual property rights, including their copyrights, trademark rights, trade
names, trade secrets and patent rights. As a result, USCF may have to litigate in the future to protect its trade secrets,
determine the validity and scope of other parties’ proprietary rights, defend itself against claims that it has infringed
or otherwise violated other parties’ rights, or defend itself against claims that its rights are invalid. Any litigation
of this type, even if USCF is successful and regardless of the merits, may result in significant costs, divert its resources from
USDHO, or require it to change its proprietary software and other technology or enter into royalty or licensing agreements.
The success of USDHO depends on the
ability of USCF to accurately implement trading systems, and any failure to do so could subject USDHO to losses on such transactions.
USCF uses mathematical formulas built into
a generally available spreadsheet program to decide whether it should buy or sell Diesel-Heating Oil Interests each day. Specifically,
USCF uses the spreadsheet to make mathematical calculations and to monitor positions in Diesel-Heating Oil Interests and Treasuries
and correlations to the Benchmark Futures Contract. USCF must accurately process the spreadsheets’ outputs and execute
the transactions called for by the formulas. In addition, USDHO relies on USCF to properly operate and maintain its computer
and communications systems.
Extraordinary transaction volume, hardware
or software failure, power or telecommunications failure, a natural disaster or other catastrophe could cause the computer systems
to operate at an unacceptably slow speed or even fail. Any significant degradation or failure of the systems that USCF uses
to gather and analyze information, enter orders, process data, monitor risk levels and otherwise engage in trading activities may
result in substantial losses on transactions, liability to other parties, lost profit opportunities, damages to USCF’s and
USDHO’s reputations, increased operational expenses and diversion of technical resources. Any failure, inaccuracy or delay
in implementing any of the formulas or systems, including implementing upgrades and compatibility with the computer systems of
third parties, and executing USDHO’s transactions could impair its ability to achieve USDHO’s investment objective.
It could also result in decisions to undertake transactions based on inaccurate or incomplete information. This could cause substantial
losses on transactions.
The occurrence of a terrorist attack,
or the outbreak, continuation or expansion of war or other hostilities could disrupt USDHO’s trading activity and materially
affect USDHO’s profitability.
The operations of USDHO, the exchanges,
brokers and counterparties with which USDHO does business, and the markets in which USDHO does business could be severely disrupted
in the event of a major terrorist attack or the outbreak, continuation or expansion of war or other hostilities. Global anti-terrorism
initiatives, political unrest in the Middle East and Southeast Asia, as well as political hostility towards the United States continue
to fuel this concern.
Risk of Leverage and Volatility
If USCF permits USDHO to become leveraged,
investors could lose all or substantially all of their investment if USDHO’s trading positions suddenly turn unprofitable.
Commodity pools’ trading positions
in futures contracts or other commodity interests are typically required to be secured by the deposit of margin funds that represent
only a small percentage of a futures contract’s (or other commodity interests) entire market value. This feature permits
commodity pools to “leverage” their assets by purchasing or selling futures contracts (or other commodity interests)
with an aggregate value in excess of the commodity pool’s assets. While this leverage can increase the pool’s
profits, relatively small adverse movements in the price of the pool’s futures contracts can cause significant losses to
the pool. While USCF has not and does not currently intend to leverage USDHO’s assets, it is not prohibited from doing
so under the LP Agreement or otherwise.
The price of diesel-heating oil is
volatile which could cause large fluctuations in the price of units.
Movements in the price of diesel-heating
oil may be the result of factors outside of USCF’s control and may not be anticipated by USCF. Among the factors that
can cause volatility in the price of diesel-heating oil are:
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worldwide or regional demand for energy, which is affected by economic conditions;
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the domestic and foreign supply and inventories of oil and gas;
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weather conditions, including abnormally mild winter or summer weather, and abnormally harsh winter or summer weather;
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availability and adequacy of pipeline and other transportation facilities;
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availability of storage facilities;
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domestic and foreign governmental regulations and taxes;
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political conditions in gas or oil producing regions;
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technological advances relating to energy usage or relating to technology for exploration, production, refining and petrochemical manufacturing;
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the ability of members of OPEC to agree upon and maintain Oil prices and production levels;
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the price and availability of alternative fuels;
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the impact of energy conservation efforts; and
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the impact of environmental and other governmental regulations.
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Over-the-Counter Contract Risk
Currently, over-the-counter transactions
are subject to changing regulation.
A portion of USDHO’s assets may be
used to trade over-the-counter contracts, such as forward contracts or swap or spot contracts. Currently, over-the-counter
contracts are typically contracts traded on a principal-to-principal basis through dealer markets that are dominated by major money
center and investment banks and other institutions and that prior to the passage of the Dodd-Frank Act had been essentially unregulated
by the CFTC. The markets for over-the-counter contracts have relied upon the integrity of market participants in lieu of the
additional regulation imposed by the CFTC on participants in the futures markets. To date, the forward markets have been
largely unregulated, forward contracts have been executed bi-laterally and, in general, forward contracts have not been cleared
or guaranteed by a third party. On November 16, 2012, the Secretary of the Treasury issued a final determination that exempts both
foreign exchange swaps and foreign exchange forwards from the definition of “swap” and, by extension, additional regulatory
requirements (such as clearing and margin). The final determination does not extend to other foreign exchange derivatives, such
as foreign exchange options, currency swaps, and non-deliverable forwards. While the Dodd-Frank Act and certain regulations adopted
thereunder are intended to provide additional protections to participants in the over-the-counter market, the current regulation
of the over-the-counter contracts could expose USDHO in certain circumstances to significant losses in the event of trading abuses
or financial failure by participants. On November 28, 2012, the CFTC issued its final clearing determination requiring that certain
credit default swaps and interest rate swaps be cleared by registered DCOs. This is the CFTC’s first clearing determination
under the Dodd-Frank Act and became effective on February 13, 2013. Determination on other types of swaps are expected in the future,
and, when finalized, could require USDHO to cenrally clear certain over-the-counter instruments presented entered into and settled
on a bi-lateral basis. See
“Item 1. Business – Regulation”
for a discussion of how the over-the-counter
market will be subject to much more extensive CFTC oversight and regulation after the implementation of the Dodd-Frank Act.
USDHO will be subject to credit
risk with respect to counterparties to uncleared over-the-counter contracts entered into by USDHO or held by special purpose
or structured vehicles.
Historically,
over-the-counter contracts were not sent to a clearing house for central clearing. Provisions of the Dodd-Frank Act require the
mandatory use of clearing house mechanisms for sufficiently standardized (as determined by the CFTC) swaps executed in the over-the-counter
markets. On November 28, 2012, the CFTC issued its final clearing determination requiring that certain credit default swaps and
interest rate swaps be cleared by registered derivatives clearing organizations (DCOs). This is the CFTC’s first clearing
determination under the Dodd-Frank Act and became effective February 11, 2013. On March 11, 2013, “swap dealers,”
“major swap participants,” and certain active funds will be required to clear certain credit default swaps and interest
rate swaps. Determination on other types of swaps are expected in the future and, when finalized, could require USDHO to centrally
clear certain over-the-counter instruments presently settled on a bi-lateral basis.
For over-the-counter contracts
that are not cleared, USDHO faces the risk of non-performance by the counterparties to those contracts. Unlike in
futures contracts, the counterparty to these contracts is generally a single bank or other financial institution, rather than
a clearing organization backed by a group of financial institutions. As a result, there will be greater
counterparty credit risk in these transactions. A counterparty may not be able to meet its obligations to USDHO, in
which case USDHO could suffer significant losses on these contracts.
If a counterparty becomes bankrupt or otherwise
fails to perform its obligations due to financial difficulties, USDHO may experience significant delays in obtaining any recovery
in a bankruptcy or other reorganization proceeding. USDHO may obtain only limited recovery or may obtain no recovery in such circumstances.
USDHO may be subject to liquidity
risk with respect to its over-the-counter contracts.
Over-the-counter contracts are less marketable
because they are not traded on an exchange, do not have uniform terms and conditions, and are entered into based upon the creditworthiness
of the parties and the availability of credit support, such as collateral, and in general, they are not transferable without the
consent of the counterparty. These conditions make such contracts less liquid than standardized futures contracts traded on
a commodities exchange and could adversely impact USDHO’s ability to realize the full value of such contracts. In addition,
even if collateral is used to reduce counterparty credit risk, sudden changes in the value of over-the-counter 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 over-the-counter 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 over-the-counter 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 over-the-counter contracts,
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 over-the-counter derivatives transaction.
The Dodd-Frank Act requires the CFTC and
SEC to establish “both initial and variation margin requirements on all swaps that are not cleared by a registered clearing
organization” (i.e., uncleared swaps). In addition, the Dodd-Frank Act provides parties who post initial margin to a swap
dealer or major swap participant with a statutory right to insist that such margin be held in a segregated account with an independent
custodian. At this time, the CFTC has proposed a rule addressing this statutory right of certain market participants but has not
yet implemented any final rules. On November 16, 2012, the Secretary of the Treasury issued a final determination that exempts
both foreign exchange swaps and foreign exchange forwards from the definition of “swap” and, by extension, additional
regulatory requirements (such as clearing and margin).
Risk of Trading in International Markets
Trading in international markets
could expose USDHO to credit and regulatory risk.
USDHO invests primarily in Futures Contracts,
a significant portion of which are traded on United States exchanges, including the NYMEX. However, a portion of USDHO’s
trades may take place on markets and exchanges outside the United States. Some non-U.S. markets present risks because they
are not subject to the same degree of regulation as their U.S. counterparts. The CFTC, NFA and the domestic exchanges have
little, if any, regulatory authority over the activities of any foreign boards of trade or exchanges, including the execution,
delivery and clearing of transactions, and have little, if any, power to compel enforcement of the rules of a foreign board of
trade or exchange or of any applicable non-U.S. laws. Similarly, the rights of market participants, such as USDHO, in the
event of the insolvency or bankruptcy of a non-U.S. market or broker are also likely to be more limited than in the case of U.S.
markets or brokers. As a result, in these markets, USDHO has less legal and regulatory protection than it does when it trades
domestically.
In some of these non-U.S. markets, the
performance on a contract is the responsibility of the counterparty and is not backed by an exchange or clearing corporation and
therefore exposes USDHO to credit risk. Trading in non-U.S. markets also leaves USDHO susceptible to swings in the value of the
local currency against the U.S. dollar. Additionally, trading on non-U.S. exchanges is subject to the risks presented by exchange
controls, expropriation, increased tax burdens and exposure to local economic declines and political instability. An adverse development
with respect to any of these variables could reduce the profit or increase the loss earned on trades in the affected international
markets.
International trading activities subject USDHO to foreign
exchange risk.
The price of any non-U.S. commodity interest
and, therefore, the potential profit and loss on such investment, may be affected by any variance in the foreign exchange rate
between the time the order is placed and the time it is liquidated, offset or exercised. As a result, changes in the value of the
local currency relative to the U.S. dollar may cause losses to USDHO even if the contract traded is profitable.
International trading activities
subject USDHO to foreign exchange risk.
The price of any non-U.S. commodity interest
and, therefore, the potential profit and loss on such investment, may be affected by any variance in the foreign exchange rate
between the time the order is placed and the time it is liquidated, offset or exercised. As a result, changes in the value of the
local currency relative to the U.S. dollar may cause losses to USDHO even if the contract traded is profitable.
USDHO’s international trading
could expose it to losses resulting from non-U.S. exchanges that are less developed or less reliable than United States exchanges.
Some non-U.S. exchanges may be in a more
developmental stage so that prior price histories may not be indicative of current price dynamics. In addition, USDHO may
not have the same access to certain positions on foreign trading exchanges as do local traders, and the historical market data
on which USCF bases its strategies may not be as reliable or accessible as it is for U.S. exchanges.
Tax Risk
An investor’s tax liability
may exceed the amount of distributions, if any, on its units.
Cash or property will be distributed at
the sole discretion of USCF. USCF has not and does not currently intend to make cash or other distributions with respect to
units. Investors will be required to pay U.S. federal income tax and, in some cases, state, local or foreign income tax, on
their allocable share of USDHO’s taxable income, without regard to whether they receive distributions or the amount of any
distributions. Therefore, the tax liability of an investor with respect to its units may exceed the amount of cash or value
of property (if any) distributed.
An investor’s allocable share
of taxable income or loss may differ from its economic income or loss on its units.
Due to the application of the assumptions
and conventions applied by USDHO in making allocations for tax purposes and other factors, an investor’s allocable share
of USDHO’s income, gain, deduction or loss may be different than its economic profit or loss from its units for a taxable
year. This difference could be temporary or permanent and, if permanent, could result in it being taxed on amounts in excess
of its economic income.
Items of income, gain, deduction,
loss and credit with respect to units could be reallocated if the IRS does not accept the assumptions and conventions applied by
USDHO in allocating those items, with potential adverse consequences for an investor.
The U.S. tax rules pertaining to partnerships
are complex and their application to large, publicly traded partnerships such as USDHO is in many respects uncertain. USDHO
applies certain assumptions and conventions in an attempt to comply with the intent of the applicable rules and to report taxable
income, gains, deductions, losses and credits in a manner that properly reflects unitholders’ economic gains and losses. These
assumptions and conventions may not fully comply with all aspects of the Internal Revenue Code (the “Code”) and applicable
Treasury Regulations, however, and it is possible that the U.S. Internal Revenue Service, will successfully challenge USDHO’s
allocation methods and require USDHO to reallocate items of income, gain, deduction, loss or credit in a manner that adversely
affects investors. If this occurs, investors may be required to file an amended tax return and to pay additional taxes plus
deficiency interest.
USDHO could be treated as a corporation
for federal income tax purposes, which may substantially reduce the value of the units.
USDHO has received an opinion of counsel
that, under current U.S. federal income tax laws, USDHO will be treated as a partnership that is not taxable as a corporation for
U.S. federal income tax purposes, provided that: (i) at least 90 percent of USDHO’s annual gross income consists of
“qualifying income” as defined in the Code, (ii) USDHO is organized and operated in accordance with its governing
agreements and applicable law and (iii) USDHO does not elect to be taxed as a corporation for federal income tax purposes. Although
USCF anticipates that USDHO has satisfied and will continue to satisfy the “qualifying income” requirement for all
of its taxable years, that result cannot be assured. USDHO has not requested and will not request any ruling from the IRS
with respect to its classification as a partnership not taxable as a corporation for federal income tax purposes. If the IRS
were to successfully assert that USDHO is taxable as a corporation for federal income tax purposes in any taxable year, rather
than passing through its income, gains, losses and deductions proportionately to unitholders, USDHO would be subject to tax on
its net income for the year at corporate tax rates. In addition, although USCF does not currently intend to make distributions
with respect to units, any distributions would be taxable to unitholders as dividend income. Taxation of USDHO as a corporation
could materially reduce the after-tax return on an investment in units and could substantially reduce the value of the units.
USDHO is organized and operated as
a limited partnership in accordance with the provisions of the LP Agreement and applicable state law, and therefore, USDHO has
a more complex tax treatment than traditional mutual funds.
USDHO is organized and operated as a limited
partnership in accordance with the provisions of the LP Agreement and applicable state law. No U.S. federal income tax is paid
by USDHO on its income. Instead, USDHO will furnish unitholders each year with tax information on IRS Schedule K-1 (Form 1065)
and each U.S. unitholder is required to report on its U.S. federal income tax return its allocable share of the income, gain, loss
and deduction of USDHO. This must be reported without regard to the amount (if any) of cash or property the unitholder receives
as a distribution from USDHO during the taxable year. A unitholder, therefore, may be allocated income or gain by USDHO but receive
no cash distribution with which to pay the tax liability resulting from the allocation, or may receive a distribution that is insufficient
to pay such liability.
In addition to federal income taxes, unitholders
may be subject to other taxes, such as state and local income taxes, unincorporated business taxes, business franchise taxes and
estate, inheritance or intangible taxes that may be imposed by the various jurisdictions in which USDHO does business or owns property
or where the unitholders reside. Although an analysis of those various taxes is not presented here, each prospective unitholder
should consider their potential impact on its investment in USDHO. It is each unitholder’s responsibility to file the appropriate
U.S. federal, state, local and foreign tax returns.