COLUMN - Is the hedge fund barrel half full or half empty?

Tue Jun 21, 2011 8:34pm IST

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-- John Kemp is a Reuters market analyst. The views expressed are his own --

By John Kemp

LONDON (Reuters) - Hedge funds and other money managers continue to liquidate their net long position in WTI-linked futures and options, but the pace of drawdowns has slowed in recent weeks, and the hedge fund community still holds a bigger net long position than at any time before 2011.

In the week to June 14, hedge funds and other money managers cut their net position in WTI-linked futures and options to just 249 million barrels, from 254 million the previous week, and down from a peak of 365 million on April 26, according to data published by the U.S. Commodity Futures Trading Commission (CFTC).

It was the fifth time in seven weeks that money managers have cut their exposure to WTI. Total exposure has been reduced almost 32 percent in a series of persistent liquidations (Chart 1). But the rate has slowed in recent weeks, and the hedge fund community's 249 million barrel position is still larger than anything it had recorded prior to December 2010 (Chart 2).

Hedge funds remain overwhelmingly bullish or at worst neutral towards oil. There are few bears. The ratio of long to short positions has fallen from 10.3:1 to 4.3:1, but it is still higher than anything recorded before February 2011 (Chart 3). There are only 75 million barrels of hedge fund short positions in WTI, which is unusually low (Chart 4).

Hedge funds have continued to run long positions in WTI-linked futures and options, even though WTI has underperformed Brent, and the WTI forward curve remains locked in contango, so it has cost them to remain long.

Continued bullishness about the short and medium term outlook seems to have persuaded many to look past the poor performance compared with Brent and the short-term roll cost of running positions.

In addition to the WTI positions, money managers were running net long of 81 million barrels in Brent futures and options. Long positions outnumbered shorts by a ratio of 3.7:1 (112 million barrels to 30 million), according to newly released data from Intercontinental Exchange.

A BIGGER STRUCTURAL LONG?

Hedge funds and other money managers have been continuously long WTI-linked futures and options since June 2006, which is as far back as the CFTC's disaggregated data goes.

The hedge fund and technical trading community seems "structurally long" of crude futures and options. There appears to be a natural bullish bias, or what amounts to the same thing, relatively little interest in being short.

The overall long bias has been modified by a pronounced cycle of position building and liquidation -- as waves of bullish and less-bearish sentiment sweep across the sector. But each wave of position building and liquidation has left the sector with a bigger structural long position than the previous one.

At the low point of the 2006 cycle, hedge funds held a net long position of less than 30 million barrels of WTI.

But at the low point of the 2008 cycle, with the global economy heading rapidly into the deepest recession since the 1930s, the net long position never fell below 40 million and was only briefly below 50 million.

In the 2010 cycle, hedge funds net long position never fell below 70 million barrels, and was only briefly below 100 million barrels.

The growth in the structural net long position corresponds with a massive expansion in the number of specialist commodity-focused hedge funds as well as an increased interest among macro funds wanting to express their views on the global economy by taking a position in commodity derivatives.

As the number and size of commodity focused hedge funds grows, the structural long position appears to be getting bigger. In theory commodity focused hedge funds could be equally long or short. In practice most seem to prefer the unlimited upside of long positions to the unlimited losses of short ones.

HAVE WE REACHED "EQUILIBRIUM"?

With a steady increase in hedge fund long positions, the question is whether the money managers' structural long has increased further since 2010, and if so, whether it has more than doubled to over 200 million barrels of WTI (on top of 80 million barrels of additional positions in Brent)?

The slowdown in liquidations and the apparent stabilisation of oil prices at $90-100 (WTI basis) and $110-120 (Brent) suggests the current cycle of liquidations "might" be drawing to close. If true, that would suggest the expanded hedge fund community is now structurally long over 300 million barrels (WTI + Brent) amounting to around 30 percent of OECD commercial crude stocks.

If the structural position is indeed 300 million barrels (and that's a big if, which would be invalidated should the CFTC and ICE reports show significantly more long liquidation in the coming weeks) the question is whether the market has yet built up enough extra physical inventory to offset increased demand for long positions from the hedge funds?

The reverse side of the big increase in hedge fund long positions has been a sharp rise in physical oil inventories hedged by short positions in the derivatives markets.

The CFTC data show swap dealers carrying a record short position in WTI-linked futures and options in the first six months of 2011 -- presumably hedged against some of the large holdings of crude in commercial storage in the United States and elsewhere across the OECD. Producers and consumers are also running larger than normal short positions in paper barrels, matching big holdings of crude and products inventories.

The market has clearly adjusted to the demand for extra hedge fund long positions by building stocks -- but it is not clear whether the adjustment has been completed or if a further period of stock building will be required to satisfy the increased hedge fund demand.

If the adjustment is largely complete, prices should stabilise around current levels, at least until the market receives another shock. Prices might even ease if hedge fund liquidation continues. But if the adjustment is still ongoing, the upward (bullish) bias in prices will remain until stocks have risen sufficiently to saturate it.

(Editing by Anthony Barker)

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