March 7, 2013 / 5:38 PM / 4 years ago

COLUMN-A closer look at Brent: Kemp

(John Kemp is a Reuters market analyst. The views expressed are
his own)
    By John Kemp
    LONDON, March 7 (Reuters) - One valid criticism of some
columns over the last year is that they have illustrated the
impact of hedge fund positions on oil prices by focusing on WTI
rather than Brent, even though Brent is clearly now the main
benchmark for prices outside the central United States.
    The reason is simple: there is a longer and richer history
of data on U.S. light sweet crude futures, WTI, and it is
available in a more accessible format from the U.S. Commodity
Futures Trading Commission's (CFTC) commitments of traders
    The CFTC publishes data only on futures and options
contracts that relate to commodities registered or deliverable
in the United States, which does not include the main Brent
contract offered by ICE Futures Europe.
    Since 2011, ICE has been publishing similar data on Brent
positions using the same classification system, though in a
format which is considerably less easy to use and analyse.
Nonetheless, it is possible to reconstruct the same time series
of positions from the weekly reports published on ICE's website.
    The attached charts show how hedgers, swap dealers, money
managers and other traders have varied their positions since
January 2011, replicating the same sort of analysis I have
published elsewhere on the WTI market. They show total positions
across all Brent-linked futures trading on ICE and NYMEX.
    Chart 1:
    Chart 2:
    Chart 3:
    Chart 4:
    Positioning in Brent and WTI has been broadly similar over
the past two years, and the impact on prices has been the same,
with two important exceptions.
    First, the Brent market continues to show vibrant activity
by crude producers and stock holders using short futures and
options positions to hedge exposure to price changes in the
physical market, while short-hedging in the WTI market has
    Between January-February 2011 and January-February 2013, the
average volume of short hedging positions in WTI has fallen by
half from 977 million barrels to 490 million, according to the
CFTC. By contrast, short hedging positions in Brent have risen
from 560 million to 813 million barrels, according to an
analysis of data from ICE and the CFTC.
    As landlocked WTI has disconnected from conditions in the
global market, crude producers and inventory owners outside the
United States have discovered it no longer provides a
well-matched hedge for their price exposure, and have switched
to using seaborne Brent.
    Second, despite WTI's increasingly idiosyncratic behaviour,
it remains favoured by hedge funds and other money managers.
    Fund managers' long positions in WTI hit a recent peak of
313 million barrels on Feb. 12. The corresponding peak in Brent
positions was just 240-242 million barrels on Feb. 12-19.
    Fund managers in WTI appear more prone to herding and
following momentum-driven trading strategies than their
counterparts in Brent. Fund positions in WTI have been
overwhelmingly on the long side of the market. Funds have held a
much more diverse range of positions in Brent.
    The ratio of hedge fund long to short positions in WTI has
spiked to more than 10:1 twice in the last 24 months, but has
rarely exceeded 6:1 or even 5:1 in Brent.
    Despite Brent's international exposure, WTI seems to have
attracted more interest from fund managers taking a view on the
macroeconomic outlook, financial market sentiment, and crude
market fundamentals.
    One theory is that most commodity hedge funds and similar
investors remain based in the United States so the choice of
derivatives displays location bias. But it remains impossible to
test because the CFTC does not disclose the identity of money
managers or their residency.
    With these two important caveats, which is remarkable about
the positioning data for Brent and WTI is their similarity.
Given the very different physical markets for these two crudes,
different price levels, and wildly fluctuating arbitrage, hedge
fund and other money managers' positions in the two markets are
notable for their similarities rather than differences.
    In a recent column, I suggested most of the short-term
movements in Brent (and WTI) prices since mid-2010 could be
traced to changes in money managers' positions rather than
    The suggestion drew an impassioned response from Professor
Craig Pirrong at the University of Houston's Bauer College of
Business ("Riding his Anti-Hedge Fund, Anti-Speculation Hobby
Horse" March 5).
    Pirrong believes this "demonises" the role of the hedge
funds. But it is meant to be a description rather than a
prescription (here).
    Overall, oil market fundamentals have been remarkably
balanced for two years. Rising crude production in the United
States, and continued conservation, have been matched by growing
demand from Asia and the Middle East, and a series of supply
    Unsurprisingly, Brent prices have remained range bound,
capped above at $115-120 by the threat of an economic slowdown
and demand destruction, and from below at $100-105 by Saudi
production policy.
    Within this range, most short-term price movements have
coincided with the accumulation and liquidation of hedge fund
positions, especially in WTI but to a lesser extent Brent, which
display a strong momentum-like behaviour.
    The position data suggests, however, that position
accumulation is unable to push prices beyond $120 and that such
cycles are reversed within 2-3 months. Moreover, the price
impact appears to be getting weaker, and the duration of the
cycles is getting shorter.
    The point is not to demonise the behaviour of hedge funds
and other investors, who provide valuable liquidity, and without
whom the futures markets could not function. Nor criticise them
for "herding" behaviour, which is evident in the markets for
most financial instruments, including equities and fixed income.
    The results have been described by behavioural investors and
theorists like George Soros ("The Alchemy of Finance" 1987),
Didier Sornette ("Why Stock Markets Crash" 2003) and Robert
Shiller ("Irrational Exuberance" 2009).
    The point is that it is a mistake to try to ascribe every
$5-10 move in the price of Brent and WTI to "fundamental"
factors, when much of it is just the impact of shuffling
positions in markets with imperfect liquidity.
    The broader picture is one where supply and demand have
remained broadly in balance in the short term. 
    The balance is unlikely to last. In particular, spot crude
prices are substantially above the marginal cost of production,
and are providing both an incentive and the cashflow for a huge
expansion in output over the next half-decade. But those changes
are prospective rather than actual at present.
    Pirrong and I agree in one area. "Brent may be broken, but
hedge funds haven't broken it. It is a classic problem in
derivatives markets: a burgeoning derivatives market balancing
on top of a declining deliverable supply," Pirrong writes, which
is a good diagnosis of the problem.
    Neither Brent nor WTI is a good proxy for the broader global
supply-demand balance. Shrinking liquidity in the one case
(Brent) and takeaway problems in the other (WTI) mean both work
fairly poorly at the moment as benchmarks.
    Nonetheless, they are the best we have, for now. Both are
subject to a variety of idiosyncratic influences. And the
accumulation and liquidation of hedge fund positions appears to
play a small but important role in short-term price movements
over time spans ranging up to a month or two.
    Humans are hard-wired to find fundamental patterns; however
many of the short-term moves are just noise. Journalists and
analysts should resist the temptation to find complicated
fundamental explanations for every small price move where there
may be none.

 (Editing by Anthony Barker)

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