By John Kemp
LONDON, June 11 The overdone selloff in commodity prices, especially crude oil, has created the potential for a strong rally once fundamentals reassert themselves and hedge funds re-enter the market, according to researchers at Goldman Sachs.
"We believe that the selloff in commodity prices is likely overdone and the price risks are shifting more to the upside," Goldman wrote in a note published on Monday ("Commodity Watch: Stepping back into the markets" June 11, 2012).
"Even against other assets, the selloff in commodities was exceptionally extreme, as the liquidation of length in the broad oil market, which started from relatively high levels, was the second-largest monthly decline on record," the analysts observed.
Near-record amounts of hot money in the market created conditions for a sharp correction mirroring May 2011. But now all that stale length has been flushed out, the market is again primed to rally hard if sentiment improves and investors focus once again on Goldman's hoped-for tightening of supply-demand balances in the second half of the year.
"We believe that the financial participation in many markets is now below what is consistent with both the underlying market fundamentals and the broader macroeconomic environment," Goldman wrote. The implication is that prices will rise once hedge funds re-establish long positions.
It is this belief that oil prices have oversold, especially for U.S. crude, that makes Goldman bullish. Goldman's research team was the most accurate forecaster in 2011.
It has encouraged the bank to stick with its painful recommendation that investors hold a long position in the September 2012 U.S. crude contract -- first made in February when the contract was trading at $107.55 and recently showing mark to market losses of almost $25 per barrel (Charts 1 and 2).
THE HEDGE FUND NETWORK
Goldman's note highlights the strong coincidence between the rise and fall of oil prices in both 2011 and 2012, and the accumulation and liquidation of positions in NYMEX light sweet oil future and options by the class of market participants the U.S. Commodity Futures Trading Commission (CFTC) calls "money managers," a category that includes many hedge funds.
The bank is careful to sidestep the debate about whether speculation drives prices, or simply reacts to or anticipates fundamentals. But it is reasonably clear that by reacting to fundamentals (or perceptions of fundamentals), building and then liquidating positions equivalent to 100-150 million barrels of crude oil, the hedge fund community has exerted a powerful short-term influence on pricing.
The CFTC's weekly commitments of traders reports shed some light on the size and behavior of the secretive community of specialised commodity hedge funds and macro funds with an appetite for taking periodic commodity risk.
Most hedge funds still take on exposure to oil prices through NYMEX's main light sweet crude futures and options contracts.
The weekly reports show the number of hedge funds with long exposure to U.S. crude futures and options has never really dropped below 60 during the last three years. But at times when fundamentals and sentiment turn bullish, the number of money managers with long positions can almost double to 110-120 (Chart 3).
The money managers category includes only larger head funds, with notional exposure to oil of at least $28-35 million (based on a reporting threshold of 350 contracts or 350,000 barrels of crude equivalent, and prices of $80-100 per barrel). Nevertheless it captures the most significant players in the market, with the greatest potential to shift prices.
In the week ending May 29, the number of hedge funds and other money managers with reportable long positions had fallen to just 66, according to CFTC data, towards the lower end of the range that has prevailed since the spring 2009.
The number of hedge funds with reportable long positions had fallen from 114 on February 28, which unfortunately for the bank was when it issued its long trading recommendation, at what turned out to be the peak of the market, and the peak of hedge fund involvement.
But Goldman notes, correctly, that if some of the 50 hedge funds that have quit their large long positions over the last three months were to re-establish them, it would put sharp upward pressure on pricing and force a powerful short-covering rally.
READY TO HIT THE PHONES
The question is whether a critical mass of hedge funds can be persuaded that the oil market's underlying fundamentals are still strong, and that with the liquidation cycle now complete, the time is ripe to get long again.
Hedge fund trading strategies tend to be characterised by (1) an apparently strong investment rationale grounded in fundamentals, at least at first; (2) powerful network effects as trades become self-fulfilling and draw in more funds; and (3) abrupt and violent liquidations once the trade has become crowded, valuations are over-stretched, and some funds attempt to exit.
This investment cycle appears to explain the sharp rally in oil prices during the spring of 2010, 2011 and 2012, and subsequent fall back each time.
Bullish research from the leading investment banks plays a key role in propagating such network effects and similar trading strategies. Research teams and the prime brokerage desks at the banks are some of the key nodes within the hedge fund network.
But to get a rally going, there needs to be a plausible investment case. For the time being, that appears to be absent. The market is struggling against a wall of extra Saudi oil supplies, signs of slowing growth across the euro zone and Asia, a disappointing recovery in the United States, and continued worries about sovereign contagion.
Goldman's comments therefore appear to be a conditional observation: If the negative sentiment currently weighing on all risk assets lifts, and oil-market specific fundamentals improve, then the hedge fund community is positioned to allocate significantly more money to crude oil futures, which would ignite another upward price cycle.
It is a bold call which the bank may find hard to sustain if prices continue sliding.