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
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
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
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
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
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
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.