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COLUMN - Hedge funds hunt for exits in oil: John Kemp
June 13, 2011 / 3:43 PM / 7 years ago

COLUMN - Hedge funds hunt for exits in oil: John Kemp

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

Men work at an oil pump near the coast on the outskirts of Havana June 10, 2011. REUTERS/Enrique De La Osa

By John Kemp

LONDON (Reuters) - “Follow the money,” FBI Deputy Director Mark Felt (“Deep Throat”) told Washington Post reporters Bob Woodward and Carl Bernstein during their investigation into the Watergate break ins.

It remains good advice for participants in commodity markets. Most of the time the river of money coursing through the market remains hidden, visible only in part to the major dealers, leaving everyone else flailing around trying to understand what is really going on.

The one place where the flow breaks at least temporarily from its hidden culvert is the weekly commitments of traders report collated and published by the U.S. Commodity Futures Trading Commission (CFTC).

And the commitment of traders report shows hedge funds and other money managers becoming less bullish about crude oil in the week to June 7. Many used firmer prices as an opportunity to liquidate more of their holdings of WTI-linked futures and options, continuing a trend that has been in place for the last six weeks.

Comment from the main commodity banks has been almost uniformly and strongly bullish -- with warnings about the potential for a sharp market tightening in the second half of the year and explosive price increases. The International Energy Agency (IEA) last month also warned producers of the “urgent need for additional supplies” to prevent a further tightening of the supply-demand balance.

Prices have responded to all this insistent bullishness by firming from the lows hit in early and mid-May. But hedge funds and other money managers have used the rally to scale back their exposure and trim their record long position following the upsurge in volatility and amid signs of a faltering economy.

In the seven days ending June 7, hedge funds and other money managers cut their net long position in WTI-linked futures and options another 29 million barrels (10 percent). It was the fourth time in six weeks the macro and commodity hedge funds had cut their long positions. The net long position has been cut almost 111 million barrels (30.3 percent) since peaking on April 26 (Charts 1-2).

Crucially, more funds are emerging on the short side of the market. Money managers established more than 14 million barrels worth of new short positions in the week, while long positions were cut by 14 million barrels.

Shorting the market remains a minority interest. There are still only 65 million barrels worth of short positions among money managers compared with 319 million barrels of long positions ( a ratio of 4.92:1). But the imbalance is much less than on May 3, when the hedge funds were running long by a ratio of 10.3:1 (Chart 3).

In contrast, other categories of speculative traders, including those that the CFTC classifies as “other reporting” and “non-reporting” boosted their net long positions by 15 million barrels (14 percent) and 9.6 million barrels (63 percent) respectively.

So firming prices enabled macro and commodity focused hedge funds to continue exiting positions at better prices and with less disruption -- with price risk being transferred to smaller traders and speculators.

It is not clear whether hedge funds have become less bullish about the outlook for prices in recent weeks, as fears about demand destruction and Saudi output increases trump concern about shrinking spare capacity -- or if they have simply become more alive to the risk of being caught in a crowded trade following the large price drop on May 5.

Perhaps the hedge fund community noted the seeming loss of price momentum that has so far capped front-month Brent futures below $120 per barrel, or picked up early indications of a sizeable Saudi output increase (the kingdom has promised to raise production up to 10 million barrels per day according to some credible reports).

Maybe the big funds simply sensed a shift in the balance of risk and reward, with downside risks growing as the economy slows.

The report is for positions ahead of the OPEC meeting on Wednesday, when ministers failed to agree an output rise, and Saudi Arabia indicated it would pump more anyway.

But the tide of smart money that began pouring into oil futures and options around the time the Fed launched its second round of quantitative easing (QE2) in September-November 2010 now seems to be in retreat, at least temporarily.

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