The Fuse

Hedge Funds’ Bullishness on Oil Isn’t Supported by Fundamentals

by Matt Piotrowski | March 07, 2016

In the past month, oil has seen a tentative production freeze involving almost three-quarters of the world’s producers, shale oil output falling, talk of a possible OPEC cut later this year, improved macroeconomic data and fewer fears of a recession, and China soaking up barrels for its Strategic Petroleum Reserve. With all these factors taking place, it makes sense for hedge funds and other investors to place large bets on higher oil prices.

Or maybe not.

The oil markets have rebounded by more than 30 percent since February 11, with Brent contracts for May now back above $40, and many hedge funds have seized on the current rally to cut short positions and pile on the long side, betting on higher prices. As of March 1, net length in ICE Brent futures and options reached record levels, hitting 342,460 contracts, up by almost 179,000 (or 179 million barrels of oil) since the end of last year.

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In NYMEX WTI, speculators aren’t as bullish, but they are holding net length of 135,440 contracts, after cutting short positions by a massive 25,640 contracts, or 15 percent, last week, according to the Commodity Futures Trading Commission (CFTC).

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This data shows that financial players, as a group, believe the markets have bottomed out and the worst (from a producer perspective) has passed.

Whether the current rally has staying power is up in the air, but overall fundamentals suggest otherwise, despite recent ambiguous headlines that have been interpreted as supportive.

Whether the current rally has staying power is up in the air, but overall fundamentals suggest otherwise, despite recent ambiguous headlines that have been interpreted as supportive. While these headlines include the potential production freeze and shale output grinding slightly lower, the rebound has been largely technical in nature, with hedge fund positions exaggerating the price move upward.

From 2004-2014, hedge funds and other speculators were blamed by many regulators, producers and analysts for causing volatility and lifting prices beyond levels that were justified by physical fundamentals. Since prices are now in the $30-$40 range, they aren’t the subject of public ire, but they did help accelerate the market collapse from $115 in mid-2014 to the $20 neighborhood early this year.

“In some ways, speculators are not much different than in the past when prices were higher,” David Tabarelli of Nomisma Energie in Bologna, Italy told The Fuse. “They played a large role in exacerbating the downward move. But now why are they so bullish? They use a lot of chart analysis that is calling for a recovery. They might be right, but prices will remain unstable.”

Tabarelli, however, sees the current weakness in fundamentals persisting throughout 2016, forecasting Brent to average $35 per barrel.

Last month at IHS CERAWeek, Saudi Oil Minister Ali al-Naimi highlighted the impact of speculators in the market. Naimi said that in the long run, supply and demand sets the price, but in the short term, speculators push prices around and heighten volatility. The problem, he quipped, is that “the short term is here to stay.”

Fundamentals still weak

Bullish speculators might be wrong-footed in the coming months. As prices have rallied, little has changed regarding the fundamental outlook. In fact, the market looks sloppier.

“There hasn’t been a distinct fundamental shift,” Matt Smith of ClipperData told The Fuse. “There has been a shift in sentiment and it keeps on feeding off itself.”

Bullish speculators might be wrong-footed in the coming months. As prices have rallied, little has changed regarding the fundamental outlook. In fact, the market looks sloppier.

Smith notes that last year in March and August, prices rebounded swiftly and quickly based on technical recoveries, but both times the upward momentum didn’t have any staying power because fundamentals remained weak—at the time, both shale and OPEC producers were continuing to boost output, and inventories continued to build. “The market is looking for a reason to justify its actions, and is focusing on OPEC and Russia freezing production to give credence for a bout of short-covering,” said Smith, who says the current rally is the result of prices becoming too overstretched to the downside, with speculators now taking profits.

The most supportive headlines have come from major producers, such as Russia and Saudi Arabia, saying they would freeze production at current levels. Others have expressed willingness to go along. But there are a several reasons with seeing this news as supportive, at least in the short run. First, this action is a freeze, not a cut: No barrels would be taken off the market. Second, producers are capping production at already very high levels—OPEC watchers have compared the production freeze to reaching a ceasefire when both parties are out of ammo. Third, major producers such as Iran and Iraq, along with U.S. shale, have not agreed to freeze output, and they are the three biggest wild cards on the supply side for this year.

Market bulls believe that the freeze, which may bring possible collaboration for an OPEC/non-OPEC cut later this year, will do the trick to tighten fundamentals during the second half of the year. Against this backdrop, OPEC producers and the likes of Russia have successfully talked up the market for the time being, with speculator activity adding to the volatility.

In fact, the combination of speculative movements and OPEC/non-OPEC freeze talk (along with conjecture of a cut) has pushed implied volatility in the oil markets to levels not seen since 2008-9, when prices spiked to $147 and retreated to the $30 range (see below).

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As a counterpoint to the freeze, a number of bearish supply developments have occurred. Iran’s first cargo to Europe since sanctions were lifted last year has landed, while Saudi Arabia sent close to 1.3 mbd of crude to China last month, a whopping 75 percent increase versus January. U.S. stocks last week hit 518 million barrels, another record, putting them up an enormous 73.6 million bbl versus the same time last year. The inventory situation is similar in other regions, with storage tanks brimming with oil. Also in the U.S., crude production, although it is falling, is still holding above 9 mbd, thanks to strong Gulf of Mexico increases and lower costs and greater efficiency in the shale patch.

When will the market turn around for good?

Amid all the bearish factors mentioned above, it’s really hard to see the current speculative-driven rally become sustainable. But most market observers believe the market will reverse course for good at some point. It’s just hard to pinpoint an exact time, particularly since there is so much inventory that needs to be worked off.

“You can’t rule out that $26 [for NYMEX WTI] was the bottom, but the market will be fighting high inventories for a while.”

“There’s been this overriding belief since November 2014 [when OPEC decided not to cut production] that every time prices fall by $10-$20, the market will turn back around, but so far that hasn’t happened,” said veteran analyst Andy Lebow, senior partner with Commodity Research Group. “You can’t rule out that $26 [for NYMEX WTI] was the bottom, but the market will be fighting high inventories for a while. If you look forward, the decline in capital expenditures will be a bullish factor sometime in the future,” he said, emphasizing that it’s uncertain when that inflection point will be.

Whether speculators turn out to be correct in the current upswing remains to be seen. But one thing is for sure, when fundamentals do indeed eventually tighten, whether it occurs this year or in 2017-18, financial players will ride the price wave upward, spurring further volatility in an already uncertain market.

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