After hitting multi-year highs earlier this month, crude oil benchmarks WTI and Brent have pulled back to $56 and $61, respectively, on concerns about softer-than-expected demand and the possibility of strong non-OPEC supply growth in 2018. Oil prices are now in a holding pattern as the market waits for the outcome of the OPEC meeting on November 30.
The 20 percent rally in oil prices since the beginning of September has developed as a result of a sharp tightening in oil market fundamentals—OPEC’s compliance has been consistently high, the North American rig count sputtered during the past few months, and crude inventories have declined.
Hedge funds and other money managers have amassed record net-long bets on oil futures, a reflection of the increasingly bullish market sentiment.
The stronger price environment can also be attributed to the rapid buildup in speculative positions in the two main crude oil futures benchmarks. Hedge funds and other money managers have amassed record net-long bets on oil futures, a reflection of the increasingly bullish market sentiment. But the surge in speculative long positions has become lopsided, exposing the market to a possible selloff and downside risk.
Speculators get bullish
The price surge over the past three months has coincided with a rush into bullish positioning by major investors. As John Kemp of Reuters recently pointed out, speculators boosted their combined long positions in the major futures and options contracts for Brent, WTI, U.S. gasoline, and U.S. heating oil to a record high on November 14.
However, based on previous upswings, the bullish bets are starting to appear overstretched. According to Reuters, hedge funds have built up a long-to-short ratio of 6.9, an incredible shift in net length since June, when traders held only 1.6 long bets for every short. Over the past three and a half years, this sort of herding on the long side has been followed by a quick liquidation of positions.
With the current makeup of positioning by speculators heavily weighted toward long bets, there is a significant risk of another downward price correction.
For instance, in February of this year, the long-to-short ratio hit an enormous 8.69, according to Reuters, when WTI was trading in the mid-$50s per barrel. However, by the end of February and into March, hedge funds and other money managers exited their positions. WTI fell sharply and by mid-March reached $47 per barrel. With the current makeup of positioning by speculators heavily weighted toward long bets, there is a significant risk of another downward price correction.
The two main crude benchmarks have received different treatment from futures traders for most of this year. Brent has seen a record run-up in bullish bets in recent weeks, but WTI has lagged behind with investors more cautious on the outlook for the U.S. benchmark. The difference is the result of regional disparities in fundamentals. In the U.S., persistently high crude inventories, particularly at pricing point Cushing, Oklahoma, have weighed on the benchmark. Even as inventories have declined in 2017, the rebound in shale production has kept supply ample in the U.S.
Conditions in the global market for crude oil, reflected in Brent, are much tighter than in the U.S., thanks in large part to OPEC’s production cut and instability in oil-producing countries.
Meanwhile, conditions in the global market for crude oil, reflected in Brent, are much tighter, thanks in large part to OPEC’s production cut and instability in oil-producing countries. The uptick in geopolitical tension in recent months (outages in Iraq and a spike in Saudi-Iranian tension) has pushed up Brent at a faster pace than WTI.
Moreover, U.S. shale drillers rely heavily on hedging their production, and selling barrels on the futures strip helps keep a lid on WTI futures. “We estimate that they hedged 70-80 per cent of their output for this year but only about 25 per cent for 2018,” Tamas Varga of PVM told the FT in October. “[A] further price rally would make it irresistible for them to add to their positions which, in turn, limit any further upside potential.”
The gap between bullish bets on Brent and WTI is also visible in the spot differential between the two benchmarks. WTI has traded at a roughly $6-per-barrel discount relative to Brent for the better part of three months, which has motivated U.S. sellers to export more crude.
However, last week the gap between the two benchmarks narrowed, at least in terms of the positioning by hedge funds and other money managers. Reuters pointed out that the most recent buildup in net length came from WTI, while Brent saw a mild selloff. The slight decrease in net length for Brent in the week ending on November 14 could be a sign that investors are starting to shift toward expectations for prices to decline.
Increasing financialization of the oil market
Last week, the Energy Information Administration (EIA) showed in its weekly commentary the growing presence of investors in the crude oil futures markets. Interest in gaining exposure to movements in oil prices has surged over the past three years as investors look for ways to make money on volatility. That has led to substantial increase in interest in exchange-traded funds (ETFs) that are linked to crude oil prices. The largest and most prominent is the United States Oil Fund (USOF), an ETF that tracks the daily price movements of WTI. Investors have poured money into the ETF, and the USOF has scooped up more crude futures contracts. The USOF has become a major player in the oil futures market, even if the number of outstanding shares have dropped as of late. The EIA notes that at times the USOF “has held as much as 20 percent to 25 percent of the open interest in front-month futures.” This likely translates into greater influence on oil prices themselves—although the EIA cautions that the effects are unclear.
Direction of price, speculative bets hangs on OPEC
The direction of hedge funds bets in the coming weeks and months will depend on a number of factors, including the U.S. rig count, the strength of the dollar, the Fed’s decision on whether to raise interest rates, and, of course, OPEC. The cartel knows that the market is expecting that its members, along with its non-OPEC allies, continue the production cut throughout 2018. They will game expectations the best they can. If the producer group fails to follow through with extension, the market is likely in store for a selloff.