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Hedge Fund Action Adds to Oil Market Froth

Date: Wednesday, April 23, 2008
Author: Jane Merriman

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Hedge fund activity is playing a part in oil's surge to record highs above $118 per barrel, but long-term fundamental supply constraints are the key driver of the price boom.

"In the short-term, you have hedge fund flows affecting prices," said Bob Greer, executive vice president at PIMCO, which manages more than $17 billion of commodity mandates. "They are increasing the volatility of the markets," he told Reuters.

Commodities have grown in stature as an asset class among investors because they behave differently over the long term from equities and bonds and can diversify investment portfolios. Mr. Greer estimated about $200 billion is tracking a variety of long- only commodity indexes, which investors use to gain exposure to commodities."Plus there is an unknown amount of hedge fund money both long and short," he said.

Hedge funds have turned to oil and other commodities to escape turmoil in equities and bond markets caused by the credit crisis. Some hedge fund flows may be reflected in data from the U.S. Commodity Futures Trading Commission.

So-called crude oil speculators increased their net long positions last week on the New York Mercantile Exchange, according to latest CFTC data. Mr. Greer said the CFTC report was not a full picture as some exposure to commodity indexes is gained over the counter rather than via commodity futures exchanges.

Hedge funds can also be more focused on trading strategies rather than prospects for physical oil supply and demand. "They tend to operate in the futures trading world rather than the real world where physical commodities are traded," Mr. Greer said.

Some funds, for example, have been trading oil's relationship to the U.S. dollar, where weakness in the U.S. currency tends to trigger rises in the oil price. "Ultimately, though, the supply and demand fundamentals of a commodity will determine the price level," Mr. Greer said.

People's perceptions of the oil market's fundamentals have changed. "The news that Russia, the largest non-OPEC producer, will produce less this year than the year before and Nigeria's output may be set to fall because of lack of investment makes people realise high prices are justified," he said.

This is reflected in a surge in long-dated oil prices above $100 out to 2016. "In the long term, you have to consider supply and supply will not just magically appear. It takes years to increase the supply of some commodities."

By Jane Merriman