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Bonfire of the hedge fund oil longs

Date: Tuesday, May 15, 2012
Author: John Kemp

John Kemp is a Reuters columnist. The opinions expressed are his own.

Bullish investors finally abandoned hope for a recovery in oil prices, at least in the short term, in the week ending May 8, slashing their long positions in WTI-linked futures and options by the largest amount in more than five years.

Hedge funds and other money managers reduced their long position in U.S. crude by the equivalent of nearly 54 million barrels of oil, the largest one-week decline since at least June 2006, according to data released by the U.S. Commodity Futures Trading Commission (CFTC) on Friday [May 11].

The long liquidation was three times greater than in the “flash crash,” almost exactly a year ago on May 5, 2011, when speculative longs were cut by a little under 19 million barrels.

Tumbling prices drew some fresh interest from speculators on the short side. Money managers boosted their short positions in WTI-linked contracts from 48 million barrels to 75 million, the highest level recorded for seven months.

The ratio of hedge fund long to short positions halved from 6.2:1 to just 3.2:1, the lowest since October 2011, and far below the recent peak of 11.8, back at the height of the oil price spike in February.

Net long positions held by hedge funds and other money managers have fallen from 304 million barrels on Feb. 28 to just 169 million barrels on May 8. The net long position has fallen to seven-month lows, reversing all the build up in speculative length since October last year.

Curiouser and curiouser

Long liquidation by the hedge funds and commodity trading advisers (CTAs) will grab the limelight, but the other side of those position changes is just as interesting.

Part of the adjustment came about from a fall in the massive net short position run by banks and other swap dealers, which was down by 27 million barrels. Another chunk came from a drop in reported producer/processor/merchant/user net short positions, down 15 million barrels.

But a big and unexplained chunk was simply transferred to the mysterious “other reportables” category. Net long positions held by other reportables rose just over 27 million barrels to a record 171 million barrels. Other reportables boosted their long positions by 11 million barrels and cut shorts by 16 million barrels. Other reportables now have larger gross long and short positions, and a larger net position, in the market than hedge funds, CTAs and other classified as money managers.

The overwhelming bulk of other reportables’ positions are held in the main NYMEX light sweet crude oil futures and options contracts, or in NYMEX calendar swaps, with a few more in average pricing options, with minimal holdings in European-style options and financial settled contracts.

The category is the fastest-growing participant in the WTI futures and options market, according to CFTC data, but almost nothing is known about the traders in this segment. The CFTC defines them simply as “every other reportable trader that is not placed into one of the other three categories is placed into the other reportables category,” which is not terribly helpful.

Repeated requests to the Commission’s staff to explain what sort of firms are classified under this heading, whether the classification has changed, or if the rise in other reportables’ position is due to organic growth, have failed to elicit any response.

What is clear is that other reportables have become crucial liquidity providers. Their willingness to take the other side of hedge fund/CTA positions helps explain why prices have moved so smoothly in recent months, despite the hefty accumulation and then liquidation of hedge fund holdings.

It goes some way towards explaining why the much larger long liquidation seen in the past fortnight has not generated the same flash crash as the much smaller liquidation in May 2011.

Market participants should press the CFTC for a more satisfactory explanation of the sort of firms being classified under this heading, which has become an expanding “black hole” in the commitments of traders report.

Behavioral trading rises

The cyclical accumulation and then liquidation of hedge fund long positions over the last seven months shows the increasing role of behavioral trading in the oil market.

While fundamental traders take a position based on their own evaluation of supply, demand, inventories and spare capacity, behavioral traders are more interested in the views of other market participants. Behavioral traders are anxious to spot and join the big waves of enthusiasm and repudiation that sweep across markets.

Most behavioral trade is grounded in fundamentals, at least at first, but the accumulation and liquidation of positions then takes on a life of its own as the market constructs its own narrative.

Something similar appears to have happened with crude oil over the past six months.

The threat of sanctions on Iranian oil exports, rising tensions between the western powers and Tehran, coupled with a string of supply outages from South Sudan and Yemen to the North Sea, was enough to prompt hedge funds to assemble a near-record long position.

Initial positions may have been established by fundamentals and the smart inside money, but once the trend was underway, the rally seems to have drawn in large amounts of behavioral trend-chasers.

Once the market had peaked, however, it is this behavioral money that has headed for the exits, slowly at first, but gradually accelerating.

This sort of liquidation (where slow selling at first triggers an avalanche of later sales) is characteristic of asset markets with strong behavioral or bubble characteristics.

Liquidation during the last fortnight is hard to square with any other explanation. Most of the bearish factors weighing on oil prices (rising Saudi output, swelling crude inventories, de-escalating tensions with Iran, signs of slowing growth in China and the eurozone, and a stalling labor market recovery in the United States) have actually been evident for some weeks, if not a month or more.

Nothing changed in the fundamentals in the week ending May 8 that could explain the huge liquidation of hedge fund long positions. Instead it appears to have been driven by the accumulation of selling itself, and the steady retreat in prices, that eventually convinced many fund managers that this time there would be no bounce back, and the uptrend was well and truly broken for now.