ANALYSIS: Hedge fund positioning in oil looks stretched

LONDON: Hedge funds have accumulated a large net long position in crude oil futures and options but the size of the position and its implications for future movements in prices are disputed.
Hedge funds and other money managers had accumulated a net long position in the three main futures and options contracts linked to Brent and West Texas Intermediate (WTI) equivalent to 885 million barrels by Jan. 31.
The combined position had a notional value of $48 billion at prevailing prices, according to an analysis of records published by regulators and exchanges.
Measured in barrels, the net long position is at record levels, comfortably exceeding the net long position of 626 million barrels hedge funds had amassed in June 2014, before prices slumped.
In terms of notional value, however, the position is well below the $68 billion exposure hedge funds held in 2014. The slump in oil prices means hedge funds can now hold twice as many barrels for the same amount of notional value.
So the combined hedge fund position in Brent and WTI looks very stretched in barrel terms but less so in dollar terms. Both approaches to measuring positions have strengths and weaknesses; it is not clear which is a more relevant indicator.
A more useful measure of hedge fund positioning and its impact on prices is the ratio of long and short positions. The ratio is a dimensionless quantity without any physical or financial units because the barrels or dollars cancel each other out.
So it provides some insight into how bullish or bearish money managers are in aggregate and is unaffected whether the price of oil is $50 or $100 per barrel.
Long-short ratio
Hedge funds do not determine the level of oil prices and have only a partial influence on the direction of price movements over the short and medium term.
But the short-term rise and fall in WTI prices has been somewhat correlated with the accumulation and liquidation of hedge fund long and short positions since 2010.
An increasing long-short ratio has typically been associated with a rise in WTI prices while a decreasing long-short ratio has generally been associated with a fall in WTI.
In WTI, for which there is a longer time series, the ratio of long to short positions has been cyclical, with an irregular magnitude, and subject to sharp reversals.
The long-short ratio currently stands at 9:1, a substantial increase since the ratio of 2:1 in the middle of November 2016, before members of the Organization of the Petroleum Exporting Countries (OPEC) reached their output deal.
Hedge fund managers have become increasingly bullish about OPEC’s ability to drain excess inventories and push oil prices higher, or at least to establish a price floor.
As a result, the ratio is the highest since July 2014, when oil prices had just started to fall and were still above $100 per barrel.
But it is well below the ratios of 18:1 and 17:1 reported briefly in June 2014 and February 2014 respectively or the record 22:1 reported momentarily in February 2012.
None of these very high long-short ratios was sustained for more than a week or two and they were all followed by a sharp downward correction in the ratio and prices.
The ratio of 9:1 in the week to Jan. 31 was in the 86th percentile for all weeks since the start of 2007, so it was unusually high.
There is some scope for the ratio to become even higher in the short term if funds continue adding to long positions or cut their already low short positions further.
But with the ratio already looking stretched, there is an increasing probability it will reverse, as hedge funds pare long positions and/or increase the number of short positions.
Impact on prices
How much impact that would have on WTI prices is unclear. The accumulation of hedge fund long positions has had only a relatively modest impact on prices since the middle of December.
Liquidity has been high in the last seven weeks. Fund managers have found plenty of willing sellers, especially among producers and traders, eager to take the short side of their long positions.
If liquidity remains high, fund managers may find plenty of willing buyers when they try to reduce their net long position, with only a modest correction in prices.
But if liquidity evaporates, funds may initiate a sharper correction of prices when they try to close out some of their long positions and open new short ones.
• John Kemp is a Reuters market analyst. The views expressed are his own.