LONDON: One valid criticism of some columns over the last year is that they have illustrated the impact of hedge fund positions on oil prices by focusing on WTI rather than Brent, even though Brent is clearly now the main benchmark for prices outside the central United States.
The reason is simple: There is a longer and richer history of data on US light sweet crude futures, WTI, and it is available in a more accessible format from the US Commodity Futures Trading Commission's (CFTC) commitments of traders report.
The CFTC publishes data only on futures and options contracts that relate to commodities registered or deliverable in the United States, which does not include the main Brent contract offered by ICE Futures Europe.
Since 2011, ICE has been publishing similar data on Brent positions using the same classification system, though in a format which is considerably less easy to use and analyze.
Nonetheless, it is possible to reconstruct the same time series of positions from the weekly reports published on ICE’s website.
The attached charts show how hedgers, swap dealers, money managers and other traders have varied their positions since January 2011, replicating the same sort of analysis I have published elsewhere on the WTI market. They show total positions across all Brent-linked futures trading on ICE and NYMEX.
Positioning in Brent and WTI has been broadly similar over the past two years, and the impact on prices has been the same, with two important exceptions.
First, the Brent market continues to show vibrant activity by crude producers and stock holders using short futures and options positions to hedge exposure to price changes in the physical market, while short-hedging in the WTI market has withered.
Between January-February 2011 and January-February 2013, the average volume of short hedging positions in WTI has fallen by half from 977 million barrels to 490 million, according to the CFTC. By contrast, short hedging positions in Brent have risen from 560 million to 813 million barrels, according to an analysis of data from ICE and the CFTC.
As landlocked WTI has disconnected from conditions in the global market, crude producers and inventory owners outside the United States have discovered it no longer provides a well-matched hedge for their price exposure, and have switched to using seaborne Brent.
Second, despite WTI’s increasingly idiosyncratic behavior, it remains favored by hedge funds and other money managers.
Fund managers’ long positions in WTI hit a recent peak of 313 million barrels on Feb. 12. The corresponding peak in Brent positions was just 240-242 million barrels on Feb. 12-19.
Fund managers in WTI appear more prone to herding and following momentum-driven trading strategies than their counterparts in Brent. Fund positions in WTI have been overwhelmingly on the long side of the market. Funds have held a much more diverse range of positions in Brent.
The ratio of hedge fund long to short positions in WTI has spiked to more than 10:1 twice in the last 24 months, but has rarely exceeded 6:1 or even 5:1 in Brent.
Despite Brent’s international exposure, WTI seems to have attracted more interest from fund managers taking a view on the macroeconomic outlook, financial market sentiment, and crude market fundamentals.
One theory is that most commodity hedge funds and similar investors remain based in the United States so the choice of derivatives displays location bias. But it remains impossible to test because the CFTC does not disclose the identity of money managers or their residency.
With these two important caveats, which is remarkable about the positioning data for Brent and WTI is their similarity.
Given the very different physical markets for these two crudes, different price levels, and wildly fluctuating arbitrage, hedge fund and other money managers’ positions in the two markets are notable for their similarities rather than differences.
In a recent column, I suggested most of the short-term movements in Brent (and WTI) prices since mid-2010 could be traced to changes in money managers’ positions rather than fundamentals.
The suggestion drew an impassioned response from Professor Craig Pirrong at the University of Houston’s Bauer College of Business (“Riding his Anti-Hedge Fund, Anti-Speculation Hobby Horse” March 5).
Pirrong believes this “demonizes” the role of the hedge funds. But it is meant to be a description rather than a prescription.
Overall, oil market fundamentals have been remarkably balanced for two years. Rising crude production in the United States, and continued conservation, have been matched by growing demand from Asia and the Middle East, and a series of supply interruptions.
Unsurprisingly, Brent prices have remained range bound, capped above at $ 115-120 by the threat of an economic slowdown and demand destruction, and from below at $ 100-105 by Saudi production policy.
Within this range, most short-term price movements have coincided with the accumulation and liquidation of hedge fund positions, especially in WTI but to a lesser extent Brent, which display a strong momentum-like behavior.
The position data suggests, however, that position accumulation is unable to push prices beyond $120 and that such cycles are reversed within 2-3 months. Moreover, the price impact appears to be getting weaker, and the duration of the cycles is getting shorter.
The point is not to demonize the behavior of hedge funds and other investors, who provide valuable liquidity, and without whom the futures markets could not function. Nor criticize them for “herding” behavior, which is evident in the markets for most financial instruments, including equities and fixed income.
The results have been described by behavioral investors and theorists like George Soros (“The Alchemy of Finance” 1987), Didier Sornette (“Why Stock Markets Crash” 2003) and Robert Shiller (“Irrational Exuberance” 2009).
The point is that it is a mistake to try to ascribe every $ 5-10 move in the price of Brent and WTI to “fundamental” factors, when much of it is just the impact of shuffling positions in markets with imperfect liquidity.
The broader picture is one where supply and demand have remained broadly in balance in the short term.
The balance is unlikely to last. In particular, spot crude prices are substantially above the marginal cost of production, and are providing both an incentive and the cashflow for a huge expansion in output over the next half-decade. But those changes are prospective rather than actual at present.
Pirrong and I agree in one area. “Brent may be broken, but hedge funds haven’t broken it. It is a classic problem in derivatives markets: a burgeoning derivatives market balancing on top of a declining deliverable supply,” Pirrong writes, which is a good diagnosis of the problem.
Neither Brent nor WTI is a good proxy for the broader global supply-demand balance. Shrinking liquidity in the one case (Brent) and takeaway problems in the other (WTI) mean both work fairly poorly at the moment as benchmarks.
Nonetheless, they are the best we have, for now. Both are subject to a variety of idiosyncratic influences. And the accumulation and liquidation of hedge fund positions appears to play a small but important role in short-term price movements over time spans ranging up to a month or two.
Humans are hard-wired to find fundamental patterns; however many of the short-term moves are just noise. Journalists and analysts should resist the temptation to find complicated fundamental explanations for every small price move where there may be none.
— John Kemp is a Reuters market analyst. The views expressed are his own.
