The recent fall in the crude price has seen hedge fund managers pile on with a big increase in short positions. A longer term perspective, however, indicates that from this point, the damage to the commodity price will likely be limited.
The U.S.-based Commodity Futures Trading Commission released data on commodity futures positioning each Friday. The numbers are reported in two broad categories, commercial and non-commercial. Commercial positioning (not shown in the accompanying charts) aggregates the futures activity of oil industry companies as they lock in selling and buying prices for activity in the next few years. The second category, non-commercial futures positioning, is widely used as a proxy for speculative hedge fund trades in futures markets.
Investors should be aware that, while data are released Fridays, it includes activity up until the previous Tuesday. Last week, the crude sell-off extended in the Wednesday to Friday period, so the trends in the chart likely extended further.
The top chart below compares the West Texas intermediate crude price to the total amount of non-commercial short positions on oil. The inverse correlation is obvious – short positions increase as the crude price falls – for the three-year period.
The chart also highlights the sharp increase in short positions since the end of May, 2016. Short increased by more than 90,000 contracts from May 31 to July 26.
The lower chart shows the oil price compared with the non-commercial net position – total long contracts minus total short contracts. The net position moves with the crude price as the total number of long contracts increases as the commodity price rallies.
The period this year from Feb. 9 to May 17 on the chart is the most instructive. A sharp rise in the orange line indicates a surge in optimism as hedge funds reduced short positions and bet heavily on higher oil prices. This confidence proved misplaced as the commodity price rally peaked in early June and oil prices headed sharply lower.
The recent increase in short positions is, for the most part, likely not a matter of speculators betting on further, deeper declines in crude prices. It looks more like hedge funds were caught offside and forced to scramble and cover their bullish positions. In other words, futures markets represent a removal of optimism rather than a big increase in pessimistic forecasts.
Futures markets, particularly short term contracts, play a major role in determining the price of oil. The good news is that the lower chart suggests that hedge fund positioning in crude is at least close to reflected current commodity prices, and investors can reasonably hope that futures market volatility is set to decline.