Global hedge funds reduced their bearish positions on oil by the biggest weekly amount ever last week and, while this is good news for sentiment in the sector, the trend may also signal a temporary slowdown for the sharp rally in crude.
This first chart compares the number of futures contracts representing short interest by hedge funds and other speculators – their value rises as the price of oil falls – versus the commodity spot price. The two lines historically move in opposite directions as we'd expect. Bearish futures positions are less attractive as the oil price rises and more popular as the price falls.
The past month has seen a massive reduction in short positions at a pace that Bloomberg calls "the fastest on record." The number of bearish futures positions declined by 25 per cent in the week ended April 24 alone and is down more than 35 per cent for the past four weeks. Hedge funds and speculative investors were clearly caught offside and were forced to scramble and cover their bearish bets.
Last week then was, at least in part, a stereotypical short-covering rally in crude prices. To "flatten out" bearish trades, fund managers were forced to allocate assets to the bullish side of the ledger. For a simple example, if a manager bearish on crude sold a futures contract with a $52 (U.S.) strike price, they would be showing huge losses for every dollar the commodity price rose above that level. To stem the damage, the manager would have to buy the futures contract back in the market or buy a bullish position that offset the loss as the commodity price climbed.
Similar activity would have been taking place across every energy-related asset class. The end result was a big inflow of funds into bullish bets that pushed all prices – futures, call options, equities, corporate debt and the spot price – higher.
The severity and speed of the position changes in futures markets over the past month suggest they were a major reason for the sharp rally in the commodity price last week. It all suggests that most of the fuel for the rally is spent. Short-covering rallies don't last forever.
The crude spot price is far closer to the five-year futures price than a few shorts months ago. I and others have been using the latter as a loose proxy for fair value for the commodity. Former Goldman Sachs economist Jim O'Neill has postulated that the five-year futures price is actually the best indicator of future value for the commodity spot price. He argues that speculators are not active in futures markets with such a long maturity and the preponderance of informed bets from oil producing firms in the five-year futures market provides the best guess on future prices.
The current five-year future price for oil is near $67 a barrel, about $11 higher than the spot price. In late January, the spot price was $21 below the five-year future which, in hindsight, helped predict the recent rally.
The potential end to the short-covering rally in crude does not necessarily mean the price will fall. But investors should expect a more measured pace for the commodity price now that so much leverage has been removed.
Follow Scott Barlow on Twitter @SBarlow_ROB.