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inside the market

An oil pump jack pumps oil in a field near Calgary, Alta., in July, 2014.Todd Korol / Reuters

Futures markets are where the real action in oil prices takes place and right now they have an interesting story to tell. Or rather two stories – the rising bearishness of oil companies and a simultaneous jump in bullishness for speculative investors.

The U.S.-based Commodity Futures Trading Commission publishes a weekly report on commodity positioning in futures broken down into two categories. The non-commercial section of the report is dominated by hedge funds and other speculative investment portfolios. The commercial portion of the report details the futures transactions by the energy industry itself – exploration and production companies as well as refiners looking to lock in future selling and buying prices.

The two charts below show that where oil prices are concerned, futures positioning is going in decidedly different directions in each section of the CFTC report.

The first chart shows the net position – the number of bullish futures contracts minus the number of bearish contracts for non-commercial or speculative investors. A rising line represents a rising amount of bullish bets on the crude price relative to bearish contracts.

From June, 2014, until February of this year, the trend was bearish. The falling orange line on the chart indicates increasingly bearish positioning on West Texas intermediate crude prices. The trend among hedge fund managers switched abruptly at that point however and the bullish oil price positions grew rapidly.

The lower chart shows the aggregate futures bets (often called the hedge books) for the oil industry. The recent trend is the reverse of the hedge funds – futures contracts betting on a decline in the oil price have been rising steadily (causing a falling line on the chart) since February.

The reasons for the divergent trends are relatively straightforward, I think. In the case of speculative investors, bearish, short positions have resulted in severe losses because of the 88-per-cent jump in the oil price from the February lows. The bearish futures have been bought back or otherwise retired in order to stop the financial bleeding, and the overall net position has become more bullish as a result – a rising line on the chart.

Oil industry participants, many of them fresh off of a near-death financial experience, are using the futures markets to lock in future sales at commodity prices close to current levels. A contract that guarantees oil delivery at a specified price is a short position in the same way shorting a stock involved a guarantee to buy it back at a future date. The oil companies aren't gambling on a decline in the oil price as much as they are insuring against a price decline. If the oil price falls, they can still sell oil at the previously agreed upon commodity value.

Futures trading for speculators and producers is putting opposing pressures on the commodity price. When a lot of producers want to sell oil in forward markets, this puts downward pressure on future prices (they have to compete on price to make the sale), which bleeds through to shorter term and spot prices. The short covering that speculators were forced to do, largely in the form of buying bullish positions to "net out" the trade, put upward pressure on both longer term and shorter term prices.

The relative stability of oil prices in recent weeks implies that, for now, speculative short positions are likely already covered. This suggests that forward selling by oil producers might have a larger effect in the short term, with a negative effect on crude prices.

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