Smoke rises from stacks as processing slowly resumes at the Imperial Oil refinery in Nanticoke, Feb. 28, 2007.J.P. Moczulski/Reuters
We can argue about the short-term outlook for the oil price, but there's little doubt that speculators betting against the commodity price got hurt badly last week, and then panicked to cover their positions.
The next few weeks will be telling – is the crude rally sustainable, or will the shorts just reload and push the oil price lower yet again?
Many investors are unaware that there is no one spot price for physical oil. The West Texas intermediate crude prices is often cited but there are numerous regional prices – including the West Canada select price – at which only refiners trade.
The real action is in WTI Nymex futures contracts. Each Friday, the Commodity Futures Trading Commission publishes the Commitment of Traders report aggregating all speculative futures trades (largely hedge fund, called "non-commercial positions" by the CFTC) on the oil price, both long and short, and this provides invaluable insight for investors in the energy sector.
Last week's Commitment of Traders report was especially enlightening as it showed a major change in investor positions. The first chart below highlights the sharp decline in short positions as the rising crude price caught the shorts offside.
The most recently reported week has seen the number of short contracts on oil fall by 31,500 contracts. The removal of short positions involves buying of long positions in one form or another, so the decline in short positions helped push the crude price higher.
The second chart below shows why pessimistic hedge fund may have been caught offside. From September, 2014, the number of short positions has increased roughly in accordance with U.S. crude inventories. This was a perfectly reasonable bet: Rising inventories is the primary sign of oversupply – too much production relative to demand – that has depressed the commodity price.
Last week, however, the oil price rallied despite a large 10-million-barrel weekly build in crude inventories. In other words, more signs of glut conditions were followed by crude buying, not selling – a break from usual patterns.
Merrill Lynch research expects the oil price rally to continue, writing that trends in managed-money-portfolio positioning follow the oil price: "Managed-money-positioning change has a strong positive relationship with the price change of the past week … they are [a] price follower and buy crude futures as price goes up, and vice versa," the report said Monday.
In other words, Merrill Lynch believes that short positions rise after the oil price falls and decline after the commodity price climbs. This implies that after last week's rally in oil, short positions will continue to be removed during this week, further fuelling gains in the WTI commodity price.
Scott Barlow