Speculative optimism in oil futures peaked in February of this year and the sharp decline in bullish crude bets since that time has helped hedge funds avoid much of the portfolio damage from the recent weakness.
In the short term, however, it appears the unwinding of futures positions has some ways to go, and the process would form a short-term hurdle for oil prices.
The accompanying chart compares the West Texas intermediate crude price to aggregate futures bets (bullish contracts minus bearish positions) on the commodity price. The non-commercial net futures data are published weekly by the Commodity Futures Trading Commission and are widely used as a proxy for hedge fund positioning in the sector.
The relationship between the oil price and futures speculation was loose at best before the big sell-off began in the summer of 2014. From January 2015, however, the scale of bullishness and bearishness in the futures market closely tracked the commodity price as hedge funds became far more active traders.
The modern era of speculative excess began in November, 2016. Bullish hedge fund bets on oil exceeded bearish positions by about 276,000 contracts on Nov. 15, and 556,600 on Feb. 21, 2017 – more than doubling in three months. After an initial increase from $46 to more than $53 (U.S.) per barrel in the final weeks of 2016, the crude price remained stuck in a narrow range, largely between $52 and $54 in 2017, before the recent decline.
At this point net bullishness has declined by a third, or 183,000 contracts since the February peak, pressuring the commodity price. The current aggregate futures position of about 373,000 contracts remains above the five-year average of 295,000, indicating higher than usual optimism remains.
The five-year average futures position carries no particular significance – I'm just using it as a rough benchmark. There is no reason, for instance, that current speculative activity needs to revert to the mean and fall to the grey line on the chart. Citi analyst Tim Evans, cited by Bloomberg, believes that oil investors in general are "no longer overinvested" and sees the possibility of bullish speculation jumping higher from here.
At the same time, markets driven by speculation tend to overcorrect, with excessive optimism swinging to an overshoot to the downside. In this case that would take the form of bearish, negative positioning in oil futures with more bearish positions than optimistic ones.
Caught between the bullish effects of ongoing OPEC production cuts and a steady increase in U.S. shale activity that threatens to exacerbate an already-bloated oil inventory situation, oil markets have been twitchy and headline-driven in recent weeks. The weekly Department of Energy report on U.S. crude and gasoline inventories has frequently caused significant fluctuations in commodity prices, and every utterance from Saudi officials is closely parsed.
This makes it more difficult than usual to predict the short-term course for oil prices. The mid-term outlook, as I've stated previously, remains constructive, provided that current estimates of annual growth in global oil demand stay in the range of 1.2 million to 1.4 million barrels per day. Whatever happens in the coming weeks, recent activity in futures markets suggests the response from hedge fund managers will be swift and decisive, and higher levels of volatility can be expected.