Oil prices drop as hedge funds head for the exit

March 13, 2017 5:56 pm


Hedge funds and other money managers had barely started liquidating their record bullish position in crude oil futures and options before prices tumbled on March 8.

The critical question is how much more of the position will need to be liquidated before the market stabilises again.

Hedge funds still held a net long position in the three major Brent and WTI futures and options contracts amounting to 874 million barrels at the close of business on March 7.

Fund managers had reduced their net position by 16 million barrels compared with the previous week and by a total of 77 million compared with the record of 951 million barrels set on Feb. 21.

The net position has been trimmed in the two weeks ending on March 7 but only after increasing by 529 million barrels in the previous 14 weeks.

The net long position is still more than double the low of 422 million barrels set in mid-November before OPEC announced its production-cutting agreement.

Fund managers still held an overwhelming bullish position at the end of March 7, with long positions outnumbering shorts by a ratio of 7:1.

The near-record concentration of hedge fund long positions in oil significantly raised the risk of a crowded trade and likely contributed to the sharp fall in the price of oil starting on March 8.

The drop in prices started after the cut off for the latest commitments of traders reports issued by the U.S. Commodity Futures Trading Commission and ICE Futures Europe.

But the next reports, for the week ending March 14, are likely to show hedge funds liquidated more long positions when they are published on March 17 and March 20.

CROWDED TRADE

The sharp fall in prices that occurred on March 8 and continued on March 9-10 is consistent with the rush for the exits which occurs when a crowded trade breaks down (“Predatory trading and crowded exits”, Clunie, 2010).

The rush normally starts shortly some time AFTER prices have peaked and after a small number of traders have already started to shift their positions (“Why stock markets crash”, Sornette, 2003).

In this case, Brent prices reached a recent peak of $57.31 per barrel on Feb. 21, and the hedge funds’ net long position also peaked at 951 million barrels on the same date.

Since then, there has been gentle liquidation of hedge fund positions and a barely perceptible downward trend in prices.

This gentle exit by a small number of traders turned into a rush on March 8 in much the same way an avalanche picks up momentum.

Critically, some traders seem to have anticipated the market was close to a turning point, with the number of short positions rising from 102 million on Feb. 21 to 144 million on March 7.

The absence of fresh hedge fund buying and the emergence of a small band of short sellers created a liquidity hole and was likely responsible for the abrupt drop in prices which started on March 8.

The next commitments of traders reports, published on March 17 and March 20, will reveal how much of the remaining net long position was liquidated between March 8 and March 10, and give some idea of how much more needs to be liquidated before prices steady again.

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By Reuters
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