Cycling oil prices and the rise of the generalists

LONDON: In the past two years, crude oil markets have become an increasingly important sector for hedge funds and other money managers, attracting even more interest than during the great price spike in 2008.
Many new players are generalist fund managers, who have joined the market alongside traditional energy sector specialists, as the hedge fund industry has struggled to earn sufficient returns in other asset classes like equities and turned to oil markets instead.
According to the US Commodity Futures Trading Commission (CFTC), the number of hedge funds and other money managers running long futures and options positions in the flagship NYMEX light sweet oil contract above the reporting threshold peaked on three separate occasions during 2011 and 2012 at between 90 and 120, and has never fallen below 59.
In contrast, the number of funds with reportable positions never exceeded 67 in the first seven months of 2008, and was generally below 60, even as oil prices were running up to a record $ 147 per barrel.
Under the CFTC’s large trader reporting system, futures and options positions must be reported if they exceed 350 contracts, equivalent to 350,000 barrels of crude oil. The reporting threshold therefore makes a convenient, observable if somewhat arbitrary distinction between large and small positions in the market.
The number of fund managers with reportable “spreading” positions has also risen, but more slowly, from a peak of 76 in Jan-July 2008 to 104 in 2011-2012.
Spread positions, where a fund offsets long positions in some months with short positions in others, are a more sophisticated way to speculate on temporary price shifts. They are often favored by specialist traders who want to gain exposure to fundamental shifts in the oil market while insulating themselves as much as possible from macro influences.
In contrast, outright long or short positions are often favored by generalists, who use oil derivatives to express a macro view on the economy, or simply try to exploit an emerging trend.
The rising number of hedge funds with reportable positions, especially outright long positions rather than spreads, is therefore consistent with a big expansion in the number of hedge fund managers entering the oil space from equities and general macro.
The views of this new generation of hedge fund managers are markedly less diverse and more uniform than traditional sector specialists.
While oil prices were soaring in the first seven months of 2008, the number of money managers with reported long and short positions was about equal — reflecting considerable uncertainty among oil experts about whether prices would continue rising or fall back to earth.
This division of views helps explain why econometricians have struggled to establish a relationship between prices and speculators’ positions during the oil spike. The large volume of speculative long positions was matched by an almost equally big number of speculative shorts, so hedge funds’ net long position remained quite modest.
But in each of the three big price spikes during 2011 and 2012 (ending in May 2011, February 2012 and September 2012), the number of money managers with reportable long positions has been roughly three times the number with reportable shorts. As a result the sector has repeatedly built up enormous net long positions on three occasions over the last 18 months.
In April 2008, shortly before the height of the price spike, the ratio of hedge funds’ long positions to their shorts reached a maximum of just 2.6:1. But in May 2011, the ratio hit 10.5:1, and in February 2012 it reached a record of almost 12:1.
As hedge funds have become less specialist and idiosyncratic, and more subject to herding behavior and moving as a pack, they may be changing the way in which oil prices behave.
Econometricians have struggled to find a statistical link between hedge fund positions and the rise in oil prices during 2008 because hedge funds were heavily represented on both sides of the market.
Policymakers have wrongly interpreted this absence of evidence as evidence of absence, and concluded that speculation has no impact on the price of oil or other commodities.
Even a simple review of the record suggests that conclusion is implausible. It reveals more about the flaws and limitations of the econometric techniques used than about how the market actually works.
But there has been a much closer association between the accumulation and liquidation of hedge fund positions and the repeated spikes in oil prices in 2011 and 2012.
The impact is still very non-linear, which is why it is so hard to pick up with common econometric techniques, and the direction of causality remains ambiguous. Does the accumulation and liquidation of hedge fund positions drive prices, or are hedge funds just following price trends passively? The evidence is unclear.
But because hedge funds are increasingly non-specialist, operating as a pack rather than taking diversified and contrarian views, they may be having a bigger impact on prices in 2012 than they did in 2008, as all the funds try to establish net long positions simultaneously, and then rush for the exits at the same time.
The result is more pronounced cycling behavior in oil prices, tied closely to the accumulation and liquidation of hedge fund positions.

— John Kemp is a Reuters market analyst. The views expressed are his own.