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Expert Commentary: How Hedge Funds Play The OPEC Deal Extension

Oil Barrels

We’ve had a good two-way crude oil market since the first of the year which has helped hold crude oil in a relatively narrow range as aggressive traders continue to play the long side, in anticipation of a balance between supply and demand.

This year began with an oversupplied crude oil market, but with a bullish tone set by OPEC when they decided to start reducing output in an effort to trim supply and stabilize prices. On paper, the idea seemed bullish. What they didn’t expect, however, was the surge in U.S. production that skewed their forecasts and timetables for global supply and demand to reach a balance.

For nearly six months, traders have been pelted with stories nearly every day telling them about OPEC supply cuts and increased U.S. production. The stories seem to have neutralized the markets to a point where crude oil prices have become range bound.

In order for a market to become range bound, some major market player has to be selling enough crude oil to stop a rally and some major market player has to be buying enough crude oil to stop the decline.

However, inside the trading range we’ve seen several pockets of volatility and these moves can only be blamed on the speculators and namely, the hedge funds.

If you’ve traded speculative markets, I’m sure you’ve noticed that markets come down faster than they go up. Essentially, this is because speculative buyers tend to be very careful about where they buy or enter the market, but when it’s time to sell, they don’t care what they pay to get out. Related: Was Last Week’s Oil Crash Inevitable?

In my opinion, the hedge funds came into 2017 with a bullish bias. They had one story to work with – OPEC production cuts – and they decided that this was the card they were going to play this year.

In effect, they were following the Herd Theory of Trading. Several times this year, we saw evidence in the market when one hedge fund bought and the others followed. We saw numerous times this year when hedge funds and other money managers purchased a record number of futures and options contracts linked to crude oil, in massive bets that prices will rise.

On February 21, hedge funds and other money managers held a net long position in West Texas Intermediate equivalent to 414 million barrels according to Commodity Futures Trading Commission (CFTC) data.

There was also evidence that hedge fund and other money manager increased their net long position in WTI by 254 million barrels since early November.

Two weeks later on March 8, crude oil prices plunged nearly 5% in one session.

This pattern was repeated again on April 19 and last week when crude prices fell over 8% over a two-day period.

(Click to enlarge)

These aggressive funds used various indicators and oscillators and perhaps even the news to build their long positions. This buying strategy worked when prices were low and there was room to run, but when the selling became greater than the buying as the market neared the top of the range, they stopped buying and the market sat in an even smaller range.

Hedge fund money managers don’t care about crude oil, they care about performance. And when the market stopped moving higher, they saw massive amounts of cash just sitting idly in the market. When frustration and impatience set in, they decided to lighten up or take profits on some of their positions.

But like I said earlier in regards to the Herd Theory, when one hedge funds starts taking profits, the others start doing the same. Eventually, the selling starts to feed on itself. Hedge funds end up both buying and selling and support begins to erode. Related: Corruption, Terrorism, And Mafia: The Global Black Market For Oil

At some point, this type of price action drives the market into a critical support area. Recall that when it’s time to buy, its scattered at various price levels, but when it’s time to sell, there is usually only one exit. And if all the hedge funds decide to sell at the same exit, we see huge price breaks in the market. This is what we’ve seen several times this year and this is what we are going to continue to see until the crude oil market breaks out of its trading range.

The hedge funds need momentum to make money. Coming from a low to high, the market has upside momentum, but once the momentum stalls, the hedge funds have no other choice but to sell out and liquidate their long positions. Only after the weakest long is taken out of the market, does new speculative buyers enter.

On May 25, OPEC is going to meet to discuss extending the production cuts. At this time, traders believe they will agree to an extension. If the extension is 6 months and the amount of production cuts remains the same then we should continue to see a range bound market.

If the cartel decides to extend a full year or if it decides to increase the size of the cuts then we may finally see crude oil rally enough to breakout of its trading range.

The hedge funds should remain major players on the long side of the market throughout this process.

By James Hyerczyk of Oilprice.com

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