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Nick Cunningham

Nick Cunningham

Nick Cunningham is a freelance writer on oil and gas, renewable energy, climate change, energy policy and geopolitics. He is based in Pittsburgh, PA.

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Are Hedge Funds Pushing Oil Prices Too High?

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Hedge funds and other money managers continue to gobble up bullish bets on oil futures, but the speed with which spot prices have risen in the past few weeks raises the prospect of a short-term correction.

Major investors continue to push their bullish bets on oil futures to new heights, confident that the rally still has more room to run. Strong demand, falling inventories and geopolitical uncertainty have fueled a sense of optimism not seen in years.

But the risk is that investors are taking things too far, at least in the short run. As John Kemp of Reuters recently put it, the “accumulation of bullish positions is easily the largest on record and far outstrips anything seen even during the spike in oil prices during late 2007 and the first half of 2008.” He pointed out in his column that hedge funds now hold more than 10 long positions in oil futures for every short, a ratio that is sharply up from 1.60:1 from June 2017.

Such lopsided positioning looks overstretched, which could prompt a selloff as investors scramble for the exits. That kind of correction in both hedge fund positioning and crude prices has happened several times in just the past few years.

Other analysts are also sounding the alarm. “Typically when the boat gets tipped greatly to one side, like it is right now, you get a reversal,” John Kilduff, a partner at Again Capital LLC, told Bloomberg. “There’s a lot of technical aspects working against” the rally, he added.

It is not as if the bullishness is entirely unfounded. U.S. crude inventories have fallen sharply over the past year, and are at their lowest level since early 2015. Venezuela’s output is declining at a scary rate, and tension in the Middle East leaves open the possibility of more outages. All the while, demand continues its inexorable rise, year after year.

Related: Has Oil Become Overbought? 

But that doesn’t mean that prices will continue to increase uninterrupted. The steep increase in prices over the past few months may have outpaced the fundamentals. “[C]urrent prices appear over-stretched, and we expect a short-term correction to the downside. Crude oil looks overbought on a technical and positioning basis,” Standard Chartered analysts wrote in a research note. “The 14-day Relative Strength Indices (RSI 14) have been firmly in overbought territory since 10 January… While we think prices could still rise by a couple of dollars in the near term, the next USD 3-5/bbl move is likely to be down.”

Not everyone agrees. David Sheppard, energy markets editor at the FT, made the case that hedge funds and other money managers are not irrational to continue to scoop up bullish bets. He cites real progress in the fundamentals, which is solid evidence of a tightening oil market.

Perhaps more importantly, however, is the downward sloping futures curve. With near-term contracts trading at a premium to longer-dated futures — a structure known as backwardation — traders can turn a profit simply by taking long positions on crude, even taking into account a bit of volatility. By buying up contracts along the curve at lower prices, traders can sell higher priced spot contracts as they come up, pocketing the difference. The practice could earn traders a 5 percent return this year, Sheppard argues, which can certainly beat out other investments.

Sheppard does point out that such an investment strategy only works if the fundamentals continue to improve, providing the basis for elevated spot prices.

Related: Strong Oil Demand Growth Supports Oil At $70

Whether or not the fundamentals do justify confidence in prices at current levels is, to a large degree, a matter of opinion. While some see more room to run, others see things getting out of hand. Norbert Ruecker, head of commodity research at Swiss bank Julius Baer, said a price "correction should occur... (as) hedge fund expectations for further rising prices have reached excessive levels,” according to CNBC.

What happens next will quite possibly hinge on whatever news trend investors latch on to. If, say, an outage occurs in Libya, or Venezuela reports another shocking decline in output, then hedge funds may not worry about the extreme net length right now in the futures market. On the flip side, if the U.S. rig count soars, or inventories start rising again, there will be a lot of pressure to liquidate those long bets.

Stay tuned.

By Nick Cunningham of Oilprice.com

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  • Mamdouh G Salameh on January 18 2018 said:
    Hedge funds and money managers not only gobble up bullish bets but also bearish sentiments as they have done through 2014-2017. However, their contribution to the oil price does not exceed 10% at best.

    I keep repeating that the current strong bullish trends in the global oil market are underpinned by positive fundamentals in the market such as growing global economy particularly in China, fast-growing global demand for oil and also by the fact that the market is re-balancing fast.
    This enables the global oil market to absorb any extra oil supplies US shale oil could throw at it.

    If there is to be a correction in the oil price in the current environment, it will be upward despite what analysts are saying.

    Dr Mamdouh G Salameh
    International Oil Economist
    Visiting Professor of Energy Economics at ESCP Europe Business School, London
  • Johnny on January 18 2018 said:
    Dramatic correction!?Inventories have been drained dramatically.That is dramatically happening now,no oil price correction.
  • Kishore on January 18 2018 said:
    OPEC agent Dr Mamdouh G Salameh spotted again.
  • Bob Armstuingly on July 18 2018 said:
    The Nopec law the US is pushing for will allow anyone to sue hedge funds and banks for manipulating the price of oil with long and short positions. Current law allows the average Joe or Jane to sue a company or person who is with holding tax or committing a crime and if they win they get a share of the judgement. This is perfect, hedge funds look out the time for a recconning is upon us. And you will pay!

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