Have Hedge Funds Set Oil Markets Up For A Rebound?

Hedge funds and other major investors have soured on oil prices, and the pessimistic turn has corresponded with the deep selloff in recent weeks.

Since the beginning of June, the long positions held by speculators have been liquidated and they have moved to scoop up short bets equivalent to 162 million barrels, almost a record high, according to the FT. The sudden bout of pessimism came after the market concluded that OPEC's efforts, following the group's late-May meeting in which it extended the production cuts for another nine months, would be insufficient in balancing the market.

We have previously explored the multiple reasons why the market could remain oversupplied, from the resurgence of Libyan and Nigerian production, to ongoing increases from U.S. shale, elevated crude inventories, and questionable demand figures.

It all adds up to a growing consensus that we may not see a rebound in prices anytime soon. JP Morgan just put out a new forecast in which it predicted that Brent crude would average below $50 per barrel…through the end of 2018. The investment bank says WTI will average just $42 in the fourth quarter of next year.

In the near-term, however, the sentiment of hedge funds is very important. Hedge funds are now holding the lowest net-long position in nearly a year, a sign of just how pessimistic they are about oil prices in the short run. Prices have declined by more than 15 percent since OPEC's meeting a month ago. But the short bets continue to rise, which could push oil prices even lower - a sort of self-fulfilling prophecy. Related: Crisis-Stricken Venezuela Looks To Import Fuel

"If the funds decide to take on OPEC there's no doubt we'll go below $40 a barrel," Doug King, co-founder of the Merchant Commodity Fund, told the FT. "Oil is still extremely vulnerable to a serious nosedive as we're just not seeing what we need to see."

Others agree. "Prices can go below $40 a barrel given the market is being dictated by sentiment and not fundamentals. There is nothing to stop it right now," Amrita Sen of Energy Aspects, told the FT.

The flip side of this situation is that as investors flock to bearish positions, it sets the market up for a potential rebound. These financial flows tend to snap back in the other direction when the herd takes things too far. This has occurred multiple times over the past year as oil prices enter bullish and bearish phases.

For example, in the weeks following the OPEC deal late last year, investors piled into long positions on crude contracts, betting on rising prices. After an initial rise into the $50s, prices plateaued. The bullish bets kept rising even as prices got stuck. By early March, the buildup in bullish bets looked untenable, and everyone rushed for the exits. Oil prices fell from the mid-$50s to the mid-$40s in about two weeks as investors unwound their positions.

All of that is to say that we may very well see a sharper dip, perhaps below $40 per barrel. But with so many bets placed on lower prices these days, a string of bullish news could cause traders to close out shorts and buy up long positions, causing prices to snap back up. "It's near the lows of what it's been this year, which to me signals that we're closer to a bottom," Rob Thummel, portfolio manager at Tortoise Capital Advisors LLC, told Bloomberg.

Indeed, the oil market has seen several consecutive days of stable trading, and even some small price increases. It is too early to tell, but perhaps crude has stabilized, which could convince some investors that there is little room left on the downside. "It is just the fact that the oil market stopped falling ... I suspect short-covering," Ric Spooner, chief market analyst at CMC Markets, said in a CNBC interview. Related: Oil Industry To Waste Trillions As Peak Demand Looms

So, some small but non-trivial increases in WTI and Brent are possible in the near run. With oil "perhaps as egregiously oversold as it has been in several years…I suspect that you're gonna get a much larger than anticipated dead-cat bounce, maybe taking front-month WTI back to $46," Dennis Gartman of The Gartman Letter told CNBC. "I bet you get over the next two weeks a $5 bounce."

However, Gartman went on to add that the short-term is entirely different from what will happen to oil in 2018 and 2019. "But, I'll tell you one thing. In the long run, crude oil is heading egregiously lower. A year from now, two years from now, three years from now…we will be much lower than we are now."

By Nick Cunningham of Oilprice.com

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