The rally in oil prices over the past three months has been impressive, building confidence among market analysts that prices are heading in the right direction. But part of the gains can be at least partially attributed to the sharp increase in interest in oil exchange traded products.
The Wall Street Journal reports that net bets on rising oil prices represented 40 percent of all the front-month and second-month U.S. oil futures contracts in 2015 and 2016. There has been an uptick in money in exchange traded products compared to investments in broader commodity indexes. "If you have one instrument that's as much as 40% of the total open interest in the front contract and it's mostly long, that clearly creates froth on the price," said Ed Morse, global head of commodities research at Citigroup, according to the WSJ. Related: The Offshore Oil Business Is Crippled And It May Never Recover
In other words, money is piling into oil exchange traded products, such as ETFs, that specifically trade crude oil, as investors become interested in gaining direct exposure to a potential oil rally. At the end of 2015, money invested in exchange traded products exposed to specific commodities surpassed the value of swaps in broader commodity indexes.
The collapse in crude oil prices has created a once-in-a-generation opportunity to profit big from a rebound - assuming a strong rebound occurs. That has investors jumping out of diversified commodity indexes and into specific ETFs on crude oil. Investing in commodities "is becoming much more specific to short-term opportunistic [trading], rather than long-term strategic portfolio diversification," Kevin Norrish, head of commodities research at Barclays, told the WSJ. "We've had huge volatility and if you got the timing right, you certainly could have made a huge amount of money this year in commodities." Related: Are Low Oil Prices A Bigger Threat Than Terrorism For Algeria?
Of course, the frenzy in ETFs has, in turn, helped to push up oil prices. Speculative-driven price rallies are always more fragile than ones clearly driven by changing fundamentals. As soon as positions pile into one side of a price change, the chances of a correction moving prices back the other way tend to rise. That is especially true if the rally appears to exceed what is justified by the underlying fundamentals.
For now, the rally is holding just shy of $50 per barrel. And indeed the fundamentals are improving - U.S. supply is falling quickly and demand continues to rise at a 1.2 million barrel-per-day annual pace. If the rally continues, ETFs could be returning a lot of money to investors.
By Charles Kennedy of Oilprice.com
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