(John Kemp is a Reuters market analyst. The views expressed are his own)
* Chart 1: tmsnrt.rs/20oD3ol
* Chart 2: tmsnrt.rs/20oD63J
* Chart 3: tmsnrt.rs/20oDteD
* Chart 4: tmsnrt.rs/1RIsawi
By John Kemp
LONDON, Jan 25 (Reuters) - Hedge funds had covered only a small part of their record short position in crude oil by early last week, but it was still enough to send prices surging more than $6 higher over the course of Thursday and Friday.
Hedge funds reduced their combined short positions in the main Brent and WTI futures and options contracts by 16 million barrels, just 4 percent, over the seven days to Jan. 19 (tmsnrt.rs/20oD3ol).
Combined short positions in the main NYMEX and ICE Futures Europe contracts were cut from a record 392 million barrels to 376 million barrels, which was still the second-largest short recorded.
Shorting by hedge funds and other money managers has been closely correlated with the rise and fall of crude futures prices since the start of 2015 (tmsnrt.rs/20oD63J).
The enormous short positions built up by hedge funds over the last three months have coincided with the decline in oil prices to the lowest levels since 2003.
But the concentration of short positions has left the price crash looking over-extended and vulnerable to any change in sentiment or simply profit-taking.
So it comes as no surprise once the selling pressure paused and some hedge funds began to lighten their short positions it triggered an aggressive rally (tmsnrt.rs/20oDteD).
Past experience suggests large concentrations of similar positions in any market, bullish or bearish, are associated with large momentum-driven price moves followed by even sharper partial reversals.
The process of price formation and reversal has been described by physicist Didier Sornette (“Why stock markets crash”, 2003) and portfolio manager James Clunie (“Predatory trading and crowded exits”, 2010).
The biggest price corrections come not when the first few position holders try to exit from their positions but when the mass of position holders tries to follow (when the trickle of early exiters turns into a flood).
With well over 350 million barrels of short positions still hanging over the oil market, the process of short covering has barely begun, so the main correction and volatility could still lie ahead. (Editing by David Evans)