LONDON, Aug 29 (Reuters) - The rapid rise in oil prices since the beginning of June has all hallmarks of a mini-bubble, drawing in a host of hedge funds and money managers, nearly all of whom are positioned the same way, expecting prices will rise further.
The question is whether it will inflate further, or is about to burst?
Could the commencement of military action against targets in Syria be the trigger for oil prices to turn lower?
Between June 6 and July 23, U.S. light crude oil futures rose by nearly $14 per barrel (15 percent) while Brent futures were up $5 (5 percent).
Over the same period, hedge funds and other money managers raised their net long position in U.S. crude futures from the equivalent of 258 million barrels to a record 401 million. Their net long position in Brent futures went up from 164 million barrels to 188 million barrels (Chart 1).
In U.S. crude, the ratio of money managers’ long to short positions doubled from 4.5:1 to 9.3:1. In Brent, it went from 3.9:1 to 4.6:1 (Charts 2 and 3).
Hedge funds and money managers have since started to lighten their positions, while prices remained firm and then rose further, as the security situation in the Middle East worsened, first in Egypt and more recently in Syria.
By August 20, money managers’ net long positions had been trimmed to 361 million barrels in U.S. crude, and they were running long: short by a ratio of 7.1:1.
But the co-movement of prices and speculative positions is unmistakable, especially in WTI. Since 2010, there has been a close correspondence between the accumulation and liquidation of money managers’ positions and the rise and fall of futures prices (Charts 4 and 5).
The correspondence is closer and more striking in U.S. crude than Brent. U.S. crude remains more popular with financial investors, and more obviously influenced by them than the more physically dominated Brent market.
Being in a bubble does not mean the rise in prices was not sparked by solid fundamental reasons. Solid fundamental factors for the rise in prices include the drawdown in commercial crude inventories in the United States, summer maintenance in the North Sea, disruption to oil supplies in North Africa, and now the deteriorating geopolitical environment across the Eastern Mediterranean.
But the market has become “locked” into a classic bubble as all the hedge funds and money managers have tried to implement the same, bullish, view on prices at the same time by taking long positions in WTI and Brent futures and options.
Market locking is the defining characteristic of a bubble, according to Didier Sornette of the Swiss Federal Institute of Technology. Locking behaviour, when the normal diversity views on prices is replaced by unanimity, precedes both asset bubbles and crashes, resulting in explosive price increases and falls, as Sornette outlined in his 2003 book explaining “Why Stock Markets Crash”.
Once the market locks, price movements tend to accelerate, until the market moves far out of line with fundamentals, and at least some market participants attempt to bail out, sending the movement into an equally brutal reversal.
Locking and exponential price moves are usually a sign the end of a rally or crash is near, at least in terms of time, though not necessarily in terms of price. The usual dictum that the market can remain irrational longer than you or I can remain solvent still applies.
The question is whether the current mini bubble in oil is near to its fullest expansion, or could yet inflate further. There are some reasons to think, cautiously, that it might be near full inflation.
By late July and early August, hedge funds had amassed 115-120 positions in U.S. crude futures above the reporting limit, currently 350 futures contracts, equivalent to 350,000 barrels. Some hedge funds may have controlled more than one position. The number of reported positions was up from a recent low of just 91 on June 4, according to the U.S. Commodity Futures Trading Commission.
In the last six years, the number of reported hedge fund long positions has ranged from a low of 51 to a peak of 162 (in March 2011, only a few weeks before the market crashed on May 5, 2011). The average number of reported long positions has been 100.
By late July and early August, the number of hedge funds already invested was well above average, and their collective net long position was at a record level. The average hedge fund long position was over 3,500 contracts (3.5 million barrels).
There was still some potential for positions to be increased and for more hedge funds to be drawn in to the market, but it was clearly much less than it had been two months earlier.
Brent on Thursday was traded at $115.75 a barrel, back from six-month highs the previous session above $117.
“We believe that in the coming days, Brent could gain another $5-10, surging to $120-$125, either in anticipation of the attack or in reaction to the headlines that an attack had started,” Socgen’s Mike Wittner said in a note to clients.
“If the regional spill-over results in a significant supply disruption in Iraq or elsewhere, Brent could spike briefly to $150,” he added.
At least some hedge funds may see a military attack by the United States and its allies on targets in Syria, and any associated spike in prices, as an opportunity to reduce their net long positions by selling into strength.
“Buy the rumour, sell the fact,” remains sound advice. It is one reason some oil analysts think prices might spike higher once military action gets underway, but price gains might not last long.