Forget the interplay between supply and demand. When it comes to oil prices, hedge funds and speculators are exerting an uncommonly large influence, say many in one of the world’s most important markets.
Oil traders have watched future prices rally to their highest level this year, within touching distance of $70 a barrel, even as the price of physical cargoes flounders under the weight of a massive oversupply.
In an attempt to explain the conundrum, experienced traders are pointing at the influence of mult ibillion-dollar macro funds. While much of the increase in speculative demand has been driven by a perceived improvement in oil fundamentals, as US drillers have curtailed activity, other factors have been at work.
Traders say funds have bought oil futures not just as a bet on an eventual oil price recovery, but as a hedge against a weaker US dollar, rising government bond yields and shifting inflation expectations, which have roiled the bigger part of their portfolios.
“Ultimately, the dominant force in the crude market today is macro funds, with talk of diversification and inflation back on the agenda,” says Energy Aspects, a London-based consultant.
“Some of these multibillion-dollar macro funds may only be putting 1 per cent of their portfolio in oil, but that is enough to dwarf far smaller fundamentally focused funds at times.”
After the European Central Bank announced the launch of quantitative easing in January, a popular trade was to sell euros and buy the German Bund and US dollar.
But German 10-year Bund yields have risen towards 0.70 per cent after threatening to turn negative last month. That has led some funds to start unwinding the trade or look at additional hedges for large positions they might struggle to exit quickly.
“If you fear a Bund price fall driven by inflation, then buying Brent provides some protection,” says David Hufton, chief executive of PVM, an oil broker. The correlation between Brent and Bund yields is more than 90 per cent, he adds.
More broadly, buying oil when the dollar weakens also acts as an offsetting position for some investors, given most commodities are priced in the world’s reserve currency.
The dollar was a contributing factor to oil’s crash between June and January as it rose 16 per cent against a basket of other currencies. However, the 60 per cent decline in crude from about $115 to $45 a barrel over the same period illustrates how crude was largely trading on its own fundamentals, as the US shale boom contributed to oversupply.
But the scale of futures based trading in the oil market is immense, and an important driver of prices.
During the past decade there has been a surge in the volume of crude contracts traded on ICE and Nymex, the main commodity exchanges. Daily average turnover has increased from 350,000 futures contracts in 2005, when electronic trading started to dominate, to 1.5m — or 16 times the world’s global daily oil demand — according to calculations by the Financial Times.
Exchange and regulatory data show that funds hold net positions in futures and options markets in London and New York equivalent to about 510m barrels of crude. That is equal to more than five days of global demand, or the combined monthly output of Saudi Arabia, Iraq and Iran, the biggest producers in Opec.
Some investors are warning that fund buying could dry up or reverse, putting pressure on prices. When oil was $10 lower “there was a lot of hedge fund interest in buying oil as it looked oversold”, says one manager of a fund-of-funds in London. “But there’s less interest now after the rally, as it has started to look a little too extended.”
A third of the most active US oil futures contract is controlled by exchange traded funds, popular with retail investors and hedge funds.
Hedge fund short positions, or bets that the price will fall, increased during the oil price rout, though in West Texas Intermediate, the US benchmark, they peaked in March at about 200m barrels, almost two months after the price had troughed.
Some market participants see the closure of more than half of those short positions since then as helping accelerate oil’s recovery. WTI was just below $60 on Friday.
“Futurisation of oil has been as dramatic in its impact as the arrival of horizontal drilling and fracking,” says Mr Hufton. “Fracking transformed oil supply dynamics; futurisation has transformed the factors driving oil prices.”
Goldman Sachs, one of the most influential banks in commodity markets, is warning that the rally may have gone too far. While its analysts see stronger demand from Asia and other fundamental factors as supportive of the price, they wrote in a note this week that the large hedge fund long position in oil could trigger a sell-off if the funds take profits.
“While it is possible that markets have become more forward looking and are already looking beyond the near-term fundamentals, just like they did last fall, we ultimately don’t share this forward view of sharply improving fundamentals, even in 2016,” the bank said.
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