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Hedge Funds Killed The OPEC Rally

Nick Cunningham

Oil investors were confident ahead of the OPEC meeting last week, holding onto their bullish bets, but now there seems to be a bit of an OPEC hangover after weeks of hype.

Heading into the meeting, hedge funds and other money managers increased their bullish bets on crude futures, despite already collectively holding a disproportionately bullish set of positions. The week before the meeting, bets on WTI jumped to their most bullish since February, according to Bloomberg. The shift occurred largely because short bets were liquidated, a sign that investors had fled the scene when they realized that OPEC wasn’t bluffing.

“There was definitely a consensus that we were going to see a six- to nine-month extension, so to be short in front of that obviously would not be a good positioning for hedge funds,” Nick Holmes, an analyst at Tortoise Capital Advisors LLC, told Bloomberg. “There was definitely some bullishness that we were going to see a pretty good result out of OPEC, which we did.” Net-long positions on WTI jumped by 15 percent in the week ending on November 28.

Even though OPEC signaled its resolve ahead of the meeting, the shift toward bullish bets was somewhat of a surprise given how overstretched on the long side investors appeared to be. Investment banks such as Citi warned that OPEC could disappoint, and the fact that major oil investors had built up record bullish positions meant that the price correction could have been painful. Nevertheless, investors put their money on OPEC.

Related: The Drastic Drop Off In U.S. Oil Imports

With that said, spot oil prices did not exactly surge despite the positive outcome. WTI surpassed $58 per barrel the day after the OPEC meeting, but fell back before the close. Since then, however, WTI has dropped significantly, dipping just below $56 per barrel by Wednesday.

In fact, the bullish bets may have merely kept oil prices afloat in the immediate aftermath of the OPEC announcement. And because there were hardly any gains to speak of, it is possible that at that moment—when everyone realized oil prices weren’t going to shoot through the roof on OPEC’s announcement—that investors began to unwind their bets. The data comes out on a lag, but the losses to crude in recent days could very well be attributed to profit-taking from hedge funds that believed that sentiment was turning. As John Kemp of Reuters put it on December 4, “the imbalance between long and short positions has become extreme, which suggest that the risk of a sharp price reversal remains high in the short-term.”

Still, this by no means that we are heading for another slide for any lengthy period of time. Far from it. Inventories are still declining and the OPEC cuts are now assured through at least mid-2018, if not the full year. That at least puts a floor beneath prices, a floor that is probably quite a bit higher than the $40/barrel threshold that we have seen for more than a year. $50 is the new $40. That is especially true with the inclusion of Nigeria and Libya into the production cut deal, which will remove any unwanted surprises from those two OPEC members.

Related: Nigeria Reforms Oil Sector To Draw New Investment

For its part, Goldman Sachs hiked its oil price forecast for 2018, putting spot Brent at $62 per barrel and WTI at $57.50. Importantly, the investment bank says that while uncertainty remains, the risks are “skewed to the upside into 2018 on the risk of an overtightening, either because of new disruptions, demand exceeding our optimistic forecast or OEPC letting the stock draw run hot.”

Goldman cites the shape of the futures curve—the backwardation will continue to steepen, due to higher near-term prices and lower longer-dated prices. The steeper backwardation will induce stronger inventory drawdowns and higher prices for the next year or so, before more shale production starts to drag down prices again into 2019.

By Nick Cunningham of Oilprice.com

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