Hedge Funds Find Plenty of Willing Sellers: Kemp

Posted by Joseph Keefe

For every buyer of futures and options there must be
a seller. For every long position there must be a corresponding
short position.

Hedge funds and other money managers have purchased a record
number of futures and options contracts linked to Brent and WTI,
betting that prices will rise.

As a group, hedge funds now hold a record net long position
equivalent to 951 million barrels across the three main Brent and
WTI contracts (http://tmsnrt.rs/2mm1HeI).

Hedge fund long positions outnumber short positions by a record
ratio of 10.3:1 (http://tmsnrt.rs/2mvnvBA).

With hedge funds almost all long, some other group of traders
must have sold a correspondingly large number of futures and
options contracts, either as a hedge or betting prices will fall.

OIL TRADERS

Since September 2009, the U.S. Commodity Futures Trading
Commission (CFTC) has employed a four-way classification for all
traders with reportable positions in crude oil.

Traders are classed as a producer/merchant/processor/user, a swap
dealer, a money manager, or into a miscellaneous "other
reporting" category.

Traders with positions less than 350,000 barrels do not have to
report them but they show up as a residual "non-reporting"
category.

The classification is discussed on the commission's website
("Disaggregated commitments of traders report: explanatory
notes", CFTC, undated).

If a trader's market activities span more than one category, the
commission makes a judgment about their predominant activity, and
all trades are then classed in this category.

Unfortunately, the commission does not disclose how individual
traders are classified, which creates considerable uncertainty
about the composition of the categories.

For example, if a major oil company hedges its inventory as well
as providing price risk management services to customers, we
don't know whether its trades are classified as
producer/merchant/processor/user or as a swap dealer.

NYMEX WTI

On Feb. 21, hedge funds and other money managers held a net long
position in WTI on the New York Mercantile Exchange (NYMEX)
equivalent to 414 million barrels, according to CFTC data.

"Other reporting" traders also held a net long position of 173
million barrels while non-reporting traders were net long by 15
million barrels.

The corresponding short positions were held by
producer/merchant/processor/users, with a net short position of
291 million barrels, and swap dealers, with a net short of 310
million barrels.

As hedge funds have increased their net long positions in WTI,
the majority of the contracts have been sold to them by swap
dealers (http://tmsnrt.rs/2mlWLGN).

Hedge funds and other money managers have increased their net
long position in WTI by 254 million barrels since early November.

Swap dealers increased their net short position by 202 million
barrels over the same period (with the balance of extra short
positions coming from producer/merchant/processor/users).

Hedge fund positions in WTI are more closely correlated with swap
dealers than with any other category of traders.

The CFTC defines swap dealers as any "entity that deals primarily
in swaps for a commodity and uses the futures markets to manage
or hedge the risk associated with those swaps transactions".

According to the commission, "the swap dealer's counterparties
may be speculative traders, like hedge funds, or traditional
commercial clients that are managing risk arising from their
dealings in the physical commodity".

Swap dealers function as market makers and intermediaries and may
assume positions on their own account or act as intermediaries
for other traders.

Swap dealers (or their clients) have been eager sellers of
futures and options linked to WTI because as hedge funds have
accumulated a record position prices have scarcely risen since
mid-December.

ICE BRENT

Intercontinental Exchange (ICE) employs a similar four-way
classification for trades in its Brent and other commodity
contracts listed in London.

But although ICE employs the same criteria there is no guarantee
that individual classifications by ICE and the CFTC are the same
because the CFTC does not disclose how individual traders are
categorised.

The positioning of traders is very different in Brent, which may
reflect differences in the structure of the market, or
inconsistencies in classification.

On Feb. 21, hedge funds and other money managers held a net long
position in ICE Brent futures and options equivalent to 508
million barrels.

Swap dealers also held a very large net long position amounting
to 428 million barrels in Brent, according to records published
by ICE, which contrasts with their large short position in WTI.

In Brent, the corresponding short positions all came from
producer/merchant/processor/users with a net short position of
790 million barrels (http://tmsnrt.rs/2mvw1jS).

Hedge funds have boosted their net long position in Brent by 241
million barrels since Nov. 8, with most of this supplied by an
increase in producer/merchant/processor/user short positions of
193 million barrels.

Swap dealers have also cut their net long position in Brent by 66
million barrels since early November, but this has supplied only
a small part of the hedge fund long positions.

Despite the differences between the commitments of traders in the
two markets, hedge fund buyers of Brent have found plenty of
willing sellers, with prices barely changing for the last two
months.

TWO-WAY MARKET

Not much is known about the identity and motivation of the short
sellers, other than that have been willing to sell large numbers
of extra futures and options contracts at Brent and WTI prices
just over $50 per barrel.

Some of them, especially in WTI, are likely to be U.S. shale oil
producers keen to hedge their production for 2017 and 2018 and
lock in revenues in case prices slump again.

Some could be hedging inventories, though in theory the demand
for inventory hedging should be declining as crude stocks fall.

Some could be outright shorts with a more bearish view on the
outlook for oil prices than hedge fund managers and willing to
take the other side of the trade.

And some could simply be making a market for their hedge fund
clients by willing to sell futures and options to them on demand.

While we know very little about the identity of the shorts, their
motivations could be crucial, because at some stage the hedge
funds will want to take profits and liquidate some of their
record long position.

At that point, the readiness of the short sellers to buy back
these futures and options will make a big difference to how that
liquidation occurs.

There has been a good two-way market for the last two months
which has kept prices trading in a narrow range despite a large
number of futures and options changing hands.

The critical question is whether that liquidity will remain high
in the months ahead or evaporate, which could lead to either a
spike in prices or a sharp drop when some of the trades are
closed out.

By John Kemp

Feb 27, 2017

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