Hedging Energy Bets: The Case for a 2018 Oil Bull Run

Hedge funds are the most bullish about oil prices in years, expecting further gains even as prices touch multi-year highs and ignoring the risk linked to such a large concentration of positions.

A record net long position has been accumulated by hedge funds and other money managers, amounting to 1,183 million barrels in the five biggest futures and options contracts covering crude, gasoline and heating oil.

Portfolio managers held a record 1,328 million barrels of long positions in Brent, WTI, U.S. gasoline and U.S. heating oil on Dec. 26, according to data published by regulators and exchanges.

By contrast, hedge funds held only 145 million barrels of short positions, the lowest level for 10 months and among the lowest at any point since the start of 2013.

Fund managers now hold more than nine long positions for every short position, the most bullish picture for at least five years.

There are record net long positions in Brent crude (561 million barrels), WTI (461 million barrels) and U.S. heating oil (82 million barrels).

There are also large, if not quite record, net long positions in U.S. gasoline (79 million barrels) and European gasoil (131 million barrels).

In many of these contracts hedge fund positioning appears extremely stretched, with the ratio of long to short positions at multi-year highs.

The concentration of so many bullish positions poses a significant downside risk to prices if and when portfolio managers decide to close them out and realise some of their paper profits.

For the time being, however, most fund managers are ignoring the liquidation risk and focusing on the prospect of further price increases first.

There are plenty of reasons to be bullish about the outlook in 2018. The global economy is in a synchronised upswing and world trade is growing at the fastest rate since the start of the decade.

Stocks of crude and products have fallen significantly since the middle of 2017. Oil demand is growing rapidly while OPEC and its allies have extended their production pact until at least the middle of the year.

History suggests OPEC is more likely to tighten the oil market too much and allow prices to overshoot on the upside than rather than relax production cuts too early and risk prices falling back.

Such was the case after both the previous oil market slumps in 1997/98 and 2008/09, with prices overshooting the producer group's initial targets.

OPEC’s tightening bias probably explains why many hedge funds remain bullish despite benchmark Brent prices moving towards $70 a barrel.

The main downside risk comes from a resurgence of U.S. shale oil production, with WTI prices now above $60 a barrel.

If shale output starts to climb faster than expected OPEC could be forced to halt production cuts earlier than currently envisaged.

The existence of so many hedge fund long positions could eventually magnify the downside risk posed by U.S. shale.

However, most hedge fund managers seem to have concluded that the risk is some way off and prices have more scope to climb before the inevitable correction.

(John Kemp is a Reuters market analyst. The views expressed are his own)