US crude futures start to look stretched: John Kemp

Is the oil market heading for a repeat of last year: a big run up in prices during the first few months followed by a sudden crash when the inflows of investment money dry up and early entrants try to realise their gains?

There are eerie parallels. Like last year, strongly accommodative central bank policy from the Federal Reserve and signs of recovering economic activity in North America and Western Europe are coupling with physical supply disruptions to encourage a more bullish outlook for oil.

In 2011, it was Libya and Fukushima, combined with the Fed's second-round of large-scale asset purchases (QE2). This year it is Sudan and tensions around Iran, while the Fed indicates interest rates are set to remain low through 2014.

The potent cocktail of recovering demand with continuing supply disruptions has turned investors bullish for the first time in over six months.

Hedge funds and other money managers are now running more than six times as many long positions in U.S. crude futures and options (287m barrels) as short ones (45m barrels).

The ratio of long to short positions has doubled since October and is more stretched than any time since May 31, 2011, when funds were still liquidating long positions after the flash crash on May 5.

There are some important differences between the current market position and the corresponding point last year.

The big imbalance between funds' long and short positions is not apparent in the Brent market, where commitment of traders data published by Intercontinental Exchange shows funds running a long/short ratio of 3:1.

Much of the net length in the U.S. crude market comes from the absence of short positions, which have shrunk more than half, from around 90m barrels in October to 45m barrels in the week ending February 7, according to commitments of traders data published by the U.S. Commodity Futures Trading Commission (CFTC).

Money managers' combined long positions total just 288 million barrels, up just 20 million or so since October, and far below the peak of 350-400 million barrels in first half of 2011.

If last year's commitment of 350-400 million barrels indicates how much money investors could potentially commit to a convincing bull market, there are still of funds on the sidelines that could come into the market and lift prices further.

It may though need more convincing evidence of a sustained increase in oil demand or actual disruptions, not just threats, to Gulf supplies to draw in the next wave of investment money.

Despite the differences, it would be dangerous to take too much comfort from the fact the large net long position in U.S. crude currently comes from the absence of shorts rather than an overhang of long positions. Short positions provide stability because they represent a pool of willing buyers when prices dip.

Sharp movements in prices are often preceded by a big imbalance in long and short interest. In this instance, there may not be much short buying interest below the market at current levels to stabilise prices if the rally falters.

Many hedge funds and other money managers couple positions in U.S. crude with contrary positions in Brent to trade the spread and a comparative view on supply and bottlenecks. It seems likely at least some of the long positions in U.S. crude are twinned with short positions in Brent as funds bet on convergence.

So if there is increasing fragility in the US crude market, it could be expressed as a sharp widening of the Brent-WTI spread, a decline in outright WTI and Brent prices, or some combination of the two.

But the heavy imbalance in US crude positioning suggests that one way or another the market is increasingly being set up for a sharp move.