By John Kemp
LONDON Dec 19 (Reuters) - In a tough landscape for commodities, most hedge funds and other money managers have decided to stick with long positions in crude oil, boosting their investments even as prices slide.
For commodity funds, who must basically be long of something to justify their continued existence, crude is the least-dangerous among a series of tricky alternatives.
According to commitments of traders data released by the U.S. Commodity Futures Trading Commission, money managers' long positions in futures and options linked to U.S. crude (285 million barrels) are running at almost five times the level of short positions (59 million barrels).
The long:short ratio has almost doubled from 2.6:1 at the start of October, and is well above average for the last five years, though still only half the 10:1 ratio recorded just before the flash crash in oil markets on May 5 ().
Most of the adjustment has come from the short side, where funds with short positions in WTI, either outright or as part of a Brent-WTI spread, have bought them back as U.S. crude prices have risen.
Shorts linked to WTI are down 40 percent from 98 million barrels to 59 million since Oct 4. Longs are up 9 percent from 263 million to 285 million. For the most part funds have become less bearish on WTI, rather than more bullish, though a few aggressive traders have been adding to their upside exposure.
The same pattern is apparent in Brent. Managers have taken profits on their shorts, while adding cautiously to long positions, as prices have dropped to some of the lowest levels since February. Fund managers have boosted long positions by 22 million barrels (23 percent) while slashing shorts by 34 million barrels (50 percent) ().
The persistence of so much bullishness seems odd at first glance. Political risks linked to Iran continue to offer support, but the economic outlook is worsening, cutting expectations about demand next year. And on the supply side, fears about disruption of Iran's exports are offset by expectations of improved availability from 2013 onwards as a result of fracking and other technology developments.
But it has been a rough year for commodity funds as a whole, as the darkening outlook has snuffed out first-half price gains. There are signs money managers are becoming more conservative, focusing on relative value rather than directional trades, with crude winning a beauty contest among ugly alternatives as the commodity with the least-worst prospects.
Conservative allocations favour crude for three reasons:
(1) In principle, a commodity fund could be long or short of commodities as a whole. But most investors have allocated money to specialist commodity funds because they believe the asset class will outperform.
Justifying a net short exposure across the portfolio is difficult. It is even harder if prices rise, and they find themselves losing money in an asset class to which they had made a strategic allocation.
Commodity fund managers therefore have no option but to be long of something. The best they can do in troubled times is to raise their exposure to cash in a bid to dampen the impact of market moves on the portfolio's performance.
(2) For outsiders, the asset class is synonymous with oil and gold, which are the most visible, with prices quoted daily in the media. Fund managers are under intense pressure to remain long or at least neutral towards crude.
Most investors may be prepared to overlook a fund's losses when oil prices are tumbling as bad luck rather than poor management. In contrast, a manager who loses money when oil prices are surging is unlikely to survive long. Long positions in crude futures and options therefore provide "right-way" exposure to the asset class.
(3) Given the long lead times needed to develop new crude oil supplies (5 years or more), compared with shorter lead times in agriculture (1-2 years) or aluminium smelters (2-3 years), oil is a much better defensive option when the short to medium term outlook becomes uncertain.
In a prime example of increasing conservatism, the giant Schroder Alternative Solutions Commodity Fund has battened down in the face of the storm, boosting its cash allocation from an already-high 24 percent at the end of August to 31-32 percent in September and October and more than 32 percent at the end of November.
In the meantime, allocations to Brent and WTI have remained steady or increased. The result is that crude accounts for an increasing share of the non-cash part of the portfolio.
The fund's total exposure to energy has edged up slightly, from 21 percent at the end of August to 23 percent at the end of November. In contrast, exposure to agricultural products has been slashed from 34 percent to 23 percent, according to performance data published on Schroders' website.
The same strategy is being replicated at other funds. As the outlook becomes confusing, exposure is being pulled back to the "core" of the portfolio and away from riskier outlying areas.
In a more turbulent environment, the risks of straying too far from the herd have risen, and managers are sticking with bellwether commodities most familiar to investors, with the longest supply lead times to minimise downside risk.