COLUMN-Oil bulls face severe test of faith (and pockets): Kemp

Mon May 14, 2012 10:31am EDT

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By John Kemp

LONDON May 14 (Reuters) - The collapse in oil prices since the start of May is posing a severe test for oil market bulls who must meet big margin calls to maintain their positions -- or close them out and accept their losses.

On February 22, the highly respected research team at Goldman Sachs recommended a long position in September 2012 WTI futures, then valued at $107.55 but now down more than $12 per barrel to a low of just $94.70 in trading earlier on Monday.

Goldman was the top oil price-forecaster in 2011. But it was in good company earlier this year in predicting a revival in WTI prices. Bullishness towards crude, especially WTI, was common around the market, even as the price surged above $120 per barrel and economists began to warn about potential risks to the recovery.

By the time Goldman issued its recommendation, hedge funds and other money managers had amassed a near-record long position in WTI-linked futures and options, equivalent to 300 million barrels of crude.

While Goldman analysts continued to see more upside potential in both Brent and WTI, they recommended exposure to discounted WTI in the expectation that the price gap would narrow and provide a bigger boost to U.S. light sweet crude futures ("Global Energy Weekly: Repositioning our trade recommendation as Brent crosses $120/bbl" Feb 22).

However, the imminent reversal of the Seaway pipeline has failed to narrow the spread. September 2012 WTI is actually trading at an even bigger discount ($13 per barrel) compared with when Goldman first issued its trading recommendation ($11). In the meantime, September Brent prices have fallen $10 per barrel.

The result is that long WTI futures positions like Goldman's are now doubly underwater (Charts 1-2).

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The price collapse has already prompted many hedge funds and commodity trading advisers to pull out of WTI.

Money managers have cut their gross long positions in WTI-linked futures and options from 331 million barrels to just 244 million since February 28, while the net long position has almost halved from 303 million to 169 million barrels, according to the latest data from the Commodity Futures Trading Commission .

The week ending May 8 saw the largest one-week drawdown in hedge fund long WTI positions for more than five years .

Most of the speculative length that had built up in the U.S. oil market since October 2011 has now been flushed out.

TO CLING ON OR QUIT?

In April and especially May, plunging Brent and WTI prices are likely to have inflicted significant pain on many hedge funds. Month-end performance letters are likely to reveal some big casualties.

While prices continue to slide (September WTI is down another $2 already today) the remaining longs will continue to haemorrhage cash and face tough margin calls.

The key question for traders still trapped in old longs, as well as others thinking of re-entering the market on either the long or the short side, is whether the liquidation has run its course, or is there more to come?

For the time being, momentum clearly favours the downside. Most days, both Brent and WTI prices are being offered lower. Price falls have also emboldened hedge fund shorts, which boosted their positions to 75 million barrels on May 8, up from 48 million on May 1, and the highest level since October 2011.

But appetite for short positions appears limited. Uncertainty about relations between the western powers and Iran, as well as the threat of other supply interruptions, may deter all but the most aggressive hedge funds from shorting crude. Besides, few commodity-focused funds are genuinely comfortable being short of the most important commodity of them all since it rather undercuts their reason for trading.

WTI longs also prospectively benefit from the continuing discount to Brent, which continues to provide an interesting, if serially delayed, relative value trade.

Set against this, Saudi Arabia has clearly expressed a desire to see (Brent-linked) oil prices fall back to around $100 per barrel. As long as the kingdom continues over-pumping and building inventories, it can exert a powerful downward pressure on prices.

On the other side of the Gulf, Iran and the western powers, even Israel, appear keen to avert an uncontrolled escalation of sanctions and military strikes, taking much of the short-term political risk premium out of the market.

With Brent languishing, and bulging stockpiles around the NYMEX delivery point at Cushing, Oklahoma, WTI prices may struggle to rally much.

For traders still holed by long positions established earlier this year, the climb out is uncertain. Many must now be more focused on minimising losses than maximising gains.

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