(Removes typo in first paragraph)
By John Kemp
LONDON, March 5 Observing Brent in the first two months of 2013 has been a bit like watching a broken barometer. It is not clear what the market has been reacting to, as prices swing to and fro, but it certainly hasn't been fundamentals.
Volatility has fallen to its lowest level for almost two decades. But what remains seems to have been induced by hedge funds rather than changes in physical supply and demand.
The now customary rally at the beginning of 2013 started a little later than last year. But between Jan 17 and Feb 8, front-month futures climbed steadily from $110 to more than $119 per barrel, before subsiding with the same steady consistency and ending up back where they started by the start of March .
Ostensibly, the rally was triggered by the strengthening macroeconomic outlook, especially in the United States, after policymakers skirted the edge of the fiscal cliff, as well as improving sentiment in other financial markets. Saudi Arabia's aggressive production cuts between October and December removed fears about a possible crude market surplus and downside risk.
The subsequent price reversal has been attributed to worries about the impact of higher prices on demand and the economy, renewed economic worries stemming from the euro zone, and hints that Saudi Arabia will up production in March and April, as policymakers change course.
Overlaying all these broader factors are continuing problems with production of the four North Sea crude streams (Brent, Forties, Oseberg and Ekofisk) that physically underpin the Brent futures prices. BFOE crudes remain in short supply, keeping the market in a steep backwardation, with futures prices tending to rise sharply in the run up to contract expiry.
But none of these factors can provide a convincing explanation for the behaviour of futures prices so far this year.
FUNDS ARE DRIVING SPOT PRICES
Changes in the macro outlook and sentiment were too tenuous to provide a convincing explanation for an 8 percent rise in prices that took Brent futures to their highest level in nine months. Saudi Arabia's change of production policy also appears too limited to provide a convincing reason for the market's sudden about turn.
Even the physical Brent market cannot explain the sudden price increase and subsequent decline. Widely reported production problems which shutdown the Brent pipeline system last weekend have not produced the expected rise in prices. Instead front-month prices have remained unchanged.
So what has really been driving the market?
The recent rally has looked and felt a lot like the upturns that culminated in May 2010, April 2011, March 2012 and September 2012.
Each rally and reversal has coincided with the accumulation and liquidation of a large number of long futures positions by hedge funds and other money managers, both from existing funds adding to positions and new funds temporarily entering the market.
Each price cycle has been accompanied by a sharp rise and then fall in open interest.
In each case, price increases for futures contracts about to expire have not been matched by a similar rise in contracts still years from maturity. The price for far forward futures contracts has remained virtually unchanged throughout each of these rallies in near-dated prices.
The result has been a marked changed in market behaviour stemming from the start of 2010.
It is more readily apparent in the market for U.S. crude, West Texas Intermediate (WTI), than for Brent, but applies equally to both markets.
ACCUMULATION AND LIQUIDATION
Prior to 2010, there was no clear link between futures prices, hedge fund positions and open interest. Extensive analysis of the massive escalation in oil prices before July 2008 failed to find any straightforward link the data between speculators' positions and futures prices. But since the start of 2011, there have been easily observable linkages between hedge fund positions, oil prices and open interest (Charts 1-4).
Chart 1: link.reuters.com/tus46t
Chart 2: link.reuters.com/xes46t
Chart 3: link.reuters.com/fus46t
Chart 4: link.reuters.com/hus46t
Correlation is not the same as causation.
Perhaps hedge funds have just become better at reacting to oil market fundamentals in the past two years (though the poor track record of commodity-focused funds in the last couple of years strongly suggests otherwise)? What is remarkable is how quickly and completely each rally has been reversed (which suggests that if hedge funds are reacting to fundamentals, those fundamentals are not very durable).
The increasingly close linkage between hedge funds and spot prices since 2010 has also coincided with a sharp reduction in the correlation between front-month and far-forward prices. Correlation between spot month and forward prices, generally above 90 percent until 2010, is now often less than 50 percent (Charts 5-6).
In 2008, the sharp rise in nearby prices was accompanied by an equally large rise in forward prices. Now the spot and forward markets have become almost entirely separated.
Something has clearly changed in the way the futures market works. Hedge funds and other money managers are the prime candidates. There are more of them operating in the oil market than before, their views and positions have become less diverse, and their aggregate position is bigger than previously (at least when they are all positioned on the long side of the market) (Chart 7).
Chart 5: link.reuters.com/nus46t
Chart 6: link.reuters.com/qus46t
Chart 7: link.reuters.com/kus46t
The bottom line is that Brent (and WTI) prices are now easier to explain in terms of the accumulation and liquidation of hedge fund positions than any of the supposed "fundamentals".
CUTTING THROUGH THE NOISE
The balance of views encapsulated in futures prices appears to have changed remarkably little over the last two years. Near term tightness is matched by greater confidence over longer-term supplies. Tightness in the increasingly peculiar Brent market is largely disconnected from the supply-demand balance elsewhere.
As a result, prices remain largely range-bound between $100 and $120 per barrel. Most of the short-term cycling in prices is just "noise" related to hedge fund positioning.
Brent's mounting problems as a benchmark are widely acknowledged. Both Platts (which is the main price assessing agency for the Brent market) and Shell (whose SUKO90 contract terms are widely used for Brent trading) have revised their pricing systems to reverse falling liquidity. It is too early to say whether either move will be successful in rescuing Brent's role as a useful marker.
Though the Brent price is entirely unreflective of the wider market, it is still popular with hedge funds and other investors. Many have switched from the even more idiosyncratic WTI contract to benefit from Brent's persistent backwardation (which rewards investors for holding a long position, in contrast to WTI's contango, which penalises long futures owners).
Brent prices are an increasingly faulty indicator about the state of the wider oil market. But it may not matter much, since price swings are reversed relatively quickly (in just 1-3 months), and are getting smaller (now generally under $10 per barrel rather than $20-30 previously).
The important thing is resist the temptation to over-interpret this hedge fund-induced noise as evidence of changing fundamentals. Most recent price changes have provided more insight into the state of sentiment within the hedge fund community than supply and demand trends in the oil market. (Editing by William Hardy)