(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
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
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
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
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 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
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)