By John Kemp
LONDON Feb 20 The chances of a sharp drop
in oil prices similar to the record one-day fall on May 5 last
year are increasing sharply as the market becomes locked into a
classic price spike.
By close of business on February 14, hedge funds and other
money managers were running 7.3 long futures and options
positions linked U.S. crude prices (308 million barrels) for
every short position (42 million barrels), according to
commitments of traders data published by the U.S. Commodity
Futures Trading Commission (CFTC).
Investors have not been this long of U.S. crude futures and
options since July 2011, when longs were still liquidating their
positions in the aftermath of the May 5 "flash crash". The flash
crash saw prices fall by more $11 per barrel within a single
day, equivalent to more than four standard deviations.
Heading into the crash, money managers were running long
positions amounting to around 400 million barrels of crude, with
a ratio of 10 long positions for every short, and front-month
WTI prices trading around $109 ().
The parallels with the current position are striking. Money
managers now have long positions amounting to 300 million
barrels, up from 250-280 million through last autumn, in a
long/short ratio of 7.3:1 compared with a more normal ratio of
3:1 or less, and flat prices are around $105 per barrel, just $4
short of the level before last year's flash crash.
Predicting the timing and level of market reversals is
impossible. But all the conditions for a price spike and
subsequent collapse are now in place.
Price spikes and crashes are most likely to occur when the
normal diversity of opinions in a market is replaced by near
unanimity about the direction of prices, as Professor Didier
Sornette explained in his seminal 2003 book "Why Stock Markets
Crash: Critical Events in Complex Financial Systems".
Diverse views lend markets liquidity and stability, ensuring
a rough balance between buyers and sellers near current price
levels. But when one view comes to predominate, and everyone
tries to trade in the same direction, liquidity falls and the
risk of big price discontinuities rises sharply.
In 2011, the supply disruption caused by Libya's civil war,
coupled with production losses in the North Sea and Azerbaijan,
a big boost to fuel demand after the Fukushima earthquake, a
stream of positive economic news from the United States, and
continued support from the second-round of large-scale asset
purchases by the Fed (QE2) all came together to convince
investors that oil prices could only go one-way: up.
Sure that prices must continue rising, investors raised
their long positions in U.S. crude from around 320 million
barrels to 400 million between February 2011 and the start of
May, while cutting short positions from 80 million to less than
40 million, stretching the long/short ratio from less than 4:1
to peak at more than 10:1.
Something similar appears to be occurring again. Sanctions
are curbing Iran's exports; production has been lost from South
Sudan, Yemen and Syria; economic news from the United States is
positive; the Fed has indicated continued support by promising
to postpone rate rises until 2014 or beyond; and the Bank of
England, European Central Bank and People's Bank of China are
all providing more liquidity and stimulus.
Once again, everyone is trying to trade the same way,
cutting liquidity and substantially increasing the risk of a
The reversal process has already started. Prices for both
U.S. crude and North Sea Brent have entered the "danger zone"
above $100 per barrel identified by the International Energy
Agency. Recent price rises, if sustained, are likely to harm the
recovery underway in the United States and intensify the
slowdown in Western Europe.
As last year, the full impact will only become evident with
a delay. So in the early stages, it will appear economies are
absorbing rising costs without much harm. But if price rises are
sustained, the impact on consumer confidence and spending will
be magnified and eventually slow global growth, restoring
balance to the oil market.
It is impossible to say whether prices will peak in
February, March, April or even later, and whether the rally will
crest at $120, $130 or even $150 per barrel (Brent or WTI). The
course of a price spike is fundamentally indeterminate. If it
were not, the spiking process could not get underway.
But it is possible to offer general observations. Price
moves accelerate towards the peak for a spike (or trough for a
crash) as liquidity dries up and the market becomes "locked" in
bullish or bearish mode, driving contrarian traders to the
Spikes and crashes also become inherently more unstable the
longer they persist and the more stretched valuations becomes.
On all these measures, the risk of both a sharp further rise
in oil prices, and an eventual sharp reversal, is increasingly