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By John Kemp
LONDON (Reuters) - Hedge funds' enthusiasm for U.S. crude has cooled off, at least for now, as the relentless rise in domestic shale output and the prospect of extended refinery maintenance in the Midwest extinguishes any hope of a rebound in U.S. oil futures to narrow the gap with Brent.
Hedge funds and other money managers cut their net long position in WTI-related futures and options to just 154 million barrels on October 30 from 260 million on September 18, according to the U.S. Commodity Futures Trading Commission (CFTC).
Gross long positions have been trimmed by 45 million barrels to 272 million. But the bigger change has come on the short side of the market, where money managers have added 61 million barrels to take their total short positions to 118 million, the biggest concentration of bearish positions for two years.
The ratio of long positions to short ones has fallen to just 2.3:1, the lowest since November 2010. It is far below recent peaks of 5.6:1 (September 2012), 11.8:1 (February 2012) and 10.6:1 (March 2011) as investors' bullishness about the outlook for WTI fades (Chart 1).
The liquidation of hedge funds' net length in U.S. oil has coincided with a significant downturn in WTI prices, confirming the pronounced link between hedge fund positions and WTI prices evident since 2009/10 (Chart 2).
Hedge fund bullishness was predicated on upside risks for the oil market as a whole and the superior relative value of WTI compared with other international crudes such as Brent. Both elements have come under pressure in recent weeks.
Prospects for an uncontrolled escalation of tensions in the Middle East appear to have receded in the short term. With election day less than 48 hours away in the United States, it no longer appears likely that Israel will take advantage of the Obama administration's need to appear tough on defense during the campaign to strike at Iran.
Once the election is out of the way, a re-elected Obama administration is likely to take a much harder line with Israel.
If Romney wins, Israel is unlikely to risk souring relations with the incoming administration by launching strikes during the transition. So if there was a window of opportunity for Israel to strike at Iran before the election, it has now closed.
In the meantime, Saudi Arabia and other oil producers have successfully replaced more than a million barrels a day of Iranian crude lost from the market as a result of U.S. and EU sanctions.
An increasing number of prominent analysts are convinced oil prices have reached a sufficiently high level to ensure adequate supplies in the years ahead. Current prices of more than $100 per barrel for Brent and $80 for WTI are high enough to make most new sources of supply profitable, including shale wells and Canada's tar sands.
In recent weeks, even an improving news flow about the state of the U.S. economy has failed to rally crude prices.
The relative value case for WTI compared with Brent has also been reassessed. Hopes that land-locked WTI would close some of the gap with seaborne Brent following the reversal of the Seaway pipeline have finally been abandoned.
BP's giant Whiting refinery in Indiana will take offline its largest crude distillation unit, capable of processing more than 250,000 barrels per day of raw feed, for around nine months and equip it with a new coking unit as part of an upgrade to enable it to handle heavier Canadian crude.
The BP distillation unit, 12 Pipestill, accounts for 6 percent of refining capacity in the entire Midwest, according to Energy Information Administration data.
With so much capacity offline, investors are no longer confident the crude glut in the heart of the United States will clear, even with new takeaway capacity provided by pipeline reversals and the increased movement of oil by rail.
While hedge funds appear to have fallen out of love with U.S. crude for the time being, it remains unclear whether there is much potential for shorting the market further.
U.S. crude prices are already towards the bottom of the trading range that has prevailed since late 2010. The large build-up of hedge fund short positions suggests the market may already be oversold and vulnerable to a short-covering rally.
For now, though, most hedge funds seem to have soured on the U.S. oil market. (editing by Jane Baird)