(John Kemp is a Reuters market analyst. The views expressed are his own)
* Chart 1: tmsnrt.rs/2fUkaZj
* Chart 2: tmsnrt.rs/2guUA0B
* Chart 3: tmsnrt.rs/2guTLoO
* Chart 4: tmsnrt.rs/2guQTrU
By John Kemp
LONDON, Nov 21 (Reuters) - Hedge funds have taken a more cautious stance on oil prices amid a flurry of diplomatic activity aimed at securing a production-limiting deal among OPEC members by the end of the month.
The funds cut their combined net long position in the three major Brent and West Texas Intermediate (WTI) futures and options contracts by just 3 million barrels to 422 million barrels in the week ending Nov. 15 (tmsnrt.rs/2fUkaZj).
The much smaller reduction came after fund managers cut net long positions by a record 149 million barrels the previous week, according to an analysis of data from regulators and exchanges (tmsnrt.rs/2guUA0B).
Fund managers continued to add short positions in WTI (23 million barrels) and Brent (15 million barrels) in the expectation that prices would fall further.
But for the first time since early October, funds added to long positions in both WTI (32 million barrels) and Brent (3 million barrels).
Hedge funds have been shorting crude aggressively as OPEC members ramp up their output and amid growing doubts about whether the organisation could finalise a credible production agreement.
This is the fifth time since the start of 2015 that fund managers have accumulated a large short position in oil prices.
Each accumulation and subsequent liquidation of short positions has been accompanied by a fall and then a rise in oil prices.
The pattern has become sufficiently predictable that it is being exploited by simple momentum-based trading strategies.
Front-month futures for WTI and Brent stopped falling on Nov. 14, which was the signal to start buying back short positions and establishing fresh longs in anticipation of short-covering.
Crude prices have since rallied by more than $3 per barrel in what has all the hallmarks of a short-covering rally.
Comments from key OPEC officials including the oil ministers of Saudi Arabia, Iran and Iraq have indicated the group is narrowing differences in an effort to reach a credible agreement by the deadline of Nov. 30.
Ministerial chatter has turned from pessimistic at the start of the month to positive in recent days, which has raised the risk of running short positions going into the OPEC meeting and fuelled the rally.
The previous fall in prices has highlighted for all members the consequences of failing to reach a realistic agreement by the end of the month and sharpened the incentives to compromise.
The fifth short-selling cycle has been the fastest and most aggressive so far as hedge funds piled in rapidly to exploit the down-cycle (tmsnrt.rs/2guTLoO).
But there are strong indications the fifth cycle has already entered the liquidation phase, which would also make it the shortest and shallowest in the last two years.
The decline in prices during this wave of short-selling has also been much smaller than during previous cycles (tmsnrt.rs/2guQTrU).
The balance of risks seems to be shifting, with bearish news and short-selling producing a smaller drop in prices than before.
Overall, the bearish bias that has characterised the oil market over the last two years appears to be lifting in favour of a more neutral or even bullish outlook.
Prices seem to have established a floor around $45 per barrel for Brent, with the market now looking to explore an upper boundary for the trading range.
If OPEC fails to reach a credible output-limiting agreement at the end of the month, confidence in that floor price could be severely tested.
But prices started to improve long before OPEC embarked on its current search for an output-limiting agreement.
The cyclical upturn in the oil market does not depend on an OPEC agreement, though a credible deal or failure to reach one will affect the pace of rebalancing and any further price gains.
Besides OPEC, there are a number of negative factors for oil prices going in to 2017 including a warmer-than-normal winter so far in the United States and Europe, sluggish global trade and continued economic weakness.
The reactivation of U.S. oil drilling rigs in response to higher prices suggests more shale production is on the way next year.
The forthcoming Donald Trump presidency is the biggest source of uncertainty since his policies remain almost entirely obscure.
But set against all those negative price risks is the fact the slump has now lasted nearly 30 months and the necessary adjustments in supply and demand are now well under way.
For at least some hedge fund managers, and oil industry executives, the most likely medium-term trend is for a gradual increase in prices over the next couple of years. (Editing by Dale Hudson)