LONDON (Reuters) - Hedge funds were badly caught out by the production cuts announced by OPEC at the end of last month, triggering a furious rally as managers raced to buy back loss-making short positions.
When OPEC announced a deal had been reached on Nov. 30, a substantial number of short positions were still uncovered, providing the opportunity for a classic squeeze.
Now the hedge fund community has turned its bearish position going into the meeting into the largest bullish position on record.
Hedge funds and cut their short positions in Brent and WTI futures and options by 134 million barrels in the week to Dec. 6 (tmsnrt.rs/2gwFSXn).
Fund managers also added 94 million barrels of fresh long positions, according to positioning data published by regulators and exchanges.
The shift from short-to-long amounted to a record 228 million barrels in a single week, and took the total net long position to 728 million barrels, which was also a record (tmsnrt.rs/2hm1C5f).
There has never been a comparable shift from bearishness to bullishness among speculators over such a short space of time in the last 25 years.
The scale of the turn round explains why Brent prices jumped by more than $7.50 per barrel or 16 percent in the week following the OPEC meeting.
By the end of Dec. 6, however, most hedge fund short positions in Brent and WTI had been closed out, which explains why the upward momentum which had carried prices higher began to stall.
The faltering rally left Brent trading below $54 per barrel, which probably disappointed Saudi Arabia and other OPEC members, hoping to be rewarded with a bigger jump.
Most analysts and traders expected OPEC to deliver only around half of the promised cut of 1.2 million barrels per day (“OPEC expected to deliver only half of target production cut”, Reuters, Dec. 6).
As a result, crude stocks were expected to remain high throughout the first half of 2017, before starting to draw down in the second half (“Oil traders see no market rebalancing until later in 2017”, Reuters, Dec. 8).
But the announcement of a deal between OPEC and non-OPEC countries on Dec. 10 has given the rally renewed momentum.
Saudi Arabia has sought to drive oil prices higher again using “shock and awe” tactics by assembling unexpectedly large production cuts from an unusually broad group of non-OPEC countries.
Eleven non-OPEC countries have pledged to reduce their oil output by a combined total of 558,000 barrels per day, voluntarily or through managed decline, starting in January 2017.
Most of the cuts and declines will come from Russia, Mexico Oman and Azerbaijan with token contributions from other countries.
Production cuts will initially last for six months, but will be extendable for a further six months, depending on market conditions, according to a press statement released by OPEC.
Output reductions will be carried out concurrently with cuts of almost 1.2 million barrels per day agreed by OPEC at the end of November (“OPEC deal expected to tighten oil market in 2017”, Reuters, Dec. 1).
The global agreement is intended to accelerate oil market rebalancing by drawing down some of the excess inventories built up over the last two years.
Some analysts have expressed doubts about whether the deal really will cut crude oil supplies and reduce stock levels. Past experience suggests there is significant potential for non-compliance.
The deal does not restrict output from U.S. shale producers, who are likely to respond to higher prices by increasing their production.
The number of rigs drilling for oil in the United States has already risen by 182 or 58 percent since hitting a low at the end of May.
And OPEC’s agreement leaves strife-torn Nigeria and Libya free to increase their production if they can re-establish security around oil installations.
For now, however, most traders seem convinced the market will rebalance with a big drawdown in crude stocks, but from the second half of 2017.
Brent futures prices continue to trade in a wide contango during the first six months of 2017, signaling that traders think stocks will remain high.
But the contango has vanished for the second half of the year and futures prices in 2018 are now trading in backwardation, suggesting most traders think stocks will be falling by then (tmsnrt.rs/2hm4zT1).
Editing by David Evans