LONDON (Reuters) - For every buyer of futures and options there must be a seller. For every long position there must be a corresponding short position.
Hedge funds and other money managers have purchased a record number of futures and options contracts linked to Brent and WTI, betting that prices will rise.
As a group, hedge funds now hold a record net long position equivalent to 951 million barrels across the three main Brent and WTI contracts (tmsnrt.rs/2mm1HeI).
Hedge fund long positions outnumber short positions by a record ratio of 10.3:1 (tmsnrt.rs/2mvnvBA).
With hedge funds almost all long, some other group of traders must have sold a correspondingly large number of futures and options contracts, either as a hedge or betting prices will fall.
Since September 2009, the U.S. Commodity Futures Trading Commission (CFTC) has employed a four-way classification for all traders with reportable positions in crude oil.
Traders are classed as a producer/merchant/processor/user, a swap dealer, a money manager, or into a miscellaneous “other reporting” category.
Traders with positions less than 350,000 barrels do not have to report them but they show up as a residual “non-reporting” category.
The classification is discussed on the commission’s website (“Disaggregated commitments of traders report: explanatory notes”, CFTC, undated).
If a trader’s market activities span more than one category, the commission makes a judgment about their predominant activity, and all trades are then classed in this category.
Unfortunately, the commission does not disclose how individual traders are classified, which creates considerable uncertainty about the composition of the categories.
For example, if a major oil company hedges its inventory as well as providing price risk management services to customers, we don’t know whether its trades are classified as producer/merchant/processor/user or as a swap dealer.
On Feb. 21, hedge funds and other money managers held a net long position in WTI on the New York Mercantile Exchange (NYMEX) equivalent to 414 million barrels, according to CFTC data.
“Other reporting” traders also held a net long position of 173 million barrels while non-reporting traders were net long by 15 million barrels.
The corresponding short positions were held by producer/merchant/processor/users, with a net short position of 291 million barrels, and swap dealers, with a net short of 310 million barrels.
As hedge funds have increased their net long positions in WTI, the majority of the contracts have been sold to them by swap dealers (tmsnrt.rs/2mlWLGN).
Hedge funds and other money managers have increased their net long position in WTI by 254 million barrels since early November.
Swap dealers increased their net short position by 202 million barrels over the same period (with the balance of extra short positions coming from producer/merchant/processor/users).
Hedge fund positions in WTI are more closely correlated with swap dealers than with any other category of traders.
The CFTC defines swap dealers as any “entity that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge the risk associated with those swaps transactions”.
According to the commission, “the swap dealer’s counterparties may be speculative traders, like hedge funds, or traditional commercial clients that are managing risk arising from their dealings in the physical commodity”.
Swap dealers function as market makers and intermediaries and may assume positions on their own account or act as intermediaries for other traders.
Swap dealers (or their clients) have been eager sellers of futures and options linked to WTI because as hedge funds have accumulated a record position prices have scarcely risen since mid-December.
Intercontinental Exchange (ICE) employs a similar four-way classification for trades in its Brent and other commodity contracts listed in London.
But although ICE employs the same criteria there is no guarantee that individual classifications by ICE and the CFTC are the same because the CFTC does not disclose how individual traders are categorized.
The positioning of traders is very different in Brent, which may reflect differences in the structure of the market, or inconsistencies in classification.
On Feb. 21, hedge funds and other money managers held a net long position in ICE Brent futures and options equivalent to 508 million barrels.
Swap dealers also held a very large net long position amounting to 428 million barrels in Brent, according to records published by ICE, which contrasts with their large short position in WTI.
In Brent, the corresponding short positions all came from producer/merchant/processor/users with a net short position of 790 million barrels (tmsnrt.rs/2mvw1jS).
Hedge funds have boosted their net long position in Brent by 241 million barrels since Nov. 8, with most of this supplied by an increase in producer/merchant/processor/user short positions of 193 million barrels.
Swap dealers have also cut their net long position in Brent by 66 million barrels since early November, but this has supplied only a small part of the hedge fund long positions.
Despite the differences between the commitments of traders in the two markets, hedge fund buyers of Brent have found plenty of willing sellers, with prices barely changing for the last two months.
Not much is known about the identity and motivation of the short sellers, other than that have been willing to sell large numbers of extra futures and options contracts at Brent and WTI prices just over $50 per barrel.
Some of them, especially in WTI, are likely to be U.S. shale oil producers keen to hedge their production for 2017 and 2018 and lock in revenues in case prices slump again.
Some could be hedging inventories, though in theory the demand for inventory hedging should be declining as crude stocks fall.
Some could be outright shorts with a more bearish view on the outlook for oil prices than hedge fund managers and willing to take the other side of the trade.
And some could simply be making a market for their hedge fund clients by willing to sell futures and options to them on demand.
While we know very little about the identity of the shorts, their motivations could be crucial, because at some stage the hedge funds will want to take profits and liquidate some of their record long position.
At that point, the readiness of the short sellers to buy back these futures and options will make a big difference to how that liquidation occurs.
There has been a good two-way market for the last two months which has kept prices trading in a narrow range despite a large number of futures and options changing hands.
The critical question is whether that liquidity will remain high in the months ahead or evaporate, which could lead to either a spike in prices or a sharp drop when some of the trades are closed out.
Editing by David Evans