Hedge funds have turned very bearish towards both crude and refined products over the last two months amid signs of an oversupply of gasoline.
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Hedge funds and other money managers added the equivalent of 56 million barrels of extra short positions in the three main Brent and WTI futures and options contracts in the week ending July 26.
Hedge funds also added an extra 6 million barrels of short positions in the main U.S. gasoline futures and options contract.
By contrast there were only small changes on the long side of the market, with hedge funds adding 3 million barrels of crude and 0.15 million barrels of gasoline contracts.
The hedge fund community's increasingly bearish tilt towards crude and gasoline prices continues a pattern evident since the end of May.
Since May 31, hedge funds have added 197 million barrels of crude short positions and 12 million barrels of gasoline shorts.
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The result is that hedge funds had cut their overall long position in Brent and WTI from 639 million barrels at the end of May to just 400 million barrels by July 26 (http://tmsnrt.rs/2aFLmvQ).
The hedge funds' net long position in crude is the smallest since the end of February when Brent was trading around $33 and WTI at $32 per barrel.
In gasoline futures and options, hedge fund managers have actually established a net short position of 5 million barrels (http://tmsnrt.rs/2aFLknI).
Hedge fund net short positions in gasoline are exceptionally rare and this is the largest recorded net short since the current data series began in 2006.
Hedge funds have embarked on the fourth major short-selling cycle in crude oil futures and options since the start of 2015 (http://tmsnrt.rs/2aFL5ZH).
The number of hedge funds with short positions in the NYMEX WTI contract above the reporting threshold of 350,000 barrels has increased from 40 to 63 since May 31.
The average short position of those hedge funds has more than doubled from 1.33 million barrels to 2.86 million, according to data from the U.S. Commodity Futures Trading Commission.
In this latest wave, the short selling of crude has been accompanied by shorting of gasoline futures and options as well.
The number of hedge funds with short positions in NYMEX gasoline blendstock futures and options over the reporting threshold of 150,000 barrels has increased from 25 to 42.
The average short position in NYMEX gasoline has fallen slightly from 1.07 million to 0.91 million barrels but not enough to offset the big increase in the number of hedge fund shorts.
In the current short-selling cycle, crude prices have generally fallen less than during previous cycles, especially the wave of short-selling that started in October 2015 and saw oil prices tumble below $30 at the start of 2016.
Unlike previous waves of short selling, this one has seen much more diversity of views among hedge funds and other money managers about the outlook.
Many hedge funds with long positions have held on to them, even as prices have tumbled by around $10 per barrel, around 20 percent.
Hedge funds still hold 700 million barrels of long positions in Brent and WTI, down from 743 million at the end of May, and a recent peak of 790 million in April, but up from 554 million barrels a year ago.
The short-term outlook for crude and gasoline prices is now dominated by four cross-cutting influences which will create uncertainty and volatility:
(1) It will take some time for refiners to clear the build up of gasoline inventories and may require them to process less crude, which will add to the excess of crude in the physical market and intensify downward pressure on oil prices.
(2) Hedge funds have established large short positions in crude of 300 million barrels, but past experience suggests the maximum short position could be at least 390 million, indicating there is more scope for short-selling to push prices lower.
(3) More bullish hedge funds have clung on to a large number of long positions, some of which at least could be liquidated if the losses become too great, which would again add to downward pressure on prices.
(4) But the concentration of hedge fund short positions in crude and gasoline has raised the risk of a short-covering rally and partial price reversal if some fund managers decide the time has come to take profits.
The ebb and flow of hedge fund positions and oil prices has shown a high degree of cyclicality for the last 18 months ("Hedge funds turn cautious on crude just as Goldman gets less bearish," Reuters, May 16 ).
The build up of hedge fund long positions between January and May coincided with rising oil prices but eventually presaged the rally's demise ("Risks rise as hedge funds place record bet on oil," Reuters, May 3 ).
The rapid accumulation of hedge fund short positions since the end of May has accompanied a sharp price drop but could also herald a partial rebound.
In the very short term, bearish factors may predominate, which could help push both crude and gasoline prices lower.
But hedge funds are becoming very extended on the short side of the market which suggests reversal risk is increasing.