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SPECULATION or REALITY?
by Elliott H.
Gue
Editor, The Energy
Letter
March 24, 2006
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The argument continues that the oil futures market is hot, so it's attracted a lot of momentum-oriented speculative cash. Once that cash disappears, oil prices will fall. While that might seem a rather convenient explanation, it just doesn't hold water if one cares to examine the actual data available on speculators. The CFTC publishes the COT every week. This report reviews all of the open interest in various futures contracts by both position type and type of trader. In other words, every week, the CFTC tells us how many futures contracts traders hold in a particular market and whether they're long or short that market. The report also divides speculators into large speculators (mainly hedge funds and institutions) and smaller traders. And there's also a section that covers commercial traders--mainly these are large companies that are using futures to hedge exposure to a particular commodity. One of the more interesting bits of data is the commitment of large speculators. In most markets, large speculators are basically trend followers, but they tend to get overly bearish (and extremely net short) near major lows and overly bullish (extremely net long) near major highs. Extreme positions can give us an early warning of potential turning points. In other words, the position of the long speculators can act as a key contrarian tell near major turning points for oil futures. The way I keep tabs on this data for the crude oil markets is simple. I look at the total long position held by large speculators and then subtract the total short position held by large speculators. For example, in the most recent report released last week, the CFTC reported that large speculators were long 130,086 contracts and short 145,344--a net short position of more than 15,000 contracts. I then divide this number by the total open interest (OI)--the total number of contracts outstanding--for the crude oil contract (the OI number is included in the COT report). In the same report, total reported open interest was 980,280, so large speculators net short position totaled about –1.6 percent of total open interest. Using data going back to 1993, I produced the chart below of this ratio over time. While data is available weekly, I used a monthly chart for simplification.
The net speculative position in oil futures tends to oscillate in a wide band between roughly 10 percent net long and 10 to 12 percent net short. We can see several sharp upside and downside spikes around an average level. A few points are worth noting. First, the large speculators that are supposedly driving the oil market higher rarely have large net long or net short positions. And currently, far from riding the bull market in oil higher, it seems that speculators are actually net short the commodity, betting on a decline or moderation in pricing. Second, note that the large spikes in this ratio have tended to mark important turning points. For example, traders went massively net short oil at the end of 2001 and beginning of 2002--net short to the tune of around 13 percent of open interest. Check out the chart of oil futures prices below.
I've labeled this turning point on the chart. You can see that just as traders were becoming ultra-bearish on oil it was a significant bottom--oil rallied from below $20 per barrel to more than $70 in the ensuing years. On a shorter time scale we saw downside spikes in this measure in May and October/November of last year--both occasions marked turning points. While less visible on this monthly chart, on a daily chart we see spikes under –7 percent on both occasions. Right now, the position of speculators is rather neutral having come off a fairly extreme –5 percent reading earlier this year. While not exactly at an extreme right now, it's fair to say that overly bullish speculation in the oil futures market is not a valid rationale at this time. My view is that there is downside risk to the $50 to $55 level for oil prices this year. Right now, oil is trading significantly higher due to geopolitical risks. But I don’t see political risks as temporary. Rather, with the world increasingly reliant on supplies from dangerous locales the political risk premium will remain a permanent fixture of the oil market. As we enter the summer months and the Atlantic hurricane season, I’ll be watching the price of natural gas and gas-related stocks. All have been hit hard in recent months but the market isn't yet pricing in the potential loss of supply due to another nasty hurricane season--14 percent of Gulf of Mexico gas supply was still shut in as of March 20 due to hurricanes Katrina and Rita. Nor is the market fully pricing in the potential demand shock of a hot summer heating season. This will likely offer an interesting buying opportunity.
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