Hedge funds and other money managers have begun to amass another large short position in futures and options contracts linked to the price of crude oil.

But the current wave of short-selling has been associated with a much smaller decline in WTI prices than last summer, at least so far.

Hedge funds increased their short positions in NYMEX WTI futures and options from 53 million barrels on May 31 to 141 million barrels on July 19, anticipating a further drop in prices.

On the other side of the market, hedge fund long positions were basically unchanged at just under 300 million barrels between the two dates, according to the U.S. Commodity Futures Trading Commission (CFTC).

In U.S. crude, the main adjustment has therefore come almost entirely from an increase in hedge fund short selling rather than liquidation of old long positions.

This stands in marked contrast with ICE Brent, where the increase in short positions (+45 million barrels) has been almost exactly matched by a reduction in long positions (-41 million barrels).

The dominant story, at least for U.S. crude, over the past seven weeks has been one of short sales and the emergence of a wave of new oil bears over the past two months.

This marks the fourth short-selling cycle by the hedge funds since the start of 2015 (“Hedge funds in new cycle of oil short-selling”, Reuters, July 25).

WTI PRICE RESILIENCE

The number of hedge funds and other money managers with a short position in NYMEX WTI of 350,000 barrels or more (the current reporting level) has increased from 40 on May 31 to 56 on July 19.

The rise in short positions by nearly 88 million barrels in the space of just seven weeks is one of the largest increases in short positioning in such a short period on record.

In the circumstances, the associated decline in WTI prices has been significantly smaller than might have been expected (tmsnrt.rs/2aHh0WF).

There has been a correspondence between the accumulation/liquidation of short positions and the fall/rise in WTI prices since at least 2012.

The correlation is far from perfect and should be treated with extreme caution but it is strong enough to be able to state that a fall in prices has usually been associated with a rise in hedge fund short selling.

But over the seven weeks between May 31 and July 19, WTI prices fell by just $4.45 per barrel, from $49.10 to $44.65.

A simple regression of changes in short positions against changes in prices suggests a larger decline of $10-12 per barrel would have been expected.

The last time hedge fund short positions increased by a similar amount, between June and August 2015, WTI prices fell by $12-17 per barrel (tmsnrt.rs/2ahyPhK).

Since July 19, WTI prices have since fallen further, and are now less than $43 per barrel. The next set of data from the CFTC, published on Friday, may show a further build up in hedge fund short positions.

Past experience, however, suggests WTI prices could already have been expected to be below $40 by July 19, maybe even as low as $37 (tmsnrt.rs/2aHhlZq).

In other words, the interesting question is not why oil prices have fallen so much in the last seven weeks, but why they did not fall even further.

Perhaps prices are still catching up: the price of front-month WTI has continued to fall most days since July 19.

It is possible that WTI prices will continue to head lower in the next few days and weeks.

But it is also possible that market opinion about the future direction of oil prices is more evenly divided than in 2015, providing some support.

In 2015, the physical market was obviously and substantially oversupplied and expected to remain in surplus for an extended period. Most traders, analysts and hedge funds were very bearish.

In 2016, the physical market is closer to balance, consumption is growing, albeit more slowly than earlier in the year, and non-OPEC supply is falling.

Crude oil prices are closer to the level most observers see as needed to promote continued rebalancing of supply and demand.

There is a much greater diversity of views about whether prices need to rise or fall to realign consumption growth with production over the next 12-24 months.

In 2015, waves of hedge fund short selling pushed prices sharply lower because there were so few buyers around willing to take the other side of the market.

In 2016, the market appears more balanced, with hedge fund short sellers finding more buyers willing to take the opposite view, betting on prices recovering in the next 6-12 months.