Reuters Special Report On What Caused The "Causeless" Crude Crash; Other Hedge Fund Casualties Identified

Tyler Durden's picture

A tremendous report by Reuters' Matthew Goldstein, Svea Herbst, Jennifer Ablan, Emma Farge, David Sheppard, Claire Milhench, Zaida Espana, Robert Campbell and Josh Schneyer, identifies that while the shaky macroeconomic conditions and an overbought market were among the key reasons for last week's history crude rout, the match that caused an unseen before plunge in commodities was, you guessed it, "computers." Naturally, this is not unexpected to Zero Hedge readers who have been warned about the massive instability of a market comprised almost entirely of unsupervised algos, since the spring of 2009 (a phenomenon which the CFTC and SEC will not "comprehend" and/or change, until it is too late). Additionally, in addition to the previously identified losses at Clive Capital and Andrew Hall's latest plaything, Reuters also identifies BlueGold, Winton Capital and FTC. Basically, throw out a name that has energy exposure (let's not forget Touradji or Centaurus) and you likely have a winner. Must read.

Special report: What really triggered oil's greatest rout, from Reuters

When oil prices
fell below $120 a barrel in early New York trade last Thursday, a few
big companies that are major oil consumers started buying around $117.

It looked like a bargain. Brent
crude had been trading above $120 for a month. But the buying proved
ill-timed. Crude kept on falling.

"They
were down millions by the end of the day, trying to catch a falling
piano," an executive at a major New York investment bank said.

Never
before had crude oil plummeted so deeply during the course of a day. At
one point, prices were off by nearly $13 a barrel, dipping below $110 a
barrel for the first time since March.

Oil's
descent followed the biggest one-day price drop in silver since 1980 on
Wednesday, after hedge fund titan George Soros was reported to be
selling. Exchange operators raised silver's margin requirements, making
it more costly to trade the metal and sending investors out of the
market. Silver plunged by 20 percent, more by week's end. The rout
unnerved some commodity investors.

Oil
just doesn't fall by 10 percent in the course of a normal day, though.
In commodities markets, oil is king, and its daily contract turnover,
typically around $200 billion, is usually able to absorb even large
inflows or outflows of investment.

The
rare moves of $10 a barrel usually are set off by dramatic events --
the outbreak of the first Gulf War in 1991, or the collapse in 2008 of
Lehman Bros bank, which both led to recessions.

Of course, there was major news last week. But the daring Pakistan raid that killed Osama Bin Laden had done little to shift the balance of oil markets on Monday.

In
interviews with more than two dozen fund managers, bankers and traders,
no clear cause emerged for the plunge in price. Market players were
unable to identify any single bank or fund orchestrating a massive sale
to liquidate positions, not even an errant trade that triggered panic
selling, as seen in the equities flash crash last May.

Rather,
the picture pieced together from interviews on Thursday and Friday is
one of a richly priced commodities market -- raw goods have been on a
five-month winning tear over all other major investment classes -- hit
by a flurry of negative factors that individually could be absorbed but
cumulatively triggered a maelstrom.

Computerized trading kicked in when key price levels were reached, accelerating the fall.

"It was a domino effect," said Dominic Cagliotti, a New York-based oil options broker.

The
negative factors -- prominent cheerleaders turning bearish, some weak
economic data, cheap money from the U.S. Federal Reserve ending by July,
a lessening of political risk -- merely provide a backdrop for the
waves of selling. What stands out is the way computers turned
readjustment of positions in a huge and deep market into a rout.

THE COMPUTERS

Stunningly
large jolts from so-called stop-loss trading amazed market traders. The
automated sell orders were generated as oil crashed through price
points that traders had programed in advance into their supercomputers.
In many cases, computer algorithms sold for technical reasons, as oil
dropped through levels that, once breached, could trigger ever larger
waves of selling yet to come.

The
machine trading, based on subtly different but fundamentally similar,
algorithmic models, eliminates the white-knuckles and potential human
error involved in actively trading a volatile market, and increases
anonymity. Instead of breeding hesitation, abrupt price drops can
quickly prompt these machines to unload a bullish long position in oil,
and build up a bearish short one instead.

Machine-led
trading is one plausible thesis for another apparent market anomaly
that occurred on Thursday. Exchange data shows that the total number of
open positions in the oil market -- a number that would typically fall
in a selloff -- instead rose. Normally, panicky funds selling oil en
masse would cause total "open interest" numbers to shrink, as exiting
investors closed out contracts. But some machines, following the market
trend, may have gone further, by dumping long positions and quickly
amassing sizable short positions instead.

"Computers
don't care. Momentum just increases until nobody wants to stand in
front of it," said Peter Donovan, a floor trader for Vantage on the New
York Mercantile Exchange.

Some big
Wall Street traders watched their own systems sell into the down trend
but couldn't know for sure who had initiated the selling spree. They
only knew that similar machines at other firms, from New York, to
London, Geneva and Sao Paulo, would be automatically selling in much the
same manner.

During Thursday's
crash, such selling locked in profits that high-flying commodities
traders have been accumulating for months. Some of Thursday's rout
appears to have been more a product of the wisdom of crowd computing
than of widespread human panic.

"We
believe the magnitude of the correction appears in large part to have
been exacerbated by algorithmic traders unwinding positions," Credit
Suisse analysts wrote in a report.

High frequency trading and algorithmic trading accounts for about half of all the volume in oil markets.

BIG NAMES TURNED BEARISH

Some
of the seeds for the rout were sown earlier. In April. Goldman Sachs'
bullish team of commodities analysts, led by Jeff Currie in London,
issued two notes to clients in rapid succession recommending they pare
back positions. In one, the bank called for a nearly $20 dollar
near-term correction in Brent oil, while maintaining a bullish
longer-term outlook.

The closely
watched money king, George Soros, who runs a macroeconomic hedge fund,
had said for months that gold was pricey. Even online advisors to
mom-and-pop investors such as The ETF Strategist had warned of a bubble
in precious metals that could be ready to pop.

On
Wednesday, the Wall Street Journal had reported the Soros Fund was
selling commodities including silver, and four sources from other hedge
funds told Reuters they believed Soros was busy selling commodities
positions again on Thursday.

Silver
markets already had suffered four days of carnage and ended the week
down nearly 30 percent. But silver is a tiny market, much more
susceptible to sharp price moves. Some traders suspect that big holders
were cashing out of the least liquid commodity market first, before
moving onto the big one - oil.

As
crude crashed on Thursday, it dragged down every other major commodity.
The Reuters Jefferies CRB index, which follows 19 major commodities, was
on its way to a 9 percent weekly drop, the biggest since 2008.

Oil's selloff began in London, and accelerated as New York traders piled in.

A
routine report on U.S. weekly claims for unemployment benefits spooked
investors, showing the labor market in worse shape than expected. That
fed a growing pessimism about the resilience of the global economy after
industrial orders slumped in Germany
and the massive U.S. and European service sectors slowed. Then the
European Central Bank surprised with a more dovish statement on interest
rates than expected, signaling its wariness about the euro zone
outlook. The dollar rose sharply.

Before noon New York time, Brent crude oil prices were already trading down a jaw-dropping $8 a barrel.

Fourteen
hundred miles southwest of New York's trading floors, on Texas refinery
row, oil men were stunned by the drop, which played havoc with their
pricing models.

"It was nuts. Our
risk management guys were tearing up their spreadsheets," said a major
U.S. independent refiner, who asked not to be identified.

A
range of factors, both economic and political, were also at play. The
recent rise in raw goods has been fueled in part by the U.S. Fed pumping
cash into the markets by purchasing $600 billion in bonds. This program
has pushed interest rates extraordinarily low, making borrowing
essentially free once adjusted for inflation. Investors have been using
the super-cheap money to buy into commodity markets. But the Fed's
program is slated to end on June 30.

"Funds
were likely to take profits before June when the direct (Fed) bond
purchases stop. All were eyeballing each other to see who would take
profits first," said a London-based oil trader.

China,
the world's fastest-growing consumer of commodities, also is tightening
monetary policy to tamp growth rates and control inflation, raising the
prospect of a slowdown in demand for oil.

The
political risk premium built into oil prices also came under scrutiny
last week. The unrest sweeping through the Arab world - home to over
half of world oil reserves - has boosted oil this year. The only major
supply disruption so far is from Libya, where war has cut off at least 1
million barrels a day.

"We've been
in a world thinking there's more risk, more risk, more risk," said
Sarah Emerson of Energy Security Analysis Inc. "People took this week,
and the news of bin Laden's death, to simply reflect. They stopped and
said, maybe there's less risk."

GAME OVER

Put
all these factors together, and they amounted to a reason to sell.
Traders and brokers who spoke with Reuters speculated that macro funds
like Soros and others, which had been aggressively overweight
commodities, were cutting the portion of their portfolio allocated to
commodities. Because those positions had grown so large, even a small
rebalancing would amount to billions and billions of dollars in
contracts sold. After weeks of thin trading in Brent oil futures,
Thursday's trade volume hit a record.

Early
Thursday, investment advisory firm Roubini Global Economics had also
joined the fray, telling clients for the first time in years to cut
commodities in their macro portfolios. Many funds were merely taking
months of handsome profits off the table.

Yet Thursday's rout certainly produced casualties.

By
the afternoon New York time, some of the world's biggest money managers
thought they smelled blood. Several banks and funds seemed to be
selling oil in an orderly fashion, even if the price drop was
extraordinary. But could a hedge fund be struggling for survival?

They
wondered whether any major commodities funds were on the losing end of
bullish oil bets, and were getting forced by margin calls from brokers
into dumping massive positions.

One
trader at a major bank in New York called a colleague at one of the
world's largest hedge funds. During the conversation, they exchanged
notes, suspicious that one or more commodities-focused hedge funds might
be facing a moment of reckoning, one of the participants said.

No
fund could be pinpointed. By the end of the day, the person said, they
were less suspicious -- a view shared by week's end by many market
participants who spoke to Reuters. No one was naming a major hedge fund
in dire trouble, or a computer trading algorithm that went haywire.

And
unlike last May's flash crash in equities markets -- when stocks fell
by a similar 9 percent margin in just minutes -- Thursday's decline came
in rolling cascades, playing out over at least 12 hours.

Even after Brent fell to settle around $110 by the end of the day, crude prices were still up 38 percent from a year ago.

"Since
prices have been advancing well beyond any reasonable measure of value,
Thursday's declines felt more like orderly corrections than chaotic
panics. There was no sense that anyone was ready to jump from the
window," said oil analyst Peter Beutel of Cameron Hanover in
Connecticut.

CASUALTIES

The
day left some commodities-heavy funds nursing wounds - weekly losses of
10 to 20 percent, according to several fund managers who invest in
other hedge funds.

Two of the
sources said that London-based BlueGold, a fund known for taking
aggressively bullish directional bets on oil in the past, had sizable
losses. It was not immediately clear how much the fund dropped, and
BlueGold declined comment.

One money manager said of BlueGold's head trader Pierre Andurand: "He's had tougher weeks so I don't think it's game over."

Fund
sources also cited losses at $20 billion Winton Capital, of around 2.2
percent, on Thursday. FTC Capital, a $300 million European commodities
fund, lost 4 percent in one of its larger funds, the sources said.
Neither fund was available for comment.

In
the space of just hours, the drop in the price of crude oil had shaved
nearly $1 billion off the cost of supplying the world's daily oil needs.
That could be good news for gasoline consumers. But Eric Holder, the
U.S. Attorney General who has recently formed a government working group
to investigate manipulation in oil markets, had a blunt warning for oil
traders. He wants proof the savings are being passed on to end users.

"This
working group was created to identify whether fraud or manipulation
played any role in the wholesale and retail markets as prices increased.
If wholesale prices continue to decrease, fraud or manipulation must
not be allowed to prevent price decreases from being passed on to
consumers at the pump," Holder said on Friday.