In a time when traditional momentum-chasing strategies have busted out, and the best-performing strategy of 2018 has been a bet on trend reversal and against rising momentum as we showed on Friday...
... countless CTAs, algos and 22-year-old traders who only know to buy when others are buying, are suddenly left with nothing to trade. Yet while all momentum appears to have abandoned stocks, one asset class has come to the rescue: commodities in general, and oil in particular, and the direction for both in recent weeks has been sharply higher.
And so, having found some momentum they can desperately latch onto, the sharp increase in oil prices over the past month has been accompanied by a further rise in spec positions which as the JPMorgan chart below calculates has now risen to new record highs..
... suggesting that hedge funds and other speculative investors have been at least partly behind the recent sharp spike in oil prices.
As JPM further notes, both Systematic and Discretionary hedge funds have been building up long positions in oil, with the former induced entirely by momentum and positive carry, while the latter have rushed in due to geopolitical issues, continued inventory declines in the US and expectations of Saudi Arabia engineering a higher oil price ahead of privatizations next year.
Bloomberg confirms the recent surge in commodity fund inflows, noting that hedge funds investing in oil are luring capital at the fastest pace in more than a year. After years of pain, commodity funds have recovered the client outflows they suffered last year. According to eVestment data, investors allocated $3 billion to commodity-focused hedge funds from January through March, the most since the third quarter of 2016. In 2017, investors pulled $680 million from the strategy in the first net outflows since 2014.
But it is not only speculative investors such as hedge funds, systematic or discretionary, responsible for the rise in oil prices, "it is also real money investors such as retail investors and asset allocators that have been buying oil indirectly via purchases of commodity tracking funds as they seek to increase their overall allocation to commodities" according to JPMorgan.
Looking at the broader $300bn universe of commodity tracking funds for which we have data up until the end of 2017, it seems that the inclination by real money investors to add broad commodity exposure to their portfolios began in 2016. This is shown in Figure 3 and Figure 4, which show the AUM and the net inflow respectively into the broader universe of commodity tracking funds until the end of last year. The inflow was very strong during 2016 but it slowed somewhat during 2017. However, given the positive YTD picture from the high frequency commodity ETF flow data in Figure 2, it is likely that the broader flow into commodity tracking funds depicted in Figure 3 also saw a renewed positive impulse this year..
According to JPM, this "strong commodity buying by real money investors and asset allocators is a powerful background force helping to sustain oil prices at high levels and reducing the risk of short-term mean reversion."
Meanwhile, according to various hedge funds quoted by Bloomberg, the recent surge in oil is set to continue well above $80. Here’s a summary of the oil price forecasts from Westbeck and Commodities World Capital :
- Westbeck’s energy fund recovered earlier losses from this year — including a double-digit decline in February — and is now up 11 percent through April 19, according to Chief Operating Officer Jari Habib. The fund lost 17 percent in 2017. The firm sees WTI crude climbing to more than $85 a barrel in the second half
- Commodities World Capital is about flat this year through April 19 after recovering losses that saw it drop 4.4 percent in the first quarter. It predicts oil will hit the mid-$80 area by the second half, though Chief Investment Officer Luke Sadrian said it’s better to “trade around the volatility whilst maintaining a core bullish view” than to simply buy and hold.
OPEC, likewise, has voiced a renewed optimism that it is just a matter of time before triple-digit oil prices are back.
However, pouring some cold water on the rally, Bloomberg's Julian Lee rhetorically asked this morning "is this really 2018? It started to sound a lot like 2008 in Saudi Arabia on Friday, as the kingdom's oil minister argued that the world could tolerate a higher crude price."
"I haven't seen any impact on demand with current prices," Khali Al-Falih told reporters at the meeting of OPEC and non-OPEC producers in Jeddah. Arguing that the energy intensity of global economic growth hadn't declined, he offered the view that "there is the capacity for higher prices."
As Lee reminds us, the Saudi comments are troubling for one main reason: they are an eerie echo of the "ghost of 2008", a vivid reminder of the comments made almost exactly a decade earlier by a former OPEC grandee: Libya's Shukri Ghanem. The world economy "has not reached the tipping point where it can't accept higher prices," Ghanem said back in April 2008.
Little did he realize just how close that tipping point was. West Texas Intermediate crude, which had touched a record $116.97 a barrel the previous day, continued to climb for another 3 months as OPEC insisted it didn't need to raise production. But then the collapse came, and it was quite a crash. After trading above $145 a barrel in the first half of July, WTI was below $40 by the end of the year.
For the sake of OPEC, history better not repeat itself. Meanwhile, however, OPEC is all too eager to tempt fate: when the cartel met in May, oil ministers were talking quite casually about $50 a barrel as a good price for crude. By the time of the December meeting, several were suggesting that a "fair" price for oil was $70 a barrel and at least one put it higher. Now that OPEC's basket of crudes has reached that $70 level, the target appears to have mysteriously moved upwards again.
This is mission creep, OPEC-style.
OPEC's biggest bet is that nothing will happen to derail the global economy, which as numerous banks warned last week - chief among which Morgan Stanley - finds itself in the late, late stages of the credit cycle.
To be sure, what OPEC does have going for it, is that global oil demand does indeed seem remarkably robust, for now. OPEC sees it increasing by 1.6 million barrels a day this year. If that happens, it would be the first time since the early 1970s where we've had four consecutive years of oil demand growing by more than 1.5 million barrels a day, as the Bloomberg chart below shows.
Besides ongoing solid demand, a perfect storm for higher oil prices in recent weeks emerged as a result of developments in the middle east, where Trump’s recurring threat to pull out of the Iran nuclear deal - which allows the Mideast country to export over 1 million barrels per day in exchange for curbs to its nuclear program - had been pushing prices up.
Declining output in Venezuela and falling global inventories are also playing their part, as are the worsening tensions in Syria, which threaten to disrupt supply from across the region. Meanwhile, Saudi Arabia, the world’s biggest exporter, wants to push prices to $80 a barrel to help pay for the government’s policy agenda and to bolster demand for the upcoming Aramco IPO.
However, rising oil prices could plant the seeds of their own demise: if crude reaches $80 a barrel by the middle of the summer driving season, those gasoline prices could be pressing $3.30 a gallon. Al-Falih might not have seen any demand impact yet, but that could change very quickly.
There is also the impact of high oil prices on US oil production which is already at all time highs, surpassing that of Saudi Arabia, and set to keep rising (the latest Baker Hughes oil rig count rose to 820, up 5 on the week, and over 120 from a year ago.
Then there is Trump, who after repeatedly taking pot shots at the FX market by lashing out at "devaluing" currencies such as the yuan and ruble, decided to take on the commodity market and slam OPEC with a Friday morning tweet which said that "With record amounts of Oil all over the place, including the fully loaded ships at sea, Oil prices are artificially Very High! No good and will not be accepted!"
Trump's tweet promptly sent the price of oil sliding...
... even if it recovered all losses by the end of the day, although there is now the added uncertainty of how Trump will escalate his feud against high oil prices, which as we reported earlier last week, threaten to offset most if not all US household consumption gains from the Trump tax cut.
So does Trump's OPEC war, coupled with record long spec positions mean that a sharp reversal is imminent? If the past is any indication, the answer is a clear yes: WTI climbed in January, only to plunge 13% in about two weeks - leading to particularly sharp losses by some bullish hedge funds in February. Now it’s on the rise again and is more than double the price reached in early 2016 when concerns about a world economic slowdown were at their worst.
To be sure, there are the optimists: JPM - for one - remains sanguine. According to JPM's Nikolaos Panigirtzoglou, the new record high spec positions on oil futures pose downside risk to oil prices "only to the extent that geopolitical/fundamental news turns decisively negative."
Without a decisive negative turn in geopolitical/fundamental news, the spec positions in oil are more likely to stay at very high levels and less likely to mean revert. We argued before that backwardation and positive carry are powerful forces in creating more persistence and less mean reversion in oil spec positions relative to periods when carry has been negative. Indeed, as can be seen in Figure 1 oil spec positions exhibited a lot more mean reversion in the period before the summer of 2017 when oil was in contango and the carry was negative.
However, the best advice comes again from Bloomberg's Julian Lee who again takes us back 10 years, and reminds us that not everyone was as sanguine as Libya's Shukri Ghanem. OPEC's then Secretary General Abdalla el-Badri sounded a warning a couple of months later, just before the market peaked. He warned that high prices were "not a bonanza" for OPEC because they had the potential to "destroy everything" by curbing oil demand, the chief revenue-generator for most of his group's members.
As Lee warns Saudi's oil minister Al-Falih and his boss Mohammed bin Salman, they would do well to remember his words, because fast forward 10 years, when the lessons of the past are long forgotten, and greed - both amid OPEC and hedge funds - rules again. And if the past is about to be repeated...
... all those momentum-chasing traders and strategies that got crushed in the stock market in the February vol explosion only to find some respite in the oil market, are about to be demolished all over again.