Column: Hedge funds prepare for another oil spike - John Kemp

By John Kemp

LONDON (Reuters) - Hedge funds and other money managers have started to ready themselves for another big spike in oil prices in the next few months, according to positioning data from the U.S. Commodity Futures Trading Commission (CFTC).

By August 28, hedge funds had accumulated a net long position in WTI-linked futures and options equivalent to 207 million barrels, up from 151 million a month earlier, the largest net long position since May.

The rising drumbeat of war in the Middle East, coupled with heightened chatter about more quantitative easing from the Federal Reserve and the steady rise in prices itself has gradually drawn in more hedge funds on the bullish side.

The number of hedge funds and other money managers running long positions of at least 350,000 barrels in the main NYMEX light sweet crude oil contract has risen from 65 at the end of July to 82 at the end of August.

On the other side, the number of funds running similar-sized short positions, expecting prices to fall, has been reduced from 53 to 39, according to CFTC records.

Hedge funds are running long rather than short of WTI-linked futures and options by a margin of 4.48:1, up from 2.90:1 at the end of July and the widest margin for four months.

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Chart 1: link.reuters.com/cep42t

Chart 2: link.reuters.com/dep42t

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The accumulation of net long positions exactly mirrors the build-ups of hedge fund positions between October 2011 and March 2012 (when U.S. crude prices rose from around $75 to $110) and earlier between November 2010 and May 2011 (when U.S. prices increased from around $75 to $113) (Charts 1 and 2).

So far, prices have risen from just over $75 in late June to just over $95. The past is never a perfect guide to the future. But if history repeats itself, hedge funds could accumulate around another 100 million barrels of oil and U.S. crude prices could rise another $10-15, with a similar increase in Brent, before the market peaks.

Recent experience from price spikes in 2011 and early this year suggests prices of $105-$110 (WTI basis) and $120-$125 (Brent) are sufficient to produce a marked decline in growth with a lag of around three to four months, which implies a price spike between August and October would start to depress GDP growth by the end of the year.

HEDGE FUND BULLS

Several factors have come together to draw hedge funds back into a sector from which many retreated during the second quarter.

The previous liquidation of speculative positions and drop in prices cleared out some of the potential selling that was overhanging the market earlier in the year and has made the risk/reward ratio much more attractive for bullish investors.

The economic slowdown that started in the second quarter has proved relatively mild, not deep enough to damage oil consumption to any serious extent or trigger another financial panic but just bad enough to convince central banks they should consider further stimulus, which is a bullish signal for many investors in "real assets" such as commodities.

Extra crude output by Saudi Arabia and a build-up of stocks in April, May and June have been reversed as demand has remained firm and the kingdom's domestic fuel consumption has risen during the hot summer weather.

Following Saudi Arabia's earlier output increases, the kingdom's spare capacity to reduce a further spike in prices has been significantly reduced.

Speculation about a possible unilateral strike by Israel against Iran is again intensifying as sanctions against Iran fail to break the diplomatic deadlock.

Consuming nations are deeply divided about whether to employ strategic stockpiles, which could delay or even prevent an emergency release. Germany and Italy are resisting pressure from the United States to agree to a stocks release, limiting the risks to investors from accumulating a long position in oil and trying to ride a rally higher.

Hedge funds tend to operate with a strong herding tendency visible in positions, which can make their views self-fulfilling, at least in the short term.

The net result is that most hedge funds are positioning themselves to benefit from a further increase in crude oil prices.

The only real constraints are (1) the risk of an unexpected stock release if the United States and some other countries decide to act on their own; (2) the recognition that price spikes are inherently unstable and sow the seeds of their own destruction; and (3) fear that prices have already risen so much that the top is near.

For the time being, a clear majority of hedge funds and other money managers believe crude prices are set to rise further, before any hit to the economy and demand destruction sets in or policymakers intervene and the spike unravels.

(editing by Jane Baird)