John Kemp is a Reuters market analyst. The views expressed are his own.
Oil hedgers held the smallest net short position in WTI-linked futures and options for at least six years in the week ended April 24, according to commitments of traders data published by the U.S. Commodity Futures Trading Commission (CFTC).
This physical hedgers category, which the CFTC identifies as “producers, merchants, processors and users” (who use futures predominantly to manage or hedge risks), typically runs an overall short position in U.S. crude futures and options, according to CFTC records.
Companies that sell or store physical oil and run a short position in futures and options to hedge price changes generally run larger positions than oil buyers who hedge their price exposure with a long futures position. But that net overall short position has been dwindling since the start of 2010. At the close of business on April 24, short futures hedges outnumbered long ones by just 15 million barrels, down from 220 million at the same point in 2011 and 256 million barrels in 2010 (Chart 1).
If the net position continues to adjust at the same rate, producers/merchants/processors/users will find themselves net long of WTI-linked futures and options this week for the first time since at least 2006 (Chart 2).
From Producers to Banks and Dealers
The shrinking net short position held by physical hedgers is part of a big realignment of the oil derivatives market. Until 2011, producers/merchants/processors/users were the major net sellers of futures and options, while hedge funds and other money managers were the main buyers. This accorded with the theory of risk transfer and hedging pressure popularized by John Maynard Keynes and others in the 1920s and 1930s. Producers transferred (downside) price risk to investors by selling production forward, or hedging inventories, while investors gained exposure to any upward move in oil prices by buying derivatives.
The remaining positions were supplied by swap dealers, who were sometimes net long, sometimes short, depending on the imbalance between physical hedging and investor buying.
But two things have happened since 2010 and especially the start of 2011. First, net sales of futures and options by producers/merchants/processors/users have dwindled and now nearly vanished altogether. Second the swap dealers have stepped into the void to become the main sellers of futures and options to hedge funds and other money managers.
Swap dealers have not run a net long position in WTI since September 2010. In March, dealers ran a record net short of 404 million barrels of oil. It was the direct counterpart of the massive net long of 290 million barrels run by hedge funds and other money managers. Producers etc supplied only 53 million barrels of net short positions.
Where Have the Physical Sellers Gone?
It is not clear why the producer/merchant/processor/user community has stopped being a supplier of net short positions.
One possibility is that producers and stock holders have cut their forward sales as working inventories have fallen and WTI remains depressed compared with Brent, especially for forward dates, where WTI prices are subject to large discounts. Producers may prefer to retain price risk in the hope of realizing higher prices in future, rather than accept big discounts for locking in prices now. WTI futures for December 2014 are currently priced under $97 per barrel, compared with spot prices of $105.
Another possibility is that some producers have switched from hedging in WTI to Brent. WTI prices have been depressed owing to congestion around Cushing, while Brent is a better benchmark for seaborne crude sales.
A third explanation is that some hedgers, such as large oil companies formerly classified as producers, merchants and processors, have been reclassified as swap dealers, or that hedging previously conducted by oil companies is now being undertaken by banks and other dealers instead.
We don’t know. The CFTC will not disclose data on how it classifies market participants and on whether the policy has changed, despite requests, so we don’t know if the shrinking producers/merchant/processor positions are due to reclassifications, a change of behavior or a combination of both.
The lack of an explanation is unfortunate, because the disappearance of the producer/merchant/processor/user net short is as much a driver of oil prices as the accumulation of a massive net long by the hedge funds.