U.S. Independence Day marked a turning point in the oil market, when a short-covering rally ran out of momentum and gave way to a renewed and very aggressive bear market.
Hedge funds and other money managers increased their net long position in futures and options contracts linked to Brent and WTI by 46 million barrels in the week leading up to July 4 (http://tmsnrt.rs/2uInAFV).
Funds increased their net long position for the first time after reducing it by a cumulative 231 million barrels over the previous four weeks, according to data from regulators and exchanges (http://tmsnrt.rs/2tzCiRh).
The move had all the characteristics of a short covering rally, with crude prices rising steadily between June 21 and July 4 (http://tmsnrt.rs/2t4K7ek).
The commencement of short-covering was widely anticipated after hedge funds established a record number of short positions in crude, gasoline and heating oil by June 27.
The total number of short positions held by hedge fund managers in the five major crude and products contracts declined from a record 510 million barrels on June 27 to 463 million barrels on July 4 (http://tmsnrt.rs/2u9sW00).
Fund managers cut short positions in WTI by 14 million barrels, Brent by 13 million, U.S. gasoline by 8 million and U.S. heating oil by 13 million in the week running up to Independence Day.
Even so, only a small number of short positions had been closed out by July 4.
But then something very unexpected happened. Instead of prices continuing to climb as more short positions were closed, prices began to sink in the second half of last week.
From a positioning perspective, the balance of risks remained tilted to the upside, with a small number of long positions left to liquidate and a large number of shorts still needing to be closed out.
So the renewed decline in oil prices therefore marked an unusual and aggressive move, with extra selling from unknown traders pushing prices lower.
Oil prices continued to slide despite an unusually large drawdown in U.S. commercial crude stocks reported on July 6.
From a positioning perspective, positions still appear very stretched on the downside. There is still a very high risk of the trade becoming crowded.
But sentiment in the oil market has become exceptionally bearish, with most traders concluding OPEC won't, or can't, do anything to support prices, and U.S. shale producers can't, or won't, moderate the drilling boom.
Prices may therefore have to continue falling low enough for long enough to enforce a strategy correction from the shale drillers or OPEC.
The result is an unresolved tension between positioning risks (which remain biased to the upside) and fundamental risks (which are increasingly tilted to the downside).
By John Kemp