Redstate

What are the Hedge funds smoking, and can I have some?

By blackhedd Posted in Economy — Comments (5) / Email this page » / Leave a comment »

Crude oil markets have been pretty busy and pretty stomach-churning of late. The last two weeks have been mostly down and more down, with a benchmark barrel price dropping just below $50 last Thursday. Today, prices are up sharply, with the expiring February contract trading at nearly $53 early this morning (East Coast time).

This wire story attributes the sudden run-up to the end of global warming which took place over the weekend, as all you Bears fans enjoyed yesterday's game from snowy Chicago. But why are crude prices so volatile (no pun intended)?

Update: Posted at 5:15pm EST on 22Jan. Wild day in the energy markets. Crude futures finished the day down nearly a dollar, after rising more than a dollar this morning.

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Oil markets are very complex (no surprise) and prices are affected by a wide range of factors. Sentiment by traders is of course a big driver in uncertain times, and it can easily drive sharp swings as perceptions of market fundamentals change.

We're getting to the time of year when people start looking closer at gasoline inventories as opposed to heating oil, and I heard some predictions over the weekend that seasonal shifts in demand will put upward pressure on crude prices.

After all the weather forecasters and global-warming zealots laid a great big goose egg (bagel, empty, zero, you pick the epithet) on hurricane predictions last year, it's probably a good bet that storm-related price volatility won't happen this year, unless the storms actually do.

Inventories of various refined products are always closely scrutinized, as they provide key supply-and-demand signals. They move the markets too.

But there's another important factor at work, and it's a lot harder to get information on: the presence of sophisticated financial players (hedge funds) in the energy markets.

You may have been wondering how crude prices could fall from their July highs near $78 all the down below $50 (and possibly soon to the mid-forties) in the absence of a financial crisis or serious downturn in the global economy. Of course our lefty friends think the Republicans did it. But if they had the power to drop world crude prices through November 7, then why weren't they able to stop the slide in time to make their oil-soaked Texas buddies whole again?

Energy-market fundamentals did indeed shift bearish last spring. When that happened, a huge amount of long positions held by speculators (probably mostly hedge funds) came unwound in a big hurry, and accelerated the slide. The stampede caused one erstwhile high-flyer to bite the proverbial dust last fall.

I've been suspecting for some time that the hedgies are now all crowded on the short side of the market. It often happens that these people trade as a pack, magnifying the impact of market moves. When these moves get overdone, opportunities get created. That clearly happened last year, and it may be happening this year. This morning's action provided some supporting evidence, as short-covering probably drove the nearly $3 advance in crude prices since late last week.

So what are the hedgies smoking? They are clearly expecting soft fundamentals for energy this year, but just as clearly they'll bail at the first sign of a change. Expect further volatility and wide price swings. A lot more than commercial demand is driving this market.

As an aside: you've probably been following the recent machinations of OPEC. Saudi Arabia, the 800-pound gorilla in the room, recently announced lower production targets but also cut their dollar prices in certain long-term contracts in early January. That corresponded to the recent sharp bear move. What gives?

One country that gets damaged really hard when oil prices fall is Iran. (Venezuela too, for that matter.) Both of these countries are pursuing government policies that make it difficult or impossible to upgrade their production infrastructure (because that requires foreign capital and expertise). So they suffer directly from lower prices because there's a limit to how much more they can pump.

Now it's well known that Saudi Arabia is frightened enough by Iran's ambition to become the undisputed heavyweight champ of the Middle East, that they're thinking about building their own nukes. But Iran turns out to be quite vulnerable to oil-revenue shortfalls, because these dollars are an enormous proportion of government spending (at least half, perhaps two-thirds). Is it possible that by engineering lower oil prices, the Saudis and other large producers are pursuing a policy of economic warfare against the Iranians?

Quiet economic pressure may be part of why the signals out of Iran have been showing internal weakness and dissension lately. We'll get a big clue in the next few weeks as OPEC's production numbers come out.