Bets On Lower Oil Prices Driving Price Up

Posted by Bull Bear Trader | 5/23/2008 06:48:00 AM | , , , | 0 comments »

A recent WSJ article highlights a commonly overlooked effect or consequence of commodity trading - that of bad hedging or speculation bets causing buying pressure, driving prices higher. As for speculators, we often assume that they are just following the short-term trend, which is currently up, adding further momentum buying pressure. Sometimes the buying pressure comes from speculators and hedgers that are simply exiting out of a bad past position, either due to margin calls, or simply because they can no longer take the pain.

Many producers entered into contracts to sell crude oil in the future, locking into higher prices for future delivery. While the future prices were higher than the spot price at the time the contract was written, some of the contact prices are now as little as half the current spot price, even for contracts with a delivery of less than one year. As a result, companies and traders are being forced to close these deals by buying back existing contracts that were wrote just months ago.

Longer-term trading has increased over they years, with Nymex oil futures contracts tripling over the last four years, with much of the growth coming from futures contracts that expire more than one year out. This form of long-term hedging and speculation was relatively rare in the past and is certainly contributing to some of the current increase in trading activity and price movement as these trades, which were probably not expected to be as speculative, are now needing to be unwound.

A recent Bloomberg article also discusses the impact of speculators selling out their contracts, but focuses more on short-term speculators that have recently closed out short positions after making bets that the price of crude oil would decrease after the recent run-up. The closing of these contracts has put further buying pressure on the commodity. As evidence, open interest has been falling for months. The CFTC list how "non-reportable" small-size speculators have been closing out their short positions, which were 47% higher than long positions. Any time you have a rising and shrinking market (open interest is decreasing, while prices are rising), it is usually a good indication that speculators are closing out positions and leaving the market.