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Short Speculators Chase Crude-Price Volatility in Range-Bound
Market
Hedge fund positions increase since price collapse.
Morningstar Commodities Research
Sept. 12, 2016
Rinse and Repeat
At times, the oil market this summer appears to be behaving like a broken washing machine caught in a
rinse-and-repeat cycle. Prices are bid up by talk of production cutbacks, producer outages, or the latest
Sandy Fielden
Director, Oil and Products Research
+1 512-431-8044
[email protected]
hope for an OPEC agreement to curb output. Then new inventory data bursts the bubble by
demonstrating that supplies are plentiful and that while demand is strong, it is not strong enough to
soak up the surplus, so prices drift down again. The cycle is endlessly repeatable—with tweeters
eagerly chirping out the latest market-moving headline and traders buying the rumor and selling the
news.
Longer term, like most analysts, we believe the oil market is going to balance—in our case by the end of
2017. Low crude prices have led producers to slash investment in existing and new fields, meaning new
crude output will start declining in 2018. Even though demand is not increasing dramatically, it is
increasing slowly and will exceed supply in the same time period. As demand exceeds supply, excess
inventory will get used up and oil prices will firm in the face of a tighter market during 2018. Because of
improving fundamentals, we recently raised our 2018 forecast for the price of West Texas Intermediate
oil to $65 per barrel from $52.50, which we believe is the level sufficient to drive a major increase in U.S.
tight oil activity.
Until then, and bearing in mind that we are still over a year away, we expect the market to remain
range-bound between $40 and $55 per barrel—with ups and downs following the rinse-and-repeat
rumor/news cycle. This note examines heightened crude price volatility during this period of market
uncertainty.
Historical Volatility
Since the beginning of the oil price collapse in June 2014, prices have experienced greater historical
volatility—an annualized statistical measure of the standard deviation of daily percentage price changes
over 21-day periods. Between January 2010 (when crude prices settled down after the Great Recession)
and the end of May 2014, daily prompt-month WTI futures' historical volatility averaged 24%. Since the
start of June 2014 (up until Sept. 2, 2016), crude price historical volatility averaged 39%. This increase in
volatility is shown in Exhibit 1 along with prompt WTI futures prices.
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Exhibit 1 WTI Futures Historical Volatility
Historical Volatility
Price
100
120
90
percent volatility
70
80
60
50
60
40
price $/ barrel
100
80
40
30
20
20
10
0
1/1/2010
1/1/2011
1/1/2012
1/1/2013
1/1/2014
1/1/2015
1/1/2016
0
Source: CME Group, Morningstar
The cause of the sudden increases in price volatility in commodity markets like crude oil is the subject of
much contention among commentators. A lot of the steam in that debate is usually reserved for the role
of speculators, the financial players who bet on prices using paper futures contracts. As we shall see,
nobody knows for sure what causes increased volatility, but one thing is clear: Higher volatility attracts
speculative investors.
Noncommercial Speculators
The federally regulated Commodity Futures Trading Commission requires U.S. futures market clearing
members to report the daily open positions held in their own accounts and on behalf of clients above set
reporting levels. The CFTC aggregates this data to produce a weekly snapshot, the Commitment of
Traders report. The report structure varies by commodity, but there are two versions for crude oil. The
first is a legacy report that tallies the open positions held by commercial and noncommercial traders. The
term “commercial trader” was designed to encompass both physical and financial players engaged in
hedging. Noncommercial traders covered all other reported trades—deemed to be speculative. For each
group, the CFTC records the number of long positions (future commitments to buy oil) and short
positions (future commitments to sell). A second version of the COT report started in 2009 after the
financial crisis and breaks down commercial and noncommercial players into more categories to
increase transparency. In this version, commercial players are separated into purely physical players
(producer/merchant/processor/user) and swap dealers (financial hedgers), while the noncommercial
players are divided between managed money investors and the catch-all “other reportables.” Again, for
each category there are shorts and longs.
Exhibit 2 compares CME Group WTI futures noncommercial, or speculative, open-interest long positions
(orange line, left axis) and speculative short positions (black line, left axis) from the legacy COT report
format and historical volatility in the underlying prices (blue shaded area, right axis). The chart illustrates
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two clear trends. The first is a consistent upward trend over the period in the number of speculative long
positions. This trend in long positions reflects increasing investment in commodity index funds and
exchange-traded funds that track oil futures. As investment in these funds increases, they increase their
long positions in WTI futures. The second clear trend in the chart is the extent to which speculative short
positions track historical volatility. The implication here is that speculative traders increase their
accumulation and liquidation of short positions when oil prices are more volatile.
Exhibit 2 WTI Speculator Open Interest and Volatility
Volatility
Speculator Long
Speculator Short
600000
100
90
500000
80
open interest
60
300000
50
40
200000
percent volatility
70
400000
30
20
100000
10
0
1/1/2010
1/1/2011
1/1/2012
1/1/2013
1/1/2014
1/1/2015
1/1/2016
0
Source: CME Group, Morningstar
Money Managers
Disaggregating the noncommercial speculator data by looking at the newer version of the COT report
helps narrow down the source of the speculative shorts that are chasing historical volatility to the
category represented by managed money. Trades categorized by the CFTC as money manager positions,
are made by investor vehicles, a category that includes hedge funds. Exhibit 3 shows the volume of
managed money short positions and crude historical volatility from January 2015 to present. The
accumulation of short positions by hedge funds appears to anticipate many of the run-ups in volatility,
followed by liquidation of the shorts once volatility subsides. This relationship is not exact and because
of limitations in the data it is not possible to determine cause and effect. Nevertheless, keeping track of
managed money short positions offers analysts insights into the impact of speculators.
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Exhibit 3 Managed Money Shorts and Volatility
Volatility
Managed Money Short Positions
250000
100
90
80
70
150000
60
50
100000
40
30
50000
percent volatility
open interest
200000
20
10
9/1/2016
8/1/2016
7/1/2016
6/1/2016
5/1/2016
4/1/2016
3/1/2016
2/1/2016
1/1/2016
12/1/2015
11/1/2015
10/1/2015
9/1/2015
8/1/2015
7/1/2015
6/1/2015
5/1/2015
4/1/2015
3/1/2015
2/1/2015
1/1/2015
0
0
Source: CME Group, Morningstar
Limitations
Market analysis using COT data suffers from two major limitations. The first is the difficulty of classifying
the trader categories exactly. Some larger companies may have traders making physical hedges as well
as swap dealers acting on behalf of other counterparties. That makes categorizing positions an art not a
science. A second and more significant challenge with COT data is that the CFTC does not identify the
maturity of reported positions. For example, we might know Trader A has 100 short positions, but we do
not know whether the positions are for delivery next month or two years out. We know from futures
exchange reports that the vast majority of open positions are in nearby delivery periods. For example,
analysis of the WTI curve on Sept, 2, 2016, showed that total open interest in WTI futures was about 1.8
million contracts. Roughly 53% of that open interest was in the first three delivery months, 69% in the
first six months, and 82% in the first year (Exhibit 4). We can tell the depth of speculative activity from
the COT reports but not the maturity of their positions, making it harder to discern trader motives.
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Exhibit 4 WTI Open Interest and Price Curve
9/2/2016 - Open Interest
9/2/2016 - Price
500000
58
450000
56
400000
50
250000
48
200000
46
150000
100000
44
50000
42
0
40
Oct-16
Feb-17
Jun-17
Oct-17
Feb-18
Jun-18
Oct-18
Feb-19
Jun-19
Oct-19
Feb-20
Jun-20
Oct-20
Feb-21
Jun-21
Oct-21
Feb-22
Jun-22
Oct-22
Feb-23
Jun-23
Oct-23
Feb-24
Jun-24
Oct-24
open interest
52
300000
price $/ barrel
54
350000
Source: CME Group, Morningstar
Given these limitations, the COT data cannot be relied on to explain or anticipate trader activity in
different circumstances. However, as we have seen, there has been a noticeable uptick in overall open
interest since the crude price crash in June 2014 and a lot of that increase can be attributed to investors
interest in oil price volatility. That speculative interest helps increase price volatility—that is unlikely to
slow down until market fundamentals increase confidence about future price direction. Once the market
has a clear consensus about direction, the volatility and speculative activity will damp down. K
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About Morningstar® Commodities Research™
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