By Leah McGrath Goodman
On the first day of April, as crude futures soared past $85 a barrel—marking an 18-month high—the words finally escaped someone's mouth: "Anyone talking $150?"
Uttered by one very wary New York hedge fund manager, it was a question not far from the lips of many an oil trader. It also spoke reams about the mind-set of the speculators behind an increasingly popular trade right now: betting on the rising price of oil futures—although just when is the tricky part. So tricky that some hedge fund managers think any price pop will be temporary and are lining up short bets for 2011 as a cautionary backstop.
Although oil prices have been in the doldrums for more than a year, there are signs that they could get comfortable in a higher range. The United States is facing the summer driving season, along with expectations the economy will grow about 3% this year, easily topping its performance in 2009. Throw in the largest gain in domestic payrolls since 2007 and accelerated growth in China, and it suddenly seems possible that crude oil could shoot into the triple digits again.
"In energy alone, it's basically a buy," says Danny Masters, founder and director of energy hedge fund Global Advisors, headquartered in the UK's isle of Jersey. "The question is, are you going to be right tomorrow or in two years' time? If you buy now, you of course risk negative carry, and there could always be another financial crisis. It is a safer bet to buy the back months or buy options. If it turns out to be true that oil's headed up again in earnest, there'll be 50 different ways of making money."
This line of reasoning, Masters says, is driving the long bet quietly gaining sway among hedge fund traders brazen enough to position themselves ahead of another potential oil comet. Already, crude futures' back months are perking up, with long bets at entry points above $80 while crude calls with strike prices of $100 and even $110 are being nabbed by the dozen.
Many traders remain wary, remembering what happened in 2008, when oil took a swan dive from $147.27 to almost $30 a barrel in a matter of months. "Oil keeps bouncing off this $80 low, and it definitely looks like it wants to break out," says Conrad Goerl, a commodities trader at Houston energy hedge fund Centaurus Energy, which manages about $5 billion. "I'd have to say it's almost by definition a self-fulfilling prophecy. But I wouldn't say it's the obvious market to be in right now. It's been stuck in a range for too long."
For hedge funds willing to take the risk, however, the play is simple: Take out long bets on crude oil for delivery in December 2010, one of the most heavily traded months of the year. In the first quarter, many traders did just that, pushing up open interest as much as 35% to peak at around 212,000 contracts in mid-March and finishing out the quarter at about that level, according to the New York Mercantile Exchange.
Similarly, Nymex data show December 2010 calls at $100 and $110 have been sweet spots for traders of crude, which is a cheaper way to speculate than buying futures outright. On the flip side, short-betting traders looking for a way out in case the bounce is only temporary have sent open interest in the December 2011 crude contract up close to 50% in the first quarter to around 80,000 contracts. Given crude's tendency toward Icarus-like rallies and crashes, the thinking is that it's better to be positioned for a short rise before going full throttle.
"Crude oil has certainly experienced a strong uptrend in the past month, and the uptrend has not been limited to the front months," observes Brent Hankins, senior portfolio manager for Welton Investment, a $500 million systematic hedge fund based in Carmel, Calif., which sinks about 30% of its funds into commodities at any given time. "Back months have also experienced strong price rallies, and the liquidity in back months allows traders to readily take a position."
The move marks a departure from funds' typical confidence in the near term over the long term. Historically, traders have felt much surer of the price trajectories in the front months than those further along the curve, but since the global financial crisis took hold, there's been a protracted muddying of the near-term waters, says Michael Guido, associate director of hedge fund coverage and commodity flows at Macquarie Bank in New York. "The front of the curve, until recently, has been in a range since February of $79 to $83 a barrel because there's no real confidence in the short-term fundamentals," he says. "One day we're up on Greece, the next day we're down on Greece. Then we're up on China and down on the dollar. Because of a lack of conviction and strong oil supply in the Gulf, no one has been willing to take any big bets."
Masters points out that when rising demand looks like it might cut spare capacity on a global scale, as it did in 2008, traders begin fretting about the broader macro trends—namely, whether there will be enough oil to go around. "That's why sometimes high oil inventories will bring down the price, and at other times, like in 2008, high oil inventories did nothing to keep the price from going up, which is completely counterintuitive," he says. "People tune out things like the weekly inventory data with peak oil fears at hand. At present, we're back to looking at the near term, but based on what we've been seeing in the market lately, we could be getting ready for another regime change."
Of course, rising prices come with their own built-in downside risks. As its members ramp up an estimated $45 billion of oil projects shuttered two years ago when prices tanked, OPEC appears to be getting ready to cash in. The group's own production-quota compliance rates are dropping like a stone as member countries look to offload excess oil supply. "Whenever we're above $80, OPEC cheats, so we are seeing more oil coming out than their quotas," says the head of commodities research at a New York multibillion-dollar global macro fund, which has decided to wait a little longer before tiptoeing back into the crude market.
Most OPEC members have made it clear they would like to stick to an oil price band of $70 to $80 a barrel. But Wall Street banks and hedge fund managers, true to form, are way ahead of that, talking $80 to $90 and up. Among themselves, they augur that further recovery of demand in the second quarter could certainly push oil prices back to $100. ("If this thing blows through $90," one warns, "watch out. It will be $100 fever all over again.")
That said, $150 oil, a high-water mark that's never been reached, remains the stuff of a heady Don Quixote epic—merely a windmill to be tilted at. AR