War on Oil: Hedge Funds Go Short
Recession Fears Fuel Market Turmoil, while the world looks at the Middle East
We are at war with the hedge funds, which are net short commodities for the first time since 2016! The last 2 days have been mildly put a sea of red across all indices. While there are several reasons for that, we can say that there are 2 main reasons for the sell off. Firstly, recession fears are coming back, driven by recently released unemployment and PMI manufacturing data. Secondly, the carry trade involving shorting the Yen and buying U.S. tech is imploding in front of our eyes. As funds are forced to cover, they take down the market with them. In a war you need to understand what you own and why you own it. Conviction is the name of the game! In this piece I will share my thoughts on oil and commodities.
The situation with oil is frustrating. Sentiment is in the trash and long term bulls are throwing in the towel. I personally bough calculated position in Geopark on Tuesday evening in anticipation of large draws in U.S. inventories. The next morning we had nice draws across the board, but more importantly Hamas leader Ismail Haniyeh was assassinated in Tehran. Oil was up 4% and was happy with my decision. On Friday I was staring at a sea of red with E&Ps down massively.
To understand oil, we need to understand what the current narrative of the market is and compare this with the data we have.
Recession or just overblown fear?
The main fear is, that we will see a recession that will destroy demand for gasoline and oil in the U.S. While we have seen weaker PMI manufacturing data, we have to clear up something related to the unemployment rate. Corporate media reported that the unemployment rate stood at 4.3% in July. However, due to Hurricanes we saw temporary layoffs which elevated this number. If we adjust for this change, we would have seen unemployment rate at 4.1% (still quite high). The most important piece of data for oil however, is painting a vastly different picture than one would expect from recent headlines. U.S. gasoline demand this week is up 5.1% from last week. Looking at other data, the EIA was forced to revise oil products and consumption data upwards, as “US oil demand rose by 404kbpd or 2.0% y/y to 20.800mbpd in May - that is a record high for the month of May” - EIA.
U.S. oil products consumption
Demand, Supply & Inventories
Demand is healthy, even though we have some weakness in China. Supply however is taking a different turn, as U.S. oil production is flat over the past 12 months. Production has also become gassier, resulting in a higher share of gas in overall production. As gas is trading below breakevens for most producers, you can expect continued weakness in U.S. crude production.
Liberty Energy, a North American company focused on fracking has noted the following around 3 weeks ago:
“Crude production, it's been flattish for six or eight months, and we've still seen activity decline a little bit since then. It's probably flat at best oil production.”
“Our expectation for growth in '25 is likely modest, but the current activity today, it would not support even flat natural gas production because it overshot, it overshot.”
- Liberty Energy
Also, the U.S. Frac Spread Count has dropped significantly over the past months, supporting the statements by Liberty.
The bottom line is, that demand is healthy, while supply growth in the U.S. will not reach the levels we have seen over the past couple of years. The result will be more market share to OPEC, which is balancing the oil price, as OPEC has openly communicated that they want stable oil prices. Saudi Arabia needs high oil prices to support their mega projects and with its leverage on the group, will have substantial impacts on the oil price.
Inventories in the U.S. are below their 4 seasonal average, with draws across the board (oil, cushing, distillates & gasoline) over the past weeks.
Globally, we have a similar situation with oil inventories (onshore + oil on water) near record lows.
Betting against WallStreet
In the meantime, hedge funds are net short a basket of 20 commodities.
The last time we saw this, commodities went on to rally massively over the following months. During this rally, oil went from $29 a barrel to $53 a barrel in 12 months.
Apart from just shorting commodities, hedge funds reduced Brent Crude Oil long positions by the most since March 2022.
In my experience, short term price movements in oil are nearly entirely driven by positioning, while mid to short term moves are driven by supply & demand. When funds are this bearish, while we have a favorable supply & demand balance, it gets interesting. Considering that we have tensions in the Middle East funds could soon be forced to cover their shorts, driving the price higher.
War in the Middle East?
As a wildcard, we have the potential for a full blown war in the Middle East between Iran, its proxies & Israel. the world is watching and we will see how Iran retaliates.
“ Our response will be difficult and painful, the possibility of mediation is out of the question. We have no doubt that Israel will pay dearly for its actions.”
- Iran's foreign minister in a message to the Jordanian foreign minister
Israel also threatened Iran that in the case of a severe attach against them, Israel would destroy key oil facilities in Iran in retaliation. Iran is backed by Russia and China, while Israel is supported by the U.S. military, which is sending a large amount of warships towards Lebanon and Iran. Let’s hope that we can avoid a large scale war that would result in tragic events on both sides. As a retail investor I have no option but to hedge against this scenario. The best hedge out there are oil stocks operating in regions far away from this turmoil. Geopark, Sand Ridge, Canadian oil stocks and Norwegian ones offer geographical advantages while being valued as if they’re going bankrupt (hint: they don’t ).
Conclusion & Positioning
Putting it all together, oil is driven by positioning in the short term, while fundamentals drive price in the mid/long term. The current bearishness among fund managers is driven by recession fears. Recent data suggest that oil demand is healthy, while supply is flattening. There are not enough data points to make a reliable forecast regarding a potential recession in the U.S. economy yet. Inventories are low and declining while a war in the Middle East is brewing. The risk/reward is favorable here with oil producers such as Geopark trading at ridiculous levels (Twitter/X LINK). I want to close this article saying, that oil always over-shots. To the upside and the downside! Can the price drop further when the market goes insane? It sure can! But if this happens, I will just buy and don’t look at the positions for a few months.
I hope this article was useful and in the meantime, I’m off to the beach clearing my thoughts.
Yours sincerely,
MODERN INVESTING
That was well thought out and written thank you
Great one! thank you! Who looks oil tomorrow is afraid, but if one looks after tomorrow gonna be happy. Oil and others Commodities will suprise a lot of investors.