FT Alphaville " Where have all the oil hedgers gone? An interesting chart from John Kemp at Reuters on Monday (click to enlarge): The chart breaks out which players are net short or long of Nymex and Ice light sweet at any particular time. The groups are defined by the CFTC and consist of five main categories: swap dealers, managed money, producers/consumers/merchants (a.k.a hedgers), non-reporting and other reporting entities. Focus on the green. In the chart, that colour represents the positions of producers/consumers/merchants - what you could define as "the physical trade." They are entities with genuine hedging needs because they deal in physical crude itself. As Kemp notes, this category has through the years typically run a net short position because companies who sell oil generally run larger positions than those who have to buy oil. Sellers, after all, have a tendency to warehouse their inventory until it is sold. Yet, since the start of 2011 the net short position held by the physical market has been dwindling in size. At the close of business on April 24, short futures hedges outnumbered long ones by just 15 million barrels, down from 220 million at the same point in 2011 and 256 million barrels in 2010 . So what's been happening? According to Kemp it's hard to say. It could be down to a reclassification of some hedgers such as large oil companies into swap dealers. Or that hedging previously conducted by oil companies is now being undertaken by banks and other dealers instead. Ultimately, however, we don't know: The CFTC will not disclose data on how it classifies market participants and on whether the policy has changed, despite requests, so we don't know if the shrinking producers/merchant/processor positions are due to reclassifications, a change of behaviour or a combination of both. The lack of an explanation is unfortunate, because the disappearance of the producer/merchant/processor/user net short is as much a driver of oil prices as the accumulation of a massive net long by the hedge funds. Classification changes are definitely one potential explanation. However, there are a few others. First, consider what the polar opposite of the historical trend actually means on the ground. As we noted above, the physical industry's tendency to run a net short position is usually explained by the fact that companies which sell or produce oil tend to warehouse inventory until it is sold. For the period that they hold the inventory, the companies are consequently exposed to price declines. These exposures can be managed by taking short positions in oil futures, which allow holders to profit when prices decline. The fact that this is no longer happening possibly means one of a few things. The first: that physical sellers don't (for some reason) have any inventory to manage. Why, we're not sure. Possibly because they are finding it incredibly difficult to accumulate stock. Something which doesn't make sense because inventories are at multi-year highs. The second: that they are so bullish they don't want to hedge; they want to have full exposure to any upside gains in the price of oil. But, again, this doesn't make sense - from a risk management point of view this would be completely nuts. One last alternative, of course, is that demand from buyers (for example refiners) is so high that these entities can't help but run net physical shorts, which now have to be hedged with long positions in futures. This might even explain why product prices are so high, while refiners struggle to make money. But it still doesn't explain the abundance of crude inventory in the US. One thing that might explain that, however, is the idea that a large portion of the inventory is "not available for sale" in the conventional sense. At least not to the overall market. Which leaves us with three plausible explanations for the disappearance of hedgers: 1) The Brent explanation The decline in physical hedgers" net short positions is purely the result of a switch in hedging preferences in the market from WTI futures to Brent futures at the beginning of 2011. We reported on the trend back in May 2011. If this is the case, a net short position in Brent futures should have been building up as the WTI net shorts were declining. The rise in swap dealers" net shorts, meanwhile, could also have been explained by swap dealers taking positions on the WTI-Brent spread as a result. Either way, it would be interesting to see a comparable chart for the Brent market. 2) The securitisation explanation We've been reporting on the trend towards commodity securitisation for a while now. In this scenario, cash-strapped producers and physical traders unable to get traditional financing from banks are being asked to pledge commodity inventory in return for loans. If the deals are securitised in such a way that the commodities are taken completely off the balance sheet of the physical hedgers in question, the banks are left holding the exposure. In which case it makes sense that traditional hedgers are no longer in need of short hedges, while the "swap dealer" banks are. We presume many of these short-hedges would be embedded directly into the securitisation deals. As in subprime securitisation, the banks are left warehousing the exposure until they can pass it on to the buyside. This could explain why large reported inventories are appearing in bull markets (across many commodities). The inventories in question have been securitised and are not available for sale. They've become "dark inventory." This we presume would also apply to oil repos, a type of funding in which oil inventory is transferred as collateral to the banks for the duration of the loan. These sorts of funding arrangements are increasingly being transacted by banks. In some cases they pop up on the balance sheets of trading houses as "bilateral uncommitted secured inventory facilities." 3) The "short" producer explanation This is an odd one, but bear with us. Imagine that in return for financing producers provided banks with the right to yet-to-be produced oil. Something like a pre-pay transaction. Since the oil was not yet produced, these producers were effectively running short positions, which most likely needed to be hedged with derivatives that provide them with exposure to the upside. That's to say, they needed to run a long position in the futures or options market, especially if they were not confident that they would have the spare capacity to produce "more" in the event that they had to deliver the oil. The alternative would have been running high inventory positions of their own (unavailable for sale). To conclude, we'd say that the "Brent explanation" scores most highly on the probability scale. But that's largely because options two and three still need much more investigation and reporting on. However, if there was a way to quantify the impact of securitisation and off-balance sheet funding on the market, we'd be willing to bet that some sort of impact would be noted. Perhaps one day we'll have the data. Until then, unfortunately, we can only speculate. Related links: China is being buried alive in copper - FT Alphaville Just like a giant secured loan to commodity producers - FT Alphaville The Saudi oil sales enigma - FT Alphaville This entry was posted by Izabella Kaminska on Monday, April 30th, 2012 at 16:53 and is filed under Capital markets, Commodities. Tagged with Banks, commodity repos, commodity securitisation, dark inventory, inventories, oil.