How Have Hedge Funds Been Affected By Oil Prices? by Rakesh Upadhyay
After suffering large losses in 2014, trying to find a bottom in crude oil, the hedge fund industry wizened up: In 2015, it reduced its weightage to the energy sector to the lowest levels since 2008, saving themselves from profound losses when crude hit new 12-year lows—levels not seen since 2004. It was a short-lived euphoria, however, as most missed the stellar run in crude from the lows and are scrambling to enter after the rebound.
When crude oil started its bear market in 2014, barring a few, most hedge funds did not expect it to plunge to pre-crisis levels. A few famous hedge fund managers lost millions betting on the energy sector. But by 2015, most of them had dumped their energy holdings. By the end of the last year, the total hedge fund allocation for energy averaged a paltry 6.1 percent, which is the lowest recorded since 2008, according to data compiled by Bloomberg.
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When the markets fell during the start of the year, crude oil prices took a sharp knock, pulling the S&P 500 down with it. Due to their underweight positioning on the sector, the hedge funds outperformed the S&P 500 during the drop, as seen in the chart below.
Subsequently, crude oil prices jumped more than 50 percent from the lows formed in February 2016. Though a few top hedge funds bought energy stocks worth $1.5 billion in the fourth quarter of 2015, and a few others increased their bullish bets on Brent crude by February end, most of the industry continued to be sellers during the first 10 weeks of the year, according to UBS AG’s 2016 flow data.
Pierre Andurand, founder of London-based hedge fund Andurand Capital Management LLP, had correctly predicted the drop in 2014. His bearish wager returned an excellent 38.1 percent for his investors in the same year. However, in a recent letter to his investors, Mr. Andurand has turned, “cautiously constructive on oil prices at the moment,” as reviewed by the Wall Street Journal.
Does the entry of the Hedge funds at the current levels guarantee higher prices? No, it doesn’t.
Many had entered in 2014 and got burned. Nevertheless, after reaching $26 per barrel (bbl), consensus believes that a bottom is in place, but they expect recovery to be slow.
In January 2016, a survey of investment banks projected an average price of $50/bbl for Brent crude and $49/bbl for WTI, for the year. By February, the consensus average was down to $39/bbl for Brent and $38/bbl for WTI. This indicates a tilt towards a range-bound action instead of a runaway rally.
Key Takeaways from this news
The entry of hedge funds alone won’t change the fundamentals of the sector. The current rally in crude prices is merely a sharp pullback in a downtrend, because once the price nears $50/bbl, the supply glut will take over and prices will drop back.
Even if prices don’t make a new low, they will spend time in a range until fundamentals start to look better before commencing a new bull run.
With a floor under crude oil prices, it’s time to look at a few cash-rich and fundamentally sound oil stocks during the next retrace.
As prices are expected to remain in a range, traders should be quick in taking profits at the upper end of the range. Similarly, when prices drop to the lower end of the range, traders should muster courage and buy with a suitable stop-loss, ignoring the scary bearish numbers put out by a few experts.
By Rakesh Upadhyay for Oilprice.com