A little validation

From Bloomberg.com this morning, Barclay analyst Kevin Norrish stated that oil and copper are at risk of a steep pull-back in prices :

"Given that recent price appreciation does not seem to be very well founded in improving fundamentals, and that upward trends may prove difficult to sustain, the risk is growing that any setback will result in a rush for the exits that could again lead commodity prices to overshoot to the downside."

It's always risky trying to call turns in the market and to what extent prices will move, but it is pretty clear that speculators are the main force behind price movements.

Another piece published the day before on Bloomberg provided interesting evidence on the underlying cause--it was not that investors were making bets on higher prices, rather, as the article stated, the recent price uptick was a consequence of investors with bets on lower prices, fearing the bottom had been reached, needing to close out their positions:

"The rally has come from shorts getting scared out of their positions, and you’re not seeing a lot of money coming in on the long side," said John Kilduff, partner at Again Capital LLC, a New York hedge fund focused on energy. "It really calls into question the fortitude and staying power of the rally."

Investor-speculators who make bets using futures contracts have to close their positions by taking what's known as an "offsetting position." If they don't do this, then oil contracts held to maturity must either deliver oil if you're holding a contract to sell oil (short position), or you must take delivery if you're holding a contract to buy oil (long position). For example, if one bets on falling prices, one "sells" a futures contract on WTI oil, and to close the position--to take profits or minimize losses, the trader must "buy" an equivalent contract.

As the article notes, since February 2nd long positions of investors fell by 971 contracts, but short positions were reduced by over 130,000. In other words, those betting on lower prices, in order to lock in their profits before prices increased, had to close out their short sell positions with buy orders, and those offsetting buy orders are what drove prices higher. This is the problem when speculators dominate markets: if they heavily bet on one side of the market, when they close their positions--so they don't have to deliver or take delivery, it creates an equal and opposite reaction on prices.

That's the kicker: the market is now set up for an equal, opposite reaction--what Barclay's Norrish is predicting, and what I've been predicting. Speculative positions are now seriously net long--there are about 65,000 bets on falling prices and 300,000 bets on rising prices, so their net positions are long by 235,000 contracts. With the continued glut of supply in the real market for oil, the only way these paper bets can be maintained is if more rubes join the bet on higher prices. If this doesn't happen, and prices start to weaken, there could be a run for the exit! That is, as prices start to weaken--as they have in the past two days, in order to prevent further losses on their long positions, speculators will have to sell contracts to close them out. And, just as buying to close their short positions is what raised prices, selling to close their long positions will cause prices to fall further. Look out below!

I'm sure it all sounds confusing; however, there is a very important point here: this behavior will continue--price volatility and bubbles--as long as speculators are allowed to dominate trading in futures markets. Deregulation in 2000 allowed speculators to take over the markets, and it's safe to say that markets are less efficient, not more. It's time to bring back stricter position limits on speculators.