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[LONDON] On the surface, the oil market is getting worse and worse: there are now more bearish bets on benchmark Brent crude than at any time in at least six years. But to many traders, that's a signal prices are vulnerable to a sudden, sharp rebound.
Oil's ripe for a so-called "short-covering" rally - where traders who sold contracts hoping to benefit from falling prices buy them back to take profits or avoid losses. Short positions held by speculators in Brent rose to 169 million barrels last week, the highest since records started in 2011, according to exchange data.
"The market is vulnerable to a very violent short-covering move," said Thibaut Remoundos, founder of Commodities Trading Corporation Ltd, which advises on hedging strategies.
Oil slumped into a bear market last week as physical oversupply and unexpected increases in US inventories weighed on sentiment. In the preceding weeks, technical indicators had also turned more bearish, and last Wednesday Brent hit US$44.35 a barrel, the lowest since mid-November. Since then, prices have begun to bounce back after those same indicators suggested the slump had gone too far - or as traders say, oil had become oversold.
Investors and analysts believe there is now a growing likelihood that futures will rebound sharply, without any change in market fundamentals.
Brent crude closed 1.8 per cent higher on Tuesday at US$46.65, a fourth straight daily gain. Prices fell 0.6 per cent early on Wednesday after an industry-funded group reported that US crude inventories unexpectedly rose once again.
Though short-covering rallies can be dramatic, they rarely last and supply and demand fundamentals reassert themselves.
Yet, the oil market is increasingly driven by so-called Commodity Trading Adviser (CTA) funds, that buy or sell crude futures largely based on technical indicators. CTA funds had built a large short position in recent weeks and if that reverses it could trigger a short-rally, investors and traders said.
The market has already seen a similar pattern over the last year. Bearish bets on crude surged before the Organization of Petroleum Exporting Countries and other nations agreed to cut output in November 2016. On that occasion, oil speculators were forced to slash their bearish bets, cutting the equivalent of 114 million barrels worth of short positions in Brent in a month. Prices rallied as much as US$12 a barrel over the same period.
This time around technical indicators and weak fundamentals have combined to leave oil bears ascendant. Short positions increased after US oil inventories unexpectedly increased in early June and a drop below a closely watched technical level - the cross of the 50-day and 200-day moving averages for Brent - triggered further selling.
"The world was getting mega bearish so some of the new shorts will be washed out," said Richard Fullarton, founder of London-based hedge fund Matilda Capital Management. "I can't see a rally having legs unless something fundamental changes, it's just a better entry point for shorts."