Hedge Funds Are Now Betting on Oil Going Down?

Oil has been recovering for a few months now, but in the past few weeks, hedge funds have been betting on that trend coming to an end.

In this clip from Industry Focus: Energy, Motley Fool analysts Taylor Muckerman and Sean O'Reilly explain what's behind these hedge fund decisions, and how much investors should take these trends into account when they consider buying into oil today.

Sean O'Reilly: Hedge funds betting on a renewed decline below $50 a barrel. What's up?

Muckerman: That's what the Financial Times headlines said a week ago. This was after all the headlines are saying hedge funds have never bet this much on rising oil prices, in the history of oil trading. And now they have a historical decline in their long bets. I think it was 153 million barrels reduction in net long position across WTI --

O'Reilly: Just, for the layman, these are futures contracts.

Muckerman: Yeah, so, they're betting on the future price of oil.

O'Reilly: Right, and these are contracts to theoretically buy 153 million -- that was the decrease? Or was that the total?

Muckerman: That was the combined decrease across WTI and Brent --

O'Reilly: So the net longs are way more than that?

Muckerman: Yeah, they are. It was the third straight week of selling after they hit a net long peak of 951 million barrels at the end of February.

O'Reilly: That's the number I needed, OK.

Muckerman: So that's your relative number. It was a peak of 951 million. And last week, they sold off a combined 153 --

O'Reilly: And it dropped off to 800.

Muckerman: Well, that was the third week of declines, but that was the biggest decline in history. Because, I mean, you're starting from the biggest --

O'Reilly: Percentage-wise, you're starting from 16%-17%. So, for the layman, these guys and their ties on the New York Mercantile Exchange, they have all these futures contracts to essentially take delivery of crude oil at a future date, at a set price, for 953 million barrels, which is actually a lot of oil.

Muckerman: That's a considerable amount.

O'Reilly: Then it decreased to 800. And just so everybody knows, most of these never actually -- nobody ever actually takes delivery of the oil; it's just a financial asset. But theoretically, you could take delivery if you wanted to. But most people don't. Isn't there $1-$2 per barrel that you pay in addition if you actually take delivery?

Muckerman: I'm not 100% sure how these future contracts work. I know how they can impact prices, but I've never personally bought a futures contract.

O'Reilly: We should pool our money and buy one future.

Muckerman: One barrel of oil? Yeah.

O'Reilly: "We want to buy a future for three months from now."

Muckerman: We'll look into it. We'll advertise it. If listeners want to chip in, we'll start our own hedge fund.

O'Reilly: We both live in Arlington. Which of our places could we keep this barrel when we take delivery? 

Muckerman: I have a garage.

O'Reilly: How would your wife feel about that? Oh, you have a garage! We'll put the barrel of the oil in your garage!

Muckerman: It's a communal garage. People might siphon it.

O'Reilly: They couldn't refine that.

Muckerman: It's like the episode of It's Always Sunny in Philadelphia several years back, when they were filling their Land Rover on barrels of gasoline because gasoline prices were rising through the roof.

O'Reilly: Oh, man. You know Dylan from the Tech show loves Always Sunny, right?

Muckerman: I hope more than just Dylan loves it.

O'Reilly: No, so do I, and I'm so glad you brought that up. Anyway. It seems to me like they're not necessarily betting on oil being below $50. They're just being a little less bullish.

Muckerman: Being a little less bullish, but also, because they still have such high long bets if oil starts to fall a little bit more and they get a little nervous and they sell, that could just be added pressure to the downside for oil prices.

O'Reilly: You could get a cascade.

Muckerman: A cascade, yeah, that's a good word.

O'Reilly: Well, you know, I'm a bit of a poet. Do you care about any of this? For our listeners who are, obviously, long-term Foolish investors?

Muckerman: It's just funny to see how whimsical these hedge funds really are, to go from record longs one day to, the very next week, record selling.

O'Reilly: I think it's algorithms.

Muckerman: It very well could be.

O'Reilly: There was one hedge fund that was an algorithmic trading firm; the name escapes me.

Muckerman: There's more than one.

O'Reilly: Bottom line, 90% of the trades on the New York Stock Exchange, it's just algorithms going nuts.

Muckerman: I would imagine it's very high, I don't want to call out a number, but it's very high. It's higher than 50%.