Bets on oil and bank shares unravel

THE big momentum trade of 2008 is unwinding fast, helping to push battered banking shares upward while adding downward pressure to tumbling oil prices.

The trade, which bet that energy prices would go higher and bank stocks would crater, has created huge volatility on financial markets and helped wreak havoc on pocketbooks and retirement accounts around the world.

When trouble erupted last summer in the US market for home loans and related securities, investors bet the US Federal Reserve chairman Ben Bernanke would be forced to cut interest rates to ease a fast-developing credit crunch.


A lot of the buying seen from late August until early September was all predicated on Bernanke's "new transparency." - Reuters

They also thought lower rates would weaken the US currency and prop up the price of dollar-denominated commodities like oil. And investors bet the credit crisis would simmer for a long time, to the detriment of banks and brokerages.

The bet was dead-on – crude more than doubled from last August as it hit a record high of US$147.90 two weeks ago, and banking shares like Citigroup and Merrill Lynch tumbled 70%.

“A lot of the buying that we had seen from late August and until early September was all predicated on Bernanke’s “new transparency,” basically telling everyone he would cut interest rates early and often,” says Peter Beutel, president of Cameron Hanover, a trading consultancy in New Canaan, Connecticut.

The trade seemed linked; when oil increased, banking shares fell. But two events – one affecting oil; the other, banks – have come to the fore to snap the popular trade.

The first crack appeared after US government data began to show demand for energy was waning, a clear warning that oil prices could not climb forever.

Then on July 13, the US Treasury Department and the Fed moved to shore up Fannie Mae and Freddie Mac.

The trade started to unravel later that week after the Securities and Exchange Commission cracked down on short-selling in financial shares, causing bank stocks to soar.

An unexpected jump in US crude supplies also caused oil prices to fall sharply, forcing traders to reverse bets that oil prices would rise further.

The KBW bank index soared 17.3%, by far the biggest single-day gain since it was started in May 1992.

Brian Gendreau, an investment strategist for ING Investment Management Americas in New York, said the trade got “killed.”

A reversal of the trade has accelerated the recent increase in financial shares and the decline in oil prices, even in the face of some dismal bank results this week.

“A lot of hedge funds, particularly those involved in short trading, had the long-oil/short-financials trade for some time,” says Rick Meckler, president of the hedge fund LibertyView Capital Management in Jersey City, New Jersey.

“So once that trade started to reverse, it has provided particularly strong support even to banks that have had weak quarterly results.”

Crude prices have shed nearly 15% since the price for a barrel of oil peaked, while the KBW bank index of mostly big US banks has shot up more than 45% after sliding to a multidecade low.

The about-face can be seen in the amount of open interest in crude oil futures, which has tumbled to its lowest level since Jan 2, 2007. Open interest refers to contracts that have not been exercised, closed out or allowed to expire.

Open interest for all oil futures contracts on the New York Mercantile Exchange fell to 1.217 million on Tuesday, down from 1.36 million contracts on July 11, when crude oil hit its all-time high.

The drop came as prices for September crude oil settled down US$3.98 at US$124.44 a barrel on Wednesday, amid growing indications that high fuel prices are driving down US demand.

“It is a sure sign of long liquidation; certainly the unwinding of length is pretty obvious,” says Mike Fitzpatrick, vice president of energy risk management for MF Global.

Hedge funds have aggressively driven oil’s rise this year, but institutional investors have gone in the opposite direction, taking profits on equity stakes in energy when prices rose, says Saul Henry, head of US equity strategy at State Street Global Markets.

But in recent weeks, both hedge funds and institutional investors have seemed to anticipate the trend of higher oil prices and sliding bank stocks would reach a limit.

In the six weeks through last week, “hedge funds have not been very aggressively putting those shorts back on in financials,” Henry says. – Reuters