Hedge Fund Subprime Liquidations Could Hit Crude-Oil Futures

Crude-oil futures are feeling the tremors emanating from the credit markets and weakening on fears that they could be the next casualty of the risk exodus.

When markets began to gyrate two weeks ago, traders and analysts assumed that oil markets would only be indirectly affected. The lack of information on losses from the subprime crisis could spread to the broader economy, cutting energy demand. Now, however, some say oil futures could be hit head-on. The flight to cash could force hedge funds to dump commodities futures contracts as they reduce risk. It's these hedge funds and other speculators that recently have helped drive crude to record highs. The likelihood of such measures increased Thursday when The Wall Street Journal reported that two Goldman Sachs (GS) hedge funds have been forced to sell down positions amid fears the U.S. subprime crisis, which was sparked by a rash of foreclosures in the past year, is spreading. Also, French bank BNP Paribas said it temporarily froze three funds backed by asset-backed securities because of "the complete evaporation of liquidity" in certain U.S. markets. "If liquidity dries up, or slows down (in credit markets) and speculative interest that has supported energy markets dissipates, there is real downside risk for crude," said Jason Schenker, an economist at Wachovia Corp. in Charlotte, N.C. "There is no upside to oil prices at all in this credit risk."

Selling Spiral

Light, sweet crude on the New York Mercantile Exchange has slumped 9% from its all-time intraday high of $78.77 a barrel, set Aug. 1, partly as a record fund net long position, or bets on a price gain, spurred jitters that any price fall would be exaggerated by funds rushing for the exits. While some of the funds have obviously discarded their crude positions in the past week, news that Goldman Sachs and other hedge funds are liquidating various investments to curb risk is creating edginess over the potential for more fund selling. Adding to concerns, hedge fund Black Mesa Capital said at least one very large hedge fund or investment bank is liquidating "massive" trading portfolios, according to a letter the Santa Fe, N.M.-based firm sent to investors. The portfolio liquidation is causing disruptions and triggering losses among other hedge funds, Black Mesa said. "Clearly, something is amiss in the markets that few in our strategy team, if anyone, have experienced before," Black Mesa wrote. While evidence of an economic slowdown is yet to be seen, "what is not in doubt is that investors are raising cash and that could weigh heavily on energy prices as speculative interests turn defensive," said Mike Fitzpatrick, vice president of energy risk management at MF Global in New York.

Going Long

The extent of hedge fund interest in Nymex crude oil futures was shown in U.S. government data last Friday. The net long position rose to a record 127,941 in the week ended July 31, from 55,998 at the start of May. Crude prices plunged 4.5% on Monday as funds headed for the exits, concerned the market was too heavy with speculative interest. The next report, for the week ended Aug. 7, is due Friday. Crude futures on the New York Mercantile Exchange ended down 56 cents, or 0.8%, at $71.59 a barrel Thursday on subprime concerns. They were supported somewhat by a 6% jump in natural gas prices and avoided the type of deep selloff that struck U.S. equities and recently had the Dow Jones Industrial Average almost 3%. Apart from the chances of funds selling off, uncertainty over whether the subprime crisis will spread to business borrowing and crimp economic growth continues to spook crude markets. "The worry is that if the current subprime concerns spread to the cost of credit in the whole economy and it leads businesses to pull back their investment, unemployment could go up and the whole thing could spiral," hurting energy demand, said Wachovia's Schenker. "Right now, though, the market isn't sure whether this is a credit blip or a crunch, so it's desperate for information." The extent of the reach of securities that carry exposure to U.S. subprime mortgages was shown Thursday when the European Central Bank lent an unprecedented $131 billion in emergency funds to European banks to backstop their exposure.