By the close of business on March 22, money managers held a net long position equivalent to almost 579 million barrels in the three largest crude oil futures and options contracts.

Hedge funds have more than doubled their net long position from just 242 million barrels at the end of last year, according to an analysis of data published by regulators and exchanges.

The net long position has passed the previous peak of 572 million barrels, set in May 2015, and is closing in on the record of 626 million, set in June 2014, when Islamic State fighters were racing across northern Iraq.

Hedge funds have established a record net long position in Brent crude futures and options traded on ICE Futures Europe equivalent to 364 million barrels of oil.

At the same time, hedge fund managers have largely closed out their previous record short position in U.S. oil futures and options and started to accumulate long positions instead.

Combined WTI short positions on the New York Mercantile Exchange and ICE Futures Europe have been cut from 261 million barrels at the start of February to 112 million barrels.

The net long position in WTI has surged from just 60 million barrels in early February to 215 million barrels on March 22.

The accumulation of a near-record net long position has coincided with a sharp rise in oil prices, with U.S. crude up from $26 per barrel to more than $41, and Brent up from $30 to $42.

The closing out of the previous record short position in U.S. crude futures and options has been accompanied by a predictable short-covering rally.

There has been a close correspondence between hedge fund positions and the movement of oil prices since early 2014.

Just as record shorting of U.S. crude futures and options helped push oil prices to multi-year lows below $30 per barrel in January and February, so the unwinding of those positions has sent prices sharply higher.

This is the third time that hedge funds have established a large short position and then unwound it since the start of 2015 and each cycle has ended with a sharp short-covering rally.

But the current short-covering rally now appears over with hedge funds now fully exited from the record short position established since October 2015.

With the hedge funds switched from a record short position to a near-record long one, the balance of risks in the market has shifted to the downside.

Instead of a short-covering rally, the main risk in the short term is now long liquidation if funds try to take some of their profits following the rise in prices.

The current hedge fund long positioning puts the market at risk from a sharp drop in prices such as occurred after June 2014, May 2015 and October 2015.

There seems to be some awareness of the shifting balance of threats.

In the last three weeks, oil prices have risen by less than expected given the large reduction in hedge fund short positions.

The rally in WTI has stalled at or just below $40, while the liquidation of hedge fund short positions implied it should have risen closer to $50 per barrel.

PROFESSOR PANGLOSS

Hedge funds are betting growing consumption and shrinking oil output will swiftly rebalance the oil market.

Like the optimistic Professor Pangloss in Voltaire’s “Candide,” hedge funds have established a near-record long position on the assumption the oil market will be in the best of possible worlds in 2016.

The newfound bullishness has been based in part on the view that oil prices have already fallen so far (probably too far) that they must increase again in the medium term.

Few analysts, traders, and investors think that oil prices could be sustainable at $30 in the medium and long-term so a correction was inevitable at some point.

Hedge funds have turned very bullish about the outlook for oil prices based on indicators showing that gasoline demand in the United States and India.

Investors appear more hopeful the U.S. and global economies will avoid a return to recession in 2016, ensuring that oil consumption keeps increasing.

U.S. shale production appears to be falling swiftly based on state production data and the wholesale idling of drilling rigs, which should gradually help tighten the oil market.

Sentiment about possible production restraint from members of the Organization of the Petroleum Exporting Countries has also improved.

OPEC members appear to be inching towards agreement on a standstill production agreement in cooperation with key non-OPEC countries.

Critically, the possibility of a standstill agreement is no longer being conditioned on adherence by Iran, which remains determined to increase its oil production to pre-sanctions levels.

Global oil inventories remain high and continue to swell, but the most rapid stock-building phase may be over and stocks could start to draw down in the second half of 2016 or during 2017.

Unplanned production and pipeline outages in the Middle East and Africa have underscored how little spare capacity there is in the market, with almost all countries producing close to their maximum.

It is possible to construct a very bullish narrative in which the oil market rebalances thanks to strong gasoline consumption growth, a rapid decline in U.S. shale output and production restraint by OPEC.

Global oil inventories peak within the next six months and thereafter start to draw down as the global economy continues to expand, freight movements accelerate and a colder northern hemisphere winter arrives.

Hedge funds appear to have bought heavily into this narrative over the last couple of months, anticipating and accelerating the recovery of oil prices from unsustainably low levels.

But the market has risen so far so fast, and the hedge funds are now so heavily invested, that the balance of risks has shifted, at least in the short term.

The biggest price risk comes from long liquidation, either because hedge funds try to book some of their profits or because data on supply and demand fail to live up to expectations.