Dallas Fed warns on oil prices

I wonder if a Fed warning will cause some profit taking next week?  The article basically states the arguments made here: inventories are still rising, and:

"Speculative long positions on crude oil have risen to all-time highs on the futures markets, a sign that the rebound may have lost touch with fundamentals."

Read the article here: Dallas Fed warns..

Bulls are charging...

Not much to add on the current rally not already captured in this article from OilPrice.com:

Has the Oil Price Rally Gone Too Far?  

The pertinent quotes:

Speculators could be overextending themselves. Any time there is a run up in bullish bets, the chances that long positions could start to be trimmed rises. Speculators could realize that the rally has run out of steam and then decide to pocket their profits. The liquidation could then spark a correction, forcing prices back down. As Morgan Stanley put it, “a macro unwind could cause severe selling given positioning and the nature of the players in this rally.”

The potential for a correction is mirrored by the fact that the fundamentals still look rather grim, with possible bearish indicators looming on the horizon. Oil storage levels set a new record last week at 538 million barrels in the United States and many analysts expect that figure has room to grow. "Still-elevated inventory levels, the return of some disrupted supply, further boosts to Saudi and Iranian supply, and increased non-OECD product exports all have the potential to move prices lower over the next several months, especially if broader macro sentiment shifts," Barclays wrote.

Don't fight the trend?

A Whirlpool of Speculation...

It's certainly  fascinating and frustrating trying to "call the oil market," and I should know better than to try to discern market psychology; however, it is my profession...

How is it that oil prices aren't reacting to the fundamentals (inventories increased again this week)? My thesis has been that speculators dominate price movements in the short run, and market sentiment (among the macro hedge fund traders) is currently bullish.  How long can this last?  

Here's one answer: Crude is about to drop by 30% again.  Analyst Brett Owens' view is based on the current long positions of money managers in the futures market--my own thesis, and here are some snippets from his piece:

1. Money Managers (MM) are trend followers--when prices go up, they buy, which creates a self-fulfilling movement upward--it works in reverse too!
2. When WTI was $103/barrel in August 2014, MM positions were net long 320,000 contracts (recall, speculators must offset their positions in futures before expiration of contracts, otherwise they will have to deliver or take delivery of oil). 
3. As inventories increased in 2014, Owen states: "Oil had nowhere to go but down – there was nobody left to buy. Fundamentals tipped prices over a cliff – as oil supplies skyrocketed, the speculators sold. The more they sold, the more intense the selling got. The trend was down, and they had a big pile of bets to liquidate – which took 20 months to (mostly) clear."
4. Finally, (Owens again): "Over the last three months, money managers have quadrupled their bullish bets on oil to more than 200,000 contracts. They haven’t been this bullish on oil since July 2015… which preceded a 50% price drop in 7 months."

At some point (sooner than later), just as happened in August 2014, MM traders will have to close their positions with offsetting sells, putting downward pressure on prices.

While I am sympathetic to Owens' analysis, and I have been expecting a sharp pull-back, I am not so sure the bullish sentiment will dissipate over the medium term.  For the past 10 years, the price of WTI oil has (mostly) been above $75.  All of the hype about peak oil and Chinese growth is certainly embedded in market psychology.  Surely oil prices will move back up, won't they?  

While I expect a pull-back, a 30% drop would put WTI back to the low $30s, which I believe is the price floor.  Given embedded beliefs and the eventual return to balance in the global markets, I'm not so sure we'll see a permanent liquidation of the long positions.  That is, it will be difficult for the Money Manager bulls to resist continuing to take long positions in oil.  As one closes the current maturing long contract with a sell order for the same contract, many will simply roll their positions into new long contracts.  

The problem with futures data is it doesn't provide the distribution of positions by month, and oil contracts are offered for every month some ten years forward.  The impact on prices from closing positions will depend on how many of those long positions are in the nearer dated months.  But that's not all.  One can also "hedge" the long bet with a spread position.  The speculator can protect the long position by also engaging in a spread position, which simultaneously takes a long position in one month and a short position in a different month.  For example, the speculator with the long June contract might also have a spread position with a sell for July and buy for December.  If near-term prices fall, the July short position will help offset any loss on the June long position.  While MM speculators are currently net long 200,000 contracts, they also have 350,000 spread positions!  

Again, while I'm sympathetic to the Owens view, I am becoming skeptical that there will be a rush for the exits that pushes prices down that far.  It would take a strong turn-around in bullish sentiment, not just the technical need to close positions.  At least, in my view... 

 

A Dollar-driving rally in oil?

Despite the negative news on the attempt to freeze output among the major suppliers, the quick drop in oil has been reversed, and it's (WTI) heading over $40 again.  Is this irrational behavior?

The main driver in the news today is the drop in the dollar.  Analysts discuss this relationship as if it's  "natural"--as the dollar falls, commodities priced in dollars rise because they are cheaper in terms of other currencies.  However, this negative correlation was non-existent until commodity markets became financialized, formally through deregulation in 2000 (the Commodity Futures Modernization Act).  Prior to 2000, the simple correlation in oil prices and the dollar was near zero, and there were even periods of positive correlation.  Since 2000, the simple correlation between prices has been about -0.8, the perceived natural relationship.

In my view, now that hedge funds and other investors dominate trading in commodity markets--especially oil, they have incorporated this "trade" into computerized models.  So, we end up with what appears to be a conundrum: despite the lack of agreement on supply and continued growth in oil inventory, the dollar-oil trade fuels a nice price rise.

Ahhh...the difficulty of predicting short run price movements....

Hopes Dashed

The attempt to cap oil output has failed, so hedge funds will head for the exit.  Oil price turmoil should continue for a bit longer.  Prices need to stay below $40 to force more suppliers out, because, even with the proposed cap, global supply was still greater than demand.

A few more months of pain for suppliers ought to do it...