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...