Strange Brews in Oil

I've been trying to write about other markets, but oil just keeps pulling me back.  The price of WTI oil has traded above $50/barrel since the OPEC-Russia production agreement in early December last year.  However, despite the attempt to cut production and stabilize prices, global oil inventories have continued to rise. Global inventory (OECD countries) stocks are at an all-time high no matter how one measures them.  OECD stocks currently stand at 3.1 billion barrels and US privately held inventory is at 508 million barrels. An article from OilPrice.com, Why sub $50 oil is more likely than $70 oil, looks at comparative measures of inventory, and no matter which way you slice it, the world is drowning in oil.

As I previously argued, there are two actions taken by investors who dominate futures markets (and price determination) that will maintain the current glut of oil inventory and its persistent anchor to higher prices: first, they do not allow prices to fall to a level that will restore balance via a significant shake out of producers because they tend to pile right back in and make bets on rising prices when oil prices fall significantly--a price drop creates a good "buying opportunity;" second, the stories of "peak oil" and rising demand from China, which provided the foundation for the price peak of $140/barrel in 2008, have left a persistent hangover, a belief that prices WILL again reach those levels at some point in the near future, therefore any news that provides ammunition for the bulls creates a flood of buying, pushing prices up too quickly.

Given the continuous rise in inventory one would expect a sharp pull-back in prices any day now, however there appears to be a new force or player in the market preventing the drop.  An article in the Financial Times this morning, "In oil mystery, traders resort to 'buy the build' mantra," discusses a market phenomenon that has occurred for the past few months:

Over the last five reports US commercial crude oil stocks rose by a total of 29.6m barrels. Each weekly rise surpassed expectations. While declining immediately after each report, the price of the West Texas Intermediate oil benchmark was trading higher 20 minutes later, often accompanied by a burst of volume. WTI prices also settled higher after four of the past five releases.

This morning's EIA inventory report created a similar reaction.  The report is published at 10:30 a.m. (EST) and showed another build of 9.6 million barrels, pushing US private crude stocks up to 518 million barrels. The reaction at 10:30 was a slight drop of 10 cents per barrel; however, 25 minutes later, the price was pushed up by 40 cents to $53.41(it is currently trading close to $53).  As the FT article points out, these actions have many market traders wondering who is behind the push to keep prices afloat?  From the piece, suggested suspects:

1. Hedge Funds who hold record long positions need a burst up before they can exit without taking serious losses.
2. OPEC who has cut production and needs higher prices to support budgetary needs of various countries.
3. The possibility that the behavior has influenced other traders to follow the strategy.

I have another theory: Wall Street banks have billions of dollars in loans outstanding with US shale oil producers and prices at $40 or less was pushing many toward bankruptcy.  Between the banks and OPEC, these are two very powerful forces with interest in maintaining higher prices.  However, despite the interest in maintaining higher prices, it will not stand.  While the EIA estimates that current demand and current production will come into balance sometime in the second quarter, the pressure from oil inventories will break the market at some point.  Currently, the one-year forward rate for WTI oil is $2 higher than the spot price of $53, which is not high enough to cover storage costs.  The price drop, then, will come from either Hedge Funds bailing on their historically high long positions or holders of storage, unwilling to carry inventory at a loss, selling off their stocks. Most likely the two forces will reinforce each other.

The bottom line: there is no change in my 2017 forecast that prices will not fall below $30 nor will they rise above $70.  In fact, I believe we can tighten that range to a minimum of $40 and maximum of $60, though the chances are better they will hit the low range (very soon!) rather than the high. While it's possible the price will drop below $40, any price drop of that magnitude will simply offer the bulls another opportunity to jump back in.  The more interesting story is the long term outlook and alternative energy's impact on oil, but that's a story for another day...