A brief Oil Market brief

Having recently just eclipsed the $70 high end of my price range, WTI appears to be receding back into range. According to a Reuters article today:

 "A sea of red is washing over the energy complex as rising U.S. production coupled with a looming relaxation in OPEC-led cuts sends bulls scurrying for the exits," said Stephen Brennock, analyst at London brokerage PVM Oil Associates.

In addition, the article notes the most recent COT report shows that Hedge Funds have decreased their long positions, which signals they believe the price rise has run its course. This belief is based on the above noted recent increases in oil output by both US shale and OPEC, specifically the Saudis and Russians are relaxing the production cuts that were put in place a year ago to help re-balance global markets.

Barring further geopolitical issues (the odds of which are getting higher that one will occur with Iran!), WTI prices should remain on the high side of my range, from $60-$70.

"Fire!"

Someone screamed "Fire!" in the oil theater, and the Hedge Funds headed for the exits.

As predicted, the weight of "pork oil" finally broke the back of Hedge Fund long bets, and some big players were forced to go defensive over the past couple of weeks. According to this piece from SeekingAlpha, Pierre Andurand liquidated much of his long oil position last week, with others followed suit, citing "stop loss" triggers and "risk management requirements." The article states that Andurand's fund is down 15.4% for the year.

As I've mentioned, Hedge Fund long bets in futures peaked at the end of February, and they were slowly declining for the past two months, but the trickle became a flood over the past two weeks. According to this Ft.com article, Managed Money positions fell by 26% the week prior to Tuesday (that's when Andurand closed his position). That scramble continued the rest of the week, leading to volatile price swings; for example, WTI experienced price moves in a 7% range yesterday.

Here's how dramatic the sentiment has changed: according to this Bloomberg.com article, some trader(s?) made a serious bet(s) yesterday (Friday 5/5) that WTI will drop below $40, as 14,000 July puts @$39 were sold, almost 20 times the number of contracts previously outstanding! The price of the option was somewhere between 15 and 20 cents per contract, so that amounts to almost a $3 million wager.

Will it pay off...?  I'll stick with my call here that WTI will stay above $40, as both OPEC and Wall Street banks will try to prevent that from happening. In addition, if the price does approach $40, it will most likely cause the bulls to jump back in, especially since inventories have declined over the past two weeks. Note, that doesn't mean the huge wager won't pay off, as the option premium will increase in value if the price does fall lower.

Now, I could be wrong on that price floor, and the condition for a price collapse is the unraveling of OPEC, which is certainly a possibility given every country's need for oil revenues.  Interesting times...

The Bankers are getting worried

In my February 15th piece Strange Brews in Oil, which looked at the recent phenomenon of a price bump immediately following the EIA's weekly oil inventory announcement (positive builds for the past nine weeks), I suggested the following possible explanation:

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. 

Deep down, I wondered if I was being a bit "conspiratorial?" Recent news gives me more confidence in this position.  First a little contextual reminder of the current oil market situation: with global supply outpacing demand, oil inventories were reaching record highs; (so) OPEC and Russia agreed to reduce output in December; (which led to) record long futures positions held by Hedge Funds at the end of February (they have since been pared down a bit); with prices reaching the mid-$50 range, US shale producers could profitably lock into contracts a year out (they were the sellers to the Hedge Funds buying); and finally, big Wall Street banks have serious loan exposure in the US shale oil market.  Let's start there.

This MSNBC piece from January 2016 provided some detail (from a Goldman Sachs report) on the loan exposure of the banks:

Bank of America leads the list with $21.3 billion. Citigroup is next at $20.5 billion. Wells Fargo is third at $17 billion. JP Morgan Chase is at $13.8 billion. Morgan Stanley is at $4.8 billion, PNC Bank has $2.6 billion and US Bancorp is at $3.1 billion. 

How much is that, as a percentage of the bank's total loans? 

Morgan Stanley leads the way at 5%, followed by Citi at 3.3%, Bank of America at 2.4%, Wells Fargo at 1.9%, JP Morgan Chase at 1.6%, PNC at 1.3%, and US Bancorp at 1.2%.

While the Goldman report didn't list their position, the MSNBC piece quoted Goldman's CFO who said they had $10.6 billion in oil loan exposure. 

So, here's the deal: as recent articles pointed out, OPEC, while previously castigating Hedge Funds for their speculative activity, is now courting them, and they have to because the HF long positions are what's propping up oil prices, at least until last week.

It didn't take a genius to see the situation was untenable: relying on the speculative bets of Hedge Funds to maintain prices is a fool's bet. This brings me to yesterday's piece from Bloomberg.com: Citi tells investors to stop worrying and learn to love oil. Citi analysts came out with a report urging investors to take advantage of the recent price drop because the Saudi's are likely to defend the price. The article also mentioned that Goldman Sachs analysts "called for investors to be patient and said they should go, or stay, long on oil." 

Hmmm....with $30 billion in loan exposure (though I'm sure they've reduced positions some since last year), do you think there might be a little conflict of interest for Goldman and Citi? Interestingly, according to this piece by William Engdahl, banks also "support" the trading of Hedge Funds: 

Goldman Sachs and Morgan Stanley today are the two leading energy trading firms in the United States. Citigroup and JP Morgan Chase are major players and fund numerous hedge funds as well who speculate.

According to the data above, these four banks had a combined $50 billion loan exposure to the US oil industry last year.  This is more than enough incentive for the major players to "rig" the market. However, the Hedge Funds are getting antsy, and have started to pare down their long positions. Given their herding propensity, there is a very good chance of a market rout, which is why the big banks are now publicly urging them to "hang in there." 

The current oil market situation is akin to the prisoners dilemma of Game Theory: it's in the best interest of all to collaborate and maintain higher prices (HFs benefit because falling prices will cause significant losses on their long bets); however, individual HFs may view their best option is to run for the exits (to minimize their losses) before an expected crash.  I'm thinking the exit run is going to win out...

The Pop!

After weeks of continued inventory gains, oil prices finally succumbed to the weight of pork oil.  The EIA inventory report showed a crude increase of 8.2 million barrels and prices promptly dropped on the news.  WTI crude declined by $4 (7.5%) over the next two days, with most of the loss coming on the day of the inventory news.

A good piece from FT.com highlights the main issue, the significant long bets of Hedge Funds as captured in the Commitment of Traders category "Managed Money Traders." Even though OPEC and Russia have agreed to limit output, the dominance of money managers in price determination pushed prices high enough for US shale drillers to lock in prices out along the futures price curve.  As the FT article points out, the number of shale rigs has nearly doubled since last May.  This puts everyone else in a tight spot, as it's in everyone's interest to keep prices from tanking.  The Hedgies now have to protect their long bets, and they are most likely doing so through option contracts on WTI, which experienced its second highest volume ever, according to this Bloomberg.com article.

Bad news for investors and producers, however, is good news for we consumers.  I expect the vested interests will continue to try to prevent prices from collapsing, so prices will probably fall a bit more, but they will resist at $40.

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...