Lather, Rinse, Repeat...

Nothing earth-shattering to report; it's the same 'ol, same 'ol....

After breaching $70--the top end of my prediction for WTI this year, we are now seeing the usual pull-back in prices which is, as usual, being driven by Hedge Funds. As it became apparent a peak was reached in mid-July (just over $74), the hedgies unloaded 178 million (paper) barrels of oil the week of July 17th (see this Reuters article). 

Adding insult to injury, this week's inventory data showed an unexpected rise: the "consensus" was a draw of about 2.5 million barrels, however inventories rose by 6.8 million, which was the third increase in the past five weeks.

As we move out of the summer driving season, I think it's safe to say WTI will remain in my predicted trading range for the remainder of the year (always with the caveat no unexpected geopolitical event occurs...).

Moving forward, I have been meaning to write some posts on the economy in general.  As I mentioned in a previous post, I expect a recession sometime in late 2019 or early 2020.  I will expand on those thoughts in the near future.

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.

Evaluating my 2017 forecast

It's been awhile--I had an overwhelming semester...

There are a few articles I came across over the past two months that I want to address at some point in the next few weeks, but for now I simply wanted to review my 2017 oil price forecast.

I started the year off with a fairly conservative range of $30 to $70 for WTI oil, but as I gained more confidence in my overall assessment of the market, I tightened that range to $40 to $60 in this February 15th post.  WTI hit a low of $43 in late June, and a high of $59 November 24th.  I think it's safe to say I nailed it. 

Within the next month I will provide my forecast for 2018.  I do think there is a solid floor in the low $50 range, but more on that later.

Cowabunga and Happy Holidays!

"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...

Notes from the FT's annual global commodities summit

Last month the Financial Times hosted its Sixth Annual Commodities Summit, where industry leaders gather to discuss the state of the markets.  The mood was slightly better compared to the previous year's summit, with the consensus among oil traders being "the worst has passed." However, consistent with my own arguments, most analysts believe oil prices will remain subdued, stating the re-balancing of the market will take quite some time, despite OPEC's production cut.

Two points worth mentioning.  The first relates to longer term prices.  Traders and analysts stated that low prices have significantly curbed long-term investment which could create a supply disruption 3-4 years down the road.  Much of the current investment in production is focused on shale and existing sources rather than new discoveries, which require higher prices to cover higher overall costs. I don't have a crystal ball to forecast medium and long term prices of oil, but prices will reflect the battle over alternative energy sources: will the rapidly growing impact from renewable energy countervail the declining sources of cheap fossil fuels?  I'd bet on the former.

The second issue relates to a point I made recently: oil traders stated that the increase in prices (WTI) above $50 a barrel has decreased counter party risk.  As I argued, bankers also have an interest in maintaining higher prices in order to reduce the risk of default on their loans oil producers. According to one of the FT articles, all commodity traders/producers came under increased scrutiny by banks due to the bankruptcy filing of a commodity trading house in December:

Transmar Commodity Group filed for Chapter 11 in the US last December, owing its creditors more than $400m. Its collapse has had an impact beyond “soft” agricultural commodities such as cocoa and coffee, with leading independent oil and metals traders facing increased questions about risk and compliance from their banks.

In a competitive, non-manipulated market, I believe oil prices would fall below $40 under the current market glut; however, there are too many vested interests who support maintaining prices near the current $50 WTI crude sweet spot: if prices go too low, bankruptcy risks rise; if prices go too high, the glut will be exacerbated. It's steady as she goes for the rest of the year at least.

A final point in order to toot my horn a bit. In perusing the FT articles from this year's commodity summit, I came across an article from the previous year's summit (April 2016) with a quote that supports my central thesis which is a series of speculative bubbles created the belief that higher commodity prices were the "new normal," creating false signals for producers who expanded production into riskier projects (across all commodity products).

According to Oscar Landerretche, chairman of Chile’s state-owned copper producer Codelco,

“Things might have to get a little bit worse before it gets better,” claiming too much output had been fueled by speculators boosting the price of the metal. The Codelco chairman said the spectre of non-commercial traders was haunting markets and compared them with drug dealers, arguing funds had inflated prices during the boom years and led mining companies into risky behaviour.

Speculative influences across the commodity spectrum, initially fueled by Commodity Index Funds, created a similar response in oil and grains. Given that financial traders continue to dominate markets, the shake out is taking much longer, and is more drawn out because they will not let prices fall far enough for long enough for markets to re-balance--when a new low is perceived, speculative money pours in, which pushes prices back up before the necessary reduction in supply can occur.

Maybe oil traders are right, and the worst is past them, but the "drug dealers" in the form of Hedge Funds and ETFs will continue to haunt the markets....

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.

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... 

 

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...