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...

Ireland in spring

We (the wife and another couple) took advantage of spring break this year and spent a week in Ireland. It was my third trip there, and I've never had a bad experience.  Beautiful land and beautiful people.

One of the most spectacular drives we experienced was through Doolough Valley (picture).  While the scenery was serene and idyllic, this particular place has a not-so-serene past.

Hundreds of Irish died in this valley in 1849 while seeking relief during the great famine.  A plaque commemorates the tragedy, and it includes the following quote from Gandhi:

"How can men feel themselves honoured by the humiliation of their fellow beings?"

 The juxtaposition of the serenity and tragedy is remindful  for us not to take for granted that which we have.

A little validation

From Bloomberg.com this morning, Barclay analyst Kevin Norrish stated that oil and copper are at risk of a steep pull-back in prices :

"Given that recent price appreciation does not seem to be very well founded in improving fundamentals, and that upward trends may prove difficult to sustain, the risk is growing that any setback will result in a rush for the exits that could again lead commodity prices to overshoot to the downside."

It's always risky trying to call turns in the market and to what extent prices will move, but it is pretty clear that speculators are the main force behind price movements.

Another piece published the day before on Bloomberg provided interesting evidence on the underlying cause--it was not that investors were making bets on higher prices, rather, as the article stated, the recent price uptick was a consequence of investors with bets on lower prices, fearing the bottom had been reached, needing to close out their positions:

"The rally has come from shorts getting scared out of their positions, and you’re not seeing a lot of money coming in on the long side," said John Kilduff, partner at Again Capital LLC, a New York hedge fund focused on energy. "It really calls into question the fortitude and staying power of the rally."

Investor-speculators who make bets using futures contracts have to close their positions by taking what's known as an "offsetting position." If they don't do this, then oil contracts held to maturity must either deliver oil if you're holding a contract to sell oil (short position), or you must take delivery if you're holding a contract to buy oil (long position). For example, if one bets on falling prices, one "sells" a futures contract on WTI oil, and to close the position--to take profits or minimize losses, the trader must "buy" an equivalent contract.

As the article notes, since February 2nd long positions of investors fell by 971 contracts, but short positions were reduced by over 130,000. In other words, those betting on lower prices, in order to lock in their profits before prices increased, had to close out their short sell positions with buy orders, and those offsetting buy orders are what drove prices higher. This is the problem when speculators dominate markets: if they heavily bet on one side of the market, when they close their positions--so they don't have to deliver or take delivery, it creates an equal and opposite reaction on prices.

That's the kicker: the market is now set up for an equal, opposite reaction--what Barclay's Norrish is predicting, and what I've been predicting. Speculative positions are now seriously net long--there are about 65,000 bets on falling prices and 300,000 bets on rising prices, so their net positions are long by 235,000 contracts. With the continued glut of supply in the real market for oil, the only way these paper bets can be maintained is if more rubes join the bet on higher prices. If this doesn't happen, and prices start to weaken, there could be a run for the exit! That is, as prices start to weaken--as they have in the past two days, in order to prevent further losses on their long positions, speculators will have to sell contracts to close them out. And, just as buying to close their short positions is what raised prices, selling to close their long positions will cause prices to fall further. Look out below!

I'm sure it all sounds confusing; however, there is a very important point here: this behavior will continue--price volatility and bubbles--as long as speculators are allowed to dominate trading in futures markets. Deregulation in 2000 allowed speculators to take over the markets, and it's safe to say that markets are less efficient, not more. It's time to bring back stricter position limits on speculators.

The price of oil retreats

As expected, the rally won't last.  After a nice run-up of some $8 a barrel over the past 3-4 weeks, the smart guys have taken profits the last two days.  An article on Bloomberg.com this morning has interesting quotes one can use to support either side--the bulls or the bears.  As a bear, I think this quote is most pertinent:

 “An early rally in prices before a deficit materializes would prove self-defeating,” Jeffrey Currie, head of commodities research at Goldman Sachs in New York, said in a report on March 11.

The deficit he's talking about is the supply-demand balance.  Given the current glut of crude inventory, higher prices won't be supported until global supply falls below global demand--a supply deficit is necessary to reduce inventories.  As investors' bets drive up oil prices in the short-term, the "deficit" necessary to draw down stocks won't be created.  Financial bets distort the underlying real changes necessary to bring markets back into balance.

Tomorrow's crude inventory report, which is released at 10:30 a.m., should cause a good jolt in prices--one way or  the other--depending upon the outcome.  If inventories decline, then WTI should see a jump up; if they rise, as they've done for months now, then we'll see a third day of price declines.

Interesting times.