Painful Correction Ahead
We have grown more skeptical of consensus world-view and foresee a greater probability of a painful correction in oil prices in the near term.
Record Speculative Net Length, No Price Momentum
Investor enthusiasm has lost momentum following the announcement of OPEC production cuts and proclamations of potentially inflationary fiscal policy under the new US administration. Early speculative positioning will likely suffer as the pace of transformation proves underwhelming.
The shorts (speculators expecting oil prices to fall) have been punished, and have retreated. The longs (speculators expecting oil prices to rise) have grown, but without being able to generate any kind of positive price momentum. Indeed, price action had been choppy.
Meanwhile, the speculative net-long positioning in oil is at record highs, suggesting there's no one left to buy it without considerable expansion of the market (a condition that only happens when macro money flow and price momentum crest simultaneously).
Market Focused On OPEC Compliance
OPEC compliance has been excellent, thus far. Given the net length of speculative interest, one could easily say, "Prego, it's in there" (Please excuse reference to 1980's spaghetti sauce commercial). Unfortunately, we have not seen any of those cuts show up as accelerated inventory depletion. Inventories remain at record highs. Moreover, product inventories of gasoline in the US, are growing in excess of seasonal expectations. Anecdotal evidence of gasoline tanker imports being redirected suggest the market may revisit the "oversupplied" thesis once again, and dubious demand data (derived, not measured) may even lead some to question their unshakable belief in perpetual demand expansion.
Iran Sanctions and Potential Border Tax - Bullish?
While renewed sanctions on Iran would be potentially bullish for WTi prices, the reaction thus far from the Administration for various breaches of the landmark agreement has been targeted, not broad. We believe that if anything, Iran will abandon any hint of cooperation with OPEC, accelerating exports and drawdowns of floating storage to maximize revenue while they can. Ultimately, while a new round of Iran sanctions could translate into reduced production, in the near-term the opposite will likely prove true.
Discussions about a potential Border Tax are unilaterally bullish for WTI and domestic crude oil prices, as the United States is a net importer of crude. It should be clarified that a tax would impact relative pricing, not an absolute pricing. On a global basis, it's not at all clear how a border tax might affect overall crude oil prices, as negative implications for global growth from changing trade flows might more than offset increased cost pressure. Moreover, unlike an executive order on immigration, proposed changes to broader policies, such as taxes, involve consensus beyond the executive branch of the Federal Government. Thus, we are less inclined to incorporate probabilities of a border tax into our near-term price outlook.
Forward Curves have Flattened, but Contango Persists
While the forward curve for crude oil has flattened, the market structure remains contango. Thus there is still no immediate sign that inventory draws are imminent. Without backwardation, it is unlikely the physical markets will clear the overhang of inventory.
US Shale Activity puts Ceiling on Near-Term Price Gains
The surge in activity in core areas such as the Permian has been immediate and decisive. OPEC must certainly be taken aback by the potential of resurgent US supply displacing their efforts to shift the natural supply-demand response forward. Speculative interest has seemed to ignore this response, which is one of the reasons we have grown so skeptical of the near-term outlook.
The Fallacy of "Talking Down" a Currency
Cutting thru the noise of politics, the fact is that talking down (or up) a currency is ineffective without fundamental fiscal and monetary cooperation. While the administration might suggest it would like to see a lower dollar, that's an impossible outcome when combined with inflationary fiscal policy and a Central Bank that has already begun a pre-emptive tightening cycle. The dollar will likely remain quite strong in this fundamental environment.
Furthermore, from an oil market perspective, China has not yet definitively overcome is GDP deceleration / Capital flight acceleration. We expect the Yuan to continue its path reaching 7.00 to the dollar during late 2017. A weaker Yuan suggests oil prices need to go down, not up, from here.
Aremet Energy Consulting - Unconventional Insights
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"Oil markets do not trend toward equilibrium. Balanced markets only happen by accident, and disequilibrium is the norm."
"The real cost of debt (including bankruptcy risk) for companies exposed to commodity prices is far higher than advertised, leading to poor capital allocation decisions and sub-optimal strategy execution."
About the author
Matt Epstein leads Aremet Energy Consulting, an independent advisory boutique based in Greenwich, Connecticut. With over 20 years experience as an energy specialist, Mr. Epstein is regularly engaged by oil companies, investment managers, and commodity traders for assistance managing commodity price volatility, and for innovative financial structuring solutions.
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