An Interesting Technical Backdrop
Over the weekend we had a very interesting meeting with friends who are working in various capacities in the financial industry, and one of the topics that briefly came up for discussion was crude oil.
The main reason to talk about crude oil these days is its stubborn refusal to go lower. There is a fairly widespread anecdotal consensus that prices will – nay, must – come down. In fact, only very recently the U.S. Energy Information Administration (NYSEMKT:EIA) opined that the sharp increase in U.S. domestic production portends lower prices in the future. It presumably had to point to the future because it is definitely not producing lower prices in the present. In fact, Monday's close in spot WTI at just above $97/bbl. was right at the upper end of its multi-month range and only a hair away from what would be a noteworthy technical breakout. This is evidently not what the consensus would expect, especially in view of the fundamental data accompanying this show of strength.
West Texas intermediate crude oil, spot. Closing right at multi-month resistance
On a weekly chart, one can see that a very large triangle has formed that is likely to be resolved soon (either by an upside breakout or a breakdown in price). Given the sheer size of this triangle, a fairly strong move can be expected. The question is if the move will be in keeping with the above mentioned anecdotal consensus.
Crude oil, weekly – a very large triangle has formed (click to enlarge).
The next chart shows why there is so much anecdotal evidence of either complacency or outright bearishness with regard to crude oil prices.
U.S. crude oil stocks in 2013 versus the 5-year range.
The most likely fundamental reason for this strong build-up in U.S. oil inventories is indeed the surge in U.S. domestic production. Just over the past year there has been yet another respectable increase:
U.S. domestic crude production, 2011-2012 compared to 2012-2013.
Oddly enough, there is one group of traders that is anything but bearish on crude oil – namely large speculators. They hold one of their largest net long positions in WTI futures ever. Small traders on the other hand seem to be more skeptical.
One wonders whether the big speculators trade on any fundamental information – probably there is a lot of managed money that is simply deployed in trend-following fashion. That has the advantage that any unforeseen market developments cannot come as a surprise (i.e., in case it should turn out that the market has 'sensed' some development on the horizon that no-one expected).
Still, this positioning extreme gives us some pause. It would probably serve the potential bullish case better if these positions were a bit more non-committal as well. On the other hand, we have seen that large speculators were spectacularly right during the bear market in natural gas, with a huge speculative short position proving to be no impediment to a stunning price decline, so perhaps one should not give too much weight to this indicator.
As examples for the consensus view on crude oil prices consider these articles, which argue for 'lower or stagnating prices' (example 1, example 2). These are fairly typical opinions (hundreds of similar articles are floating around).
Commitments of traders in crude oil futures, long term. Large speculators hold what is historically a near record net long position of about 270,000 contracts – (click to enlarge).
What Might be the Problem?
We would note that for one thing, in spite of apparently ample supplies, crude oil is currently in backwardation across the curve, and that goes for both WTI crude and Brent. This is slightly contradictory, as backwardation usually goes hand in hand with destocking. In fact, such a price structure makes holding inventories bad business, while it simultaneously usually indicates tight supplies in the here and now. Again, this is contradicted by the actual supply situation, which appears to be just fine.
So we have been thinking about it a bit, and here is one idea we can offer: at the same time as U.S. domestic crude production is soaring due to fracking, Iran's has plummeted due to sanctions (although Iran has recently been able to quietly increase its exports to China). Iran is capable of producing about 3.5 million barrels per day or even more, but is currently exporting less than half of that – and that is actually up from previous months (in fact, its exports have been down well over 50% at their low point since the imposition of sanctions). Over time that adds up – for instance, it is estimated that Iran is forced to hold 30 million barrels in 'floating storage'.
Much has been made of the economic impact the renewed surge in U.S. crude oil production has on the economy, but it seems actually likely that the benefit is much smaller than is generally thought. One of the reasons for thinking so is that this production is currently only possible because prices are high at the moment. It has a very high break-even costs ranging from $55 to $70 per barrel (recall that only 10 years ago, a price of $40 per barrel was considered 'extremely high'). Of course technical innovations may bring production costs down, but for now Middle Eastern oil remains far cheaper to produce. For instance, Iranian oil costs only about $20 per barrel to produce.
It makes therefore very little economic sense to replace it with domestically produced shale oil, especially as tanker rates have collapsed as well. One may well argue that inconveniencing the Iranian regime is 'worth it', but so far there are no signs that the regime has actually suffered from the sanctions. The same cannot be said of the average Iranian of course.
As for the alleged need to achieve energy independence – again, it makes no economic sense. At best it is a political program based on the idea that autarky is good, which it actually isn't (we're not saying that shale oil production is engaged in for other than economic reasons – it is after all profitable. Take it merely as a general remark on the energy independence mantra).
Anyway, we digress – the point remains that Iranian exports have sharply declined at the same time as shale production has increased. Moreover, China's demand for crude oil continues to rise. It is estimated to grow 'only' by 4.1% this year, but note that this growth comes from a much higher base than before. Its demand is set to hit about 10.65 million barrels per day this year. Still, if one reads the details of EIA's latest oil supply and demand report (a summary can be found here), it sounds decidedly bearish. Demand growth estimates have been lowered, supply growth estimates have been raised. And yet, the market seems to see things in a different light.
One possibility is that there continues to be a 'political risk' premium embedded in the oil price, as a kind of Arab Spring/Winter echo and due to the continued conflict in Syria and its perceived spill-over potential. Whatever the reason though, in spite of a plethora of bearish fundamental pronouncements, oil prices continue to be firm. Whenever a market is strong in defiance of obvious fundamental data, it is usually a good idea to pay close attention to it.
Charts by: StockCharts, Sentimentrader, Energy Information Administration