Egypt. Syria. Libya. Large inventory drawdowns. What's moving crude up so fast in the last 3-4 weeks? From a low below $93 per barrel, WTI crude (USO) has come all the way up to $108 per barrel.
The answer is rather simple: speculation. Massive speculation. Indeed, record-setting speculation.
This is not some rabbit being pulled out of a hat here when I say it was speculation. We have hard data. The U.S. Commodity Futures Trading Commission publishes the Commitments of Traders report on a weekly basis. And this report shows us the positioning of speculators, both large and small, in futures and options.
And what does this report tell us recently? It tells us that the crude rally has been driven by large speculators, which not only amassed the largest net long position ever, but have been growing it by around 20000 contracts in each passing week. 20000 contracts represent 20 million barrels, and thus overwhelm even the record U.S. crude production that's been growing by around 1.2 million barrels per day versus 2012. After all, 20 million barrels over 7 days is more than 2.85 million barrels per day, easily surpassing the increased production.
The chart below shows how large speculators have driven their position to the highest level ever (Source: Barcharts.com)
The same chart also shows us how recently peaks in speculation have coincided with peaks in crude pricing. With long positioning at its largest ever, it's likely that we're about to witness another such peak.
Fundamentals do not support the current rally
While the long speculation in crude derivatives is the strongest ever, ironically the fundamentals for the crude market are perhaps the most negative they have been in a decade or so. We have, simultaneously:
- A significant increase in Chinese crude production in June;
- An incredible increase (+19.7% y-o-y, EIA) in U.S. crude production that's taken U.S. crude back to peaks last experienced in 1991;
- A significant decrease (-12.9% y-o-y, EIA) in U.S. imports as a result of the increase in U.S. production, something which is made even more relevant to the worldwide crude market because Canada's crude production is also rising steeply;
- Lowered gasoline consumption in the U.S.
- A significant economic slowdown in China.
All put together, it makes little sense for crude's price to be trying for records right now. Such a speculation only has one reason to exist: Bernanke's quantitative easing policy. But even natural gas broke under the weight of increased production while being subjected to past quantitative easing efforts - so it's likely that crude will do just the same. After all, if it has taken record speculation to get crude to $108, what's going to drive it higher now?
Regulators are noticing this disconnect
Perhaps it's not a coincidence that Friday, we got notice that Federal Reserve is reviewing a 2003 decision that allowed regulated banks to dabble in the commodity markets. It's likely that some at the Fed have noticed the huge long speculative positioning in crude futures and options as the reason behind crude rallying.
The fact that the Federal Reserve is looking is also a powerful motivator to unwind some of those long bets for whoever is under the Fed's microscope.
I expect crude to fall steeply to at least $80-$90 per barrel during the second half of 2013. And the fundamentals might imply downside even from those levels, since to curtail some production lower levels are needed.