Oil Touches 3-Month Low, Futures Market Signals Turning Point

| About: The United (USO)
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Summary

Oil hasn't been this low since May.

Longer dated futures have been appreciating, but the tide may be turning as we saw pressure across expiration dates.

Producers may start to get anxious as the future is no longer as bright as it seemed. This may cause them to accelerate production.

Rising rig counts and higher domestic production over the past two weeks may be signs of troubles that are yet to come.

Pay very close to attention to rig counts and domestic production over the coming weeks.

Oil (NYSEARCA:USO) is touching new lows. At the time of writing, the September contract is trading at $43.23/bbl, more than 8% lower than just a week ago and the lowest we've seen since May. While I have always remained bearish on oil, the futures market has been begrudgingly telling a different story.

For the past couple of weeks, the spreads between long-term futures and short-term futures have widened significantly.

Source: Interactive Brokers

Note how the long-term futures have not lost much value, and past 2018, futures have actually gained value. However, today we are finally seeing some good pressure across expiration dates.

SEP 2016

OCT 2016

NOV 2016

DEC 2016

JAN 2017

FEB 2017

MAR 2017

APR 2017

MAY 2017

JUN 2017

-1.06

-0.97

-0.92

-0.93

-0.9

-0.87

-0.87

-0.83

-0.82

-0.83

The market has been telling us that even though the spot price is low right now, oil should be much higher in the future, but the trend is reversing. I explained some of the bullish supporting factors such as consistent inventory draws and shrinking domestic production (read Oil Outlook Deteriorated), and they are misleading; but of course the market only wanted to focus on the positives while ignoring reports of higher rig count week after week and the incentives of international producers to pump more.

Lower long-term futures prices could mean that investors are finally coming to terms with the poor fundamentals supporting a bull thesis. This does not necessarily mean that oil will nosedive (summer driving season), but it does suggest that the market is more willing to accept lower prices as the new norm. The pressure on long-term futures may have come from hedgers rushing in to secure hedges (a great idea in my opinion), or from speculators who have finally conceded that a bull thesis will not become reality. The source of selling is not important, as lower future prices will have important implications for oil producers nonetheless.

We have been seeing rising rig counts week after week. This is no coincidence, as companies are struggling to keep production above water as the result of the natural decline of producing wells. With DUC inventory going down as well, companies must consider drilling more to bringing production back up in the future to pay the bills. Last week we saw a sustained rise in domestic production. It was rather muted, but positive at 9 Mbbl/day. I can't say for certain that this is the inflection point towards rising production, but if we buy into the idea that producers are no longer confident about future prices, isn't the logical idea that they will do all they can to extract value (i.e. pump as much as they can, as quickly as possible)? This will of course contribute to keep oil lower for longer.

Takeaway

I believe that the futures market is reacting in such a way that points to a change in sentiment regarding oil's long-run potential. If producers start to accept that prices won't be going higher any time soon, they will be more inclined to accelerate production, which will only serve to depress the oil price even longer. Rising production and rig counts are the prelude, investors should pay close attention to how producers react over the coming weeks. If rig count and production continue to increase despite lower oil prices, more trouble could be ahead.

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