A Short-Term Oil Price Top Forms, But The Longer-Term Outlook Improves On Return To Backwardation

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A Trump administration potentially increases US oil production, so KSA and OPEC had to move now to limit output to stabilize oil prices before another face-off with resurgent shale output.

The tepid reaction to the deals suggests the oil market is still not totally sold on the deals. This will play a large role in the negative outlook forming near

Oil producers have been hedging like mad, and there is also some evidence that commercial hedgers are already starting to make an impact on the current uptrend of oil prices.

The long-term outlook, however, turns more positive with tentative moves of the oil curve towards backwardation, and as long-dated spreads and strips show oil prices firming 12 month out.

And there simply has been so much (geo)political capital spent in reaching those output deals, so KSA, OPEC and Russia will likely find ways to make the deals from unraveling.

The Organization of the Petroleum Exporting Countries (OPEC) agreed to cut output (although details are still murky), and oil prices have soared since the September 29 agreement at Algiers. Moreover, OPEC and non-OPEC producers agreed on Saturday, December 10, to curtail oil output jointly and ease a global glut after more than two years of low prices that wreaked havoc on the fiscal budgets of all the oil producers, big and small. This is the first deal between OPEC and non-OPEC since 2001, and caps the efforts of the Kingdom of Saudi Arabia (NYSEARCA:KSA) to put a mechanism in place to limit the production of oil.

It took almost a year of arguing within the OPEC amidst doubts that non-OPEC Russia will cooperate. Last week's OPEC and Non-OPEC's deal in Moscow brokered by Russia put paid to those doubts. There were compelling reasons for KSA and Russia to broker the agreements at a time that they are both hitting maximum output capacity - the two top producers are negotiating from positions of strength (see chart below).

The economic reality of low oil prices weighing on the fiscal viability of oil producers plus the recent political change in the US with the election of Mr. Donald Trump required decisive action. A Trump administration would potentially increase US oil production by lowering production cost through fewer regulations and lower taxes, so that meant KSA and OPEC had to move now to limit output to stabilize oil prices before another face-off with a resurgent US shale oil industry. The oil market rewarded the KSA, OPEC, and Russian initiative by moving oil prices higher (but not so much higher), despite doubts regarding the deal participants' intention to live up to their pledges of cutting or freezing output. The tepid reaction to the twin deals suggests the oil market may not be still totally sold on the deals, however. This will play a large role in the negative short-term outlook of the oil markets, which is starting to coalesce.

There is still a large volume of speculative shorts waiting for the price of the energy commodity to drop. Part of the evidence is the oil market open interest, which is currently at 2.04 million contracts - close to an all-time high level - and a large part of that is short open interest positions. There are some compelling reasons for a short-term pullback in oil prices, which we expect to manifest soon:

The short-term view is turning negative

(1) Oil producers have been hedging like mad, and there is also some evidence that commercial hedgers are already starting to make an impact on the current uptrend of oil prices (see chart 1 below). US producers have been very aggressively hedging their production over the last two weeks. We have never seen such large hedging volumes recently, which basically stopped the rally for a while, and had been mostly responsible for the negative impact on the oil price earlier this week after a spike up caused by the Moscow deal.

(2) Oil producers' long hedges, on the other hand, have been tepid, except for the cash (spot) longs - which makes sense, if the long hedgers' intent is hit-and-run. This has been the biggest, single factor that is keeping the oil term structure from becoming sharply backwardated (see chart 2 below)

(3) Commercial hedgers - not a factor supporting longs. Commercial hedgers' short positions are rising faster than commercial hedgers' long positions (see chart 3 below). Watch for this space, as this factor can help blunt the current uptrend in oil.

(4) Managed Money a.k.a. hedged funds are still net long, but watch for the reversal in the trend of short positioning, which is still falling. Once it turns upwards, you can expect some high degree of certainty that the previous uptrend in price will start to reverse (see chart 4 below).

(5) Our liquidity models also suggest that systemic funding flows are getting tighter and that is starting to undercut sentiment in many markets, including that of the oil markets (see chart 5 below).

The aggregate impact of those factors discussed above should support a price weakness in oil markets in the immediate weeks ahead. Indeed, we have probably seen a short-term top in oil prices, and we expect price weakness until late February (see liquidity model applied to oil, chart above).

The seasonality of the fundamentals will weigh on oil prices soon:

It does not also help the oil price that we are heading towards a seasonally weak period for oil. Indeed, seasonal factors should inevitably kick in once the glow from the twin deals fade. Some of those factors are:

(6) Stocks at the Cushing hub are rising quickly faster than previous seasons (see chart 6 below)

(7) US oil inventories are stabilizing, but at higher levels than even last year's blowout (see chart 7 below).

(8) The positive in the supply side is that oil refiners' volume of oil input is still rising, but usage is due to reach a seasonal peak in a few weeks, and that will take away a large chunk of the oil demand - another impending blow to prices (see chart 8 below)

However, the outlook further out is positive

Despite the negative short-term outlook, the large open interest could ignite the next leg in oil prices higher further out. We see indications of this in the long-dated oil term spreads. Term structure in the crude oil market often can provide clues as to the future outlook of supply and demand balance for the energy sector. The chart of the June 2018 minus the June 2017 NYMEX futures contract shows that forward curve has moved from a contango of $2.60 per barrel on November 9 to a backwardation of 75 cents as of December 12.

Contango, on the one hand, is a condition where deferred (further futures) prices are higher than the nearby price. Contango is a market signal of the perceived existence of oversupply, as seen during late 2014 and most of 2015 (so nearby prices are comparatively lower). On the other hand, in a backwardated structure, farther futures prices are higher than nearbys, sometimes significantly so (see chart below). One reason why there is no aggressive move towards backwardation despite the twin deals to curtail output is due to preponderance of evidence that commercial hedgers are starting to short the currently elevated oil prices (as shown in previous charts). Moreover, US producers have been very aggressively hedging their production over the last few weeks by shorting.

That the deferred futures prices are lower than nearby prices is a market signal of perceived supply tightening. The move from contango to backwardation in the one-year forward curve in June 2017 versus June 2018 futures is significant in the sense that it may be telling us that the price of oil may be higher further out. Futures prices are the market's perception of the future fundamentals for a commodity, and right now those long-term spreads are indicating that the oil market could tighten in the farther months ahead.

That picture of incipient backwardation in the long-dated spreads is even more remarkable when seen in the backdrop of massive short hedging activity from producers. The rising price of oil has attracted hedging activity from oil producers (hedging spot oil), and that depresses the spreads by their selling of deferred contracts in their effort to hedge and secure reasonably adequate prices for future production. The first signs of supply tightening are also visible in the long-dated futures curve, as 2017 contracts are trading above 2018 strip average and cash prices (see chart below).

That these things are happening can trace its origin from the successful deals signed in Algiers and Moscow, which visibly changed the oil futures curve in the last few weeks. The curve's current shape provides several notable hints with regards to market participants' view on the trajectory of the future global supply/demand balance, namely (1) oil traders appear to be betting that supply tightening in 2017 will be moderate, and (2) the market also appears skeptical an oil under-supply regime will last for very long time. That the market is discounting a short-term price weakness can be seen from the WTI curve which remains in a still steep contango at its front end, as shown in the charts above.

The oil market is still wary of the twin deals crafted by KSA and Russia

If the global overstock indeed shrinks substantially during the first half of 2017 (an OPEC belief which the oil market does not yet share), as targeted by OPEC leaders, while demand continues to grow, shouldn't the curve be more backwardated than what is being shown today? The mixed hedging reaction function from the oil producers (being reflected by the shape of the oil curve, and by the producers' recent mixed hedging activity, see chart below) is likely indicative of a prevailing but ambivalent view in the market that appears to be that the oil supply tightening in 2017 will be moderate and fragile - and even that is not at all a slam dunk.

It appears that traders are anticipating that the deals still have still sufficiently high probability of failing. The market appears skeptical with regards to an immediate strong recovery in oil prices. This speaks volume about the OPEC initiatives which a lot of investors (and even a lot of oil producers) are still betting that the agreements will fail.

We do not have high confidence in these fail scenarios - there simply has been so much (geo)political capital spent in reaching those output deals, so KSA/OPEC and Russia will likely find ways to make the deals stick. The cuts will stay in force over the next six months, with the possibility of prolonging the cut if necessary. However, the Brent forward curve suggests that production cuts need to last for one full year to stabilize the oil price between $60 and $70 per barrel (we see little KSA desiring at this time to push prices much higher - those significantly higher prices will just unleash the US fracking industry again). Given where oil prices are today, KSA, OPEC and Russia may need to push for another agreement in six months. We do not doubt that they will, and they can, if there is any need to. The oil market's pessimism that the deals would not endure seems misguided, at least to us.

"Batten the hatches," meanwhile

But six months is a long time in the oil markets. There is enough time for events to play out as hoped for, or for the deals to unravel. There will be enough time for everyone to take defensive action, if these are needed. Meanwhile, there is an immediate risk that needed to be addressed - we suggest that investors "batten the hatches" in expectation of a short-term decline in oil prices (and other risk assets, see chart below).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.