Recently, I wrote an article arguing for a short-term return to $50 per barrel on the basis of overstretched money manager short-positioning, suggesting going long on a break of the 7-day exponential moving average. This trade has (so far) been constructive as evident in the below image:
The current rally is one without a clear fundamental narrative, as U.S. inventories are still 110 million barrels above the 5-year average (an increase of 4 million barrels from last week). The market has attempted to peg the current rally to the recent end of a 24-week streak of rising rig counts, and while this may herald a stabilization or even decline in rig counts in the weeks to come, this one data point cannot take credit for the recent rally in prices.
Instead, the clear cause is Money Manager short positioning rising to levels well above 30% (36% for the week ending June 27th), creating a short-covering rally:
Every single time positioning has risen to these levels since the beginning of 2016, a minimum of 10% rally has ensued. While this is positive for bulls in the short-term, concrete movement of inventories towards the 5-year average will be required to sustain prices above $50. Inventories in the U.S. declined from a peak of 146 million barrels above the 5-year average in February, to current levels of around 110 million barrels in early May, but have since been flat.
The good news is, however, that a floor may be in for oil at around $40 per barrel. The EIA’s latest Short Term Energy Outlook projects that U.S. commercial crude inventories excluding SPR will decline from 500 million barrels in June (actual June numbers were around 510 million), down to 475 million barrels in December.
This is a drop of around 35 million barrels, which compares to an average drop from June-December over the past 5-years of 11 million barrels. Excluding 2014 and 2015 which saw builds during this period, this average is about 20 million barrels. Given the fact that some institutions (like Citi) see inventories declining by 100 million barrels from the end of March to the end of September, the EIA seems fairly conservative.
If the EIA were correct, what sort of oil prices could investors expect? One way to estimate is to look at historical inventory levels relative to the 5-year average, and then compare relative inventory levels to prices to see roughly what prices correlate to what inventory levels. If the EIA is right, oil inventories averaging 475 million barrels in December would end 2017 at about 82 million barrels above the 5-year average for the month.
As you can see in the chart below, inventories 82 million barrels above the 5-year average have been able to support oil prices above $40 fairly easily since 2013:
The red dot is current inventory levels, and a move below 100 million barrels above the 5-year average is associated with a higher bracket of prices, with a floor of $40 and a ceiling of $60. The price associated with a particular inventory often depends on the trend in inventories at the time, and if inventories are falling relative to the 5-year average consistently, investors can likely expect a price towards the high-end of that $40 to $60 range. The move below $40 per barrel when inventories were around 100 million barrels above the five-year average corresponded to a period of steadily increasing weekly inventories.
The average price between 85 and 95 million barrels above the 5-year average (where the EIA sees year-end inventories), since 2013, has been about $48 per barrel.
This leads to the question: will the EIA’s forecast pan out? This will largely come down to how OPEC performs on the export side. OPEC is going to need to bring total imports into the U.S. consistently below the 3 million barrel per day mark, and if OPEC can bring this figure below the 2.5 million barrel per day mark (which they did 2 weeks ago), storage draws will likely exceed the EIA’s forecast:
OPEC has disappointed in this regard so far, but Saudi crude exports to the U.S. will drop significantly in July and August. Until steady inventory draws begin, oil should chop around the $40 range, representing attractive short-term trading opportunities. I plan on remaining long for a move up to $50 as long as the current uptrend stays in tact.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.