Oil Rallies As Market Can Only Ignore Physical Market For So Long

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Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO, USOI, UWT, WTID, WTIU
by: HFIR

Summary

Physical market continues to be bullish leading oil prices higher.

RBC notes that with the financialization of the oil market, physical market has lost its sway on price.

Saudi's recent commitment to cap exports at 6.6 million b/d should not fool readers given its own domestic demand rise over the summer months.

Welcome to the physical market is bullish edition of Oil Markets Daily!

In last week's weekly oil markets recap, "Prices Fall Despite Bullish Storage Report," We said that the physical market has been trending bullishly and that oil prices will be supported. Here's what we said:

As we continue to forecast US crude storage to decline over the coming weeks, we expect oil prices to be supported by the recent bullishness in the physical market. The risk of oil prices declining below $40 is low and we expect oil prices to fluctuate between $45 to $50 over the coming weeks as the market fights the current narrative of "shale growth pushing market to oversupply" with clear evidence of global storage declining.

Bloomberg released an article today that noted the physical market bullishness we have been seeing for the last three weeks. Historically, the oil markets were controlled by those that controlled the physical markets. Spreads across the market often gave early indications as to how the balance of the market looks, whether it's trending towards oversupply or undersupply could often be gauged in spreads.

Since 2014 however, we have seen the proliferation of "tourist" hedge fund managers enter the oil markets. This was a topic RBC Capital discussed in a report titled, "The Tale of the Tourist."

Here's what RBC said:

The Financialization of the Oil Market

The evolving arena of oil market participants is reshaping how we think about everything ranging from market volatility to liquidity to simply even how data is interpreted. A market backed by a physical underlying commodity means that prices should typically not diverge meaningfully from true supply and demand fundamentals before converging again. Added volatility over recent years has seemingly resulted in the cycles of dislocation becoming longer and more drawn out. The base increase in the level of volatility stems from the notion that a historically physical market has developed into much more of a financially driven or paper market over recent years. Two decades ago, it was the merchant energy companies, physical players, and those who had a masterful understanding of the fundamentals behind supply, demand, and shipping logistics who dominated the oil market.

The fall of Enron and the demise of several other energy merchants in the early 2000s resulted in a subsequent liquidity gap, which was ultimately filled by financial institutions. Banks had previously not ventured into the space outside of the few who owned physical assets. The next step in the evolution process coincided with the rise of commodity hedge funds in the middle of the last decade. As such, trade volumes expanded as the financial derivative market matured. Throughout the evolution, the participants in the market shuffled seats, but the fundamental knowledge base of the career energy trader remained intact.

The detailed report goes on to discuss several other areas that have plagued oil market sentiment like "who owns market consensus," to "man vs machine."

In summary, the narrative we have gathered from physical oil traders over the last several weeks is one where the physical oil market balance continues to diverge from where flat prices are signaling. Looking at WTI which trades slightly above $47/bbl doesn't give us the full picture of how healthy the market really is. Oil market tourist will think that the oil market remains in oversupply territory, while the physical market points to oil being in the mid-$50s.

Over the next several weeks, global oil storage will continue to accelerate to the downside. Saudi has announced that it will cap its exports in August to 6.6 million b/d. This will certainly help global balances, but also readers should not be fooled by those comments. Saudi's very own domestic oil demand will rise as summer is underway, and if Saudi does not drawdown from its own storage, we estimate that Saudi would need to export a figure closer to 6.4 million b/d. See chart below:

Source: Open Square Capital

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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.