By Nick Cunningham
Oil investors have grown more optimistic as of late, as oil prices have moved back to $50 per barrel. The market appears to be on sounder footing, suggesting that things will gradually tighten for the rest of the year. But it is unclear how far oil prices can really move above today's position.
Hedge funds and other money managers have begun buying up long positions on oil futures, a sign of growing bullishness. Reuters analyst John Kemp argues that the positioning of hedge funds has entered the third bullish phase of 2017, after two previous cycles ran their course earlier this year. In fact, the most recent data saw the largest weekly increase in net-long positions so far this year, and interestingly, Kemp points out that the net-long build is due to new long positions, rather than simply just a reduction of shorts. In other words, investors are betting that crude oil prices will rise.
And for good reason. U.S. shale production growth has slowed, as has the rig count. Inventories have finally posted significant declines, which appear to be ongoing. Some high-profile shale drillers have announced spending cuts. And Saudi Arabia is moving to cut oil exports to Asia, a sign that OPEC's most powerful member intends to do its best to accelerate market tightening.
Plus, although OPEC compliance has slipped in the past two months, the cartel met this week to figure out a way to hold the laggards to their word. Nothing particularly concrete came from the meeting, but the group seems determined not to let things fall apart. "Discussions were conducted in a constructive atmosphere and proved fruitful," OPEC said in a statement. "The conclusions reached with the countries at the meeting will help facilitate full conformity." Few details were provided.
But can things continue on this upward trend? "The biggest question now is, was that July rally just a lot of short covering, or does it have staying power?" Mark Anderle, director of supply and trading at TAC Energy, told the Wall Street Journal. "The market's just content to go sideways and figure that out."
Despite the newfound optimism, analysts do not see much upside from here. For example, Barclays said in a recent research note that the rally is probably unsustainable. "Prices have moved higher, due to a perfect combination of a favorable macro environment, a seasonal uptick in consumption, continued inventory drawdowns, and geopolitical unrest," the investment bank wrote. "Certain factors that supported prices in July are unlikely to last, and we expect a downward correction during this quarter."
The recent price gains, at least in part, were driven by greater bullishness from speculators, but absent a more dramatic improvement in the underlying fundamentals, those speculative movements can only take things so far. "Fundamentals remain shaky this quarter, therefore any rally that occurs before more substantive inventory draws would be short-lived," Barclays analysts added.
One particular concern for oil bulls is the fact that U.S. shale producers are likely to turn up the pace of hedging with oil at $50 per barrel, locking in future production and ensuring that new supply comes online. Citigroup says that a new round of hedging is already underway. With the certainty of oil sales for 2018 in hand, shale producers can proceed with more drilling. That means more supply will be forthcoming, capping the price rally.
Moreover, without visible signs of ongoing improvement in the physical market, investors could start to sour on prices again. As John Kemp of Reuters points out, the liquidation of short bets on oil futures and the sudden increase of longs ultimately means that "it may prove tough to sustain the recent upward momentum in crude and product prices." When investors take things too far, the pendulum tends to swing back. With speculators having already staked out bullish positions, there is less room to run on the upside.
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.