Crude Oil: The Coming Winter Correction?

by: Rahul Salgia

Commercial hedgers are very net short crude (502K contracts).

Non-commercial hedgers are very long crude (502K contracts).

Crude oil is in backwardation, which may signify a top is near.

Oil rallied ever since the summer when many hedge funds were bearish. Now, the tide has turned and they are now very bullish. Although, sentiment has shifted, the smart money may be indicating that a reversal is on the horizon.

The commitment of traders shows that the commercial hedgers are net short 502,874 contracts as of 10/31. Compared against the last two decades, this is a very large short position. The previous time these smart individuals were this short was in February/March. The commercials were right at that time as the crude oil fund United States Oil (NYSE: USO) topped out at 11.5ish and fell to 8.75 in the summer. From that time, the tide turned and oil is trading a little over $57.00 on November 7th (for the December futures contract).

On the other hand, non-commercials are net long 502,949 contracts. Compared against the last two decades, this is a very bullish position. The only time they were this bullish was in February/March as well. As usual, they got burned with this position. At position extremes, they tend to be wrong, unlike the commercials. These non-commercials are the hedge fund types that use trend trading and are only focused on aggressive trading.

From a fundamental perspective, we can look at the futures prices of different months. The December 2017 futures contract is approximately $2.15 greater than the December 2018 futures contract as of 11.06. When the front month is greater than the later dated month, the commodity is in backwardation. Usually, the futures curve is in contango, where the current month is trading less than later dated month.

Initially, when a commodity is in backwardation, this may indicate that the price may experience a short-term squeeze. However, if we examine data throughout the years, backwardation in oil usually means a long-term top is close. In 2013/2014, the oil market was in backwardation, and the oil price managed to rally up to around 110 in the summer of 2014. The shale revolution finally cracked at the time, and oil was in a bear market until February 2016. If history were to repeat itself, oil may see another hard correction.

If we examine the EIA numbers from 10/27, we notice that crude oil inventories were 2.4 million barrels lower than the last reading. There are 454.9 million barrels and according to the EIA, “crude oil inventories are in the upper half of the average range for this time of year.” The supply side shows a mixed bag.

We still need to analyze the demand side. The EIA report states, “total products supplied over the last four-week period averaged over 19.5 million barrels per day, down by 3.4% from the same period last year.” Demand is decreasing year over year, while oil is spiking higher. This may indicate that the current rally is on its final legs.

Although, there are many reasons to be bearish regarding oil, some are overly optimistic for crude. The. U.S should be cutting corporate and personal taxes within the next year. The corporate tax should be decreasing from 35% to 20%. Cutting taxes should help corporations pour more money into the system, which would be inflationary. Crude would benefit from money coming off the sidelines according to these folks. After looking at the last two tax cuts in the 1980’s and 2003, we see different results. In the 1980’s, oil prices remained steady despite tax cuts. Oil prices significantly rose after the 2003 tax cuts, but the tax cuts weren’t the sole reason for price inflation. The major point is that even if taxes are cut, this doesn’t necessarily mean we’ll get higher oil prices.

Even though it appears that many investors are getting bullish on oil, the commercial hedgers are positioning themselves in a manner against the herd. Although this move may take some time, there are several reasons to be bearish regarding oil.

Disclosure: I am/we are long UCO. 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.

Additional disclosure: I have various short and long positions in oil etf's and option trades in the futures markets in crude.

Although I'm long UCO, it's only 10 shares.