- Oil pulls back as risks-off sentiment builds.
- Futures markets still heavily long.
- Current trends are likely priced in.
Oil pulls back as risks-off sentiment builds
The bullish run in WTI crude oil has stalled in recent weeks and I'm worried about the risk/reward setup for continued gains. This could be a good opportunity to lighten oil stocks in your portfolio or initiate an oil hedge if stock fundamentals are still appealing.
After reaching my target of $60, from the $50 level, WTI crude oil mounted a strong rally to highs around $66. The rally above the target would've been partly driven by short capitulations and after a small pullback week, the price fell almost $7 which is a reminder of the potential for a strong move lower if the sentiment turns against bullish crude oil. The price still holds above the key $60 level at the time of writing, however another bearish move in the week has me concerned that oil could see an unwind in the weeks ahead. With the Head of OPEC meeting top shale oil executives, oil traders will be watching carefully for any comments of Houston on Monday.
Futures markets still heavily long
As I mentioned previously, COT positioning shows that future traders are now long crude oil in record numbers. This level of positioning looks dangerously one-sided and history shows that the majority are always wrong in their market assessment so I feel it may be a matter of when oil unwinds, rather than if. The long futures position in crude oil is now twice the positioning that was present before the late-2014 wipeout that caught complacent markets cold.
Another interesting development in the Commitment of Traders report is the fact that markets look heavily biased towards an anti-U.S. dollar stance. Are we maybe approaching a sharp dollar rally that catches markets by surprise? Market positioning shows that the euro especially, is in a heavily-long position and I've been vocal about my expectations of further problems in the Eurozone in recent articles.
(Source: Daily FX, COT)
To add further to the "risk-on" positioning, the Swiss franc and the Japanese Yen, which are key safe havens in a financial storm, are both at low levels. This positioning looks like its brewing a potential "risk-off" environment in the near future and recent market behavior in volatility and stocks would hint at a time where investors should adjust their risk reward positioning and move away from bets with skewed risk and reward.
Current trends are likely priced in
The recent run in oil has also been boosted by bullishness expectations in other commodities as markets start to price in future inflation. Rising treasury yields have brought concern to financial markets and with industry heavyweights such as Paul Tudor Jones and Jeffrey Gundlach calling an end to the bond bubble and cheap commodities, there has been a continued wave of speculative money flowing into commodities. My guess is that they may be right in the long run but that a chance of a speculative unwind is a threat to near-term pricing. A rally in the U.S. dollar would be damaging for the commodities space and the driver of such a rally maybe a panic or shock event that forces liquidiations.
The meeting on Monday between OPEC and shale comes at a time when oil production in the U.S. has hit an all-time high of 10.05 million b/d, driven by the low-cost shale producers, which threatens the efforts of OPEC members to keep a lid on their own production in order to force oil prices higher. The recent weakness in the U.S. dollar will have boosted oil demand from foreign investors and if my expectations for a rally in the dollar are correct, the fall in demand would add another headwind. The EIA currently projects an increase in U.S. oil production to 11.2 million b/d so this continued build would apply pressure to OPEC once again.
The recent surge in oil prices has seen OPEC patting themselves on the back for their market "re-balancing", however their efforts have been boosted by external events with a healthy global economy and the continued freefall in Venezuelan oil production: the sentiment could have changed considerably before the next OPEC meeting of June 2018, if oil prices mount a more serious pullback.
Oil has had a good bullish run from the $50 level as higher inflation expectations and geopolitical strains have seen a continued build in speculative buying in the crude oil futures markets. The move higher in crude has taken the pressure off oil company balance sheets and OPEC, however markets are now heavily long WTI crude futures and this is coinciding with a "risk-off" speculative position in the currency markets. Record high production in the U.S. will keep a lid on the price for now and if we see an unwind in speculative positioning with a U.S. dollar rally, oil could test the lower levels once again. A close this week below $61.50 will likely see a test of $55-50 in March/April. I will follow this article with oil company shorts which I see as having the most favorable risk/reward.
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