Crude Reality - Shorts Are In Charge (For Now)

Nov. 06, 2019 1:43 PM ETThe United States Oil ETF, LP (USO)9 Comments3 Likes
Volatility Surfer profile picture
Volatility Surfer
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Summary

  • Bullish bets on crude oil near all time low.
  • Bearish bets have been on the rise since the Saudi attacks.
  • Negative flows out of energy ETFs points to investor nonchalance.
  • Crude is looking for "friends with catalysts"

The crude market sentiment has remained poor for a majority of 2019. Speculative longs in crude oil futures have all but vanished leaving the shorts in charge. The shorts are now the tail that wag the energy dog. I remain bullishly inclined towards crude because I tend to be a buyer at the point of maximum pessimism. However, for the overall sentiment to revert back to neutral or even bullish, we need a show of force from OPEC and in particular, the entity that got us where we are today - Saudi Arabia.

CFTC data released on Friday, November 1 showed a decline in short bets against crude oil futures. While the shorts covered ~14k contracts during the week of November 28, short bets against WTI crude oil, which is tracked by the United States Oil Fund (NYSEARCA:USO) have continued to rise since the attacks on the crude refineries in Saudi Arabia.

Source: Bloomberg

This chart above may not look all that exciting or toppy. Indeed, it isn't because what it shows is the lack of speculative volume. However, the level of crude shorts becomes particularly interesting when viewed against the size of speculative longs in crude oil, which for all intents and purposes have also dried up over the past three years.

The current net speculative positioning in crude oil (long futures minus short futures) is best described as anemic. The level of nonchalance towards crude oil has been frustrating many market watchers and investors in the energy space.

Source: Bloomberg

The frustration of those in the "know" can be felt almost as soon as an energy analyst walks into your office, or an energy analyst opens their mouth. Simply put, the bulls don't really have much data to point to in order to put together a convincing argument and the bears don't have anything to point to in order to put a convincing bear argument. The current situation is a Mexican standoff. Since the oil crash of 2014, crude has largely been stuck within a $20 per barrel range barring a few exceptions. The low being $45 and the high being $65.

Source: Bloomberg

Between $45 and $65 exists a no-mans land. The E&P companies in North America can produce some cash flows - which are promptly soaked up by existing debts. Similarly, the OPEC countries, whose lifting costs are south of $20 per barrel are making money but they have entire countries soaking up their profits. This is boring.

The boredom has prompted investors to head to the exits. ETFs such as USO (USO) and Energy Select SPDR (XLE) have both experienced and continue experience massive outflows almost daily.

Source: Bloomberg

The torrential outflows out of the energy space have fueled disastrous declines for virtually all companies linked to oil and gas production. I tell my colleagues that the share price declines in the frackers is similar to the decline rate of the wells they drill. This joke isn't funny to the bulls.

So what brings us out of this negative vortex of low oil, low sentiment and outflows? The more I think about it, the more I am convinced that the solution to the problem lies with the entity who created it in the first place.

In November 2014, Saudi Arabia chose to protect their market share rather than the price of oil. This event sent the price of oil plunging by over $100/barrel between Q4 2014 and Q1 2016.

Source: Bloomberg

While oil has somewhat recovered recently, it remains massively depressed against the ~$100/barrel average we saw between 2010 and 2014. While Saudi Arabia managed to protect their market share, they reduced the size of the market pie by over 50% as a result of their actions.

I believe if Saudi Arabia and OPEC decide to protect the market size going forward, as in, maintain a certain price floor under crude, they would be significantly better off as would the energy industry at large. It appears that this is the solution that Russia and Saudi Arabia may be working towards. Indeed, on October 10, 2019, it was reported that such an action may be in the works. Another factor at play here is the valuation of Saudi Aramco. A lower price of crude has reduced Aramco's target valuation of $2 trillion while also souring the sentiment towards the planned IPO. While MBS has compromised on his $2T valuation, an action aimed at stabilizing crude will kill two birds with one stone - increase the price of crude and increase Aramco's valuation. While Saudi does not own all the chips on the energy table, they control all the chips that matter. A Saudi led decision to right-size OPEC production will break the bearish grip on crude and bring optimism back in the space.

This article was written by

Volatility Surfer profile picture
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Investing since the dot com crash. Searching for a little wisdom every day. I enjoy uncovering quality dividend ideas for my retirement portfolio. With my play money, I enjoy hunting for commodity multi-baggers. Gold and silver bull.
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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.

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