Speculators Are Reducing Short Bets Against Oil, Pushing Oil Prices Up

Summary

• The Commitments of Traders report shows short bets from speculators at the lowest level since early June
• Given the correlation between speculator short bets and oil prices since early 2016, oil prices are where we expect, in the mid-$40s
• Even if short volumes return to their lowest level in 2017, oil prices would likely only climb to $52

The U.S. Commodity Futures Trading Commission published its weekly Commitments of Traders (COT) report on Friday afternoon. The report shows that speculators have reduced their short positions against light sweet crude oil for the third week in a row.

As expected, these reductions in short bets are accompanied by increases in oil prices. WTI had risen from the $42-43 range in late June to $46-47 through July 18, the date of the most recent COT report. 

When short positions fall, oil prices rise

The plot below shows the short positions of speculators in futures contracts for light sweet crude oil, against the WTI spot price. A futures contract covers 1,000 barrels. You can multiply the left vertical axis by 1,000 to know how many total barrels are covered by each contract position.

The gray bars show periods where speculators short positions fell. You'll see that WTI spot prices rose in each case. In fact, since the beginning of 2016, the correlation coefficient between speculators shorts and WTI spot price is -0.63. The coordinated movement between these two quantities has been pretty reliable.

Short positions are now at 119 million bbl, and have fallen from their most recent high of 202 million bbl in late June. If history is our guide, short positions can go much lower. Their 2017 low value was 44 million bbl in late February.

The recent pullback in the short positions of speculators aligns with some aggressive inventory draws in the United States. In the past 3 weeks, commercial crude and petroleum product inventories have fallen by 27 million bbl. Speculator shorts have fallen by 83 million bbl in the same period. It's not surprising that speculators on the whole would be less bearish, seeing those kinds of inventory reductions.

The range for oil prices, depending on what speculators do

I mentioned earlier that the correlation coefficient between speculator shorts and WTI spot prices since January 2016 was -0.63. If we fit a line between these two parameters over that period, we can estimate what oil prices will do, depending on the way speculators collectively change their short bets.

As of the July 18 report, speculator short bets are sitting near their 2017 average levels. If speculators got more bullish, and reduced their short bets to their 2017 lows, we would only expect oil prices to rise to $52. If speculators got more bearish, and increased their short bets to their 2017 highs, we would expect oil prices to fall to $39.

That's how strong the boundaries are around $45 oil. The boundaries aren't impenetrable. But futures markets do indicate how tight the range is, which has us living with oil in the $40s, given the dynamics in the futures market during the first 7 months of 2017.

Resetting the oil price range will require a structural adjustment

If the futures market is in control, we should expect oil prices in the $39 to $52 range. To move above this range, we need a structural adjustment to the physical market. We need to see supply considerably below, or demand considerably above, consensus projections.

Speculators speculate. Duh, right? Importantly, they speculate around a consensus view. The consensus is the baseline. Some speculators are bullish relative to the consensus. Others are bearish. But pushing the consensus is what we need to break out of range-bound oil prices. And there's no indication at the moment that the existing consensus view is vulnerable.

On Friday, we received reports of rising OPEC production in July. We take that kind of bearish news, bounce it off the bullish recent US inventory draws, and end up with stability around the prevailing view. We are under a tenuous supply deficit that looks to vanish at a moment's notice. US production will keep climbing. The strength of the OPEC and non-OPEC supply cut will weaken. The timing and magnitude of both effects are in question. But both effects will materialize, one way or another.

Long story short (no pun intended), it looks like we won't live long enough under the existing supply deficit to work off the excess inventory that is suppressing the price of oil. That's why we're range bound in the $40s. And that's why the futures data continues to tell the same story.