A short- term oil price top forms, but the longer term positive outlook improves on a tentative return to backwardation
The Organization of the Petroleum Exporting Countries (OPEC) agreed to cut output (although details are still murky, and oil prices have soared since the November 30 agreement at Algiers. Moreover, OPEC and non-OPEC producers agreed on Saturday, December 10, to curtail oil output jointly and ease a global glut after more than two years of low prices that wreaked havoc on the fiscal budgets of all the oil producers, big and small. This is the first deal OPEC and non-OPEC since 2001, and caps the efforts of the Kingdom of Saudi Arabia (NYSEARCA:KSA) to put a mechanism in place to limit the production of oil. It took almost a year of arguing within the OPEC amidst doubts that non-OPEC Russia will cooperate. Last week's OPEC and Non-OPEC's deal in Moscow brokered by Russia put paid to those doubts. There were compelling reasons for KSA and Russia to broker the agreements.
The economic reality of low oil prices weighing on the fiscal viability of oil producers plus the recent political change in the US with the election of Mr. Donald Trump required decisive action. A Trump administration would potentially increase US oil production by lowering production cost through fewer regulations and lower taxes, so that meant KSA and OPEC had to move now to limit output to stabilize oil prices before another face-off with a resurgent US shale oil industry.
The oil market rewarded the KSA/OPEC/Russia initiative by moving oil prices higher (but not so much higher), despite doubts regarding the deal participants' intention to live up to their pledges of cutting or freezing output. The tepid reaction to the twin deals suggests the oil market may not be still totally sold on the deals however. This will play a large role in the negative short term outlook of the oil markets which is starting to coalesce.
There is still a large volume of speculative shorts waiting for the price of the energy commodity to drop. Part of the evidence is the oil market open interest which is currently at 2.04 million contracts -- close to an all-time high level -- and a large part of that is short open interest positions. There are some compelling reasons for a short-term pullback in oil prices, which we expect to manifest soon:
The short-term view turns negative:
(1) Oil producers have been hedging like mad, and there is already evidence that commercial hedgers are starting to make an impact on the currently elevated oil prices (see chart 1 below). US producers have been very aggressively hedging their production over the last week; we have never seen such large volumes, which basically stopped the rally for a while, and had been mostly responsible for the negative impact on the oil price earlier this week after a spike up caused by the Moscow deal.
(2) Oil producers' long hedges, on the other hand, have been tepid, excess for the cash (spot) longs - which makes sense, if the hedgers' intent is hit-and-run.
(3) Commercial hedgers - not a factor supporting longs. Commercial hedgers' short positions are rising faster than commercial hedgers' long positions.
(4) Managed Money aka hedged funds are still net long, but watch for the reversal in the trend of short positioning, which is still falling. Once it turns upwards, you can expect some high degree of certainty that the previous uptrend in price will start to reverse.
(5) Our liquidity models also suggest that systemic funding flows are getting tighter and that is starting to undercut sentiment in many markets, including that of the oil markets (see chart 4 below).
The aggregate impact of those factor discussed above should support a price weakness in oil futures in the weeks ahead. Indeed, we have probably seen a short-term top in oil prices, and we expect price weakness until late February.
It does not also help the oil price that we are heading towards a seasonally weak period for oil. Indeed, seasonal factors should inevitably kick in once the glow from the twin deals fade.
The seasonality of the fundamentals will weigh on oil prices soon:
(6) Stocks at the Cushing hub are rising quickly faster than previous seasons (see chart 6 below)
(7) US oil inventories are stabilizing but at higher levels than even last year's blowout (see chart 7 below).
(8) The only saving grace in the supply side is that oil refiners volume of oil input is still rising, but usage is due to reach a seasonal peak in a few weeks, and that will take away a large chunk of the oil demand - another impending blow to prices (see chart 8 below)
However, the outlook further out is positive
Despite the negative short term outlook, the large open interest could ignite the next leg in oil prices higher further out. We see indications of this in the long-dated oil term spreads. Term structure in the crude oil market often can provide clues as to the future outlook of supply and demand balance for the energy sector. The chart of the June 2018 minus the June 2017 NYMEX futures contract shows that forward curve has moved from a contango of $2.60 per barrel on November 9 to a backwardation of 75 cents as of December 12.
Contango, on the one hand, is a condition where a deferred price is higher than a nearby price. Contango is a market signal of the existence of oversupply. On the other hand, in a backwardated structure, there is already evidence that commercial hedgers are starting to hit the currently elevated oil prices (see chart below). US producers have been very aggressively hedging their production over the last few weeks.
The deferred futures prices are lower than nearby prices which is a sign of supply tightness. The move from contango to backwardation in the one-year forward curve in June 2017 versus June 2018 futures is significant in the sense that it may be telling us that the price of oil may be higher further out. Futures prices are the market's perception of the future fundamentals for a commodity, and right now those long-term spreads are indicating that the oil market could tighten in the farther months ahead.
That picture of incipient backwardation in the long-dated spreads is even more remarkable when seen in the backdrop of massive hedging activity from producers. The rising price of oil has attracted hedging activity from oil producers (hedging spot oil), and that depresses the spreads by their selling of deferred contracts in their effort to hedge and secure reasonably adequate prices for future production. The first signs of supply tightening are also visible in the futures curve, as 2017 contracts are trading above 2018 strip average and cash prices.
That these things are happening can trace its origin from the successful deals signed in Algiers and Moscow, which visibly changed the oil futures curve in the last few weeks. The curve's current shape provides several notable hints with regards to market participants' view on the trajectory of the global supply/demand balance, namely (1) oil traders appear to be betting on only a moderate supply tightening in 2017, and (2) the market also appears skeptical about the oil under-supply regime lasting for very long. That the market is discounting a short-term price weakness can be seen from the WTI curve which remains in steep contango at its front end, as shown in the chart above.
The oil market is still wary of the twin deals crafted by KSA and Russia
If the global overstock indeed shrinks substantially during the first half of 2017 (an OPEC belief which we do not yet share), as targeted by OPEC leaders, while demand continues to grow, shouldn't the "supply shortage" option preserve its value post summer 2017? Still, the current shape of the curve is indicative of a prevailing view in the market that appears to be that the oil supply tightening in 2017 will be moderate and fragile -- not at all a slam dunk.
Moreover, it appears that traders are anticipating that the deals still have still sufficiently high probability of failing. The market appears skeptical with regards to an immediate strong recovery in oil prices. This speaks volume about the OPEC initiative which a lot of investors (and even a lot of oil producers) are still betting to fail. We do not have high confidence in these fail scenarios, but meanwhile we suggest that investors "batten the hatches" in expectation of a short-term decline in oil prices (and other risk assets, see chart below).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.