Oil prices are at a major inflection point. They either turn higher or break multi-year support levels and cause more pain to oil producers.
Nearly 2 months ago, we put out a note describing how we speculated on the upside of crude oil prices. We then subsequently implored if prices had indeed bottomed, and we made a case for both sides of the trade. Regular readers that follow our trades that we make public, will know that from the period spanning 1/27 till today, we have had 5 trades on oil. The results of these trades can be found in our most recent commentary dated 3/10.
In this note, we will share with readers a few takeaways we have gained, as well as what we expect going forward.
Were We Wrong?
This is the first issue we want to address. Recall that we first initiated our long on WTI crude oil in 27 January 2015; that was our first trade which reflected our views on prices were going then. That trade turned out to be a fantastic trade - having nailed the interim bottom.
However, in every of our updates and trade documentations, never did we once explicitly state that oil prices have bottomed. Our commentary which partially detailed our thought processes left the door open to Pandora's Box of possibilities. We merely questioned the efficacy of the markets' pricing function with respect to what we believed to be the reality 2 months ago.
Our trades were reflections of our opinions on future price action. Of course having made money on all of those trades, we were proven right on those opinions.
We also highlighted that we expected price action to trade within a relatively defined range until an exogenous shock occurred that would either propel prices to test the January lows or, higher above the cycle highs we saw in February. In retrospect, it is clear that the latter had transpired.
For those that wish to view all of our content regarding oil, below is a compilation for your convenience:
- Outright Long On WTI Crude Oil
- Have Oil Prices Bottomed?
- Expect Downside In Oil Prices
- Oil Update: Counter-Trend Short
- America Is Winning The Energy Skirmish
While we were not wrong, we certainly did not expect prices to breakout to the downside as they have done in the last 2 weeks. So on this front, we were indeed appalled. Strangely enough, we were actually short Brent but covered the position just before the majority of the downside happened; and for that, we are really slapping ourselves hard for missing out on 75% of the downside.
Fundamentals Are Not Pretty
Not at all. First of, readers need to digest what we said in our note we published last week; that despite low prices, the US is facing record high oil inventories and production, both of which are still surging week after week, blasting through analysts expectations. This development has been nothing short of bewildering, and beckons further investigation.
As the world's biggest consumer of energy, the US energy market is by far the largest in the world, standing head and shoulders above the European and Asian markets. The supply and demand situation there should serve as a good barometer of where the global equilibrium stands at.
Hours before we started writing this piece, US crude oil inventories as reported by the DoE surged to a record high of 9.622mbbl, from last week's 4.512mbbl, and smashing expectations of 3.572mbbl. In fact, just about every measure of crude inventories have been coming in way higher than analysts estimates, making us question how these so called analysts even form their estimates?
It is said that come June, all available storage capacity at Cushing will be filled with the black gold. Once that happens, the logistics of storing oil offshore on supertankers takes over. We believe it is an entirely new ballgame all together if that state is reached. The gist is that if sub $50 prices on oil cannot clear the excesses in production, then prices should head even lower until an equilibrium is fairly struck.
Speculation A Factor In Price Formation?
Before we continue, it must be noted that crude oil is a consumable commodity. Its prices should be a function of physical supply and demand. The financial instruments such as futures and other derivatives were originally structured on spot prices so that both commercial producers and consumers could hedge out future price risks. That is the very essence of the futures market.
However, because the prices of the financial contracts traded in market exchanges are a function of bids and offers, they are certainly also a result of speculation. The markets are not random (believers of the EMT, please bear with us), and the degree of speculative open interest can be quantified rather easily. One does not have to look too far to realize that these cycles are far from what a logical person would deem as random.
Indeed, in a transcript made public a few days ago, the Saudi Prince himself said that the low oil prices were partly due to excessive speculation in the financial markets. While the term "excessive" will mean differently to each of us, we believe that speculation has a role to play in formation of spot prices on the physical commodity. We are just unsure of its degree.
"Dumb Money" Pours Into Oil ETFs
The proverbial dumb money, or the average retail investor needs no further introduction. It is a proven fact that most retail investors and traders loose their shirt in the long run - meaning most of them are wrong in their investment decisions. The chasm between the professional investor and the retail investor cannot be wider.
We read a piece from none other than Goldman, the infamous investment bank which called its clients "muppets" back in the days, which alluded to massive fund inflows into energy ETFs that trade on American exchanges to a red flag.
In layman's terms, when retail investors pile into something, one should get the heck out of there immediately.
We believe that the key force pushing commodity markets higher has been retail investor inflows into oil ETFs. Importantly, these strong inflows have emerged despite weak commodity fundamentals, and with arguably a more bullish outlook for equities than for commodities.
We believe that these inflows are generating selling opportunities in oil and copper precisely because they are at odds with commodity market fundamentals. As we have previously outlined, even with the rapid fall in the US rig count over recent weeks, rising rig productivity, the backlog of wells and the possibility of high-grading in the near future, means that US production growth has not yet slowed enough to balance the oil market. The record US oil inventory builds seen over the last few weeks support this view, with US Gulf Cost (PADD 3) stocks now at 220 mil bbl, the highest level on record. Furthermore, we expect inventory builds to both continue over 2015H1 and to spread globally (OECD ex. US inventories have been drawing recently), as China’s oil import demand remains weak.
Apart from the obvious disconnect between recent price trends and physical fundamentals, the rationale of going long oil on an expected normalization or “mean reversion” also suffers from an incomplete view of how commodity returns are generated. Commodity returns incorporate both price returns and roll yields. And with roll yields currently around –9% for oil (–2.4% for the overall S&P GSCI), any upside to price returns is being significantly eroded by losses on roll yields. We expect this situation to continue for at least the next 6 months, with the roll yield on the S&P GSCI continuing to weigh on total returns.
Given the physical nature of commodities, these near-term supply-demand misalignments lead to a build in inventories. While the capacity to store these new stocks exists, spot and near-dated futures prices will decline, but the sell-off remains orderly. However, if storage approaches capacity limits, the market must adjust by incentivizing an even more rapid rise in consumption through more forceful price declines. In both cases futures curves are pushed into contango, generating negative roll yields over the sell-off period. Importantly, falling spot prices, negative roll yields and rising inventories are all symptoms of the same fundamental market weaknesses.
Technicals & The J-K Spread
We should first bring up an important development. It is about the huge contango in the crude oil futures market.
A contango is basically an occurrence when the front month future is priced lower than the next month's. A contango is an absolutely normal occurrence in the commodity futures market because the cost of actually storing physical commodities for a period of time in a storage facility (and the related financing) makes up for the premiums over the front month. However, when the contango gets unusually wide, it is hinting that there is an anomaly worth investigating.
Such is the case for crude oil futures traded on the CME. The J-K spread, the market's lingo for the premium the May contract (CL.K) trades over the April contract (CL.J), has recently exploded from the usual of around 50¢-77¢/bbl to wides of $2.78/bbl earlier in the week when prices were attacking January's lows. Although we would love to be able to analyze data on crude oil futures to have a better picture on how far downside protection has really been bid, we have a feeling that a lot of the selling pressure has come from 2 main sources: Weak longs being flushed from the market (that includes retail investors who have piled into Energy ETFs as we previously described); and new speculative shorts entering the market once $48 was broken.
At last check the J-K spread stood at $2.16/bbl or 4.94% over the front month contract (see the table to the right). The more interesting thing to us, is that when we look further back, CL futures are pricing in much higher prices. One only has to look at the contract for August delivery to have an idea how much the market believes that the supply glut is a short term issue. Looking one full year ahead, the March 2016 CL contract is priced at $55.72, a 27.1% premium.
While this does not mean that the market expects prices to be at $56 in a year's time, what it does imply is the general sentiment that a large part of the supply issues that the market is currently facing would have been resolved by then. We encourage readers to closely follow the futures curve in energy futures because they provide an easy and convenient glimpse into what the futures market is pricing in.
Looking at price action, the technicals look more bearish than bullish to us. The chart to the right illustrates our point. Prices are now at a very critical support level, where if broken will see prices inadvertently testing sub-$40 prices and perhaps even the lows seen at the depths of the oil bubble carnage in December 2008. The fact that we have already seen a test of this major trend line in January, and subsequently failed to absorb the selling at prices above $48 just shows us that there is a clear lack of committed buying even after the 8-month episode of discounting the fundamentals.
We should also note that much of the upwards momentum we saw in February was a result of shorts covering and retail demand. As a result of all these, we expect continued downside. It does not seem to us that we have experienced a selling climax.