Crude Oil Declines As Expected
Following our call for a price correction in Brent crude roughly 2 weeks ago, and having covered our short trade on Brent last Friday, we will now piece an succinct update on all of our crude oil trades as well as provide subscribers with further commentary as to what we foresee going forward.
But first, here is a summary of the trades we have done so far on both Brent and WTI crude:
- 1/26: First long on WTI crude oil at $44.70
- 2/11: Second long on WTI crude oil at $49.50 with half the initial notional on position
- 2/16: First long on WTI crude oil squared at $52.70 for net gain of 17.89%
- 2/19: Second long on WTI crude oil crude squared at $49.88 for net gain of 0.66%
- 2/19: Rotated into Brent crude oil at $58 shortly after all WTI positions exited
- 2/20: Brent crude long squared at $59.50 for net gain of 2.56%
- 2/24: Second long on Brent crude oil at $57.72
- 2/27: Second long in Brent crude oil squared at $60.81 for net gain of 5.35%
- 2/27: First short on Brent crude oil at $61.87
- 3/6: First short in Brent crude oil squared at $59.66 for net gain of 3.57%
We are currently flat on exposure to crude oil and will be looking more into how we plan to position ourselves in the near future.
Regular readers will recall that we called for a bottom in pieces back in January and have been proven right by price action. The price action on WTI continues to be significantly more choppy than that of Brent, reflecting the slightly more complicated supply and demand dynamics in the US energy markets; this is the primary reason why we rotated from having positions on WTI to trading Brent instead. Besides the rather directionless volatility in WTI, the premium that Brent trades at has narrowed from highs of around $11.50/bbl to the current $8.60/bbl. This is also something we have called for.
US Oil Inventories Continue To Surge
Ever week, the US Department of Energy (DoE) together with the American Petroleum Institute (API) and the Energy Information Agency (EIA) report on US crude oil inventories and production. Collectively, the reports provide the market with a good measurement of how much oil is actually in US stockpiles (excluding that of the Strategic Petroleum Reserve) and almost as importantly, the b.
Although we have not covered this topic in depth, we thought that it would be important to highlight a few takeaways from what we have been noticing from the last few months' reports.
Firstly, we know that US oil production has never been higher, ever. This is despite a collapse in the number of operational onshore oil rigs as tracked by Baker Hughes. The rig count figure has dropped more than precipitously, at a velocity not seen since the oil bubble pop of 2008.
This can only mean that those rigs that are currently still operating and drilling for the black gold, are doing so at rates they have never done before; production per active rig has is therefore at a record. It makes little economic sense to be producing a record amount of crude oil when prices have just recovered from their lowest levels in almost 7 years. This also means that operating margins have fallen tremendously for small and medium sized drillers, while energy giants are also not spared.
As a note, one cursory glance at the 12-month forward P/E ratios for the oil giants in America will reveal that however much profitability has fallen in the energy sector, the market hasn't commensurately discounted this fact. As a result, the only logical explanation for the relative outperformance of the energy sector (equity) is multiple expansion.
But It Doesn't Make Sense. Or Does It?
Low prices, record production, increases in energy consumption, and record inventories? How does that all tie up? Superficially it doesn't.
However, we urge readers to continue reading to gain perspective on how we square this circle.
If we correlate the constantly rising production with the surge in broad US oil inventories, we can safely attribute rising production to higher inventories. We have thought rather hard about this. Of course, correlation doesn't mean causation but it certainly is in this case. Record production on top of relatively stable energy imports mean a lot of that marginal output from US drillers have gone straight from the ground to storage facilities. It doesn't work the other way round, obviously.
It will make sense once we bring in one exogenous factor: A very strong dollar.
However high US oil production has risen to, Lady Liberty and her staunch appetite for consumerism has led to America being a net energy importer.
The largest oil exporters to the States are Canada, Saudi Arabia, and Mexico; the 3 make up for more than 60% of US energy imports. Canada itself constitutes more than 30%, with its prolific Tar Sands and the widely controversial Keystone XL pipeline that will allow oil to flow from Canada's Bakken oil fields.
The US dollar has been king in the currency markets for a very long while now. Ever since the Fed began its $10bn/month tapering of QE, the greenback has been bid against almost all other major currencies, including the Canadian dollar. The pace appreciation in the dollar only accelerated as the Fed started to guide market expectations for a Fed a Funds rate hike somewhen in 2015. Relatively positive US economic data has only bolstered this prevailing trend.
The sell off in the currencies of major oil exporters such as Russia, Mexico, and the OPEC (in 2014 as oil prices fell in earnest) saw the buying power of each dollar edge higher day after day.
While we will pen another note on the dollar's strength, it is hard to contest the seemingly unwavering demand for the world's reserve currency.
Linking back to the topic in question, a very strong dollar especially against the oil-weakened currencies of America's energy trading partners meant that it actually got much cheaper to import energy from overseas than to produce oil domestically. Think of it as a double whammy: the low price of oil in dollars amplified by the strong dollar agains oil trading partners. It should start to make sense at about here.
America Is Winning By Not Bowing To OPEC
An ebullient greenback doesn't however explain why US producers are still drilling at a record pace despite cratering profitability.
We have stated in many of our previous pieces that the strategy of OPEC is clear. Ever since that uneventful summit in Vienna back in November 2014, when OPEC members decided not to cut production despite a 0.5-1Mbbl/d supply cut the markets were anticipating, multiple red flags should have been raised.
OPEC knew fully well that its members would be the ones who would feel the most acute and lasting pain of a collapse in oil revenues for many months or even years to come, financial contagion as their currencies together with their stock and bond markets free fell to their cataclysmic hells. Remember that in many OPEC countries, revenues from energy exports make up more than half of their economy.
In our minds, OPEC's decision on not to cut production in their November summit was an act of desperation. By then, global oil prices have already stated their decline of around 20-25% from their respective highs. Their move was risky in the sense that they would essentially be shooting themselves in the foot by giving the markets the green light to sell off, if their American counterparts did not react by reducing production on the other side of the Atlantic.
We must understand that OPEC was already loosing market share ever since Russia and America quietly leaped frog over their heads in late 2013 and early 2014.
By mid-2014, America had overtaken the Saudis to become the world's largest oil producer. The onus was very much on OPEC to come up with a strategy to impede this development. Their strategy of aiming to crowd out US producers with yet lower oil prices was deemed smart within their own leagues because Arab drillers had substantially lower operating costs than anyone had anywhere in the world.
In short, the oil cartel's grand plan was potentially rewarding in that they would regain some of their market share, but absolutely decimating should the plan backfire.
And backfire it did. Fast forward 4 months, not only is America pumping more oil from the ground than ever before, it is also enjoying cheap energy imports, all while aggressively stocking up for future export and consumption.
By now, it should be evident to our readers on who are the winners and losers in this skirmish. We hope we have partially squared the confounding circle of why American energy stockpiles and production have been steadily trending higher despite lower prices vis à vis a grand plan by the Arabs that had not gone their way.
What We Expect
Looking at the price action of WTI, it seems to us that prices may have established a range between $48 and $53 on spot. Brent on the other hand remains trickier in juxtaposition. Current spot prices of $57.50 on Brent lies exactly at our technical level which we deem critical. If prices were to breach lower, we can expect more downside in Brent and the Brent-WTI spread to compress further. We feel a premium of around $6-$8/bbl is sustainable. Anything above $9/bbl shouldn't last for too long.
In light of the narrative we have provided, a relatively wide price range or consolidation in WTI will be logical before further developments happen. Prices will require more time and space to "discover" itself, but we feel the main driver of prices will remain the performance of the dollar as well as any external factors from the Middle East.
We are curious on when OPEC will concede that they have played their cards wrongly, if they ever do. In the extreme unlikelihood of that particular scenario, it will be safe to expect prices to execute an almost vertical up thrust.