Oil Update: Counter-Trend Short Trade

Exactly a week ago, we put out a note highlighting our concurrent views on oil prices; expect some downside to oil prices in the near to medium term. Readers are strongly encouraged to read that note to gain insight into how we think, and our strategy in which we plan on using to capitalize off volatility in crude oil prices

Fast forwarding one week, we feel that oil prices, especially Brent crude oil, are now ripe for a corrective pullback. As a result, we have initiated our first short on Brent crude oil late in Friday's trading via a sell limit. We also update our crude oil trade playbook with our first short on oil. Details are provided below.

For the record, of the 4 trades we had on crude oil (all of which were publicized), all were profitable. We leave readers to judge for themselves. What we do realize however, is that those that mocked our first long on WTI crude oil are now nowhere to be heard or seen. 


Recap

We posted in our previous note a summary of all our crude oil trades since correctly calling a bottom in prices back in late January. The following trade details have been updated and is accurate as we go to print: 

  • 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

First Counter-trend Short

The basis for our latest short on Brent are twofold: Price has been technically tactical for a short, inline with our risk metrics; fundamentals have not been fully reflected at prices above $60/bbl .

We said in last week's note:

First of all, we feel price action on prices are telling us that we might be in for more rather directionless backing and filling in the following few days to a decline in prices maybe a few weeks to a month out. We won't make predictions on the precise price and timings as it's beyond the scope of this note. A few levels that remain critical the the structure of both markets still sit under the tape and we wait to see how prices react to those areas.

Emphasis must be placed though, that this trade is a counter-trend trade - tactical rather than strategic in nature. Although we are not ardent protagonists of taking directional trades in opposition to the prevailing trend in price action, we feel the opportunity cost of forgoing this short will not be adequately compensated by future upward price action.

On the topic of trade duration and exit price, we cannot say for now. On Brent, it should be safe to expect spot prices to test the $60 handle. Whether or not we will see sub-$60 prices remains to be determined as the tape rolls forward.


Expectations

Overall, we feel prices on both oil composites should remain in a relatively large range. Although their respective ranges have not been fully established, we sense that the market will start to realize that prices below $44 on WTI will only allow OPEC to gain even more ground over their American counterparts

Once the market comes to terms with this, it would be very difficult to carve a second low below $44 on WTI.

However, prices over $57 might be deemed by market participants to be far off from the physical clearing price needed to draw down from the record inventories of American oil coupled with record high daily production output.

  US crude oil production has never been higher despite a double whammy of lower spot prices and a huge fall in the number or operational oil rigs  (data from Baker Hughes). This conundrum has left the market flummoxed and is perhaps the precise strategy US energy giants have adopted in their efforts to retain market share

US crude oil production has never been higher despite a double whammy of lower spot prices and a huge fall in the number or operational oil rigs (data from Baker Hughes). This conundrum has left the market flummoxed and is perhaps the precise strategy US energy giants have adopted in their efforts to retain market share

As a note, the market is experiencing a peculiar development in the American energy markets. Although overall rig counts have been falling through the ceiling, production has continued to climb to all time highs each week data is reported. US DoE and EIA oil reserves have also not seen a definite high. These 3 data sets contradict each other - falling rig counts imply reduced production, but the inverse has happened. It will be interesting to see how the market resolves this conundrum.

As for Brent, we expect prices to take their cue from WTI but trade at a premium of around $7-8/bbl. In our opinion, the current premium of $11/bbl isn't sustainable even accounting for the supply glut in the US energy markets. A break above $65 remains unlikely for now absent external factors such as a weakening dollar and surprise in Fed policy.

More updates to follow as we see them.