Oil market has been trading sideways since the OPEC cut agreement. I made several calls on the short side which turned profitable but the market quickly went up afterwards. Today I am not calling a short-term movement: I think we will be entering a new medium term trend to the downside. (Don’t get me wrong, I am not a perma-bear and I am pretty bullish for oil for the second part of 2017 and 2018, this will be an article soon).
- (1) Why bearish now?
- (2) Fundamentals are bad
- (3) Sentiment analysis: screaming short
- (4) Price Action
- (5) Limits to my view: USD and OPEC surprise declarations
- (6) Conclusion: I am short
(1) Why bearish for now?
The recent price action was overwhelmingly a result from political manipulations from OPEC. I won’t get in too much details but the oil producing countries have a budget to manage and Saudi Arabia / Russia were strongly enticed to push oil price higher (both were in terrible situation with a price under $50 a barrel). So we did get an agreement.
Oil went up and is now sitting above $50 a barrel. This movement is natural and reflect new expectations concerning the fundamentals. Yet those are still expectations and despite the implementation of the cut, I think fundamentals remain so-so (at best) and are not fully priced in the market. I don’t know when, but if I am right in a near future production and inventories data should send price lower.
(2) Fundamentals are bad
(See Oil, from Oligopoly to a Competitive Market: the New Fundamentals and their Consequences for Oil Traders – my view on the new fundamentals of this cycle for oil)
There are two variables that really matters: the price and the volume. OPEC played on a cut in volume to drive the price higher. Within the agreement everybody is making an effort to resorb the supply glut. But can we really expect such a diminution in production that inventories will resorb market imbalance? I don’t think so.
Without more details:
- OPEC deal
Seems to be implemented BUT: this is just the beginning, people are more inclined to respect agreement just after it and so it may not be respected as expected in the future
Recently Barclays published a report: OPEC is convincing the market that the cuts are occuring and hopes that this buys time for a more constructive oil market balance.
We have our doubts about how long OPEC compliance can last.
But even if fully respected it won’t trim the glut before 2018-2019 (in the current environment)
The impact of the deal agreement is already priced in the market, no more upside from this.
- Inventories are at historical highs
EIA sees oil inventories continuing to build until the middle of 2018 at an average rate of 0.3mb/d this year and still 0.1mb/d in 2018. According to them it will begin to decline mid 2018.
There was a global oil inventory draw during the third quarter of 2016, which was the first quarterly draw since late 2013. EIA’s previous estimates had global markets close to balance in mid-2016, but still showed inventory builds. The draw during the third quarter of 2016 was more than offset by the sizeable builds in the first and last quarters of the year, leading to an annual average build in inventories.
- Russia agreed to OPEC cuts at historical high in its production
The increase in Russian crude output is being driven by the start of new fields in the country’s far north and the Caspian Sea region. Rosneft PJSC, along with Gazprom Neft, the oil unit of Gazprom PJSC, began commercial production from the East Messoyakha venture earlier this month. Rosneft plans to start the Suzun field, a separate project in Siberia, soon. Lukoil PJSC’s Caspian Filanovsky deposit has started a second well, which is now in test production.
Russian production has every opportunity to continue growing if they were not to respect the OPEC/NOPEC deal. Why? Russia is in direct competition for market share with OPEC members. The rivalry is particularly acute in Asia, the main source of growth in oil demand and a region where Saudi Arabia is also taking steps to maintain its presence.
- Saudi Arabia agreed to OPEC cuts at historical high in its production
- US: producing more and more
Resilient production (new tech, paused and start, hedging) + investments from past decade hitting the market.
Latest figure from the EIA put US oil output at almost 9mb/d. US shale output is already back up 400 000 bpd since Semptember.
Far from shutting down U.S. production, OPEC’s actions have only helped to lower costs by putting pressure on the overall supply chain and associated prices. This has made unconventional crude more profitable at lower prices and exacerbated the problem that OPEC started with. Where unconventional crude producers once needed $80 per barrel oil prices to succeed, today breakeven levels are closer to $40. US prod is here to stay.
- Iran: increasing its production and willing to do more
Rouhani’s government has set an ambitious target: boosting Iran’s oil production by 20 percent by 2021 — from 3.8 million barrels a day to 5 million. To accomplish this, Tehran is looking for $200 billion in foreign investment over the same period.
New Iran Petroleum Contract: it will allow foreign companies to establish joint-venture partnerships with Iranian companies in which they will manage production and reservoir development
- Nigeria: pumping up
- Iraq: pumping up
- Libya is ramping up its production
Goal of reaching 900 000 barrels per day in March (=+200 000 barrels from today prod)
- Kazakhstan: will probably more than double its production in 2017
From 180 000 per day today to 370 000 (government projections).
The first oil from the Kazakhstan venture has been sent for export, after about 16 years and more than $50 billion of investments.
- Demand is sluggish
That is primarily based upon slowing demand from Asia and the EU
China (world’s largest marginal buyer) is decelerating, Brazil is in a recession, as was Russia. Most emerging market countries are struggling to grow. In mature, industrial countries such as the United States, Europe, and Japan, about the best that can be expected is 2% real GDP growth, and even that low bar may be tough to achieve. In essence, the era of strong commodity demand in the early 2000s that was supported by 10% real GDP growth in China, and strong growth in many emerging market countries is long gone, with little prospect of returning. And, in the post-2008 environment, mature, industrial economies are struggling to produce anything better than lackluster growth. The implications of this outlook are for very sluggish growth in energy demand, especially for crude oil
My conclusion: huge wall of supply for a modest demand growth
And in the end it always comes down to fundamentals. This is the main argument for my shorts.
(3) Sentiment analysis: screaming short
OPEC managed to put a floor to the market and to comfort and attract bulls.
If we analyze the current positioning in the future market, non-commercial longs (hedge funds and money managers) hit a record high recently.
If you look at the chart above, you can see that an interesting point from the short position (dark red). Each time the short positions were touching local minimum (June 2015, Oct 2015, June 2016, Oct 2016), there was a drop in prices over the next months.
Moreover, bullish bet have been going up without a rise in the price of oil: Oil is not going up despite more buyers. There is a need for a catalyst to keep this rally alive, and I don’t see any on the medium-term
- Why people are bullish?
If you are a well-educated analyst you see the historical lows in oil price and you see there were always a sharp recovery afterwards. We found the bottom recently and so the market should (as it always does) go back up quickly? I think people don’t understand that OEPC is no longer the swing producer, the US are. The cut in production is an opportunity for US shale producers and other producing countries.
Some hedge fund managers (Andurrand for instance) are calling $70-$80 a barrel sooner than later. I don’t completely disagree with them. I think oil should come back to those levels, but I am pretty sure it won’t be in Q1 2017.
- Forecast are not that good
-EIA thinks that oil will remain below $60 per dollar for 2017 and 2018!
-Investment banks: on average are predicting oil will trade in the mid-$50 per barrel in 2017 ( a year ago they were way more bullish: more than $60 per barrel)
Contrarian stand: when everyone is buying and price is high: sell. Looking back at what has happened when long positions have spiked in the past: Each time they push sharply upwards there is a drop in price immediately afterward
Possible long liquidation if catalysts (ex: data on supply and demand fail to live up to expectations). Investors will be cashing out and could amplify a potential downward move. Risk in the market have shifted to the downside.
(4) Price Action
Oil has been trading in a range for 2 months.
Brent Price dec 2016 – jan 2017
There is no clear direction in the market despite a strong positioning from long.
No more “political catalyst”, OPEC has played its “Trump card” and has not much left in its sleeve.
It it were to break, we could re-test $50 at least
(5) Limits to my view
- New “political” declaration from OPEC
Will mechanically drive price up. Saudis want oil goes up to $70-$80 very quickly to get the Aramco IPO done and collect $150-200 B dollars. Plus they want to sell more gov bonds
Could head lower after the huge increase post-Trump election, and this could be a tailwind for oil prices.
- Geopolitical event
See my analysis of a potential price surge related to this matter: A Geopolitical Approach to Oil Trading – Why Oil Prices Could Soar in 2017
We can say without doubt that the market has been driven up by OPEC. Now there is a vacuum: fundamentals should take over in the price action and drive prices lower if there is no special announcement from OPEC and no big downtrend in USD.
For sure market could go higher, but I think the downside risk looks very important for now.
This is the story of who is driving the market? Expectations vs. present. OPEC has raised expectations but the present fundamentals are telling a different story.