Oil Has Room To Fall As Speculators Bail On Bullish Bets

Last week, after WTI dipped to $48, it seemed to firm up a bit on assurances from OPEC regarding compliance with its cuts, and a better-than-expected report from the EIA showing a slight drawdown in crude oil inventories also provided a boost to oil prices. Crude closed out the week slightly up from the week before.

But the downside risk to oil prices has not gone away. In fact, with market sentiment starting to falter, a growing number of investors are abandoning their record bullish bets on oil, which could send prices down further.

The threat of a possible liquidation of net-long positions had grown in recent weeks and months, as investors piled into a one-sided bet even though oil market fundamentals were murky at best. As January gave way to February and March, and the bullish bets continued to mount, so did U.S. oil production. The optimism became increasingly hard to justify and the downside risk to prices grew more obvious. This kind of lop-sided positioning tends to correct itself when sentiment becomes too detached from the fundamentals – the only question was when that would happen.

Well, it appears to be happening now.

New data shows that hedge funds and other money managers cut their long bets and increased shorts, resulting in the sharpest net-long reduction on record for a single week. "Speculative investors have thrown in the towel it seems. We've got record selling in the week ending March 14 and the bleeding has not stopped yet," Carsten Fritsch, senior commodities analyst at Commerzbank, told Reuters. "The continued increase in U.S. oil rigs adds to the bearish sentiment." Baker Hughes reported another strong increase in the rig count last week, with 14 oil rigs added back into the field. At 631, the oil rig count is now at an 18-month high. Related: Expert Analysis: The OPEC Cuts May Be Working

For the week ending on March 14, hedge funds slashed their net-long positions by a staggering 23 percent, a record decline. That corresponded with a roughly 10 percent fall in oil prices.

"It’s sort of a negative feedback loop, where money managers were selling because the price was falling, and the price was falling in part because money managers were selling,” Tim Evans, an analyst at Citi Futures Perspective in New York, said in a Bloomberg interview.

U.S. oil production also rose in the latest EIA report, with output now above 9.1 million barrels per day and rising.

Moreover, the market could be exposed to yet another source of rising supply in the near future.

Libya had provided one of the very few sources of bullishness to the market in recent weeks, with violence knocking about 100,000 bpd offline, taking production down to 600,000 bpd. Libya’s National Oil Corporation had lost control of its largest oil export terminals Es Sider and Ras Lanuf, and the cutback in exports surprised the market. Libya had previously announced plans to dramatically ramp up production and exports this year, so the unexpected loss of output provided a lift to crude prices. Related: OPEC Favors Production Cut Extensions As Next Meeting Nears

But the disruptions might be temporary. Libya’s NOC says it will regain control of the ports and restore output. Exports could restart within 10 days, a board member of the NOC told Bloomberg. More Libyan supply will weigh on the market.

Of course, that will be small potatoes compared to what OPEC decides to do with its deal, which runs through June. Saudi Arabia has sent mixed signals over what it wants and expects, alternating between voicing frustration with laggards not complying and warning the shale industry on the one hand, and voicing optimism about compliance and sending soothing signals to the market regarding an extension on the other.

Expectations over an OPEC extension are all over the map, so there is no use at this point in speculating what might happen. Goldman Sachs’ default assumption is no extension. At the other end of the spectrum is Deutsche Bank AG, which predicts not only an extension through the end of 2017, but even an extension through the end of 2018. In between are plenty of more nuanced positions, so take your pick.

In the short run, however, oil markets are in danger of sliding. Investors are bailing out of their positions at a rapid pace, which threatens to drag oil down. Unless some positive news emerges in the next few days or weeks, WTI and Brent could lose a few more dollars.

At the same time, the liquidation of the unsustainable build up in net-long positions takes away some of the harshness of the downside risk. Sort of like a safety valve that has relieved some pressure, the reduction in bullish bets means that there will be less of a danger of another sharp correction in prices stemming from speculative moves. Short sellers are using up their firepower right now.

In other words, the mid-$50s appeared to be a stable range for the past few months, but if the market is to trade narrowly and steadily again, a more appropriate range given today’s fundamental could arguably be the upper-$40s.

By Nick Cunningham of Oilprice.com

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