Since February, major investors have predicted that oil prices were poised for a huge rally. Hedge funds and money managers piled into bets on rising oil prices, going long on the crude rally.
Short sellers were squeezed, and the stampede become too much for many, resulting in a large liquidation of shorts. The short selling drove the rally, increasing oil prices by about 50 percent since early February.
That has fueled optimism that the worst of the oil bust is over. And there is good reason to think that a rally is justified. U.S. oil production is off by about 600,000 barrels per day since the April 2015 peak. Disruptions in Nigeria and Iraq have caught the markets by surprise, knocking off another several hundred thousand barrels per day. Gasoline demand is at record highs in the United States, and OPEC is a few weeks away from meeting to discuss its production freeze deal, which may not cut into oversupply, but has nevertheless given the markets some hope. Related: Even Utilities Are Starting To Get Behind Community Solar
But there are warning signs on the horizon. The fundamentals are still very weak. Inventories are at record highs in the U.S. and still rising, and global oil production continues to exceed demand. As I wrote last week, the rally could be overdone.
Barclays backed that hypothesis up in a recent report, warning that several commodities could be poised for declines as the recent two-month price rally exceeds what the fundamentals suggest is merited. In other words, the reason that oil faces downside pricing risk is that there is a disconnect right now between the fundamentals and market sentiment.
On the one hand, you have incredibly bullish speculators. John Kemp at Reuters writes hedge funds and money managers have cobbled together a near-record high in net-long positions as of March 22, as shorts were closed out and investors bet that oil prices were on their way up. Net-long positions have surged to the equivalent of almost 579 million barrels, double the volume of net-long positions recorded at the end of 2015. The last peak in net-long positions was 572 million barrels, about a month or so before oil prices began declining. For context, the record before that was the 626 million barrels in long positions posted in June 2014 when ISIS emerged and took over swathes of Iraqi territory. Related: Does Saudi Arabia’s Play For Market Share Make Sense?
Barclays analyst Kevin Norrish says that commodities prices have surged in 2016, but the recent rush into bullish bets may have gone as far as they can realistically go. “However, in the absence of any concerted fundamental improvements, those returns are unlikely to be repeated in the second quarter, making commodities vulnerable to a wave of investor liquidation,” Norrish wrote in the bank’s latest report, referring to commodities in general, though that includes crude oil. Hedge funds may have overshot on the upside, meaning the risk of oil prices going in the other direction are now more pronounced.
“Key commodities markets such as oil and copper already face overhangs of excess production capacity and inventories, but also now face another obstacle in the recovery process, that of positioning, which is now approaching bullish extremes,” Norrish said. Related: Oil Majors Only Replace 75% of Oil and Gas Produced in 2015
Just as the rally was supercharged by short sellers abandoning their positions, the oil markets are at risk of snapping back in the other direction in the next few weeks as net-long positions are undone. If speculators start to get the sense that the market is changing directions, they will start to unwind their net-long positions. But, of course, these things tend to move quickly. Once the herd starts to see the market heading down, a stampede for the exits could ensue.
While it may seem like arcane market idiosyncrasies, the potential for speculators to shift their money back to the short side would have huge influence over the oil price. In fact, as Kemp of Reuters details in an interesting chart, oil prices and hedge fund positions are closely correlated.
In short, oil prices will only rally when the fundamentals show much more of a balance, which appears to still be a few months away.
By Nick Cunningham of Oilprice.com
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However, as of 3/22 there are still over 750,000 speculator short contracts that could be covered. And that's from an all-time high of nearly 1 million short contracts.