Expert Analysis: Oil Prices Have Risen Too Far Too Fast

Last Friday we argued that the rally in WTI and Brent looked overstretched from technical and positioning viewpoints. This week obviously didn't serve our viewpoint as geopolitical tensions in Iraq alongside bullish long-term calls from Citi and the trading group community- particularly Trafigura- at APPEC pushed the market slightly higher. There are undeniably glut-clearing trends at work in the U.S. and abroad but we continue to feel that crude oil has risen too far, too fast and positioned for length-liquidation on any fundamental speed bumps as WTI's 14-day RSI touched 70 this week while RBOB + Heating Oil net length held by hedge funds reached 2.5 standard deviations above its 2yr average.

- Despite our view that the market is technically overbought we still need to acknowledge tightening fundamentals in several key global trading hubs. PADD IB gasoline stocks are now -13 percent y/y at their lowest level since 2014, PADD IB distillate inventories are -32 percent y/y, Singapore middle distillate stocks are -7 percent y/y and ARA gasoil stocks are -20 percent y/y.

- Now for the not-so-good news. We're already seeing the next stages of shale progress in North American markets opposite increased production in Libya. U.S. crude production printed 9.55m bpd last week which is 60k bpd shy of its 2015-high following a 750k bpd rebound from Harvey disruptions. Producer hedging in Cal '18 and '19 WTI was significant this week and is currently driving a 7-vol premium for WTI M18 25 delta puts relative to the 25 delta call. We expect U.S. and Canadian production to be a thorn in the side of bulls in coming months. Further east, Libyan production also topped 950k bpd this week (according to Bloomberg) which could also pour some cold water on the current Brent spread strength.

- Speaking of spreads and bearish news, we also saw a sharp reversal of the recently bullish action in Z7/H8 spreads for Brent and WTI this week and a massive selloff in DFL Brent. We think the spread weakness could be foreshadowing the type of bearish fundamental news that flat price length feels highly vulnerable to at the moment.

- U.S. economic data was mostly better than expected this week leading with an upward revision in 2Q17 GDP to +3.1 percent (highest in 2 years) while personal consumption jumped 3.3 percent. Odds of a Fed rate hike in December increased to more than 75 percent as measured by Fed Fund futures. On the weaker side Real Personal Spending had its worst print since January 2016 and Core PCE increased by just 1.3 percent y/y.

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After three good months, Brent Dec'17/Mar'18 shifts lower

Front spreads in Brent and WTI corrected lower in the second half of the week and in our judgment, have more downside room ahead. On the WTI side, Dec'17/Mar'18 traded up to -21 early Thursday and had dropped below -40 on Friday. On the Brent side Dec'17/Mar'18 traded to +100 on Tuesday to cap a $1.88 rally over the last three months. However, the spread ran into aggressive selling at the +100 mark and traded down to +45 on Friday. We think that Brent spreads are still comfortably in overbought territory and the recent increase in global floating crude stocks serves as a reminder that there is still an abundance of crude oil to work through.

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Diff markets also told important stories this week. WTI began to strengthen against Brent correcting its year-long losing streak as USGC refiners came back online and a $5 discount sent massive amount of U.S. crude abroad. Last week's EIA data showed U.S. crude exports at nearly 1.5m bpd which we think will continue in the near-term due to generously open arbs. Dated Brent vs. the Front Line swap is also sending a sort of 'toppy' signal to us at the moment and corrected to -5 cents on Friday after trading up to +46 on Tuesday.

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U.S. producer data for last week showed a full comeback of U.S. output to pre-hurricane levels. Lower 48 production jumped 16k bpd w/w while Alaskan output added 21k bpd bringing cumulative U.S. production to 9.55m bpd for its highest mark since July 2015. The U.S. rig count, however, fell to 744 for a 3-month low despite the recent increase in flat price. As for hedging activity, WTI NYMEX gross shorts from producers and merchants increased for the fourth straight week while gross shorts in ICE Brent saw a slight decrease. Given our view of flows in the market we certainly expect to see more producer activity if Cal '18 and Cal '19 swaps continue to rally.

Funds keep buying strength

COT data for the week ended September 19th revealed a 3rd straight week of net buying from funds in NYMEX WTI and ICE Brent contracts. Combined net length between the two contracts is currently 673k contracts which is 25 percent above its 2yr average. Gross short positions in NYMEX WTI and ICE Brent are 14 percent above and 22 percent below their 2yr averages, respectively.

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Funds have also maintained aggressive buying in RBOB and Heating Oil contracts bringing net length between the two products to 123k contracts- nearly 2.5 standard deviations above their 2yr average. In ETFs, however, investors continue to doubt further strength in prices and have withdrawn money from the USO fund for three straight weeks. Related: Traders Are Betting On $100 Oil In 2018

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Hedging moves puts higher while upside risk rots

WTI option values maintained their rotting trend this week with WTI Z17 50d vol near 25.3 percent by Thursday afternoon. In terms of skew, we marked 25d puts for Z17 WTI at 28 percent on the Thursday close while 25d calls implied just 24 percent suggesting that hedgers and bearish speculators, rather than bullish funds, are driving option volatility. Realized volatility (20-day) sank to 25 percent this week.

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EIAs show Harvey aftershocks

• U.S. crude stocks fell 1.8m bbls this week as a massive export haul pushed USGC stocks lower w/w by 4.4m bbls

• Cushing and PADD II stocks continue to push higher and keep pressure on WTI spreads and WTI/Brent arbs

• Refiner demand has also fell in line with traditional y/y levels signaling that Harvey's impact is minimal at the moment.

• We're looking for an unusual fall turnaround session to keep refiner runs elevated and fill the product deficit that is partly responsible for pushing crude markets higher

U.S. crude inventories fell 1.85m bbls w/w and are flat y/y following four weeks of hurricane-damaged refiner demand. PADD I supplies fell 750k bbls to -8 percent y/y, PADD II stocks added 2.3m bbls and are +3.4 percent y/y, PADD III supplies fell by 4.4m bbls to -1 percent y/y and PADD V stocks increased by 1.6m bbls to -2 percent y/y. Cushing inventories increased for the seventh time in the last eight weeks and currently stand at 61m bbls. U.S. crude exports hit a recent record of 1.5m bpd driven by the recent hurricane backlog and newly wide WTI/Brent arbs which should continue to push U.S. barrels abroad while limiting Brent imports.

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U.S. refiner inputs came screaming back increasing w/w by about 1m bpd to 16.2m bpd. Refiner inputs in PADD I printed 1.1m bpd and are +2 percent y/y, PADD II inputs are currently 3.6m bpd and are +4 percent y/y and PADD III inputs at 8.2m bpd are lower by 22 percenty/y over the last four weeks. Strong crack margins should continue to incentivize aggressive demand gasoil/Brent trading near $15/bbl this week while RBOB/Brent traded $10/bbl and WTI 321 traded $19/bbl.

Related: Citi: An Oil Supply Squeeze Is Inevitable

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U.S. gasoline stocks jumped 1.1m bbls last week and are lower y/y by 4 percent. PADD IB inventories fell more than 1.2m bbls to their lowest level since 2014 and are -13 percent y/y. In the mid-west PADD II inventories while 479k bbls to +3 percent y/y while PADD III supplies fell 2.1m bbls and are -13 percent y/y. PADD V stocks added 1m bbls and are flat y/y. Gasoline production increased by just 60k bbls to 9.9m bpd. U.S. gasoline exports printed 550k bpd and are flat y/y while domestic demand increased to 9.5m bpd and is +7 percent y/y over the last month.

U.S. distillate supplies fell 814k bbls and are lower y/y by 15 percent. In the mid-Atlantic, PADD IB inventories fell by 160k bbls and are lower y/y by 32 percent over the last month. PADD II stocks fell 258k bbls and are -6.7 percent y/y, PADD III inventories fell 334k bbls and are lower y/y by 2.3 percent while PADD V stocks fell 193k bbls to -23 percent y/y. Distillate production increased by about 100k bpd to 4.6m bpd. As for demand, exports fell by 84k bpd to 1.1m bpd and are lower y/y by 19 percent. Domestic demand fell by more than 500k bpd to 3.7m bpd and is -1 percent y/y over the last month.

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By SCS Commodities Corp.

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