Financial markets found their footing on Tuesday, although ongoing volatility shows that we are not out of the woods yet. For oil prices, the danger is even more acute, as the soaring rally over the past two months could be in danger of unraveling.
Oil prices have fallen about 4 percent from the highs hit late last month, dropping sharply on the two trading days of Friday, February 2 and Monday, February 5. The losses were largely the result of the financial turmoil across the globe, as traders and algorithms seemed poised to reprice equities after an extraordinary bull run over the past year.
Oil was dragged down in the morass, although individual energy companies suffered far worse than benchmark prices. ExxonMobil and Chevron, for instance, lost more than 10 percent over the two trading days, and Barclays issued a double downgrade to the credit rating for ExxonMobil, moving it from Overweight to Underweight. Those losses were made much worse by the disappointing fourth-quarter earnings reports from the oil majors. The S&P 500 energy sector lost 4.4. percent on Monday, and fell by 8.3 percent over a two-day period.
The danger is that the unraveling of oil prices is just getting started. Hedge funds and other money managers have built up record net-long bets on oil futures, a run-up that only started to fall back a bit recently. Last week was the first time in six weeks that investors cut their bullish exposure, a sign that the bull run for WTI and Brent started to face resistance.
However, the reduction in net-long positioning was relatively minor and it preceded the sudden volatility that hit the entire financial system last Friday. The risk for oil prices was that without the constant drip of bullish news, investors would have unwound their bullish bets. That danger existed before the latest market turmoil, but with a broader market meltdown underway, the risk for a selloff in oil prices is heightened. Related: Oil Prices Ravaged By Financial Turmoil
"The rise in risk aversion that this expresses is prompting speculative financial investors to get out of their crude oil forward contracts," Commerzbank analysts wrote in a note on Tuesday. "Speculative net long positions in Brent and WTI were at or close to a record level in the last reporting week, meaning that there was correction potential here."
In the context of what happened to the Dow Jones Industrial Average over the last few days, on the other hand, the declines in WTI and Brent are relatively modest. But that also means that there could be more room to fall. "Longs have not yet started to flock to the exit door," Bjarne Schieldrop, chief commodities analyst at SEB, said in a statement. "If that happens it will make the buying opportunity even better for the oil consumers who buy oil on the forward curve."
BP's CEO Bob Dudley says that the price correction is probably appropriate, and when asked on Bloomberg TV if $67 for Brent was about the right price, Dudley responded by saying that "It feels like it to me. It felt a little frothy at $70 per barrel. It was geopolitical news; the dollar was weak … I mean, we are planning this year at $55 to $60. This is a healthy level for us, to plan. We don't need it at $70 per barrel."
The tricky thing is that the sudden volatility in the market has seemingly stemmed from fears of the economy overheating. Yet, strong growth would normally bolster the case for higher commodity prices. However, oil is getting dragged down by other forces, such as a strengthening of the dollar and fears of more interest rate hikes - although the very meltdown caused by such fears could lessen the chances the rate hikes occur. Related: The Shale Driller's Dilemma
Add to the picture some seasonal factors that are kicking in. Refineries are about to go offline for maintenance ahead of peak summer driving season. That will reduce crude demand and push up oil inventories. "We are heading into refinery maintenance season, and that is going to depress demand here in the United States over the next couple of months," said Andrew Lipow, president of Lipow Oil Associates, according to CNBC.
The beginning of the year saw strong inventory drawdowns, but the seasonal lull for the fundamentals lurked just over the horizon. That was expected. But now the oil market has to contend with volatility from equity markets, which could bring back a greater level of unpredictability to oil prices.
By Nick Cunningham of Oilprice.com
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Nick Cunningham is an independent journalist, covering oil and gas, energy and environmental policy, and international politics. He is based in Portland, Oregon. More
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