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Oil’s Big Drop: The Contrarian View

Rig

One of the first things I learned as I started my career in a dealing room was that, unlike in a marriage, on a trading desk being a contrarian made sense. You have only to look at the fickle nature of opinion to see why. Just a few days ago it seemed like everybody in the oil market was convinced it was going higher. OPEC’s cuts and the expected boost to U.S. growth from Trump’s administration led to everyone and their mom buying oil futures. I pointed out here and elsewhere that that huge ratio of longs to shorts in the market meant that vulnerability was to the downside, especially as the OPEC cuts could be offset by increased shale production in the U.S. and that the “Trump effect” was a hope rather than a fact at this point.

Sure enough, over the last couple of days we have seen the market turn as that increased U.S. production has become obvious, in turn leading to cracks seeming to appear in OPEC’s much heralded agreement, and with it opinion has shifted and everyone is bearish. Now that we are here, though, it is necessary to once again take a contrarian view. Now that everybody seems convinced that we are dropping back to the low $40s for WTI it is getting close to the time to buy. I can see somewhere around $47 being achievable over the next few days, but around there or at the first sign of a turnaround I would be a buyer.

(Click to enlarge)

The crazy thing about this move is that the conditions that have supposedly led to it, increased U.S. shale production as prices held above $50 and cheating by OPEC agreement signatories, were completely foreseeable and talked about by many people other than me over the last few weeks. It is more likely, therefore, that the market’s overbought state is what caused such a big drop, and that what we are seeing is essentially a big “long squeeze”. If that is the case then it can only go on so long before buyers resurface. When that happens the market will focus once again on fundamentals, and they point to higher oil.

Often, when markets move sharply in one direction it is because traders become fixated on one aspect of the influences on pricing and ignore contrary messages from another. If you think about it that was what happened over the last few weeks and months, as a focus on OPEC and an improving demand picture caused some to ignore that everybody was long and that the U.S. rig count was climbing. It is also happening now, though. Those things are grabbing the headlines but the conditions that caused the sustained run up since November are still in place. The OPEC agreement has the traditional element of non-compliance by some, but the cartel has a lot invested in its success, in terms of reputation and future viability as well as short term economic considerations. Even if there is cheating, some kind of tough talk about larger cuts and stricter enforcement is a perfectly reasonable expectation.

The supply situation could also be helped by this drop in prices, with the rate of growth in rig count dropping in response to sub $50 WTI, but it is demand that really shifts the balance. The big drop in oil a couple of years ago was, in part, about oversupply but also sluggish demand. Many expected that low demand to be a permanent thing as the world moved away from fossil fuels but, as the IEA pointed out last week, demand has been increasing steadily and looks set to continue to do so and demand growth quickly offsets supply. The outlook for oil demand is usually best indicated by the actions of the large integrated firms, and most are currently in expansion mode.

It seems, then, that just as demand increases are looking like being enough to compensate for the lack in overall cuts in oil production the market has lost sight of that and is panicking about the other side of the equation, supply. The irony of that situation is large, but so is the opportunity. Going against momentum is always risky and must be done with a keen eye to controlling potential losses, but that said the only thing for an argumentative old contrarian like me to do is to buy into the drop.




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