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Speculators Vulnerable To Short-Covering Rally

Friday June 30, 2017

In the latest edition of the Numbers Report, we’ll take a look at some of the most interesting figures put out this week in the energy sector. Each week we’ll dig into some data and provide a bit of explanation on what drives the numbers.

Let’s take a look.

1. Oil begins to rally on short covering

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- Bearish bets on crude prices hit a record high, according to the most recent data.

- That suggests traders are incredibly pessimistic, betting on falling oil prices.

- But the preponderance of bearish bets risks a sharp short-covering rally. “The market is vulnerable to a very violent short-covering move,” Thibaut Remoundos, founder of Commodities Trading Corporation Ltd., told Bloomberg. In fact, that could be underway.

- Crude prices have gained more than 5 percent since bottoming out last week.

- There could be further gains in prices. All the while the selloff (and subsequent rally) had little to do with changes in fundamentals, and much more to do with shifts in market sentiment.

2. Oil industry in danger of wasting $2.3 trillion

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- A report from Carbon Tracker Initiative estimates that the global oil industry is set to spend $2.3 trillion on oil projects that ultimately might not be needed if the world reaches peak oil demand by 2025.

- Demand scenarios vary depending on who you ask. Some see peak demand in the imminent future, including executives from Royal Dutch Shell (NYSE: RDS.A), for example.

- Others, including BP (NYSE: BP) and ExxonMobil (NYSE: XOM), see demand slowing but continuing to grow through 2040.

- The Carbon Tracker report finds that among the oil majors, Exxon is the most exposed to the peak demand scenario. If demand peaks by 2025, Exxon could waste as much as 50 percent of its planned spending.

- Needless to say, this is a massive financial risk for investors. For now, the industry is dismissing the claims.

3. High-yield energy in trouble if oil prices fall further

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- High-yield energy companies will face pressure if oil prices continue to fall.

- Already, the yields on junk bond debt have jumped more than 1 percentage point over the past month, due to the crash in oil prices.

- Deutsche Bank estimates that the crunch on high-yield energy debt could spark financial contagion in the broader high-yield market if oil prices drop to $35 per barrel.

- Not everyone agrees. Many companies have lower breakeven costs than the last time the high-yield market saw pressure from low oil prices.

- A rebound in oil prices will ease the pressure pretty quickly.

4. U.S. oil exports surge

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- U.S. crude exports have jumped from negligible levels in 2014, to above 1 million barrels per day for a period of time this year.

- Greater pipeline construction has allowed crude oil from the Permian Basin and even as far away as the Bakken, to reach the Gulf Coast for export.

- But exports could rise further because export terminals have recently proven to be able to handle some of the largest tankers. The port in Corpus Christi, TX is planning a $350 million dredging program, allowing 1 million-barrel supertankers to dock.

- Also, the U.S. refining complex along the Gulf Coast typically handles heavier forms of oil. But the crude varieties coming out of the Eagle Ford and the Permian are lighter, meaning they have to be exported.

5. Canadian oil sands producers seeing pipeline constraints

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- Canadian oil sands production has climbed during the three-year market downturn because many of the projects in Alberta have long lead times. Some of them are still coming online, projects that were planned years ago.

- As a result, Canada’s oil production is set to rise. But the country is struggling to build new pipelines that can carry those additional barrels.

- According to the Canadian Association of Petroleum Producers, Canada can ship 3.3 million barrels of oil per day. But the country will produce 3.92 mb/d this year and 4.2 mb/d in 2018 as new projects come online.

- That will force Canadian producers to ship crude by rail, a route that is two to three times more expensive than pipeline.

- This is a problem for Canadian oil producers, who already have higher costs and sell their crude at a discount.

- New pipelines are not set to come online until the end of the decade.

6. Shale drillers less hedged than last year

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- Shale drillers routinely lock in their next year’s production in a series of hedges, ensuring they can sell future production at a given price. That certainty allows them to drill with confidence.

- There was a rush to hedge after the OPEC agreement in late 2016. But as oil prices faltered this year, the pace of hedging slowed.

- Bloomberg Intelligence surveyed 31 shale companies, and by the end of the first quarter, they had only hedged about 15 percent of their 2018 production.

- In the Permian Basin (see chart), where the prospects are better, the companies had a little under 30 percent of their 2018 production hedged. That is down from nearly 70 percent of their output hedged for 2017.

- The upshot is that the shale industry will be increasingly exposed to low prices. There will be a tidal wave of hedging if prices rebound above $50 per barrel, but for now, they are going without much protection.

7. OPEC might need to cut deeper

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- In the past, OPEC has typically made multiple cuts during an individual market cycle, cutting in stages in order to fine-tune its policy.

- Goldman Sachs just concluded that OPEC will probably need to cut deeper if it wants to rebalance the market. Surging production from Nigeria and Libya are likely to cancel out the group’s effort based on the current level of cuts.

- The investment bank lowered its third quarter forecasted price for WTI from $55 per barrel down to just $47.50.

- “In the past if it didn’t work, OPEC would adjust lower,” Mike Wittner, head of oil market research at Societe Generale SA, told Bloomberg. “It’s a process. That’s what supply management means.”

- But this time is different. Unlike in the past when non-OPEC supply took a long time to respond, U.S. shale could prevent OPEC from acting. Deeper OPEC cuts would likely spark higher shale production in short order.

- OPEC faces a conundrum: cut deeper and risk ceding even more market share; stick with the current cuts and see the process through, however long it takes; or abandon market management.

That’s it for this week’s Numbers Report. Thanks for reading, and we’ll see you next week.

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