Three Wild Cards That Could Hurt The Oil Rally

The 2018 oil rally is happening at breakneck speed.

As I write this, West Texas Intermediate (WTI) is above $66 a barrel while Brent crude is breaching $71 a barrel for the first time since December 2014.

That means, as of yesterday's close, WTI has risen 12.2 percent for the month; Brent 8.1 percent.

Now, I've written about the narrowing of the global crude oil balance for some time.

But it's looking more and more like that balance is arriving quicker than anticipated.

And this is what it'll mean for oil prices…

The Single-Most Important Factor For Oil Prices

The amount of surplus volume in the market will stabilize. That's a fact.

But unlike what some pundits may say, the point isn't to eliminate the surplus.

Excess available supply provides a necessary buffer that restrains on large swings in pricing.

It's when traders have concluded the supply is increasing due to overproduction that the downward pressure on prices unfolds.

If that overproduction is further fueled by operators' desperate attempts to keep the doors open, the pricing pressure becomes even more acute.

The last month has indicated that we are now out of that period.

Wellhead prices - the first arms-length transaction, the oil exchange at which the producer makes its money - are now in the range of the low $50s.

At this point, most U.S. producers can run a profit and feeding excess volume in to the market to avoid the sheriff becomes less of a concern.

Any oil trader will tell you that predictability is the most important single factor in stabilizing transactions.

Of course, there will still be fluctuations in either direction.

But the range will be less.

The OPEC-Russian agreement on restraining production is holding, with some cartel members even extending the cuts beyond the levels agreed upon.

Continuing production problems in member nations Venezuela, Libya, and Nigeria have improved the decline perspective.

There are just three wild cards that we have to factor in…

Wild Card #1 - U.S. Production

The impact of U.S. production has always been a wild card when it comes to the price of oil.

American volume has never been a part of the OPEC accord.

With U.S. exports increasing to the global market, how much is produced in the States has a much more direct influence on prices.

For years now, crude oil prices have been determined globally, especially in developing regions, not in North America or Western Europe.

Until Congress allowed the exports after a four-decade prohibition, the U.S. influenced the marker primarily in the level of daily imports it required.

Now, U.S. producers can export to outside markets having higher than average prices, improving profit margins and relieving somewhat the domestic pricing pressure from having the produced supply remaining in the local market and depressing WTI levels.

Therefore, in the current climate, traders have concluded that the level of U.S. production does not have the same impact it had six months ago. Related: OPEC Drives Oil Prices Back Up

At home, companies can balance production since the sell revenues are higher.

Abroad, the problems in several main producing countries combined with the OPEC cuts provide greater flexibility to absorb American exports.

But that's not the only thing improving the floor for prices…

Wild Card #2 - The Dollar

The next wild card we have to factor in is that the exchange value of the U.S. dollar is, currently at least, buttressing the price of crude.

The vast majority of daily oil sales worldwide are denominated in dollars.

When the value of the dollar rises vis-à-vis other major currencies like the euro, the pound sterling, and the yuan, it costs more in local currencies and the oil price declines.

However, the converse tends to the case when the dollar weakens.

That is the case now.

The softness in the greenback has been providing support for rising oil prices.

This relationship seems less direct than had been the case in the recent past.

But it is still a factor.

Good if your selling oil abroad.

Not so good if you are importing French wine.

Wild Card #3 - Short Contracts

The last wild card is short contracts.

Oil's price rise has also been supported by the unraveling of short contracts - something I have addressed on several occasions in the past.

Shorts are run when a trader believes prices are going to decline.

Some shorts are even drawn in the hope of being self-fulfilling contracts. Related: Bank Of America: EVs To Lead To Peak Oil Demand In 2030

After all, if I appear on TV saying the sky is falling and others believe it, oil prices decline, and I laugh all the way to the bank.

Of course, running shorts when the price is rising is a certain formula for losing a lot of money.

That's because the shorts must be covered when due. That means the short holder must move back into the market and buy the contracts "covered" by the short.

If the underlying price at redemption is higher than the price paid when the short was introduced, it costs the short artist more than the short's initial face value. Taking options on the short changes some of the dynamics but not the overall result.

In the squeeze resulting, shorts will be liquidated early, resulting in a spike in the underlying crude oil prices.

Both the dollar exchange rate and the volume of short positions may change.

At the moment, both are contributing to a rise in oil prices - and will continue to drive prices even higher.

Fact is, oil's meteoric climb over the past few weeks has been incredible.

Enough so that I will be revising my 2018 oil price prediction over the next couple of days.

You see, we not only blew through my original prediction, I said WTI would be trading between $59 and $61 a barrel; Brent between $63 and $65…

We also exceeded my second quarter predictions that Brent would be trading between $67 and $69 a barrel.

All of which proves one important thing - the crude oil balance is here.

By Dr. Kent Moors

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