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Nick Cunningham

Nick Cunningham

Nick Cunningham is a freelance writer on oil and gas, renewable energy, climate change, energy policy and geopolitics. He is based in Pittsburgh, PA.

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Why Oil Prices Could Dive

Rosneft oil tanks

WTI briefly touched $65 per barrel after the EIA reported a surprise drawdown in inventories — the highest price since late 2014. Although the rally hit some stumbling blocks in recent days, prices remain at multi-year highs. However, absent further bullish news, the downside risk looms large.

One of the most acute threats to prices is the exorbitant positioning by hedge funds and other money managers, who have staked out record net longs in the oil futures market. With everyone piling into one side of the bet, there’s little room left on the upside. This kind of lopsided positioning has consistently ended with a rush for the exits, setting off a sudden — and often sharp — price correction.

Mad Money’s Jim Cramer spoke about the problem on Tuesday on CNBC. “As of last week, large speculators were holding the single largest bullish position in the history of crude oil,” he said. “Being bullish is NOT a good sign … when everyone’s bullish, well, then, you don’t have anyone to convert to be able to start buying … You need to convert bears but there’s no bears.”

Cramer, citing data from Carley Garner, co-founder of DeCarley Trading, said the current makeup in the futures market points to a near-term price correction. "As Garner points out, when one of these massive speculative bets in oil unwinds, you do not want to get caught anywhere near the blast radius," Cramer said. Related: Oilfield Services Bounce Back On Oil Rally

Another force working against the current rally is the recent decline of the dollar, which has been weakening for the last several weeks. Since oil is denominated in U.S. dollars, a weaker dollar can put upward pressure on crude prices as crude becomes relatively less expensive to much of the world. But with the dollar already having fallen by quite a bit, there could be little room left to fall, which would mean this particular bullish force could be at an end. "If the greenback stops falling, well, that will remove a major prop underneath the oil rally,” Cramer said. "Put it all together and Garner thinks the chances of a continued oil rally are pretty darned slim,” he added.

Cramer’s theatrical delivery notwithstanding, these factors do pose a threat to the current oil price rally. “The downside might be limited but last week’s highs are unlikely to be penetrated unless there is a significant bullish change on the supply front,” Tamas Varga of PVM said in a report.

The numbers from the physical market have been highly supportive thus far in 2018. Inventories have declined dramatically, OPEC compliance has looked solid and production from Venezuela is declining at a dizzying rate. U.S. shale is set for “explosive” growth, according to the IEA, but investors have not abandoned their bullish bets just yet.

That could soon change if the market gets hit with some bearish metrics. The IEA has predicted that the global oil market would return to surplus in the first half of 2018, leading to a rebound in inventories. “It is only a matter of weeks until lower crude oil processing and rising domestic production lead to crude stock builds,” said Carsten Fritsch, oil analyst at Commerzbank AG, according to Reuters.

Related: Venezuela Claims To Be Able To Boost Oil Production By 1M Bpd

The danger is that the market is still riding high from the inventory drawdown over the past few months, and investors might not be pricing in the expected forthcoming increase in inventories. “The market is dangerously focused on newly published backwards-looking data and, in our view, is not paying attention to the stockbuilds that are likely to emerge later this year and in 2019,” Barclays wrote in a recent note. The investment bank argues that oil prices are probably at their high point for the year right now, and the bank predicts Brent will average just $60 per barrel in 2018.

That brings us back to the record level of bullish bets, which could set off a price dive when the inventory surplus returns. “We still have ... nine long barrels for every short barrel, so a reversal should be interesting to watch,” Sukrit Vijayakar of energy consultancy Trifecta, told Reuters.

By Nick Cunningham of Oilprice.com

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  • Kr55 on January 24 2018 said:
    If only people knew what big money was thinking. Now that we're in heavy backwardation, it's actually a very simple play to buy a contract far out and wait to sell it for more later as the backwardation lifts the price up. Completely different dynamic than when big long positions were build before in contango where you have to buy far more near term contracts to try to make a buck, hoping some catalyst would lift prices for you. Far more risky.

    And if there is a shortage of oil, longs will be able to offload a lot of their contracts to long hedgers and refiners desperate for deliveries.

    Lots of moving parts. It's easy to just say a certain position will inevitably lead to a certain outcome, but the most interesting part of such a heavily manipulated market like the oil market is the unexpected happens all the time.
  • Kr55 on January 25 2018 said:
    Another dynamic that can play out with the large long position is that there is also an equally massive short hedge possition. One that is for many producers at regretably low prices. If there is a shortage and demand keeps outpacing supply, producer may need to bite the bullet and close out those shorts early. The longs will be the guys holding the keys to their means to do that as the shorts have to find contracts to buy to cover.
  • petergrt on January 25 2018 said:
    The collapse of the USD is pushing the oil up.

    Watch for the perfect storm, when USD starts to recover and oil speculators sprint for the exit . . . . .!!!
  • Greg on January 25 2018 said:
    WTI has firmly breached the $65 resistance - the shale companies were supposedly able to gear up in a matter of days but the EIA drawdown figures gave the lie to that myth. Next stop $80 a barrel for Brent.
  • Brandon on January 25 2018 said:
    Thanks for the in-depth analysis by the way I just got rid of my old diesel and bought a gasoline car. Fuel consumption is definitely worse but better for the environment. And like me million others.
  • Ness on January 28 2018 said:
    If you measure the long in total dollars it’s actually lower than 2014 when oil was $100 barrel
    If you have an inverse as the funds you could remain long and keep rolling and making dollars
    Oil is also a great hedge against inflation hence they may remain long for this reason
    Some nasty margin calls for producers as well right now. Do they continue to hedge and risk this. They are all still severally cash tight and shale was financed on printing shares. Hard to do when some of these small players are near all time low stock value even with $65 oil

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