The Fuse

Bullish Sentiment Collides With Record Inventories in Oil Futures Market

by Nick Cunningham | February 23, 2017

Oil market bulls breathed a collective sigh of relief after the EIA reported a drawdown in U.S. gasoline inventories on February 23. Crude prices traded up more than one percent on the news with positive sentiment from the gasoline drawdown outweighing a slight uptick in crude oil inventories.

The positioning among traders makes oil prices vulnerable to a sudden and sharp fall in prices if sentiment shifts.

The data offers a small piece of solace to investors betting on higher prices as they have amassed an unprecedented bullish position in crude oil futures. Even as oil prices have been stagnant in 2017, trading within a narrow range in the low- to mid-$50s per barrel, hedge funds and other money managers are nearly unanimous in their expectation of rising prices.

The positioning among traders makes oil prices vulnerable to a sudden and sharp fall in prices if sentiment shifts. In that context, even though the latest EIA report shows some marginal tightening, the extraordinary buildup in inventories so far in 2017 reflects a market that is still well oversupplied.

Record inventories for crude and gasoline

Since the collapse of oil prices in mid-2014, inventory levels have become one of the most closely watched metrics by oil traders trying to discern trends in supply, demand, and ultimately crude prices. The sharpest increases in inventory levels—particularly in the first quarter of 2016—have coincided with steep price declines.

More recently, however, oil prices have managed to defy gravity even though crude oil and gasoline stocks have surged. Crude oil inventories have increased every single week so far this year, rising nearly 40 million barrels to an all-time high of 518.7 million barrels as of February 17. Storage levels are now above last year’s peak of 512 million barrels when oil prices traded in the low-$40s.

crudestocks

Gasoline inventories also briefly touched a record high in February, rising to 259 million barrels. The glut of gasoline raises red flags about the state of demand in the U.S., with January gasoline consumption data showing a year-on-year decline of about 5 percent. Some oil analysts dismiss the figures, cautioning investors not to panic over what would be a staggering decline in demand. “We find little evidence for concerns on demand,” Goldman Sachs wrote in a research note. The investment bank says that EIA’s data collection is imprecise and often revised heavily at a later date. “Going forward, we expect that current low forward margins, seasonally higher turnarounds and sustained strong demand growth will lead to inventories normalizing.”

The drawdown in gasoline inventories of 2.6 million barrels for the week ending February 17 was taken as evidence by the oil markets that demand is not as bad as some originally thought. As a result, oil prices moved higher on the news.

Inventory drawdowns—for gasoline, not crude

Although the drawdown in gasoline stocks and reassurances from analysts such as Goldman Sachs helped keep prices at lofty levels, the market still has to contend with record-high crude oil stocks and gasoline inventories only one week removed from their all-time highs.

Refinery maintenance and weaker downstream margins could depress demand for crude.

Moreover, refinery maintenance and weaker downstream margins could depress demand for crude. Even though gasoline stocks may fall in the coming weeks, they will do so likely as a result of refiners scaling back production amid some of the worst refining margins in at least a year. At least three large refineries have cut back on production, according to Reuters. Marathon Petroleum lowered gasoline production by 11 percent over the past month, and PBF Energy also cut production at two of its refineries in Ohio and Louisiana.

Poor economics stemming from too much supply are forcing cutbacks. This development will likely pull down gasoline stocks faster than expected, but it will also slash the amount of crude refiners will purchase, putting more upward pressure on oil storage.

One-sided bets

The protracted adjustment process in the oil markets, which has forced traders and analysts to continue to wait for a rebalancing, has halted the price rally for now. But investors are almost uniformly in agreement regarding what should come next. Hedge funds and other money managers have built up the most bullish position on crude oil futures on record, a staggering one-sided bet that is unprecedented since recordkeeping began.

The extraordinary buildup in net-long positions over the past few months coincided with a period of time in which oil prices traded within a narrow band of roughly $4 per barrel.

The extraordinary buildup in net-long positions over the past few months coincided with a period of time in which oil prices traded within a narrow band of roughly $4 per barrel. Investors piled on evermore bullish bets, but crude prices remained stuck in the mid-$50s. The FT reported that a bizarre trading pattern has emerged this year, with unidentified traders taking large long positions on oil futures immediately after bearish reports from the EIA. The purchasers are a mystery, but some traders postulate that the buying could be coming from hedge funds protecting their bullish bets or OPEC trying to keep prices from falling. Regardless of the source, bullish positions have reached exceptional heights at a time when the data from the physical market reflects weak fundamentals.

The one-sided nature of the speculative positions in the futures market exposes the oil market to a sudden, and possibly severe, sell-off if sentiment turns negative. If investors scramble for the exits, selling off their long positions, oil prices could experience a painful correction. JP Morgan analyst David Martin told The Wall Street Journal that oil prices could shed $5-$10 per barrel in the coming weeks if crude oil and gasoline inventories continue to rise.

Ultimately, oil prices cannot defy gravity forever. OPEC has succeeded in sparking bullish sentiment in the oil market, but the fundamentals will need to tighten markedly if oil prices are to move higher. For its part, Goldman Sachs says that commodity prices are in a “holding pattern,” awaiting more concrete data that the supply overhang is disappearing. “Markets need to see that the OPEC supply cuts generate real inventory draws…In other words, ‘show me the activity’; real demand, real stock draws and empty warehouses.”

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