The Fuse

Oil Market Confusion Creates Potential for Another Dramatic Correction

by Matt Piotrowski | May 16, 2016

The oil markets are confused.

Things are getting bullish, but almost too bullish, creating the risk of another false price rally to mirror the events of last spring. The continued price rise, with NYMEX WTI hitting $47 and Brent just below $50 on Monday, has prompted widespread hedging among U.S. producers that could bring a wave of supply on line. Meanwhile, there’s the fact that OPEC is increasing its volumes even as some members deal with unexpected supply cuts. These two factors have the potential to cap prices, or possibly bring about another leg downward.

Things are getting bullish, but almost too bullish, creating the risk of another false price rally to mirror the events of last spring.

Fundamentals have no doubt tightened from a long list of supply outages and non-OPEC declines. But lost supply has also brought about the realization that there’s no reason to panic—stocks are more than plentiful to cushion against the outages, many of which will be temporary, and Iran’s quick return has had a meaningful impact in both the European and Asian markets.

Here’s a graphic of outages that shows what’s gone offline and helped propel Brent on ICE Futures to a six-month high:

goldmanoutages

Since mid-February, outages have occurred in 11 different countries, with Canada and Nigeria receiving most of the recent attention. Despite more than 1 mbd of Canadian oil sands going offline due to wildfires, the oil market failed to rally substantially last week. Nonetheless, market bulls have now latched onto headlines surrounding Nigeria’s Forcados force majeure and other supply woes in the country. Morever, the crisis in Venezuela, which pumps some 2.3 mbd, is deepening, putting its supply at risk. Libya’s output has fallen again this month to about .21 mbd, well below peak production capacity of 1.6 mbd, amid disputes between rival governments.

On one hand, given that the global oil market has very little spare capacity—about 1 mbd-1.5 mbd, mostly concentrated in Saudi Arabia—there’s some speculation that oil prices should be higher. From a different perspective, however, the market has rallied by more than $20, or 80 percent, since February lows despite stock builds—which counteract thin spare capacity—and an ongoing surplus, leaving room for a hefty correction.

Goldman Sachs report, not so bullish after all

Prices also received a lift on Monday from Goldman Sachs’ latest report, saying that fundamentals have tightened quicker than expected, signaling a stronger market than the banks’ analysts forecasted earlier this year. But the report isn’t as bullish as some of the headlines reported. First, Goldman is simply playing catch-up by updating its outlook for fundamental balances and prices forecasts. Before the most recent report, Goldman held a mostly bearish view, arguing prices would remain “trendless and volatile” in the $25-$45 range in Q2. With the recent string of outages, which have been going on for some time, the range simply moves a bit higher. Second, while Goldman sees a deficit during the second half of the year (which is common given that 2H is when demand peaks), global balances should swing back to a surplus for the first part of next year. Moreover, the bank analysts say oil won’t hit $60 until the fourth quarter of next year, not too different from what they saw before.

goldmanbalances

OPEC on the rise

Despite outages in OPEC countries, the group’s production actually rose last month, to the tune of .3 mbd as a result of higher output from Iran, Iraq and the UAE. The Saudis, meanwhile, are holding steady above 10 mbd. Iran, to regain market share, slashed its prices to customers in Asia, a bearish signal, which comes on the heels of the Saudis selling a spot cargo to a Chinese teapot refinery. The competition between the two matters for a couple of reasons: 1) It gives buyers in the region, the main center for demand growth, a lot of market power 2) It means that the rival producers will keep pumping at high levels instead of freezing or cutting output.

Nigeria, meanwhile, has seen its output fall to 1.5 mbd, down from 1.9 mbd in January, but outages there are nothing new and the country’s importance in the global oil markets has diminished greatly with the growth of U.S. shale. The country that used to be referred to a “swing supplier” when it shipped light, sweet crude to refiners in both the Atlantic Basin and the Asia-Pacific, Nigeria now sends very little to the U.S. and can only make minor penetration in the Asian market, getting mostly shut out of China. Outages in Nigeria don’t pack the same punch they did during the 2000s.

U.S. shale, hedging and speculators

The price surge has led to hedging among U.S. producers along the price curve and has also prompted a level at which drilled but uncompleted wells (DUCs) can come online. Producers and merchants have sharply increased their positions in the futures market, according to data from the Commodity Futures Trading Commission (CFTC), a sign they are indeed locking in prices along the curve. Their total holdings in NYMEX WTI are more than 700,000 contracts, the highest since October 2013, as Platts points out.

Regarding DUCs, although estimates vary, they can bring some .5-.6 mbd on line, with $40-$60 range being the sweet spot to motivate companies to complete wells. In other words, the price rebound could allow DUCs and hedges to stabilize output. U.S. total output has dropped by roughly .9 mbd in the past year or so, but crude stocks are up 11 percent year-on-year, indicating the U.S. market is doing just fine despite soaring gasoline demand and declining crude production. When compared to the five-year average, the numbers are even more eye-opening (see graphic below from Citi Futures).

citistocks

Then there are speculators, which include hedge funds and other non-commercial players. They appear to be getting cold feet about the rally. For instance, last week in NYMEX WTI, speculators slightly cut long positions but added almost 20,000 shorts, a signal many may believe the market has reached a peak for now. What’s more, speculators hold immense net length in NYMEX WTI of 217,000 contracts, or 217 million barrels of oil. A massive liquidation could soon occur.

What’s next?

Despite headline after headline signaling one supply problem after another, prices will meet fierce technical resistance, and they have yet break out of the mid-to-high $40s.

As the price reversal in 2014 indicated, the oil market can turn dramatically at the drop of a dime. Although the reversal has been on a smaller scale, we’ve seen a similar unexpected swing since mid-February, when prices bottomed out at $26. It’s ironic that prices rose some $17 ahead of the Doha meeting between OPEC and non-OPEC producers but fundamentals hardly moved. Now, though, despite headline after headline signaling one supply problem after another, prices will meet fierce technical resistance, and they have yet break out of the mid-to-high $40s. As noted in this space following the failed Doha talks, the oil markets were at a crossroads. They still are—in fact, there’s actually more uncertainty. Fundamentals have tightened, but a host of factors—commercial hedging, speculative net length, the fight for Asian market share, high inventories, the backlog of DUCs—all hang over the market. Another correction may in fact be in store.

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