The Fuse

When Will Oil Prices Break Out of This Narrow Range?

by Matt Piotrowski | August 16, 2017

  • Oil prices congested in $47-$50 range
  • Hedge funds are net long by 900,000 contracts in ICE and NYMEX petroleum contracts
  • U.S. oil production set to rise by 550,000 b/d in 2H
  • U.S. crude inventories down 5 percent y-o-y
  • Brent shifts to backwardation, signaling some success for OPEC

Oil has been trading in a tight range this month. A very tight one, in fact. NYMEX WTI has held within a mostly $3 area so far in August, chopping between $47 and $50 per barrel. For the last 12 months, the market has for the most part traded “sideways,” ranging from the low-$40s to the mid-$50s.

OPEC cuts and strong demand growth have put a floor under prices while continued high inventories and renewed growth in shale output have capped prices.

The stability is relatively rare for the oil market, which is prone to rampant volatility for numerous reasons. The market has been so stable that hedge funds have become “bored” with the current environment—OPEC cuts and strong demand growth have put a floor under prices while continued high inventories and renewed growth in shale output have capped prices.

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So, what can break oil prices out of this current narrow range?

Once the peak summer demand period is over, the oil market will be very vulnerable to downside risks. The oil futures market officially entered a “bear” market at the beginning of July, and it could easily reemerge once summer ends. The September selloff may be brutal, particularly with hedge funds building up an enormous amount of net length. They will have to liquidate at some point and many could do so all at once. The latest data put global petroleum net length—when combining ICE and NYMEX—at almost 900,000 contracts (or 900 million bbl) after rising for seven straight weeks.

A September selloff may be brutal, particularly with hedge funds building up an enormous amount of net length.

Right now, besides OPEC’s cuts, the global oil market is in part being propped up by strong gasoline demand in the U.S., direct burn for power generation in Saudi Arabia, and China’s continuing thirst to stockpile crude. Crucially, the global oil market will lose two major pillars of support once summer is over, and China could strategically hold back on buying for a while to allow prices to fall before it starts stockbuilding again.

There’s also the expected upswing in shale production for the second half of the year. Total U.S. production is forecast to rise, according to the EIA, by 550,000 barrels per day from Q2 to Q4. If that outlook is realized, it will likely reverse recent declines in crude stockpiles. Even though the latest round of corporate earnings indicated that shale companies aren’t performing as well as expected, it might take some time before production takes a hit—a backlog of drilled but uncompleted wells and output already locked in through hedges have the potential to put downward pressure on prices. The Department of Energy’s plans to sell 14 million bbl from the Strategic Petroleum Reserve (SPR) during late August into the domestic market adds one more bearish element.

Are there upside risks?

Alternatively, prices could break out to the upside, as the bearish case has a number of holes in it. Some commentators argue that the market is indeed setting itself up for a rally, not least because U.S. inventories are declining and OPEC has successfully flipped the Brent futures structure into backwardation—when prompt prices are higher than contracts further along the curve.

Some commentators argue that the market is indeed setting itself up for a rally, not least because U.S. inventories are declining and OPEC has successfully flipped the Brent futures structure into backwardation.

Stock declines in the U.S. since March do indicate a semblance of rebalancing is occurring. Last year, strong demand growth and falling U.S. shale production tightened the global market, but this year declining U.S. inventories and OPEC supply cuts are underpinning prices. During the inventory decline over the past five months, U.S. crude stocks have fallen greater than the five-year average, “underscoring the extent to which the market has tightened on a simple seasonally adjusted basis,” said Tim Evans of Citi Futures. Granted, stocks remain high by historical standards, but the pace of the decline indicates rebalancing is occurring and they are now five percent lower than this time in 2016.

The move to backwardation, meanwhile, is a huge development, should it hold. A backwardated forward curve nixes the incentive to store crude, which would lead to sustained inventory draws throughout the second part of the year. Such a scenario would indicate OPEC’s strategy has finally worked, to a certain degree, and the cartel could reach its goal of further bringing down stubbornly high OECD inventories. At the same time, OPEC could shock the market with a deeper cut than its current agreement. It may be a low probability scenario at this point, but the Saudis have kept the door open to throttling back even more.

Still, anytime the bullish case for oil is made, it’s undermined by the argument that a higher price level will simply motivate shale drillers to increase their production and hedge forward. Furthermore, the recent shift to backwardation is likely a seasonal blip. If the curve returns to contango, the amount of crude in storage could simply rise yet again. “US crude runs usually start to trend lower at the beginning of September and this should, in combination with still growing crude output, open the way for higher exports,” said analysts at JBC Energy in a note. “Such a trend should put renewed pressure on crude markets in the rest of the Atlantic Basin. All in all, we would simply deem it too early for backwardation to be sustainable beyond the high crude demand season.”

Volatility to return

It wouldn’t be too out of the ordinary for prices to trade sideways for some time until it reaches a tipping point. When the market eventually breaks out, it could do so aggressively.

Last year around this time, after the market dipped below $40 in early August, OPEC ministers made it clear that they were determined to finally cut output to shore up prices after dealing with weak prices for more than two years. Prices rallied on expectations that OPEC, along with other producers such as Russia, would take barrels off the market to tighten fundamentals. The cartel’s meeting in Algiers in late September, followed by the ministerial meeting in November, further supported prices around the $50 level. Brent reached as high as $58 earlier this year and appeared poised for higher levels, but fundamentals have shown mixed signals since. Even though the oil market is volatile in nature, it has seen extended periods of stability, meaning it wouldn’t be too out of the ordinary for prices to trade sideways for some time until it reaches a tipping point. When the market eventually breaks out, it could do so aggressively.

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