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Oil Producer Report

Crude Oil Trading Report: “Liquidity infused” markets

By January 10, 2018No Comments

At this juncture, oil markets must be traded in the broader global, macro context of “risk assets”, especially equities as oil has seen a surge of investor flows pile into the sector attracted by backwardation and momentum buy signals.

By definition, it is hard to call a top on liquidity driven markets, however, there are a multitude of signals (which are historically reliable), which point to a market that is near topping out.

Crude and product fundamentals remain solid but are set to take a backseat as we start 2018, while macro, geopolitics and fund flows move to the forefront. In this report, we look at the key signals to monitor for oil price direction.

OIL IN CONTEXT OF EQUITIES AND RISK ASSETS

June/July 2017 was the moment to focus on deep fundamentals and to understand the negative “pendulum swing” in sentiment. September 2017 was critical to analyse hedging flows and positioning changes. Now is the time to focus on investor flows and oil’s place within the overall macro context as it remains the dominant driver.

The high correlation between oil, equities and other “risk assets”, the vol compression in derivatives across the board, the influx of large portfolio rotations into commodities indices (from pension funds, insurance groups, sovereign funds etc), the substantial moves in copper, silver and gold in the last trading sessions of 2017 and dare we say Bitcoin; all appear to be linked by global investment flows chasing “alpha”. An extreme global bullish mood is at work, which could unwind in a similar way if triggered by a macro event.

POSITIONING COMPOSITION

Breaking down the composition of the all-time record breaking investor length invested in the oil complex helps provide direction.

Our analysis points to 600–700mbbls from index investors, attracted by the constructive narrative in energy, highlighted by the backwardation, or “positive roll yield” across the five major energy future contracts. No doubt this is bullish and creates a painful market for shorts (if/when they need to buy back and cover). Index money tends to be long, passive and sticky money that rebalance on a quarterly basis. Typically, index investors are less reactive to near term volatility compared to CTAs, hedge funds.

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On the other part of the long positioning, and separate to indices, CTAs/ momentum funds have had their short/medium/long-term signals flashing buy for a while now (as we alerted our clients several months ago, based on our model replication). For the moment, momentum is cooperating. However, a sentiment shift must be monitored as it would be colossal for the paper market. A trigger from max long to max short makes the U-turn equal to establishing a 700 – 800 mbbls position. For perspective, this is equivalent to the entire US shale annual hedging program or more (however the impact would be greater with a potential CTA sell-off over a few days/weeks rather than throughout the year as with US shale hedging).

LOOKING AT EQUITIES

We are not equity traders here at CTC, nonetheless, markets are markets and at least from a pattern and sentiment view, equities look overcooked (especially in the US).

A multitude of factors, such as the recent squeeze in oil service companies, point to a last sector move of the laggard. Flows into the weaker oil names in search of outperformance (or catch up to averages) and the volatility compression points offer important clues of extended positioning.

Sentiment looks extreme as well with institutional money holding a record low level of cash to equities, multi-decade number of bullish US advisors, put/call ratios on the options front heavily skewed to the calls, bullish mutual funds at records and what looks to be like margining and retail investors “all in”.

WHAT DOES IT MEAN FOR OIL?

Near-term, technicals and momentum signals will continue to dominate oil price direction, as long as equities continue to move higher.

The 100% retracement, back to the 2015 highs of $69.60/bbl, represents the first point of resistance for Brent. Failure to close above $69.60/bbl could bring out profit taking, with near term moving averages offering support in the $64-67/bbl range. A close above $69.60/bbl opens up for momentum funds the 50% Fibonacci retracement line from the 2014 highs at ~ $71.50/bbl.

NEAR TERM TRIGGER POINTS FOR OIL

MACRO | The withdrawal of central bank liquidity in 2018 represents a tipping point for liquidity infused markets. The change is unprecedented and could have important implications for yield curves, asset prices, emerging markets and oil demand growth. Keep one eye on the 10-year US yield curve currently breaking out from its long term range at 2.58%.

We should also remember that commodity price outperformance typically comes late in the economic cycle. We would quickly move into uncharted territory should a commodity price rally lead to a sharp increase in inflation; forcing central banks to increase interest rates and withdraw liquidity from the system faster than anticipated. That would have a meaningful impact on the global economy as well as longer term oil prices. Ironically, it could be rising oil prices that disrupts global macro and equities.

VOL COMPRESSION IN OIL | ICE BRENT

VOL COMPRESSION IN OIL | ICE BRENT

US SHALE | The build out of US export infrastructure is key as the backlog of DUCs, and increase in hedging activity is indicative of an acceleration in US shale growth.

The EIA recently raised its forecast for growth in US crude oil production to ~1 mb/d in 2018, the fifth consecutive upward revision. Enterprise Product Partners forecasts that US exports could grow to ~4mb/d by 2022. We are monitoring for announcements on export infrastructure and an acceleration in the Baker Hughes rig count which would feed into weekly DOE production numbers, which would be a problem for sentiment.

REFINED PRODUCT SPEC CHANGES

Tighter environmental spec changes will continue to push for lower sulphur requirements in refined products ranging from fuel oil to gasoline. An immediate effect on oil prices would be a widening premium for low sulphur versus high sulphur crudes. Furthermore, global crude flows could change dependent on spare hydrotreating capacity. We are monitoring Hi/Lo sulphur premiums and refining margins for indications into 2018.

CHINA ANTI-POLLUTION MEASURES, CHINA CRUDE CONTRACT | China’s anti-pollution measures could have a significant impact on overall crude oil demand as industrial demand ebbs and flows to control pollution. The implications of the launch of a China crude contract remain uncertain.

However, whether China is setting up an independent financial clearing system or a new crude oil contract, it is clear that there is demand for a financial system that can operate independently outside of the US and Europe. We are watching that space.

GEOPOLITICS | Explosive potential in the Middle East (Iran and Saudi Arabia) but concerns on Iran and Venezuela dominate near-term. Spare production capacity within OPEC has gone from 4 mb/d in 2010 to a projected 1mb/d in 2019. Over the same time period, oil demand has increased by ~8mb/d to more than 100mb/d in 2019. Despite shale growth, this represents too little spare capacity given the potential supply risks and strong demand. Geopolitical tensions within OPEC have been well documented and the risk premium in oil has increased as a result.

In addition, US politics may prove more disruptive in 2018 as US and China trade tensions are likely come to a head as President Trump is expected to announce in the State of the Union address an aggressive trade crackdown on China. This could have negative implications for global economic growth/trade and we are closely watching these developments.

“The solution to low oil prices – low prices, the solution to high oil prices – high prices” | Just as low oil prices stimulate demand and crimp supply, the reverse is just as true for high oil prices, where demand is likely to disappoint and supply to surprise to the upside.

Take for example global refining margins and throughput. Global refinery throughputs increased by 700kb/d in the Jan-Nov 2017 period, led by China, and primarily underpinned by strong refining margins. As we’ve seen recently, the steady increase in oil prices has weighed heavily on refining margins. If oil prices keep increasing, economic run cuts are at risk to be the first fundamental sign that we have reached a top.

We continues to assess upside and downside risks from current levels and recommend to our producer clients to layer in hedges. For existing portfolios, we see either a break through current resistance levels, or the failure as an opportunity to maximize value though enhanced hedging structures. Contact us for risk-management insights and trading view.

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Commodities Trading Corporation is a London-based private advisory company specialized in commodity risk-management, hedging & trading. We service a growing need in the natural resources sector for unbiased and strong expertise and provide our services to an array of corporate clients and financial institutions. We are experts in derivatives and monetizing volatility and develop corporate strategies for hedging energy portfolios, using bespoke derivatives solutions for price risk mitigation.

For more information on CTC, insights on risk-management strategies & trading views, contact us at contact@comtradingcorp.com.

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