Record investor length is a cause for concern for oil market bulls but without the characteristic 3-5% pullback as a “gentle reminder”, complacency is building while passive investor flow remains cemented by backwardation, positive global economic indicators and an OPEC put.
China teapots are set to have a major influence on global oil markets in 2018 with the balance between growing refining capacity and limits on refined product exports as the key concerns for oil imports.
THE OIL CONUNDRUM
Despite the market concern on the size of the net speculative length currently invested in oil, the market is trading as if positioning is net short. What we mean, is quite simply, oil doesn’t go down. We are in one of longest periods we can remember where oil prices have rallied basically in a straight line, without the typical 3-5% pullback that often provides a reminder that net length is building and lurking as a problem.
A common characteristic of markets trading with extreme net length is a number of wash out moves lower (price declines >3%) where weak length is flushed out as the participants become increasingly concerned with being last to the party.
During 1H 2017, we saw 10 oil price pullbacks >3% as ultimately the market was met with a speculative net length wash-out. In fact, 1H 2017 illustrated all the typical signs of a market trading net long – multiple moves lower of greater than 3% in combination with a broader industry consensus that the oil market had reached an inflection point despite inventory builds that argued otherwise.
The current consensus outlook is bullish – but with far more uncertainty and cautiousness relative to this time last year. The oil market rebalancing is well underway with global commercial oil inventory draws >100mbbls in Q4 2017 (Exhibit 1).

Change in Global Commercial Crude Oil Inventories | Source: Energy Intelligence
This represents the largest quarterly inventory draw since 3Q 2009 (not surprisingly a meaningful inflection point for oil markets emerging from the Great Recession). More importantly, US crude oil inventories have drawn for 10 consecutive weeks.
Ultimately, it was inventory builds, particularly in the US, that led to the net speculative wash out in 1H 2017. While global inventories are expected to build modestly (200-300 kb/d) in the 1H 2018, a strong macro environment, weak USD and positive roll yield (backwardation) are expected to provide an offset.
Refining margins and the seasonal refinery maintenance period represent a near term challenge to oil. WTI has been a clear leader of the oil price rally thus far in 2018, as illustrated by the narrowing WTI/Brent spread.
US inventory draws are expected to continue to see draws through mid-February on increased pipeline capacity out of Cushing and concerns of additional US shale production freeze offs (i.e. lower production) with a return of the polar vortex.
US shale companies are expected to report Q4 2017 and year-end results in the coming weeks. Near term, production forecasts have been revised lower. However, free cash flow generation, capex, production growth and the impacts of US tax reform on drilling activity are sure to effect trader sentiment.
Another explanation to this relentless move higher in oil prices is that producer selling has subsided. For the past 2-years, investor buying (CTAs, hedge funds, asset manager) has been met with an unlimited supply of producer hedging.
However, with Brent above $70/bbl (WTI >65/bbl) and every crude market in backwardation, producers are taking a pause to consider hedging strategies.
On the other hand, speculative buying has become insatiable, driven by the attractive roll yield, rising geopolitical risks and a positive technical backdrop. The lack of producer selling has limited an already tight supply of paper barrels.

Caterpillar’s global dealer machine sales | Bellwether for global economic growth
CONSUMER HEDGING
How long will it be before consumers join the party? Optically, consumer hedging hasn’t looked this good for some time with steep backwardation and relatively inexpensive volatility.
Quarterly reports from the major US airlines highlighted strong passenger growth (another good sign that the economy is growing strongly) but pointed to concerns on capacity growth and higher fuel prices, which are threatening to drag down operating margins and share prices for the major airlines. Over the last few years, US airlines have stayed away from fuel hedging, and have benefited as a result.
However, the commodity cycle appears to have hit an inflection point with confirmation from Caterpillar’s recent quarterly results. The bellwether for global economic growth reported healthy YoY sales growth in 2017 of 35% and strong sales momentum in 2018 with growing backlog and positive economic indicators across a breadth of markets.
The improvement in the economic and commodity outlook could drive an inflection point in flows where consumer and producer flows become more balanced. As we’ve seen in the start of 2018, the removal of that constant offer from producers has almost been a self-fulfilling prophecy of higher prices. The addition of consumer buying may only add to upward pressure.
Call option volatility at the very front of the market is currently trading at a premium to puts compared to a 4-6 vol discount to the puts for the past 2-years. The put skew has narrowed in the back of the market. We highlight this trend to illustrate the extent of the slowdown in producer flow more recently.
Again, if we look back to 1H 2017, producer selling continued unabatedly as prices moved higher. If the hedging slowdown becomes more structural and is replaced by a return of consumer hedging – needless to say this could be a very powerful shot in the arm to oil bulls and prices.

KEY OPEC/NOPEC ANNOUNCEMENTS & VOLATILITY | ICE BRENT
CHINA TEAPOT REFINERS
A trend CTC is monitoring closely is Chinese crude oil imports and teapot refineries. At the beginning of 2018, China’s Ministry China’s Ministry of Commerce approved a plan to allow teapot refiners to import 90.45 mt (1.8 mb/d) of crude in 2018, up 500 kb/d from 2017, while overall import quotas for both teapots and state-controlled refiners were raised to 2.43 mb/d, up 600 kb/d from 2017.
The ministry could opt to approve a second 400 kb/d batch of additional imports to China’s independent refiners later this year. If the quota amounts are raised and refiners maximize their imports, China’s countrywide crude imports could rise by 1 mb/d in 2018, exceeding the ~900 kb/d growth seen in 2018.
The concern is the oversupply of refining capacity and restrictions on refined product export sales. Another 200-300 kb/d of new refining capacity is expected to come on line by the end-2018, and the risk is that refining margins and refining throughput (crude oil imports) fall.
It is uncertain whether the state will extend refined product export quotas to teapot refiners or that the government will instead use the high-pressure situation to weed out the weakest teapots and force consolidation in an industry.
The significant widening in Brent-Dubai and ESPO-Dubai (Russia is a key supplier of crude to China’s teapot refineries) suggests that teapot refining margins are set to come under significant pressure in the near term.
Whether the choice is consolidation or additional product export licenses, the impact is sure to be felt across the oil market.
CTC 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.
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