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Oil Producer Report

Crude Oil Trading Report: Saudi springs into action

By February 23, 2018No Comments

The length built by the investor community means oil markets are much more susceptible to macro variables, while the repricing of volatility and backwardation challenge producer hedging programs.

Saudi and Russia set to defend $60/bbl (as we have seen this week defending price with Brent at $62/bbl). Backwardation, put skew and IMO spec changes, lends consumers an unprecedented opportunity to lock in attractive prices. Consumer flow likely to increase.

POSITIONING, VOLATILITY AND SKEW

Fears that the Fed may over react to the perceived risk of inflation, due to the sharp move higher on real interest rates, and market challenges to the new Fed Chairman, Jerome Powell, to determine IF and WHERE the “Fed put” exists, are having profound and lasting impacts on the oil markets.

Oil prices have now become more correlated to macro changes in FED policy, USD, US Treasury yields, real interest rates and equity market performance rather than fundamentals. The sheer size and volume of the net speculative length position has made oil markets much more susceptible to these macro variables and the liquidation of 215mbbls of net speculative length (across the oil complex) over the past 3-weeks is a painful reminder.

However, investor length remains sticky and while there were sizable liquidations, net short positioning actually decreased in WTI and Brent (i.e. the sell-off did not trigger an increase in short selling). The long/short ratio in WTI and Brent of 12:1 remains near record highs and highlights increased market sensitivity to these macro driven liquidation moves.

The stickiness of the net speculative length boils down to the composition. We estimate that 350mbbls (21bln) of managed money length is from CTAs and risk parity hedge funds, 250mbbls (15bln) from discretionary funds and 600mbbls (36bln) of passive index money (the sticky money).

CTAs and risk-parity funds break down into 1/3 risk-parity related strategies and 2/3 momentum/technical factors. Rising volatility levels left risk-parity players with little choice other than to cut positions. Whereas equity volatility has fallen from a brief spike, oil volatility has remained much better supported and has pushed these funds to the side lines.

CTAs and momentum funds liquidated large positions as price broke below the 100 DMA (day-moving average). However, the failure of the technical flush out to convincingly break through the 100 DMA (and the subsequent rally above) failed to trigger levels that would have signalled further liquidation and the transition to a structural short position. With Brent currently trading in the middle of the 50-100 DMA, it will take a convincing move either way to attract new CTA/momentum money.

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Implied Brent Yield versus 12-month US Treasury Yields

Implied Brent Yield versus 12-month US Treasury Yields

Passive index funds have been the sticky money given Brent’s relatively attractive implied roll yield at ~5.0%. However, if US 10-year rates continue to increase, index funds may be attracted to a lower risk yield in the form of US treasuries rather than the current oil markets.

The repricing of volatility has been another consequence of the Fed potentially hiking rates more aggressively than expectations. For the past 10-years (since the beginning of Central Bank liquidity infused markets) selling volatility (options) was an attractive and profitable way to enhance returns and income. That strategy is now under pressure across “risk assets”.

In Brent, backend vols remain well supported, due to opportunistic producer hedging and initial signs that consumers are testing the waters. Further, the absence of systematic vol selling has left volatility to naturally drift higher. December 2019 put skew (25-delta puts versus 25-delta calls) is trading in line with 2-year averages, therefore only modest producer flows have gone through the market recently as backwardation and high vol levels create challenging optics and unattractive entry levels to initiate producer hedging programs.

OPEC (SAUDIS) SPRINGS INTO ACTION

While significant uncertainty exists surrounding the FED put on equity markets, the same cannot be said for the oil markets “Fed”, OPEC. In this regard, the market was reminded of a $60/bbl floor with a re-iteration from Saudi Arabia and Russia that production cuts would be extended throughout 2018 once Brent broke the 100 DMA (day-moving-average) – noted that the Saudis appear well in tuned with market technicals – and traded towards $62/bbl.

Further, Saudi Arabia highlighted that it would lean more on the side of caution when balancing the market by overshooting (drawing down inventories beyond) its inventory goal of reaching 5-year averages.

OPEC’s message could not be clearer, they are aggressively managing price when Brent trades $62/bbl – remarkable !

KEY OPEC ANNOUNCEMENTS & VOLATILITY | ICE BRENT

KEY OPEC ANNOUNCEMENTS & VOLATILITY | ICE BRENT

SAUDI ARAMCO IPO “KNOWN UNKNOWNS”

Saudi Aramco’s IPO likely plays a key driver of Saudi’s oil policy agenda. However, the risk lies in the unintended consequences of such an agenda, namely US shale and importantly, US shale exports. A lookback to 2011, OPEC’s extended production cut, beyond what was required by the market, led to the birth of the shale oil boom. Granted, in 2011, OPEC was an un-united front (direct opposite of today) with Saudi Arabia unable to reach a consensus with other OPEC members (Venezuela, Iran, Algeria and Libya) to lift production to prevent oil prices from rising. Saudi Arabia, currently, is firmly in the driver’s seat, which is reassuring for the $60/bbl put.

However, with unclear motives, (i.e. Aramco IPO) the strategy is exposed to “known unknowns”. In this case we refer to a ramp higher in US exports. What if this time around the extended OPEC cuts leads to the US shale export boom? Is it coincidence or foreboding that US shale production averaged roughly 1.5mb/d in 2011 post the OPEC extension, not too different than current US oil export volumes? Unfortunately only time will tell.

CONSUMER HEDGING ACTIVITY INCREASE

We see an inflection point in consumer hedging volumes including airlines, shipping companies and industrials. Saudi and Russia set to defend $60/bbl, backwardation, put skew and IMO specification changes to high sulphur fuel oil, lends consumers an unprecedented opportunity to lock in attractive hedges.

Rising geopolitical risk, albeit harder to quantify, raises the attractiveness of layering in hedges.

PLEASE CONTACT THE DESK FOR FURTHER DETAILS.

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