Record short positioning, firm call skew, and higher oil prices on the back of unconvincing inventory data raises the question as to where the next incremental seller will emerge. The risk and “pain trade” is now to the upside with a real potential of short covering rally.
Producers should remain opportunistic on call skew and contango in both flat price and volatility term structure.
PRICE ACTION & POSITIONING: Five key factors suggest that oil prices are oversold:
(1) Short positioning: the ratio of money manager longs to short positions have reached new lows – Chart 1 – as investors have liquidated long positions, and momentum players have added to record short positions.
(2) Negative sentiment: Investor sentiment has done a complete 360-degree turn from only a few short months ago as questions arise on OPEC’s ability to manage the current supply crisis. To illustrate the extent of this negative sentiment – Chart 2 – highlights that the number of bear market stories on oil reported in the press has reached levels very close to Jan-Feb 2016.
(3) Oil prices are not dropping on negative inventory data. Case and point is the most recent DOE inventory data from the US. The inventory survey was disappointing and showed a small crude build and an overall small product draw (although gasoline was good).
Counterintuitively, oil prices have move upwards, up over $1 bbl since the data release. This is testament to a short market, with positioning extreme as we have noted last week.
The shorts are wobbly and there is the beginning of some sense of stress to cover. The market is drifting towards dangerous territory for them, where the bulk of the volume and open interest was initiated.
Analysis of volume weighted average price (VWAP) and open interest on the front month contract points to the “panic trigger” just under $50/bbl in Brent ($48.85 bbl to $49.70 bbl). Shorts will accelerate buying to cover at prices north of $48 bbl in Brent.
(4) Firm call skew: Call skew (ie. call premium versus equivalent puts), while down from recent highs, remains firm, driven primarily by the increase in consumer hedging activity relative to producer. Firmer 1-3 month call skew suggests that speculators may be layering in positions against a near term spike in oil prices.
Call skew has fallen from year-to-date highs as high yield debt holders hedge exposure and consumer activity has generally outpaced producer activity for the month of June.
(5) Inventory draws are coming in Q3 2017: Forecasts from the IEA, EIA and OPEC all point to stock draws in Q3 2017. The combination of potential meaningful stock draws and record short positioning could prove to be a powerful driver of a strong reversal in recent oil price weakness.
Evidence pointing to upcoming stock draws is coming from the BFOE physical window, which is beginning to strengthen as the floating storage in the North Sea is reported at 6mb (down from 9mb) on the back of local demand and Chinese buyers return moving cargoes East.
This has pushed the CFD curve into backwardation. Prompt Brent spreads have caught a bid as a result. European gasoil is also now backward, which suggests underlying strength on the overall economy.

Chart 1 | Ratio: Money Managers Long-to-Short Positions in Brent & WTI| Weekly since Jan14 | Source: Reuters, ICE & CFTC
HEDGING FLOWS: Producer hedging flow has trended lower from the lead up to the May 27th OPEC meeting – See CHART 3.
Lower prices for CAL18, CAL19 have proved a successful deterrent to higher activity levels. Nonetheless, there remain pockets of activity, mainly to layer in CAL18 hedges. The analysis of hedging flows since Monday point to clear US hedging in WTI via swaps and three-way structures with the CAL18 swap at $46.50 bbl.
Firstly, contango has returned to the market, not only in flat price but also in volatility term structure. The finance and carry trade is back, albeit at significantly lower absolute price levels. Nonetheless, low cost producers (and interested investors) will be keeping a watchful eye for an oil price rebound and for stability so as to capitalize and lock in additional hedges.
Furthermore, the change in volatility term structure (i.e. higher vol levels across the curve since the beginning of the month) has raised speculation to the timing of the annual sovereign oil hedge.
Secondly, shale oil price breakevens remain competitive as cost inflation for the larger producers remain subdued.
Pioneer CEO, Tim Dove, recently highlighted that Pioneer’s cash costs (F&D + op costs + SSGA + interest + tax) are approximately $18-20/bbl, average Permian breakeven levels between $22-28/bbl, production growth at $45/bbl and finally free cash flow neutrality at $55/bbl.
Pioneer has approximately 35% of its 2018 production hedged with a goal of 85% when opportunity calls. The levels highlighted above seem like significant pinch points that one could extrapolate to much of the US shale industry.
SUMMARY: The “emotional pendulum” continues to swing hard in oil markets. The Q1 extreme enthusiasm and large investor inflows into the oil sector has reversed to pricing a full negative: Nigerian and Libyan full return, the extrapolation of continuous “beats” in US production, a worsening picture at the surface for visible stocks (exacerbated by OPEC de-stocking) and confusion on Chinese stocks and demand.
We continue to point to fundamentals nowhere near as bearish as current sentiment (see past two reports) and a market not pricing any potential for tail risk events (recent geopolitics and Venezuela as likely catalysts).

Chart 2 | Count of Negative Oil Story Count| Daily since Jun 15 | Source: Bloomberg

Chart 3 | Producer Hedging Flows in WTI| Daily since May 16 | Source: Morgan Stanley, DTCC
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