Sentiment in oil markets is in full bearish swing with last week’s DOE stock builds putting a nail in the coffin for light sweet prices. Shorts are in clear control as the market struggles with high inventories and OPEC’s inability to reign in oversupply given the recovery in non-OPEC production.
OPEC’s decision to merely extend production cuts showed a disconnected cartel, which was not on the “market pulse”. The 15% decline in oil prices post the meeting, are now the consequences. Our thorough analysis of positioning and option strikes suggests that corrective action (i.e. deeper cuts) from OPEC/Saudi would result in a violent short covering. Short-term this is a low probability call, however Q3 2017 stock draws should stabilize prices.
PRICE ACTION & POSITIONING: Brent prices are down 15% from the 25 May OPEC meeting. To anyone closely following price action, it has been a textbook case of breakdowns through key support levels and pivot points followed by sell signal confirmations for CTAs and momentum funds.
Our OPEC call was correct, as price reaction initially moved lower to $50 bbl. However, let us be clear, we did not see the vertical drop to $46.90 bbl coming, current level as we write.
Why are prices taking a pause at current levels? Simply, oil prices are at the level representing the intraday low since OPEC started to mention production cuts. The break through $46.64 bbl in Brent and a close below would be bad news. The target for the shorts in that case is $43.57 bbl, which is the pre-OPEC low back in Nov 16.
Shorts are deep in the money and in control that is clear. Still, thorough analysis highlights (based on historical data as far as we can go back) there are very few times where the combination of volume and open interest points to such a dramatic turnaround in volume positioning but placed within so few dollars/bbl.
This is perhaps a desperate call, but the right actions and words from OPEC/Saudi Arabia could trigger a very violent short covering, at least based on positioning.
Nowhere is the recent pain more visible than in time spreads – SEE CHART 1 – Brent Dec17/Dec18 was the consensus long instead of flat price. Positioning was driven by 1) producer hedging and 2) the view that spreads were deemed as more manageable.
The dramatic collapse (as illustrated in the chart) suggests that was anything but the case. The spread was over $1 bbl backwardation on May 25th and is now over $2.00 bbl contango. We believe the length has fully exited but the surge of consumer hedging activity (reverse of producer flows) is negative for Brent time spread.
Finally, we note that consensus has become more negative. A market phenomenon typical of lower prices. The flip in most of the research, from bulls to bears; cherry picking a production rebound in Libya and Nigeria and other negatives on the US shale rebound and building US inventories to justify current prices.
Chart 1 | BRENT front month & Dec17/Dec18 spread | Daily 1 Year | Source: Bloomberg & CTC
HEDGING FLOWS: Analysis of exchange data, our activity and our numerous discussions with the market points to a significant amount of consumer hedging taking place. Airlines are initiating longer dated hedge clips than usual. Shippers are aggressively bidding fuel via swaps and options and refiners are selling deferred margins. Fuel cracks are at their highest ever and the flows easily go to CAL20.
Of greater concern, and well telegraphed, is that Mexico have come to the market. Judging purely by the spreads and trading skewedness on certain parts, Mexico has probably executed some volume, with significant more to come.
There are other requests for quotes and some producer activity but by-and-large there is very little conventional producer-type hedging going through. This must be monitored as there is a sense that “the first one to blink” can trigger producer selling volume for CAL18.
On another note, producers have been active in a multitude of restructuring. As mentioned on the spreads, 2H 2017 is the node that has collapsed and where monetisation opportunities are available. Especially important in our view, with the intention not to “give back” any hedge gains on a price reversion to $50 bbl plus – CONTACT CTC TRADING DESK FOR MORE ON THIS –
FUNDAMENTALS: Oil markets benchmark versus light sweet, commercial hedges are in light sweet and therein lies the problem. The combination of US producers growth combined with increased barrels out of Libya but mostly Nigeria is a clear negative as it competes with Dated Brent (although not a surprise).
Still, somewhat stranger things are happening such as the relative strength of US crude as OPEC cuts its US exports. It means the Atlantic basin is now bloated with light sweet needing to discount in order to find a home.
Chinese independent refiners in Shandong area “teapots” are not pulling in barrels, at the moment. It is tempting to call a global demand collapse, we think absolutely not. Our understanding is that government licenses will be issued and this will return, improving the current situation. When is the question, hopefully not as far as Q4.
It is hard to see Brent trading much higher in the current sentiment. Clearly, OPEC’s target, is perceived, by the market, to be postponed deep into 2018 at best. We would advise OPEC on market perceptions and expectations, but perhaps top of the list right now is to implement deeper cuts, in light sweet as well and cuts to Asia first so that the Atlantic can clean up. The destocking on their end, while being fully compliant on production, means that these barrels are now in “visible” data and that is the only thing the market focuses on.
Our read of fundamentals points to draws in Q3 which will stabilise the market – SEE TABLE 1 – which shows OPEC/EIA/IEA average forecast with latest data and draws.
The derivatives market currently prices Brent for end of December inside the $40 – $57 bbl range.
Contact CTC to know more about our risk-management, hedging related services and trading views: contact@comtradingcorp.com.
Table 1 | Latest Average Data | Source: OPEC, IEA & EIA
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Commodities Trading Corporation is a London-based private advisory company specialized in commodity risk-management and hedging. 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.
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