Brent selling ignited from a spill-over of equity quant funds rebalancing as volatility across all assets increased. There is a genuine fear that we might be in the middle of a fundamental repricing of volatility across all markets.
Producers are not chasing Brent lower with healthy hedge coverage ratios. Index money remains sticky with resilient Brent spreads and attractive roll yield. CTAs are in the driver’s seat with the 100dma ($63.24/bbl) and $60/bbl as the ultimate psychological barrier where meaningful tranches of selling are likely to emerge.
RISK ASSET COLLAPSE
Risk assets took a beating this week as a volatility induced sell-off hit asset classes ranging from equities to commodities. The selling in Brent was ignited from spill-over selling from equity quant funds (volatility ETPs, risk-parity funds and CTAs) selling.
These funds trimmed positions as portfolio volatility increased and asset correlations changed (higher bond yields, lower equities). For risk parity funds, volatility increases translate into selling as they slash positions to stay within risk metrics. As Brent crossed the 50 day moving average (dma) we saw an increase in short positioning from momentum funds with $63.24/bbl, the 100dma, the next trigger point to be tested.
Producers are adequately hedged therefore no need to chase prices lower. Hedge funds were bullish but don’t seem to be hitting stops just yet. Index length is very sticky money and the roll yield remains attractive as Brent spreads have held up reasonably well.
So the question inevitably revolves around CTA (momentum driven fund) models which have become increasingly important in oil markets. Although CTAs have been sellers in the last few days, $60/bbl is the ultimate psychological barrier where another meaningful tranche of selling is likely to emerge from these momentum models.
Perhaps the biggest takeaway from the macro sell off is there is a genuine fear emerging that we might be in the middle of a fundamental repricing in volatility across all markets.

Brent (Left) & Gasoil (right) | Explosive volume (grey) combined with sharp reduction in Open Interest as CTAs close positions (blue) with Price (orange)
Refined product markets have led the oil complex move lower. Weakness in refining margins have led Brent lower as the build-up of net speculative length (which has been more exaggerated as a percentage of open interest in refined products relative to oil) has started to unwind.
This has raised some eyebrows as it was the spec community’s thirst for distillate that drove refining margins higher and a subsequent one-way move higher in crude oil.
Some risk remains that the sell-off in refined products is a precursor for oil as we enter the shoulder demand and refinery maintenance period.
Upcoming refinery maintenance. Planned refinery maintenance in the Atlantic Basin (US and Western Europe) is expected to be ~1mb/d above last year (See exhibits on ref margins).
However, the peak is estimated to occur almost 1-month later than usual (late March vs. late February). This has two consequences for the oil market. First, refining margins could weaken further as higher near term refinery throughputs drive refined product stock builds and further liquidation of net speculative length.
Maintenance season should put an end to the weekly inventory builds but until then, continued downward pressure on refining margins is a high probability.
From a fundamental perspective, refined product inventories close to 5-year averages allow a buffer to seasonal stock builds that should not undermine the overall positive fundamental picture. Second, January tends to be a seasonally weak period for Brent with average monthly returns of negative 1.58% over the past 10-years.
Refinery maintenance drives this underperformance. However, with peak maintenance delayed by 1-month, the seasonal weakness now moves into February, rather than January. In this respect, the 6% move lower in February is not out of line with market moves one typically expects in January.
Producers have been, for the most part, watching from the side-lines. While there have been producers buying puts for the balance of 2018, it has been relatively opportunistic in rounding out hedging books that are well covered for 2018.

Western Europe & N. America Refinery Capacity Offline (mb/d)
Shale oil production growth revised has minor impact on spec length liquidation.
The EIA, in its most recent Short Term Energy Outlook (STEO), revised its 2018 US production forecast higher by 320kb/d and 2019 by 330kb/d. This represents growth of 1.26mb/d in 2018 and 590kb/d in 2019.
However, 4Q18 results from US independents Chesapeake, Pioneer and Anadarko have worked as a counterbalance, as large independents have instituted capital discipline and shareholder friendly policies. Each of these companies increased dividends four-fivefold, announced share buyback programs and stated that capex would stay within cash flow.
The message is that incremental cash flow from higher oil prices will not be directed to increased capex but rather a return of capital to shareholders.
The market expects US production growth, but with these policies in place the magnitude is currently discounted in the EIA’s current forecasts. We will need significantly higher WTI prices to see production levels move significantly higher from current estimates.
As a caveat, the biggest note of caution came from Pioneer Natural Resources. The company expects to ship 70-80% of its Permian production to the gulf coast on fixed contracts, where export capabilities are expanding. Growing US exports will remain a key market theme with the impacts felt in 2H 2018 – We are paying attention !
Overall, the structural fundamental picture remains bullish as inventories normalise and the Saudi Arabia/ Russia agreement anchors oil prices in the $55-60/bbl range. Consensus forecasts point to a balanced market in 2018, a very narrow margin for error in a 100mb/d market. CTC views this move lower in Brent as an opportunity to restructure hedge portfolios – CONTACT THE DESK FOR FURTHER DETAILS –

UPDATING OUR CHART FROM 2 WEEKS AGO WHERE WE POINTED OUT THE VOL COMPRESSION | ICE BRENT
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