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Oil Producer Report

Implications for Hedging and Vol as Oil Prices Set to Move Higher

By March 29, 2017April 25th, 2017No Comments

A lot has happened in crude oil, it feels right to do a status check on major points: (1) Price action (2) Fundamentals (3) Positioning and flows. The takeaway is that oil prices have found a floor, the short-term looks oversold and deal extension to cuts seems highly probable. The net result is risk skewed for a flat price move higher with strong implications for option volatility and producer type structures.

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PRICE ACTION: In the past 3 months, oil price has swung in tandem with sentiment – CHART 1 below – Just pre-OPEC/NOPEC deal, taking ICE Brent, it was trading in the high $40s and was floored/capped by its 200/50 day-moving-average (DMA) lines. The deal annoucement was followed by price gaps over 15% into the $55/bbl price area where it held into an incredibly tight range (volatility collapsed as a result).  The 200 DMA halted the pullback in Brent since March 8th.

It is interesting that prices dipped intraday (March 8) below the $50/bbl line, rejected the downside accelaration and has since traded above.  As a client mentioned, oil prices look fragile.

From a short-term flat price perspective, crude oil is oversold, negative sentiment extreme and needs to be “cleared out” (See: MACD + RSI technical indicators).  A move higher is in the cards as prices closed above the 200 DMA and the next resistance target of $53.50 (100 DMA) seems probable.  The picture does indeed look “fragile” in the meantime. However, the leading indicator has been  gasoline (RBOB), and if the correlation holds, the strength in RBOB looks constructive for crude.

In summary, prices have found a bottom after 3-4 attempts to break lower failed and oil trading above the 200 DMA suggests that we are clearing the oversold conditions.

CHART 1 – ICE BRENT (since 1 Nov16) - Source: CTC & Bloomberg

CHART 1 – ICE BRENT (since 1 Nov16) – Source: CTC & Bloomberg

FUNDAMENTALS: OPEC are very well aware of current crude stocks oversupply and the unlikelihood that stocks fall to the 5yr average level by May (there never was a chance of that by then). In my view, the market’s current hesitation is misplaced. OPEC will extend the deal. Further, the  probability is skewed towards an extention of the  NOPEC agreement (at current production levels), combined potentially with even deeper Arab Gulf cuts to follow. If this were the case, Brent prices would likely trade above the post-deal highs of $58/bbl.  A rollover of the current terms would push prices higher back into the $55/bbl range  (with much lower options volatility/ lower like-for-like premiums as a result).

Of course, the Saudi Aramco IPO looms in the background, and this was given a boost with the recent cut of the corporate tax from 85% to 50% (replaced by dividends, aligned with other shareholders). This is seen as a milestone by some and certainly comes as a fresh comfort for the longs.

On the demand side, there continues to be a strong pull from China with +1 million b/d YoY imports (combination of strong end-user products demand/exports, domestic production decline and flows into storage for commercial and SPR). Tanker/VLCC loadings off the Arab Gulf continue lower with shipping rates down over 20% on the week, suggesting that OPEC producers are adhering to production cuts.

More constructive news came this week (primarily for Brent crude), as Libya declared force majeure with production disrupted at Sharara and Wafa fields (250 kb/d). Just as the worse seemed behind them regarding its terminal issues, armed factions  issues are back, raising concerns for much more prolonged trouble ahead for Libyan barrels. Crude output is now lower at ~560 kbpd.

Brent spreads, despite a recent wobble, have traded stronger since the OPEC deal.  This remains constructive despite very little perceived signs of rebalancing, especially in visible US stocks, Brent Dec17/Dec18 has held on the 100 DMA, and now looks to be heading higher, cementing backwardation on that part of the curve.

The flipside is in the US of course, with higher inventories and rising rig counts. The comments out of the Haliburton operational call last Friday are perhaps representative of the situation (obviously they are “talking their book”): HAL claime to have made the decision in 1Q to bring back more equipment, more rapidly than planned at the start of the year, based on current customer demand are deploying nearly double the pressure pumping equipment than originally anticipated to reactivate for the entire year.

This in large part, explains the weakening differential for light sweet versus medium, heavy sour grades.  OPEC cuts were always going to take time in impacting lighter crudes given the structure of global crude supply.  If the OPEC deal extends (officially announced in April), we will then have peak refining turnaround behind us and stock draws should start appearing in the data.

CHART 2 – Managed Money VS Open Interest VS Price

CHART 2 – Managed Money VS Open Interest VS Price

Positioning & Volatility: CHART 2 is a clear testament to the extreme market enthusiasm of Dec/Jan.  It shows record length in spec/index/ETF/investors positions (note: record in terms of number of contracts, not dollar notional).

We will not do a positioning drilldown here, but suffice to say that a significant number of longs have exited while short positioning has increased. Recent data shows a decelerating in this change in positioning and suggests that the positioning “washout” is behind us.

The large majority of the length were front-end buyers on the curve.  This length provided the other side of the trade and aggressively absorbed (commercial) producer selling see – CHART 3 – mostly from the US.  This confirms our clients’ increased hedging activity post-OPEC deal and the huge hedging flows processed in the market then (Dec/Jan).

There are implications, for one, the pressure points on the curve (aggressive “spec” buying in the very front / producer selling further back) means that the curve significantly flattened.  It also means that as the short strikes held by market makers (banks processing producer flow) is around the $50 area, this translates to increased volatility as oil price trades lower towards that “line”. It therefore has an impact on implied volatility (i.e. options premium volatility), as a move higher means, less fear, further away from the short strikes and, in our view, a sharp probability for much lower implied volatility.

This scenario would be optimal for producers’ hedges.  A higher price back higher into the range combined with lower implied volatility (i.e. lower hedge costs).  In our view a highly probable scenario (with “vols” possibly lower than 1Q so far).

It is not to say that oil price is volatile right now.  It has gapped into a different range, but actual daily volatility is not high.  This is reflected in relatively low options volatility even at the current junction – see – CHART 4 – with closer dated maturities, showing the daily oil price movement required to breakeven (i.e. the cost) on a long volatility position clearly pointing lower.

CHART  5 – is interesting for producers as it clearly shows that, as prices came down they have been “disciplined”, significantly reducing hedging activity at lower prices.  This is reflected in the put premium versus calls in the backend which has receded.

This is in-line as well with the exchange data flows, showing low producer type hedges across both Brent and WTI.  There has also been good consumer activity, although not as high as in past 2 months, nonetheless diversified across products (anecdotal experience from fuel, diesel, jet/kero in Asia/EU).

Positioning is “healthier”/less extreme now which means there can be “fresh powder” to buy. The buyers from post-deal who have not exited are not going to exit now.  For further forced liquidation to materialise, either the recent price lows have to be taken out or a fresh new negative catalyst would need to emerge.  In our opinion, this is unlikely at the moment.

In summary, cleaner positioning, absorbed negative headlines, skewed risk towards a deal extension and related headlines, overall slightly more constructive fundamentals (at least ex-US).  The overall picture points to potential for an upside move in crude prices in the front of the curve.  The backend will continue to underperform, repressed by re-emergence of producer prices on a price rise.

CHART 3 - Oil Producers Shorts (futures) VS Managed Money Longs - ource: CTC & Bloomberg

CHART 3 – Oil Producers Shorts (futures) VS Managed Money Longs – ource: CTC & Bloomberg

CHART 4 – BRENT “Theta/Gamma” daily breakeven - Source CTC & Blomberg

CHART 4 – BRENT “Theta/Gamma” daily breakeven – Source CTC & Blomberg

CHART 5 – BRENT implied volatility (green) & Put “skew” (red) - Source CTC & Bloomberg

CHART 5 – BRENT implied volatility (green) & Put “skew” (red) – Source CTC & Bloomberg

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