Crude oil prices have enjoyed more than seven months of uninterrupted bullishness, but the run seems to have ground to a halt. The global equity and corporate bond market underwent a significant correction during the second week of February, dragging down the wider commodity complex and oil prices in their wake.
With a sudden peak in volatility levels, there is a stronger possibility that speculators may begin to close out their bullish positions, and hence a higher risk of lump profit-taking. “One issue to look at is the length of the market and the fact that long positions are still building-up,” said PVM analyst Stephen Brennock.
Money managers – or speculators – have built up their long positions, from 378m bbl at the end of June to 643m bbl on 23 January for Brent and down again to 580m bbl on 13 February.
For WTI, the overall length increased from 301m bbl to about 535m bbl over the same period, and back down to 487m bbl since the peak in volatility earlier this month.
However, higher volatility may not necessarily point to any particular direction for oil prices.
Greg Sharenow, a portfolio manager who co-manages $15bn in commodity funds at US investment management firm PIMCO, said to ICIS that “volatility tends to go up for most commodities in down moves owing to the imbalance in options due to producer hedging”.
The overall environment for oil price volatility will be driven more than anything by inventory levels, he added.
The equity and corporate bonds rout has intensified fears that oil demand growth in 2018 may not be high enough to drain global crude inventories, in particular if a surging US oil supply keeps feeding them.
The International Energy Agency (IEA) revised its oil demand growth forecast on 13 February, from 1.3m bbl/day to 1.4m bbl/day, essentially on higher economic growth estimates from the International Monetary Fund (IMF).
“The main takeaway from the IEA report is that non-OPEC production will drive the bulk of supply increase in 2018 and that US production may overtake the global oil demand growth forecast for 2018,” said Brennock.
A large part of the market moves are driven by speculation and the correction is reminiscent – if only on a smaller scale – of 1987, when rising inflation sparked a massive selloff, only made worse by computer trading.
A host of sophisticated players are roaming the crude oil markets, including the short-volatility sellers, the momentum traders, the systematic trading strategists, and they are the ones driving a market where fundamentals have, in fact, changed very little.
Brennock concurs that “sharp moves in the oil market tend to be overdone”, adding that fundamentals may not support a “very aggressive US shale supply” if demand growth subsides or does not materialise.
On the downside, US tight oil exploration and production companies (E&Ps) are still reliant on borrowing to fund their capital and operating costs. As long as prices remain above the $55/bbl mark, says Brennock, those E&Ps won’t struggle for finance.
“Higher interest rates could impact capital allocation to the E&P sector, but the cost of capital has been so low for so long, and credit spreads remain depressed,” says Sharenow, adding that as a result, the cost of capital has not moved that much.
At the moment, a majority of analysts remain moderately bullish and see the longer-term equilibrium price of Brent oil at about $60-65/bbl. “Broadly speaking, we do not view the oil market as beginning a downtrend”, says Sharenow.
“We think the back end will be anchored by 55/60 in Brent, talking five year forward roughly. That puts cal 18 [the calendar 18 crude price] between 65 and 70 in our opinion as likely destination.”
In the meantime, the differentials between sweet and sour grades have widened on a sharp increase in outright sweet crude prices and, in parallel, an increased availability of sour crude alternatives as the result of OPEC production curbing.
Light sweet oil from the Atlantic basin has struggled to reach the Asia markets, nevertheless, with the surge of Brent prices pulling the Brent-Dubai EFS wide apart and choking the arbitrage of cargoes, mostly west African ones, to the East.
The EFS sets the differential between Brent futures and Dubai swaps and determines the quality of arbitrage of Atlantic-based grades – typically from Angola and Nigeria – to the east.
Although regular tenders from large Indian and Chinese customers continue to be placed regardless of the EFS level, spot demand has been suffering from a continually higher spread since late July 2017.
A burning question now is whether the US will dispose of enough storage and loading capacity to export its light sweet oil to the global markets and add pressure on sweet crude. At present, most analysts seem to agree that this won’t be an obstacle in 2018.
“There is always concerns about constraints in the Permian Basin reducing export capacity. US pipeline companies have been pretty good in the past few years getting ahead of these constraints,” says Sharenow. A number of midstream developments towards the US Gulf will be actively watched in 2018.
The Louisiana Offshore Oil Port (LOOP), the largest privately owned crude terminal in the US, announced on 13 February that it had moored a very large crude carrier (VLCC) and had initiated a detailed test procedure to effectively accommodate that size of crude tanker.
The LOOP will be the first facility in the US capable of loading crude directly to VLCCs, that is, without any intermediate ship-to-ship transfers from onshore storage. This may add to the bearish cocktail of signals that seem to be in the offing.