Why Oil Prices Could Dive

WTI briefly touched $65 per barrel after the EIA reported a surprise drawdown in inventories — the highest price since late 2014. Although the rally hit some stumbling blocks in recent days, prices remain at multi-year highs. However, absent further bullish news, the downside risk looms large.

One of the most acute threats to prices is the exorbitant positioning by hedge funds and other money managers, who have staked out record net longs in the oil futures market. With everyone piling into one side of the bet, there’s little room left on the upside. This kind of lopsided positioning has consistently ended with a rush for the exits, setting off a sudden — and often sharp — price correction.

Mad Money’s Jim Cramer spoke about the problem on Tuesday on CNBC. “As of last week, large speculators were holding the single largest bullish position in the history of crude oil,” he said. “Being bullish is NOT a good sign … when everyone’s bullish, well, then, you don’t have anyone to convert to be able to start buying … You need to convert bears but there’s no bears.”

Cramer, citing data from Carley Garner, co-founder of DeCarley Trading, said the current makeup in the futures market points to a near-term price correction. “As Garner points out, when one of these massive speculative bets in oil unwinds, you do not want to get caught anywhere near the blast radius,” Cramer said.

Another force working against the current rally is the recent decline of the dollar, which has been weakening for the last several weeks. Since oil is denominated in U.S. dollars, a weaker dollar can put upward pressure on crude prices as crude becomes relatively less expensive to much of the world. But with the dollar already having fallen by quite a bit, there could be little room left to fall, which would mean this particular bullish force could be at an end. “If the greenback stops falling, well, that will remove a major prop underneath the oil rally,” Cramer said. “Put it all together and Garner thinks the chances of a continued oil rally are pretty darned slim,” he added.

Cramer’s theatrical delivery notwithstanding, these factors do pose a threat to the current oil price rally. “The downside might be limited but last week’s highs are unlikely to be penetrated unless there is a significant bullish change on the supply front,” Tamas Varga of PVM said in a report.

The numbers from the physical market have been highly supportive thus far in 2018. Inventories have declined dramatically, OPEC compliance has looked solid and production from Venezuela is declining at a dizzying rate. U.S. shale is set for “explosive” growth, according to the IEA, but investors have not abandoned their bullish bets just yet.

That could soon change if the market gets hit with some bearish metrics. The IEA has predicted that the global oil market would return to surplus in the first half of 2018, leading to a rebound in inventories. “It is only a matter of weeks until lower crude oil processing and rising domestic production lead to crude stock builds,” said Carsten Fritsch, oil analyst at Commerzbank AG, according to Reuters.

The danger is that the market is still riding high from the inventory drawdown over the past few months, and investors might not be pricing in the expected forthcoming increase in inventories. “The market is dangerously focused on newly published backwards-looking data and, in our view, is not paying attention to the stockbuilds that are likely to emerge later this year and in 2019,” Barclays wrote in a recent note. The investment bank argues that oil prices are probably at their high point for the year right now, and the bank predicts Brent will average just $60 per barrel in 2018.

That brings us back to the record level of bullish bets, which could set off a price dive when the inventory surplus returns. “We still have … nine long barrels for every short barrel, so a reversal should be interesting to watch,” Sukrit Vijayakar of energy consultancy Trifecta, told Reuters.

By Nick Cunningham of Oilprice.com