Tuesday, May 16, 2017

Oil Prices, Up 13% In Only Seven Days, Can Extend Their Gains

Russia is on board with production cuts as seasonal supply declines are nearing.


By Thomas H. Kee Jr.
MarketWatch
May 16, 2017

After reaching a capitulatory bottom in overnight trading on Cinco de Mayo, oil prices are up sharply.

The rationale matters, but in many ways momentum matters more in the oil industry. That applies to both directions.

When oil prices were peaking around April 19, right before the slide into May 5, the rationale had everything to do with an expected six-month extension of the OPEC agreement to cut production. The declines that started afterward happened because Russia did not immediately vocalize support.

Fear settled into the market, and investors who were long oil unwound positions. Back then, the data suggested bullish oil bets were higher than they had ever been. This created the downside momentum that was initiated by Russia’s inability to vocalize support.

Russia needed to meet with its producers before it was able to do that, and it took about two weeks for them to meet with them, and that created a void — no good news and plenty of questions. In the meantime, there was a barrage of negative news about oil, stemming from the supply side of the equation. Shale producers were in focus, and the U.S. supply glut seemed unyielding.

However, the supply increases were normal based on seasonal trends, but without expectations that this production cut would be extended, no one cared. Supply certainly took center stage, and the seasonality was forgotten. This is what helped fuel the downside momentum.

West Texas Intermediate crude (WTI) CLM7, +0.27% fell 18% in 17 trading days, and it was brutal. As of last week, long oil positions were back at their pre-OPEC-deal levels (last November). The data suggest that almost all of the bullish positions that were there on, or about, April 12 had been closed, and a significant short interest had developed.

However, since the overnight session on Cinco de Mayo, WTI is up 12.5% in only seven trading days. Upside momentum has already started in a space that is historically very volatile.

The rationale for the increase had everything to do with Russia, the same catalyst for the declines.

On May 5, Saudi Arabia offered an opinion after meeting with Russia the day before. The opinion was that Russia would be on board with an extension of the OPEC deal. Russia subsequently acknowledged the same, and on May 15 Russia and Saudi Arabia issued a joint statement not only suggesting that they were supporting an extension, but that they were supporting an extension beyond what the market expected on April 12.

On the supply side of the equation, we will soon enter the seasonal period when supply levels decline significantly. And although our model does not match that proposed by the U.S. Energy Information Administration (EIA), the agency’s is actually more bullish than ours. We also identify material deficits that will begin very soon.

Shale producers will continue to ramp up production, but they cannot match demand growth alone, and warnings of material deficits in 2020 even with normal OPEC production exist. The EIA says the lack of large projects and the inability of shale to pick up the slack by itself is the reason.

Oil investors care more about these issues in the near term:

• Bullish bets were significantly unwound

• Big bearish bets were placed.

• WTI is up 12.5% in seven days.

• Russia is back on board.

• Momentum is up.

• A nine-month extension is likely.

• Seasonal supply declines are on the horizon.

• Material deficits are starting or about to start.

Almost immediately, significant deficits will begin. These will come as shale producers continue to ramp up supply, and the oil market is going to get more than it wanted back on April 19.

Oil trades with momentum, and currently momentum is on the upside. Oil also undershoots and overshoots given its momentum moves, and we’re expecting it to overshoot as this next cycle continues and deficits begin to dominate the headlines. We expect oil-related ETFs like United States Oil Fund LP USO, +2.21% and iPath S&P GSCI Crude Oil Total Return Index ETN OIL, +1.93% to increase measurably even after the recent seven-day run.


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