Black gold: getting frothy

Yvan Berthoux - 1 February 2018

New year exuberance has enveloped the crude oil markets, such that the front-month contracts of the two crude oil benchmark futures, WTI and Brent, are currently trading at US$64 and US$69 a barrel, both up roughly US$20 over the past 18 months. There are strong reasons to suspect that price momentum has over-reached sustainable levels.

First, OPEC’s push to support oil prices via production cuts was one of the key drivers of the short-term appreciation of crude oil. According to the IEA, the daily production of oil breached 97 million barrels in 2016, and OPEC’s 11 were responsible for 31.2 million barrels of the total supply. As a response to a sudden drop in oil prices in 2014-2015 on a back of a US Dollar rally, OPEC and its associates agreed to cut supply by 1.3 million barrels a day on average, which spurred a little rally in the black gold. Russia, for one, may not agree to restrict output in future.

it is important to observe the behaviour of the long-end of the futures curve, also known as time spreads or term structure. We notice in figure 1 that both the term structures are currently in backwardation, meaning that the longer the maturity of the futures contract, the cheaper the price. For instance, the December 2020 futures contract on the WTI trades at US$54, meaning that the time spread is negative US$10. The current shape of the oil term structure tells us that there is some upward pressure on the front end, but the probable production of shale oil and tight oil will exert downward pressures on the oil price in the medium term. Oil frackers can adapt quickly to changing market conditions, allowing producers to ramp up production and risk an oversupply.

Third, the CFTC commitment of traders report reveals that the net speculative positioning in US oil is at its highest level ever (716.7k contracts as of Tuesday, 30 January), implying that hedge funds are heavily long oil. In figure 2, notice that the increase in speculative positioning is mainly due to a constant increase in net longs over the past few years. Hence, the oil trade looks a bit crowded at the moment and investors may start to lock profits on their trade in the weeks coming ahead, sending the front-month contracts on the downside.

Fourth, the global economy currently enjoys a very rare confluence of favourable growth developments, spurring strong demand for crude oil and refined petroleum products. To the extent that higher interest rates and widening credit spreads threaten to dampen economic activity, this will weaken the demand outlook in the medium term. A rebound in the US Dollar would also dampen the prevailing enthusiasm.

Nevertheless, figure 3, showing the ratio of the Goldman Sachs Commodity Index to SP500 over the past forty years, suggests that it is one of the best timed in ‘decades’ to own commodities. Timing is everything.

Figure 1. Oil Term Structures

Data Source: Eikon Reuters

Figure 2. Oil Net Speculative Positioning

Data Source: Eikon Reuters

Figure 3. Commodity-to-equity History Ratio

Data Source: Eikon Reuters

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