- OPEC announcement went smoothly, as the deal to limit production was better than expected
- Crude oil bull market remains intact, but two reasons to suggest caution
- Rising US supply and excessive speculator bullishness are headwinds
Judging by reactions in the crude oil market, last week’s OPEC announcement exceeded expectations. Beyond an extension until the end of 2018, OPEC surprised many by including Libya and Nigeria as part of the cartel’s production limits. Despite earlier rumors regarding Russian reluctance, the country agreed with Saudi Arabia’s push for an extension following King Salman’s landmark visit to Russia earlier this year. Now that OPEC is in the rear view mirror, markets will return to focusing on US crude oil production as well as speculator positioning in the commodity.
Bull market remains intact, but US supply remains worrisome
As demand growth remains higher than supply growth, the bull market in crude oil remains fundamentally supported. As discussed in a previous commentary, looking at demand versus supply growth in rate-of-change terms is a good way to determine the fundamental trend driving crude oil prices. The latest data from a variety of sources including the International Energy Agency suggests that demand continues to grow ahead of supply. Our technical trending indicators have also identified a bullish trend in crude oil prices, in both the short-term and the medium-term. Thus the bull market is likely to continue.
The main threat to the fundamental story today is rising US production. A day before the OPEC announcement, data from the US Energy Information Administration showed that US production is at all-time highs. A visual overview of US production and year-over-year growth is shown below:
Drill baby drill: US supply comes roaring back
As can be seen from the data, US supply is currently growing in excess of 10% per year. US production is especially impressive given healthy output numbers at this time last year. Mathematically, year-over-year growth tends to slow as the denominator gets larger (i.e. the ‘base effect’). Much to OPEC’s annoyance, the base effect hasn’t slowed down US shale this year.
Everybody’s a crude oil bull
The second issue threatening the current bull market is the fact that long crude oil has become a fashionable trade. Looking at the most recent Commitments of Traders report, speculators have increased their long crude oil positions by almost 30,000 futures and options contracts. While the crude oil market is large enough to withstand such an increase, the broader issue is that long crude oil is already a very crowded trade. Based on trailing 1-year and 3-year average net positions, speculator longs in the commodity are at a bullish extreme. This is shown below:
Is this time different?
When speculator positions become excessively one-sided, the risk of a sudden pull back rises accordingly. This happens because liquidity is limited when a large number of speculators attempt to reverse their positions at the same time. Prices then fall in order to adjust for the reduced liquidity. Thus a minor event such as a bearish news story can cascade into a rout.
Too early to call a bear market
All in all, it’s too early to call a bear market in crude oil given the fundamental dynamics powering the commodity. Until supply (most likely from the US) overwhelms demand at some point in the future, we remain crude bulls. The caveat is that excessive speculator positions in long crude oil futures and the pace of US supply growth means that crude is probably due for a short-term pullback. Upcoming US data will therefore be critical for crude oil speculators. Given steep expectations (the consensus estimate calls for US inventories to fall by 3.5m barrels), going long crude oil from here is quite risky.