Looking at this week’s COT report, long crude oil and short Swiss franc remain in extreme territory. This is shown below:
CFTC COT (futures & options combined) – November 28, 2017
Notable extremes are bolded, and are highlighted when speculator positioning is more than two standard deviations above historical trailing 1-year and 3-year trends.
This week’s COT report is fairly similar to the previous week. As doubts regarding future inflation take hold, speculators are trimming their short yen and short Swiss franc positions. At the same time, the US dollar continues to fall out of favor. Looking at the British pound, long positions continue to grow in popularity as the odds of a ‘hard Brexit’ are falling. Lastly long crude oil positions have jumped significantly ahead of last week’s OPEC announcement (November 30). Interestingly, speculators appear to be trimming their outlook on inflation while betting on crude strength at the same time (rising crude oil prices are strongly correlated to higher inflation). Today, it remains unclear which camp is likely to win the inflation debate.
Crude oil longs remain fearless
One good way to start a panic is to yell ‘Fire!’ in a crowded theater. Panic quickly ensues as a large crowd tries to make its way to a relatively small exit. For a similar reason, crowded positions in futures markets are at risk of a sudden reversal. In the event of negative news, speculators with large positions attempt to exit their positions all at the same time, discovering that liquidity (the ‘exit’) is limited. Prices fall sharply as a result. Looking at crude oil positioning in recent history, bullish or bearish extremes have tended to coincide with long-term tops and bottoms. This is visually shown below:
Is this time different?
Crude oil positions were at a bullish extreme back in the first quarter of this year. At the time, WTI traded above $50. As doubts regarding OPEC’s resolve rose, crude oil prices began falling in the second quarter. Crude eventually came to a long-term bottom in July as WTI prices fell below $45. Prices began rising once US supply growth decelerated due to hurricanes and infrastructure bottlenecks. Today, crude oil prices are once again in record bullish territory (both looking at net positions and 1-year z-scores), and WTI is trading above $58 per barrel.
As we have written in the past, the underlying balance between supply and demand is supportive for crude. So the commodity has good fundamental reasons to keep rallying. Despite rising US supply, demand remains strong thanks to strong economic growth in the US and the Eurozone (two of the world’s largest crude oil markets). Yet crowded long positions and recent history suggests that there’s a risk of a sudden pullback. While it’s too early to call a bear market in crude oil, caution is warranted.