By Ryan Fitzmaurice, Senior Commodity Strategist at Rabobank
Short-term momentum and some trend signals turned bearish for the oil complex this week, resulting in waves of selling pressure from systematic traders
Furthermore, medium-term momentum signals are also at risk of flipping from "long" to "short" over the coming days should prices continue to weaken
Large speculators have reduced crude oil futures exposure to minimal levels, especially in light of the strong positive roll-yield currently implied by the forward curves
Waves of selling
Oil markets were hit by waves of selling pressure this week as short-term systematic funds pivoted from liquidating “long” oil futures positions to building outright “short” positions. This mechanical selling was evident at times, and our own proprietary CTA model further confirmed this notion, as several key signals flipped from "long" to "short" in the oil complex mid-week.
More specifically, it was the short-term momentum and some trend signals that turned bearish this week. Furthermore, medium-term momentum signals are also at risk of flipping from "long" to "short" over the coming days should prices continue to weaken, which could bring another wave of aggressive systematic selling to the oil market before the pressure subsides. As such, we are attributing a large portion of the recent fall in oil prices to the herd-like behavior of systematic funds rather than to any material shift in the fundamental outlook for oil markets. As for fundamentals though, oil inventories continue to drain in the US as we saw on Wednesday in the weekly Department of Energy report. The official release showed a -3.23mb crude oil draw, a gasoline stock build of +696kb, and a distillate draw of -2.697mb. The net result was a draw of more than -5mb to the major product categories, and moreover, all categories remain in steep year-on-year deficits.
As for Biden’s plea to OPEC+ last week, not only did the group confirm they are unwilling to pump more oil to ease US concerns, but Saudi Arabia is reportedly considering pausing the already agreed to production increases considering delta variant concerns and weaker pricing. As such, we expect oil balances to remain tight and for prices to stabilize and grind higher as soon as the aggressive systematic selling we have been witnessing starts to wane.
A bullish setup
As we just discussed, large speculators and particularly systematic funds have dramatically reduced their “long” oil futures exposure in recent weeks. In fact, the combined net managed money position for ICE Brent and Nymex WTI is now looking quite low by most metrics, and especially in light of the still strong positive roll-yield currently implied by the forward curves. As we have explained in past notes, roll-yield is a very powerful force in commodity futures markets and, as such, speculative positioning tends to be strongly correlated with this implied yield.
Moreover, trading against this yield in either direction can be a challenging task that is often advised against without a compelling counter-argument. Nonetheless, short-term CTA-style momentum and trend funds have likely been building “short” positions this week on price alone, but this bearish stance is likely to be short-lived, as we see it. After all, it is only the short-term signals that have flipped and while the medium-term momentum is at risk for some oil contracts, the long-term signals are still firmly in the bullish camp. For these reasons, we see the recently established “shorts” as vulnerable given they are trading against both the powerful implied rollyield as well as the well-established longer-term trend. These new “shorts” are also at odds with the current inflationary concerns that are underpinning the revival in commodity index investing.
So in summary, we are viewing the current light speculative oil positioning as providing a bullish setup for oil prices, given the bullish fundamental and macro backdrops, as there is plenty of dry powder at hand to bid oil prices higher in the coming weeks and months. If oil prices do grind higher, as we expect them to once the waves of mechanical selling subsides, then these same funds will ultimately be forced to cover their oil futures “short” positions and initiate new “long” positions at higher prices. For these reasons, we see the recent washout in oil exposure as temporary and more importantly, the reduction in length provides a bullish setup into year-end.
Looking forward, we see oil prices strengthening into year-end despite the recent washout of systematic traders. Further to that end, the reduction in oil exposure by large money managers is setting the stage for a potential “short” covering rally to ensue, especially given the news that Saudi Arabia could pause or slow the pace of the planned production increases into year-end. In addition to any potential surprises from OPEC+, the strong forward curve structure is a major headwind for the oil-bears. In fact, when you look at the deferred oil contracts, the Dec-22 Brent contract is fast approaching the $60/bbl level. To our minds, that looks like a much better buy than sale in the current inflationary environment. As we mentioned in a recent note, US oil producers are already seeing meaningful inflationary pressures in their drilling budgets which is only increasing the cost of production and thereby supporting the back of the curve.