One week ago, the market was disappointed when Goldman's head commodity strategist, Jeffrey Currie pointed out the obvious, namely that the higher the price of oil rises, the greater the probability it will tumble shortly, as a result of recently shut off production going back online. To wit:
Last year commodity prices were driven lower by deflation, divergence and deleveraging which were reinforcing through a negative feedback loop. Deflationary pressures from excess commodity supply reinforced divergence in US growth and a stronger US dollar which in turn exacerbated EM funding costs and the need for EMs to de-lever though lower investment and hence commodity demand. While we believe that these dynamics likely ran their course last year resulting in signs of rebalancing, the force of their reversal has created a new trend in market positioning that could run further. However, the longer they run, the more destabilizing they become to the nascent rebalancing they are trying to price.
This follows our extended discussion of record storage not only in Cushing but PADD2 in general, as well as PADD3 and now, PADD1: it is now only a matter of time before US storage is "operationally full" and no more oil can be accepted for storage leading to a dramatic plunge in its price.
Then over the weekend, we showed why according to Credit Suisse, among the many skeptics of this furious oil short squeeze rally, the most notable sellers into strength were the entities that know the oil market better than anyone: producers themselves, who are rapidly selling the long-end to hedge prices around $40/barrel.
Since January, the spread between spot Brent prices and 2020 Brent prices has dropped nearly $8.00 to $10.71 per barrel, indicating selling in 2017, 2018, and 2019 futures contracts. According to Reuters, the majority of selling has come from E&Ps looking to lock in prices to hedge against a repeat of last year's second half commodity price-route. At the same time, the hedges indicate a lack of confidence that the current commodity rally will continue.
And now, here is Morgan Stanley's Adam Longson with an overnight note which puts all this together, in which he essentially repeats what Goldman and Credit Suisse have said by saying that "Higher Prices and Rampant Hedging Can Extend the Cycle." To wit:
2Q15 rally all over again? The 47% rally in WTI over the last month started with short covering on OPEC/Non-OPEC headlines. However, the carry through has mostly been driven by macro/CTA funds following better macro data points, a weaker USD, trend reversal and buying on hopes of recovery. Most of these factors are technical and appear temporary. But such false rallies can actually be harmful for the recovery.
Producer hedging is rampant in the $40s. Both anecdotal evidence from our trading desk and CFTC data support this. The CFTC producer short position reached new highs after the Jan lows, partly from distressed producers being forced to hedge. However, this latest uptick has not been confined to distressed producers. In our conversations, we are seeing healthy appetite from mid and large cap Permian producers as well. These producers are happy to hedge $45-50 in calendar 2017 and even high 30s/low 40s in 2016 given light hedge positions. Much of this hedging is just current production for now.
Basically, what this means is that as a result of the 50% spike in oil, producers have just succeeded in extending their $40/bbl hedges through to 2018, and no matter what happens to the price of spot, they will now resume pumping at prices that are supposedly profitable. This means that Saudi Arabia will have no choice but to retaliate; it also means that any speculation about a production cut by OPEC, or even freeze, will be promptly forgotten. More details from MS:
- Higher crude prices and hedging can ultimately slow the US production decline.
- Producers can hedge current production and shore up balance sheets. Hedging could keep supply more stable and less responsive to prices, just as excitement about declines was building. It also improves balance sheets and allows more equity issuance.
- At worst, producers could bring on more supply by completing DUCs. WLL recently cited the $40-$45/bbl range as the price necessary to incentivize DUC completions (well below the price to add rigs). Prices are nearly there in the front and are already there a few months out, which could support rapid rigless production.
- In the medium term, producers can use elevated prices to hedge future production. Most producers hedge at least 12 months out. Many entered 2016 in an under-hedged position and want to avoid that for 2017. Furthermore, credit stress has led to a decline in the hedging thresholds. Hedging 2017 at these elevated prices (currently Dec-17 WTI trading at $46/bbl) could help companies lock in returns, and/or support higher rig counts than recent flat price would have suggested
Then there is the stretched positioning which suggests the buying is over:
Positioning data suggests that crude may be getting overbought. WTI and Brent combined net spec length has increased dramatically since late 2015 to the highest level since July 2015. Brent non-commercial net length reached 147k contracts, and according to our Equity Strategy team, has only been higher 9% of the time in the last 5 years. This suggests that the market is positioned in a one-sided fashion, posing risk to the downside.
Risk of more hedging, esp sovereign. Producers will continue to hedge if prices rally. We also worry that large sovereign hedge programs could suddenly come into the market as prices rise and buyers emerge, which has historically been a catalysts for a sell off.
Some evidence refiners may need to cut runs later this year, just as balances are expected to improve. Gasoline stocks outside the US have been more challenging, and margins are slipping. If refiners continue to run harder than demand suggests, the back up in product stocks could push into crude demand.
Declines in supply may be overstated, esp if prices rally. Higher prices and hedging offer producers better cash flows and economics, and prices are now in a range where DUCs may be completed. Plus, the impact of recent supply-side fundamental developments is likely overstated (see below).
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Putting all this together, here is MS on where oil will go next:
The front should be capped by the back. Risk-on can push the rally further, but upside is likely capped near $45 even with a weaker USD. Although macro funds and short covering are lifting the front, producer hedging is limiting the rally in deferred prices. Moreover, US inventories are bloated and will continue to rise, which suggests a contango must remain in the curve. Hence, the back will cap the front. When we put it all together, it suggests WTI will struggle to break $45 in the front, even if the USD continues to pullback.
Bloated inventories will keep the curve from flipping into backwardation, particularly for WTI. We have shown many times that storage utilization drives structure in the front of the curve, particularly during periods of inventory builds. With Cushing already nearing full storage, and US inventories set to build into April or May, we don’t see how time spreads will not trade at some level of distress. As a result, WTI will need to support some level of deep contango over the first 3-6 months. Therefore, producer hedging and buying from macro funds and CTAs can flatten the curve, but we don’t see a world where the front trades in line with (let alone above) the back.
We struggle to see Dec-17 WTI breaking $50 based on producer hedging. Many producers are willing to hedge calendar-2017 WTI at $45 or higher. Much of the buying we have seen from speculators and macro funds has been closer to the front where there is liquidity. Call skew has improved in the back with a few investors and consumers buying out-of-the-money call options, but these are typically small in scale relative to the potential producer selling. As a result, we see a hard cap on 2017 prices.
Finally, if all of this resembles the strong rally of Q2 2015 when oil likewise soared, only to tumble shortly after, it is because that's exactly what it is.
The current setup is similar to 2Q15. Back in 2015, a rally in prices driven primarily by a USD pullback led to producer hedging and capped deferred prices at $65/bbl. This resulted in a flatter curve, but it also limited the rally in the front to $60 given the state of US inventories. The current rally mirrors this period in 2015 in many ways, only that producers are willing to hedge at much lower levels. As the USD and producer hedging reasserted themselves, that rally proved to be short lived.
And with that, the ball is again in Saudi Arabia's court, whose task of putting the "marginal producers" out of business was just delayed by at least one year.