Following years of acrimony between OPEC and the hedge fund community, which the cartel dismissed simply as "speculators", things suddenly changed in 2016 when the two groups got so close, there were outright reports of collusion between the two on various occasions. We documented this last month in "Why OPEC Is Colluding With Hedge Funds." However, as Reuters' energy analyst John Kemp pointed out on twitter this morning, that relationship may be ending as hedge funds start to lose confidence in OPEC.
Taking us to the beginning, Kemp notes that OPEC and some of the most important hedge funds active in commodities reached an understanding on oil market rebalancing during informal briefings held in the second half of 2016. OPEC committed to implement credible production cuts and reduce global crude stocks while hedge funds responded by establishing bullish long positions in both flat prices and calendar spreads.
OPEC effectively underwrote the fund managers’ bullish positions by providing the oil market with detail about output levels and public messaging about high levels of compliance. In return, the funds delivered an early payoff for OPEC through higher oil prices and a shift from contango to backwardation that should have helped drain excess crude stocks.
The Reuters analyst then notes that the understanding was initially successful between December 2016 and February 2017, with reports of strong compliance from OPEC, spot prices rising $10 per barrel and calendar spreads moving from contango to flat or, albeit briefly, backwardation.
But the understanding started to unravel with the calendar spreads collapsing after Feb. 21 and flat prices dropping from March 8.
The sharp reversal in both spreads and flat prices inflicted substantial losses on many bullish hedge funds in February and March. The correction came amid growing doubts about whether OPEC was really cutting oil supplies to the market by as much as anticipated.
Traders noted that global stocks of crude and refined products showed little sign of drawing down during the first three months of 2017, and in fact continued to hit record highs. Meanwhile, Bullish fund managers pushed the time horizon for expected stock draw downs back to the second half of the year.
OPEC has come under pressure to reconfirm the faith of hedge fund bulls with an early commitment to extend current output cuts beyond June.
And, as reported earlier today, Saudi and other senior OPEC ministers have been edging towards an extension commitment in recent days. But there are lingering doubts about whether OPEC can deliver real market tightening during the second half of 2017.
Meanwhile, calendar spreads have been falling along the curve with weakness extending from the prompt June-July (M7-N7) spread all the way through to December-January (Z7-F8)
Adding to the confusion, U.S. crude imports from OPEC members Saudi Arabia, Iraq and Venezuela have remained steady or increased since the start of the year, according to the U.S. Energy Information Administration.
At the same time, reported global crude and products inventories have remained stubbornly high, according to data compiled by the International Energy Agency.
To be sure, it is possible that global crude stocks "could" be falling already as previously invisible stocks are repositioned and become more visible to the market. There is some evidence that unreported crude stocks held by producer countries, in floating storage, and in tank farms in the Caribbean and South Africa are being drawn towards the major refining centres. As crude is drawn towards the United States, Rotterdam and Singapore, it is captured in published statistics.
But reported stocks need to start falling soon if hedge fund managers’ confidence in rebalancing is to be maintained.
Which is why the daily jawboning by OPEC in the form of its recurring messaging about high levels of compliance has lost much of its effectiveness and is no longer enough to justify a bullish position in crude.
As a result, reported stock changes now matter more for oil prices and calendar spreads than compliance assessments by OPEC’s secondary sources.
Kemp's conclusion: "OPEC’s credibility is on the line: stocks need to show a significant draw during the second and third quarters or many hedge funds are likely to give up on the bullish narrative prevailing since late 2016."
For now, $50 has proven to be a decisive support for WTI although with every passing week that commercial stocks don't show a material reduction, the tentative agreement between OPEC and hedge funds is one step closer to falling apart, and not even an "extension" of the production cut will be able to push prices higher.
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Finally, here is a presentation put together by Kemp which lays out some of the key variables (link)