Weak fundamentals bite back in oil
The past month has seen weak near-term fundamentals reassert themselves over bullish sentiment about the medium-term outlook in oil markets.
Crude prices have pulled back to a more realistic level, towards the middle of OPEC’s informal $70-$80 target range, as growing evidence of ample supplies and swelling inventories overwhelms the previous uptrend.
Much of the price movement has reflected changes in the shape of the forward curve rather than flat prices, and been concentrated in the NYMEX light sweet crude contract, rather than ICE Brent futures.
Front-month NYMEX futures have fallen $9.50 (11 percent) since the end of April, erasing this year’s prior gains. Losses on the December contract have been smaller, down just under $7.00 (8 percent). As a result, the Jun-Dec contango, already wide at $5.50 at the start of the month, has almost doubled to $9.25.
The steepening of the contango seems to have been triggered by consecutive weekly builds in reported oil stocks held around the NYMEX delivery point at Cushing, Oklahoma.
Based on weekly data published by the Energy Information Administration, Cushing stocks are now at a record level, and close to the area’s maximum operational capacity. The result is acute congestion around the delivery point and a large discount for crude futures that will mature in the next couple of months.
In contrast, prices for the equivalent Brent contract, which does not suffer from the same congestion problems, have fallen less, down only $6.40 (7 percent). Forward Brent is down only $6 (6.4 percent).
Unlike NYMEX WTI, the Brent forward structure has remained fairly stable. While the contango has steepened slightly in the last two weeks, from $3.85 to $4.90, discounts for prompt crude are nowhere near as large as on NYMEX.
The big difference in price structure has created an unusually large arbitrage (Brent > WTI), but only at the front of the curve; year-end prices for the two contracts are basically similar.
NOT ALL DUE TO “SENTIMENT”
Some commentators have dismissed the plunge in nearby crude prices as another instance of the congestion problem periodically affecting the NYMEX contract.
They also point out that the steep decline in oil coincided with an increase in risk aversion across all asset classes. It began at the same time as steep falls in other risk assets such as equities, and a flight to safety in U.S. Treasury bonds.
In their view, the sudden drop is no more than a correction (perhaps an irrational one) in an otherwise strong uptrend. Macroeconomic fundamentals driving this year’s fairly steady increase in oil prices remain intact.
Strong growth in emerging markets and recovering demand in the advanced industrial economies should continue to tighten the supply-demand balance and lead to a drawdown in inventories.
In this context, oil bulls believe the balance of risks is to the upside if demand turned out to improve faster than expected. Some forecasters have predicted the tight conditions characterising the market in 2007-2008 could return as early as 2011-2013.
This narrative supported expectations of further, gradual increases in the flat price, towards $90-100 by the end of the year, with further increases in 2011, and a continued strengthening of the timespreads, as the contango evaporated to be replaced by a backwardation by the end of Q3.
Except it isn’t happening. Increasing inventories are not confined to Cushing. The IEA has reported increases in global forward cover in each of the last three months. Crude stocks have risen from a recent low of 58.1 days of current consumption at the end of December 2009 to as much as 60.5 days at the end of March 2010. Crude stocks held in floating storage are rising again.
Some build in stocks is normal at this time of year in the shoulder period between the end of the winter heating oil season and the beginning of the summer gasoline campaign in North America, when many refineries shut down for routine maintenance.
Even so, the seasonal stock build is not consistent with narratives about a progressively tightening physical market. Demand improvements seem to have been slower than expected, and are being offset by deteriorating compliance with OPEC production targets.
REVENGE OF THE FUNDAMENTALS
Commodity prices have become increasingly “forward looking” in recent years, placing more emphasis on expected future fundamentals than the current supply-demand-inventories mix. Bullish expectations about market tightness in 2011 and 2012 have sustained interest from investors, pushing prices higher despite weak near-term fundamentals.
Recent price falls mark the fundamentals’ revenge.
There are good reasons to think this month’s sharp price declines should not be dismissed as simply the product of risk aversion and unthinking correlations with equities. The market has run ahead of itself and is now correcting as some of the speculative froth that had accumulated is blown off:
(1) While the sharp decline in flat prices coincided with steep declines in U.S. equities, and the two markets have been closely correlated, the forward price structure began softening much earlier, from the start of April, in response to rising Cushing inventories and other signs of slackness in the physical market.
The progression from rising inventories to a shift in the curve and then a decline in the outright price was precisely what we would expect to see if supply-demand fundamentals were driving the market rather than just “sentiment”.
(2) While oil followed the equity markets closely on the way down, it has not followed them back up again in recent days. Strong correlations on the downward leg have been replaced by weaker ones on the upward one.
The S&P 500 equity index fell 6 percent between April 30 and the close of business on May 7, before recovering most of its losses to end down just 2.6 percent by yesterday’s close. In contrast, front-month oil prices shed twice as much (13 percent), staging only a very weak recovery, so they are still down 11 percent compared with April 30.
Oil’s failure to rally along with other asset market does suggest that market-specific, fundamental factors, not just sentiment, are at work.
(3) The smooth rise in oil prices for three months from the beginning of February to the end of April, with only limited corrections, establishing successively higher price floors, seems to have drawn trend-following investors into the market in record numbers.
According to the Commodity Futures Trading Commission (CFTC)’s commitments of traders (COT) report non-commercial traders had established a record net long position in NYMEX crude futures by the start of last month.
Non-commercials’ net length more than doubled from 129,200 contracts (129.2 million barrels of oil) at the start of February to peak at 219,720 contracts in early April. Net length was far in excess of anything seen in the run up to the 2008 price spike, when non-commercial’s net long position peaked at 157,740 contracts.
The rise in non-commercial longs closely tracks the increase in prices, indicating that most of this additional interest was trend-following “hot money” rather than new institutional allocations. If so, it was both driven by the rally and helped fuel it. It almost certainly caused the market to “overshoot” on the upside.
Once the trend broke down, however, and the support points on the charts failed, much of this speculative length was liquidated, producing the abrupt sell off evident in the past couple of weeks.