Oil prices took a breather in the second half of July, but the price correction may have been a temporary reprieve rather than the start of another downturn.
On Monday, WTI breached $70 per barrel for the first time in over two weeks, rising once again on fears of supply outages.
Part of the reason that prices sank so sharply in mid-July was because of a wave of liquidation by hedge funds and other money managers, selling off their bullish positions in crude futures. Two weeks ago, investors slashed their long positions on crude oil by the most in a single-week in more than a year. As Reuters points out, the shift in positioning was concentrated in the cut of long bets, rather than the increase in shorts. That suggests profit-taking rather than a belief that a deep downturn is imminent.
The reduction of net length helped push down oil prices for a few weeks, but it also let some steam out of the futures market. Investors had become overly bullish in their positions, so the reduction in net length leaves the market a bit more balanced. That means that there is now more room on the upside for oil prices.
Last week, money managers began scooping up bullish bets once again, with net length in Brent rising by more than 4 percent. That coincided with a recovery in oil prices and it suggests that oil traders believe the price correction went far enough. “It lines up with our call to buy the dip in July,” Chris Kettenmann, chief energy strategist at Macro Risk Advisors LLC, told Bloomberg. “We’ve been pretty vocal about adding to length through the July sell-off.”
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The physical market offers some reason to feel confident in that outlook. Ongoing declines in Venezuela, combined with seesawing production in Libya and Nigeria, will keep supplies tight.
But the big driver in determining the balance in the physical market will be how much oil from Iran is lost due to U.S. sanctions. And that means that the Trump administration will have a lot of influence over what happens next. “[I]n the months ahead, US policymakers will play a more outsized role in guiding global oil prices than in recent memory,” Barclays wrote in a note. “That said, in their view, such a sizable disruption could conceivably lead to a price effect so large that the US government may ease the way in which the sanctions are applied in the second and third six-month rounds.”
In other words, Barclays says there is a good chance that oil prices spike over the next few months as Iran loses supply, but heading into 2019 the Trump administration loosens up because of the political damage from higher oil prices. What that means in practice is upside risk for oil prices over the next few months, but downside risk next year.
But the administration probably is more concerned with the November midterm elections, which means it could take a softer line than it wants vis-à-vis Iran much sooner than 2019. Because oil inventories have stopped falling at the rapid rate seen earlier this year, and because the Trump administration might not pursue its policy of “zero” oil exports from Iran, perhaps a price spike is unlikely.
The fear of political damage could reduce the upside risk to oil. But Bank of America Merrill Lynch argues that the downside risks to oil prices “are relatively limited” as well, suggesting that the oil market could see a supply deficit of around 400,000 barrels per day in the second half of 2018. Inventories may not be falling quickly anymore, but they aren’t rising all that much either. EIA crude stocks are now at their lowest level in more than three years, while for the OECD as a whole, they are right around the five-year average.
The bank says that OPEC will want to ensure the Brent futures curve remains in a state of backwardation “because it reduces volatility” and because it “penalizes forward oil sellers, essentially most of the U.S. shale oil industry, and benefits spot sellers, essentially most of OPEC+.” By ensuring that spot prices trade at a premium to oil contracts dated six months or 12 months out, OPEC can basically sell their oil for higher prices than U.S. shale drillers can.
With that dynamic in mind, OPEC+ will calibrate production so as to avoid a market contango, and to do that, they will need to avoid oversupplying the market. Long story short, because of the interests of OPEC+ members, there isn’t a lot of downside risk to oil.
In summary, the U.S. may seek to avoid a price spike while OPEC+ may try to prevent a selloff. Bank of America Merrill Lynch projects Brent prices to be “range bound” through the end of the year, averaging $70 per barrel.
