Down 10% In 10 Days: What Next For Oil? - oil sunset

Source: Clinton Steeds

 

Well, something had to give.

That about sums up the recent price movement in oil markets. Prices have plunged around 10% to $49 in just the past week or so. For the record, it hasn't been a good run for Wall Street either. It's been more bullish on oil than just about any other major asset class.

The oil trade has been a (very) crowded trade for some time. As you can see in our Chart of the Day below, our tally of institutional investor holdings (via CFTC data on net futures and options positioning) shows that hedge funds and big banks have been a big buyer of crude oil, more so than other seriously bullish positions in wheat, the Canadian dollar and Silver.

Down 10% In 10 Days: What Next For Oil? - crude oil posit

(The Z-score above is a ratio that measures investor positioning in terms of the number of net contracts today versus the average net contracts over the trailing twelve-months. This essentially allows you to contextualize what current positioning is today versus recent history. Higher Z-scores mean investors are bullish, lower Z-scores equates to bearish positioning.)

Why Did Wall Street Get Long Oil?

#Oil #WallStreet $XLE

The oil patch had been severly challenged for some time. Wall Street has been betting that the worst was behind us. In 2016, the number of oil bankruptcies reached their apex. According to energy industry consultancy Haynes and Boone, oil-related bankruptcies in North America since 2015 hit 119, impacting $79.7 billion in secured and unsecured debt (see chart below). 

Wall Street went searching for a bottom. Energy earnings were kneecapped for the better part of 2016. So, for the first quarter of 2017, consensus earnings estimates put year-over-year growth up 575%. Investors naturally got long. 

Still, in a bubbly year for U.S. equities, the Energy sector (XLE) has been the standout laggard. The sector is down -7.5% in 2017. The next worst performing sector year-to-date is Utilities, up +4.3%; the S&P 500 is up 5.6%.

Down 10% In 10 Days: What Next For Oil? - oil bankruptcies

Oil Underperformance: What Happened? 

OPEC happened.

In November, the 14-country oil cartel implemented an agreement to reduce oil output in November, from 33.8 million barrels a day to 32.5 million barrels per day, in an effort to raise oil prices. Rise they did. Crude prices went from the mid-$40s before the deal was announced until peaking in January at $55 per barrel.

In response to higher prices earlier this year, U.S. oil production has been building. "Despite two months of OPEC production cuts, US crude inventories keep rising," writes Hedgeye Potomac Senior Energy Policy analyst Joe McMonigle. EIA weekly data released on Wednesday showed US crude stocks rose for the ninth straight week by 8.2 million barrels to 528 million barrels," 

As McMonigle points out, US oil rigs increased by seven last week according to Baker Hughes oil rig data released last Friday.  Since OPEC starting implementing its production cut agreement in January, the US energy industry has added 80 new oil rigs.

In other words, Wall Street was getting bullish just as a massive amount of supply came online, a recipe for disaster.

Below is a chart showing hedge fund and big bank crude oil holdings (black line) and the Department of Energy's tally of crude oil inventories (blue line) from JonesTrading's Chief Market Strategist Mike O'Rourke.

According to O'Rourke:

We have been arguing for months that much of the current pricing of Crude is massive speculative longs amidst a record level of DOE inventories.  It is a remarkably bearish mix that has yet to hit an inflection point, maybe rising US production will be the trigger.

It happened. 

Down 10% In 10 Days: What Next For Oil? - o rourke oil net long

Oil Prices: What now?

Good question.

Below is a video from last week of Hedgeye CEO Keith McCullough weighing the bullish and bearish debate on oil. While we're cautious on the setup for oil prices right now, McCullough says, we're cognizant that energy earnings and the broader U.S. inflation outlook are looking up. 

But the real question, McCullough says, had the market already priced-in this inflation acceleration? Could we get bullish at the right price? Watch the video below...