Last week, a Reuters article suggested that OPEC production cuts would bring global crude oil supplies out of storage and onto the market.
Such a development would help work off the global glut and eventually (notably sooner than later) lead to rising prices.
At least, that’s what some folks are betting on …
But let’s think about what else is going on besides OPEC’s much-publicized production cut …
Look at the latest hype about OPEC. Members were almost perfectly compliant in February with the agreed-upon monthly production cuts.
The deal is to cut output by some 1.2 million barrels a day. In February, members were reportedly 94% compliant. That means they exceeded their better-than-80% compliance (or so) in January.
There’s even some chatter that they may continue the production cuts beyond their scheduled June end date.
After all these “revelations,” the price action in the markets suggested oil traders are bullish.
What’s the big deal, you ask? Beats me, I say.
I can’t say I keep a running track record of OPEC deal-making history. But from day 1, I’ve assumed they would fully comply with the agreement. But even with everyone sticking to their word, I still figured the cuts would fall short of:
- Reducing the global glut by a significant margin and thus
- Driving oil prices substantially higher.
I stand by that.
But to be sure, the Reuters piece is certainly worth a few thoughts …
The price of nearer-month crude oil futures contracts is rising. (That’s the market moving into “backwardation.”)
This means that many passive funds invested in later-month contracts are forced to swap their positioning.
Let me let Reuters explain …
The S&P GSCI Enhanced Commodity Index rule aims to ensure that investors are positioned to cash in when oil market fundamentals change — in this case, when supply becomes so tight that the current price of oil becomes higher than the price of oil for delivery many months or years into the future. That structure is called backwardation.
Now, the Brent crude oil futures (global benchmark) triggered the rule. As of this article’s publishing, the WTI contract (U.S. benchmark) hadn’t triggered the rule.
Anyway, such a trigger could force $2 billion from later delivery months to the upcoming delivery month.
Theoretically, that means a lot of oil will change hands.
Backwardation also suggests it makes little sense to store oil. Not when the cost of storage is not made up by higher future prices on contracts with a longer-term delivery horizon.
Moving into backwardation has the potential to change up the supply dynamics in the crude oil market.
But, with the gift of foresight (and, thankfully, hindsight) I can say the importance of that discussion is low.
Much more important are two other items.
More-Important Item #1: The U.S. Response
For whatever is at the core of the decision, Saudi Arabia spearheaded the effort to keep OPEC production running on all cylinders despite the crude oil price collapse.
I’m not smart enough to know if their game theory is winning them anything. But I will say I’m not surprised by the apparent reaction to OPEC’s production cuts.
U.S. oil producers are jumping at the chance to produce more oil. That’s because, among other things, there is a gap to be filled that was being filled by OPEC production. Until recently, anyway.
Check it out, the gap-filling that’s happened since October …
Does any more need to be said about the hasty bullish implications of OPEC production cuts?
Sure, why not …
More-Important Item #2: The Madness of Crowds
To prove that I’m not just attributing a bullish label to news I don’t “get,” let’s look to one of my favorite indicators. This one helps me get a gauge of extreme sentiment when it happens in commodity markets.
And I’m seeing quite an extreme in oil …
The Commitments of Traders report put out each week by the CFTC reveals the net positioning among three groups of futures traders: small speculators, large speculators and hedgers.
Suffice it to say, the positioning of large speculators is what I focus on.
When large speculators develop an extreme net positioning, it tends to mean their bets are about to blow up in their collective face.
The fact that crude oil speculators are extremely bullish is telling.
It suggests the underlying price of crude oil futures is due for a sharp, perhaps short-lasting, significant correction to help rebalance the positioning.
Even relative extremes can be good predictors of price swings. But the bullish bets on crude right now match the levels from 2014 … when the price of crude oil began a major collapse.
Especially when you see just how vulnerable these bets are to fundamentals that are anything but convincingly bullish.
Now, if you’re looking for ways to play this …
Consider inverse ETFs that rise in value as the price of oil falls. One is the DB Crude Oil DoubleShort ETN (DTO). Another is the ProShares UltraShort Bloomberg Crude Oil ETF (SCO).
Buying put options on oil ETFs or oil producers is another way to add “bearish” exposure.
But even if you’re not so sure about the narrative I’ve laid out — that the short term isn’t necessarily going to require a significant price correction — you could try to play the difference between the price of WTI crude vs. the price of Brent crude.
If you play the futures market, you could sell short Brent and go long an equal dollar value worth of West Texas Intermediate (WTI) contracts.
This would be a paired trade betting that either the price of WTI rises faster than Brent, or the price of Brent falls faster than WTI.
The same paired trade could be achieved with ETFs as well.
One example would be selling short shares of the United States Brent Oil ETF (BNO) while simultaneously buying an equal dollar amount worth of the United States Oil ETF (USO).
If this is indeed the dawn before the crude oil storm, any of these strategies could help you to find shelter.
And with such extreme bullish positioning out there, you’ll be able to stake out your spot before the herd rushes back to the bearish side of the trade. When that happens, then it may finally be time to become an oil bull again.