Late last year, just over a month before prices bottomed out, we noted investors had reached peak pessimism when it came to the outlook for the crude oil price.
There was nothing scientific, fundamental or technical about the view; it was formed by the deluge of bearish research notes arriving in our email inbox.
Though there were exceptions to the rule, almost the whole analyst community was bearish.
It got us thinking: if everyone is bearish, and the price has already fallen so far, just how many were willing to express a similar view, and more importantly, willing to sell at levels not seen in well over a decade?
It was classic contrarian thinking, using nothing but anecdotal evidence. Positioning was so lopsided – or crowded, to borrow market lingo – that one had to question whether the market had reached peak pessimism.
Then came the news that traders, via the options market, were placing bets suggesting that crude prices could fall by a further 50%, having already slumped 70% from June 2014.
According to a story run by Bloomberg at the time, investors were betting in ever-increasing numbers that prices would continue to slide, weighed down by OPEC’s effective scrapping of output limits, Iran’s anticipated return to the market and the resilience of production from countries such as Russia and the United States.
In particular, data from the New York Mercantile Exchange and the US Depository Trust & Clearing Corporation really caught our eye, revealing investors were willing to buy put options over the US benchmark oil price – WTI – as low as $15 a barrel that would expire in 2016.
And that’s with the price having been close to $110 per barrel just 18 months earlier.
Peak pessimism had been hit, at least for this downswing.
Shortly after, front-month Brent futures — the global benchmark — hit their nadir, rallying from a low of $27.10 a barrel on January 20 to as high as $49.83 last week, representing an increase of 84% in just three months.
It was a truly amazing recovery, underpinned by a weaker US dollar, supply disruptions and a curtailment in US crude production, along with an unwinding of bearish positioning from investors.
So where to from here? Will the rally continue, driving prices above $50 a barrel for the first time since October last year, or has the crude price seen its highs, destined to retrace based on the factors that led to its earlier decline?
No one knows that answer for sure – certainly not us – but if you look around, there are signs that the price could be at, or near, its cyclical high.
Take the news that oil traders are now borrowing from banks to store crude in idle tankers at a loss, for example.
Although using idle tankers to house crude isn’t anything new, it’s been done in the past to store crude for sale at a later date when storage costs are less than the profitability of the trade, Bloomberg, citing analysis from Morgan Stanley, note that there’s an oddity on this occasion.
Storage costs are more costly than the present profitability of buying crude near-dated to sell in the future.
“Unlike previous oil storage trades, however, this one is unusual in that current oil prices and storage costs ought to make it unprofitable,” notes Bloomberg.
“Morgan Stanley estimates that the one-month Brent storage arbitrage currently produces a loss of $0.48 per barrel, while its six-month equivalent loses $6.11 per barrel.”
In other words, although the crude market is still in contango — a scenario where prices in the future are higher than the current spot price — traders are paying more for storage costs than what they can make by buying short-term and selling long-term based on current market pricing.
“Banks are seeing a sharp uptick in interest to finance storage charters. This storage is not happening for profit. Rather, the market is looking for places to store oil,” says Morgan Stanley.
“To profit, traders need to hope for oil prices to rise enough to pay for the new debt incurred for this storage.”
Hope, and from an increasing number of oil market participants. Interesting.
“The increase in floating oil comes despite disruptions in the Atlantic Basin and an out-of-the-money floating storage arb, suggesting markets are not as healthy as sentiment suggests,” Morgan’s notes. “It also highlights the speculative nature of much of the oil bounce this year.”
Although every market requires a degree of speculation, this may be deemed by some investors as the market getting ahead of itself once again, betting that the price will continue to push higher, even after a near 90% gain since early February.
While this doesn’t automatically suggest that the crude price is destined to fall, and far from indicating that markets have reached peak optimism, contrarian investors will no doubt be taking note.
Throw in the prospect of higher US interest rates, a higher US dollar and a renewed slowdown in the Chinese economy in the second half of the year — some of the key factors that led to crude’s implosion in recent years — and there’s added reason for caution.
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