April 12, 2018, by Jim Bianco and Peter Forbes
Hedge funds have loaded up on crude oil futures in recent months, betting that strong global economic growth will spur demand and power prices higher. Bullish positioning has reached an extreme as markets try to balance a known surge in U.S. shale production with OPEC’s efforts to draw down global inventories. So far, the hedge funds are winning, with oil prices rallying in recent days to their highest since 2014 on political fears. The reality, though, is that slowing global growth and the unique flexibility of U.S. shale producers are likely to restrain prices. In isolation, extreme bullish positioning is not a reason to expect lower prices, but it does leave precious little fuel to push prices higher. In the context of a surge in domestic supplies and a concerted slowdown in global economic growth, oil prices may be more vulnerable than usual.The chart below shows the price of crude and the futures positions held by “managed money” for the three major crude oil contracts: NYMEX West Texas Intermediate, Intercontinental Exchange WTI crude oil and European ICE Brent. These positions have been converted to barrels. In mid-October these hedge funds were net long 531 million barrels of crude oil. Over the next three months these positions more than doubled to a new record well over 1 billion barrels.
Clearly, hedge funds see something in the supply/demand picture that they believe will lead to higher prices. We can estimate the demand-side of oil by adapting a method used by James Hamilton, a professor of economics at the University of San Diego, and former Federal Reserve Chairman Ben S. Bernanke in a post for the Brookings Institute. We use the U.S. Dollar Index, copper prices and global implied volatility to estimate a demand-driven price for WTI. The chart below shows actual futures prices (blue) and our demand-driven estimate (orange). Strong, concerted global growth has pushed prices higher since mid-2017.
While demand has driven prices higher, elevated global inventories and expected increases in supply may restrain prices going forward. The next chart shows the wave of new production expected to emanate from U.S. shale regions later this year. Shale producers’ focus on returns over growth paid dividends. The combined effect of the rising rig count and improving production per rig will send U.S. oil production further into record territory. The chart shows actual (blue) and estimated global production from the U.S. Department of Energy.
Sustained high oil prices may induce even more production from U.S. shale regions. A feature of shale oil has been the growing inventory of drilled but uncompleted (DUC) wells. These can be brought online quickly and at much lower cost than new wells. Many are reportedly profitable at prices below $50 per barrel. The chart shows the growth in DUC well inventory in the U.S. since 2014 by region. Nearly 3,000 wells stand ready to be tapped. We expect producers to be opportunistic in hedging future production with oil above $55 well into 2020.
The wave of new supply arrives just as OPEC sets a more ambitious target for global inventory drawdowns. Reducing global stocks to their five-year average was the stated goal of OPEC’s production cuts beginning in November 2016. The next chart shows the U.S. Department of Energy’s estimates for OECD inventories of crude oil and other petroleum liquids, along with the five-year (yellow) and seven-year (orange) moving averages. The most dramatic reduction since 2002 has pulled global inventories to their five-year average. OPEC is considering targeting the seven-year average instead, which would require a drawdown of an additional 40 million barrels.
The final chart illustrates what an impressive feat it would be to continue to reduce inventories. The chart shows the change in U.S. crude oil inventories by year since 2000, with 2017 highlighted in yellow and 2018 shown in a thicker, orange line. The drawdown that OPEC engineered with reduced shipments to the U.S. in the second half of 2017 was the largest in any calendar year since 2000. Reaching their new goal of the seven-year average would mean another once in a generation drawdown in consecutive years.
Rising production from active wells and the inventory of DUC wells would be sufficient to restrain oil prices during a period of strong global economic growth. OPEC hopes to extend its remarkable drawdown of global inventories, but that is a tall order. Tailwinds from concerted economic growth are fading just as a wave of new production will bring supply concerns to the forefront. Short of a new bout of political instability in the Middle East, the case for higher crude oil prices is getting difficult to make. Hedge funds may be caught on the wrong side of this bet.
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