Bullish oil traders recall supply glut, ignite sell-off

Ongoing concerns around extended speculative positioning in the oil market materialized last week after traders appeared to have run out of patience waiting for the OPEC/non-OPEC supply cuts to show up in U.S. inventory data. 

While U.S. inventory data from the U.S. Energy Information Administration (EIA), alone, is not a perfect proxy for the global supply and demand balance, it does provide one of the most transparent and high-frequency views of oil inventories available. 

{mosads}Since oil inventories are the ultimate arbiter of supply and demand and the U.S. represents roughly 20 percent of global oil demand, the weekly reporting of U.S. oil inventories is the industry go-to for the general health of the market.

The anticipation of a rebalancing of global supply and demand had been so fiercely ingrained into the minds of traders — and so quickly — that the market was continuously looking past relatively poor current conditions. 

The chart below shows cumulative U.S. crude inventory changes from the EIA since the beginning of the year versus how oil prices responded on those days in which the EIA report was released. 

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In essence, while the U.S. has added nearly 50 million barrels of crude to inventories since the beginning of 2017, the market’s reaction to those stock builds has been overwhelmingly positive. Typically, bearish data would result in lower oil prices. 

However, on these days in which relatively bearish U.S. crude inventory data was released, oil prices traded higher by a cumulative $2.65 per barrel (/bbl); until last week.

After largely ignoring growing crude inventories for two months, a small shaking of confidence in oil traders’ expectations led to a reversal in this trend, with oil prices falling by a little over $1/bbl last Wednesday, after the latest EIA report was released and an additional $3-$4/bbl by the end of day on Friday.

Sticking to the phenomenon of the relationship of oil prices to inventories, we broaden our view to total Organization for Economic Cooperation and Development (OECD) member inventories, which, while not reported with as high a frequency as U.S. inventory data, does provide a larger sample size by which to gauge global supply and demand dynamics. The following chart shows total OECD oil inventories versus the inverse Brent oil price since the beginning of 2010.

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While not a perfect correlation, one can see how inventories largely act as a magnet to prices. In other words, oil prices may detach from current conditions for a period of time, in order to reflect the market’s expectations about the future, but ultimately prices will revert back to fundamentals if the divergence is too wide for too long.

The initial oil price sell-off in late 2014 seemed to move quicker than fundamentals dictated, but, ultimately, the fundamentals did catch up with those expectations. Similarly, the price rebound in 2016 was likely a bit premature as well, though inventories largely began drawing down across the broader OECD nations in the latter half of the year. 

Current conditions struggled to warrant oil prices above $50/bbl, but expectations were high that additional inventory drawdowns were on the horizon. Unfortunately, U.S. data has yet to confirm it. 

The recent sharp decline in oil prices was the result of concerns regarding the pace at which U.S. shale supply is likely to grow; concerns that OPEC may not be 100 percent committed to prolonging its supply cuts if it means conceding market share to U.S. shale and the perfect storm of stretched positioning coupled with weakening expectations.

The market is now in a bit of limbo after last week’s sell-off.  Many traders who went long on oil (purchased futures contracts) late in the game (after oil already moved above $50/bbl) have likely exited. 

The question now is how shaken the traders who went long at $45/bbl are and whether their convictions in seeing improved market fundamentals in the weeks ahead have been rattled. Price action in the oil market over the next several weeks will be very telling in that regard.

Anthony Starkey is the manager of energy analysis at Platts Analytics. Platts Analytics is a forecasting and analytics unit of S&P Global Platts.

The views expressed by contributors are their own and not the views of The Hill.