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Inside the Market How large speculators are fuelling oil’s record-breaking losing streak

Crude prices declined for the eleventh day in a row Monday, extending a record for consecutive losses that’s getting painful for investors in the energy sector.

While it’s true that the fundamental supply and demand will determine the crude price in the longer term, day to day, it is speculative excess and the futures curve that have been driving the commodity price, which on Monday settled to less than US$60.

The number of large, speculative investors in energy markets has been steadily rising in recent years. These big money managers have little interest in the actual supply and demand of the physical commodity. As Citigroup commodity strategy Ed Morse said earlier this year in the Financial Times, "they don’t care about talking to people who deal with fundamentals. They have no interest in it.”

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The rise of fundamentally agnostic oil speculators has become increasingly evident during the recent spike in volatility for the commodity price.

Speculative excess & the futures curve

WTI (U.S. dollars)

CFTC non-commercial net futures position

(rhs, contracts)

$120

800,000

700,000

100

600,000

80

500,000

60

400,000

300,000

40

200,000

20

100,000

0

0

2014

2015

2016

2017

2018

WTI (U.S. dollars)

Oil curve steepness: 12M futures contract

minus 1M futures contract (rhs)

$120

$15

100

10

80

5

60

0

40

-5

20

-10

0

-15

2014

2015

2016

2017

2018

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG

Speculative excess & the futures curve

WTI (U.S. dollars)

CFTC non-commercial net futures position (rhs, contracts)

$120

800,000

700,000

100

600,000

80

500,000

60

400,000

300,000

40

200,000

20

100,000

0

0

2014

2015

2016

2017

2018

WTI (U.S. dollars)

Oil curve steepness: 12M futures contract minus 1M

futures contract (rhs)

$120

$15

100

10

80

5

60

0

40

-5

20

-10

0

-15

2014

2015

2016

2017

2018

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG

Speculative excess & the futures curve

WTI (U.S. dollars)

CFTC non-commercial net futures position (rhs, contracts)

$120

800,000

700,000

100

600,000

80

500,000

60

400,000

300,000

40

200,000

20

100,000

0

0

2014

2015

2016

2017

2018

WTI (U.S. dollars)

Oil curve steepness: 12M futures contract minus 1M futures contract (rhs)

$120

$15

100

10

80

5

60

0

40

-5

20

-10

0

-15

2014

2015

2016

2017

2018

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG

The first accompanying chart compares the West Texas Intermediate (WTI) crude price with hedge fund positioning as provided weekly by the Washington-based Commodity Futures Trading Commission. Non-commercial net futures position, the gold line on the chart, is widely used as a proxy for the difference between hedge fund long positions and short positions. A rising line indicates more bullish positions relative to bearish contracts.

The scale of speculation has definitely increased. In mid-2014, when the commodity price was well more than US$100, hedge funds owned about 460,000 more bullish contracts than bearish bets. In late January of 2018, bullish contracts outnumbered bearish by a much larger 735,000 contracts.

From February, 2015, there is a pattern on the chart whereby futures positioning snaps back whenever it deviates too far from the purple line indicating the oil price.

In November, 2016, for instance, the net futures position began a 101-per-cent surge while the commodity price stagnated. Three months later, a big portion of those bullish positions were removed quickly as an oil rally failed to materialize, exacerbating downward pressure on the commodity price.

More recently, the net futures position more than doubled between May, 2017, and February, 2018, an indication of significant bullish sentiment among hedge funds. The high degree of optimism took a rapid turn at that point, and the number of bullish contracts started a sharp decline, again helping push the oil price lower.

The shape of the oil futures curve – the difference between the price of the 12-month oil future and the one-month oil future – has also been a driver of commodity price volatility because of its indications for global crude inventories. The futures curve and the oil price are compared in the second, lower chart.

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The oil price has consistently moved in the opposite direction of the steepness of the futures curve. True to form, the curve (the gold line) has steepened in recent weeks while the crude price has declined.

The inverse relationship exists because of producer forward selling through the futures market. When the oil curve is steep, this incentivizes oil producers to sell at higher 12-month prices, rather than for quicker delivery. The end result is that producer inventories increase, which is happening now, and this creates the appearance of glut conditions and causes weaker spot prices.

The reverse case also holds, as a downward sloping oil futures curve motivates producers to sell at better near prices and deplete inventories as fast as possible.

For Canadian energy investors, the elephant in the room here is the Western Canadian Select oil price, which is depressed because a lot of it can’t be shipped anywhere. There is, unfortunately, no futures market for WCS with enough relevance to provide guidance on when these problems might be addressed. But, to the extent domestic prices are still affected by U.S. crude, or Canadian investors can look through current logistics issues to a day when domestic oil prices approach West Texas levels again, the two charts can provide assistance.

For the immediate future, the good news is that speculative trading in oil futures should calm down – the net futures position in the top chart is now in line with the spot price – and volatility in the sector should also abate. The futures curve in the lower chart, however, continues to steepen, and this should limit upside for the commodity price for as long as the trend continues.

Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.

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