OIL – A BUSTED FLUSH?

GEORGE KEREVAN

TIME for one of my regular ditties on the state of the oil market. Yes, I know the price of a barrel of crude has crashed since last summer. Everybody’s granny knows that. But how are investors reacting, now they have adjusted to the new status quo?

In the UK, largely due to the follow-on from the referendum debate, the oil price crash has – for the most part – been looked at in purely political terms.  But oil still makes the world go round, as well as constitute the feedstock for out plastic-coated consumer universe.  Oil is not going away and investors know that.

Here is the curious thing. It is small retail investors who appear to be piling into petroleum.

You can see this in the behaviour of exchange traded funds (ETFs) in the United States.  Traditional ETFs track baskets of securities. During the great commodities boom that preceded the 2008 Credit Crunch, EFTs dealing with baskets of said commodities – minerals, food and energy products – suddenly became big business.

This past year has seen a sharp decline in many commodity indices, not just crude. One might think that would signal a shift out of commodity ETFs. In fact, investors’ cash is flooding into oil ETFs at a prodigious rate, in the US despite the price of West Texas Intermediate (the standard benchmark Stateside) being half what it was a year ago.

What gives? Easy: investors are trying to guess the bottom of the crude market. Even if WTI tips a bit on its current $46 a barrel price tag, it’s not going to go a lot deeper. More to the point, it has nowhere really to go but up. The question is when? So folk are buying into ETFs that track the oil market in a big way.

The largest petroleum-related ETF is US Oil Fund, or USO.  This year to date, it has attracted an extra $2bn in cash, largely from retail investors looking to gain from a rise in crude.  Where retail investors lead, hedge funds seem to be following (in a strange reversal of the norm). Kynikos Associates, run by James Chanos. Interestingly, Chanos is normally known as a short-seller. USO, however, has bet heavily on a long term rise.

Well, hedge funds… er, hedge their bets.

What do ETFs do with their cash?  Answer: they buy commodities futures. In other words, they can end trading (and sometimes owning) real stuff like crude oil, orange juice, copper or pork bellies. Of course, ETFs don’t want to sell beef in butchers’ shops.  But by speculating in actual commodities, ETFs do impact on real prices.

One estimate says that American ETFs have bought 180m barrels of WTI crude for delivery next May – that’s nearly a third of the open market supply. The point being that if ETFs buy heavily into oil futures, they automatically drive up the price of petroleum. Unlike horse racing, the more you bet, the more you affect the outcome you are betting on.

This means that – in all probability – the recent gentle inflection in crude prices could be the result of retail investors own actions, and not the other way around.

Finally, where is the price of oil headed in the next period? Crude prices fell further at the start of this week, with North Sea Brent (the European benchmark) dipping below $55 a barrel after Saudi Arabia announced it would only consider cutting output if other producers outside OPEC (i.e. the US and Russia) did so too.

Which, of course, is unlikely.

Analysts at Barclays forecast on Monday that if OPEC production held near current levels of near 30 million barrels per day (bpd), the current market surplus would actually expand from 0.9 million bpd to 1.3 million bpd.

The other fly in the petroleum ointment is the value of the US dollar. Conventionally, oil is priced in greenbacks. If the dollar rises in value, the price of traded oil falls.  With hot money seeing the dollar as a safe haven, in anticipation of the Fed raising rates this summer, the greenback is another factor depressing oil prices pro tem.

Now here’s something to conjure with.

Historically, the US dollar usually falls when the Fed raises rates. That appears totally perverse, as higher rates – rather than their anticipation – should suck in even more foreign money into dollar securities. Not so. By the time rates start upward for real, forex speculators are likely to have already driven the exchange rate to stellar heights. An over-valued dollar then has nowhere to go but down again.

Are we in that territory now? Certainly the dollar exchange rate has shown signs of extreme volatility, lately. If the dollar starts down, then the pressure on oil prices will be upwards. So keep on your toes.

 

 

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