Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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Oil rally slows as fundamentals play catch-up
Ole Hansen
Head of Commodity Strategy
Summary: Crude oil's longest winning streak in two years has started to show signs of pausing, thereby allowing fundamentals to catch up with a rally that has taken prices higher by 22% since Saudi Arabia announced their unilateral production cut decision in early January. A decision that undoubtedly has helped the market through what otherwise would have been some challenging months, with billion of consumers still facing lockdowns and reduced mobility. Tightening market conditions driving rising roll yields, however, continue to support "paper" demand from funds buying commodities as a hedge against the risk of rising inflation.
What is our trading focus?
OILUKAPR21 – Brent Crude Oil (April)
OILUSMAR21 – WTI Crude Oil (March)
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Crude oil’s longest winning streak in two years continues despite emerging signs of the rally beginning to show signs of overheating. The cost of a barrel of crude has now risen by an impressive 64% since early November when vaccine news helped turn the focus towards the recovery while President Biden’s stimulus plans have helped turbocharged inflation expectations, and with that demand for hedges through commodities.
In addition, the rise by nearly one-quarter since January 4, when Saudi Arabia announced its unilateral production cut for February and March, has increasingly removed barrels from the market, thereby creating the tightest conditions in more than a year. While billions of people around the world remain impacted by lockdowns and lower mobility, Asian demand, led by China, has been strong.
WTI crude oil has returned to the old consolidation area between $50 and $65, an area that supported rising US oil production to 13 million b/d before collapsing to the current 11 million. The US Energy Information Administration in their latest Short-term Energy Outlook wrote: “Although oil-directed drilling has increased in the United States in recent months, the number of active drilling rigs remains lower than year-ago levels. EIA expects production from newly drilled wells will be more than offset by declining production rates at existing wells in the first half of 2021”.
As a result they see no pick up in US oil production from the current 11 million b/d in 2021. For 2022 they see oil production only rise to 11.5 million b/d, a level that would leave plenty of room for OPEC+ to increase production and attract market share as global demand starts to recover.
The International Energy Administration in their February Oil Market Report (OMR) said the rebalancing of the oil markets remains fragile during the early parts of 2021 with lockdowns and reduced mobility weighing heavily on the near-term recovery in oil demand. But the prospect of tighter markets ahead due to increased economic activity and a pledge from OPEC+ to hasten the drawdown of surplus inventories remain the overriding market focus.
They forecast global oil demand will recover by 5.4 million barrels/day to average 96.4 million barrels/day in 2021. With OPEC+ currently withholding around 7 million barrels/day, the recent price upgrades from analysts are based on discipline in rolling back production curbs and a muted non-OPEC production response to higher prices.
Supporting the energy market in general and crude oil in particular is the rising backwardation or roll yield. The tightening supply outlook has led to a relative stronger rally at the front of the curve meaning that WTI and Brent are effectively yielding 8.6% and 7.7% respectively on an annual basis for investors who keep rolling their long positions from one month to the next.
Given current strong fundamentals as OPEC+ maintain tight supply, a roll yield of this magnitude, continues to lure speculators into the sector. Not least considering the reduced threat of a sudden jump from other producers, example being those in the US, who are focusing more on bringing down debt and deliver value to shareholders instead of embarking on low profit production growth. This development further strengthen oil as one the current favorites, together with copper, platinum and gold, as the go-to commodities from macro-orientated funds looking for reflation hedges.
The combination of tightening fundamentals, reflation hedge demand and not least an unchallenged momentum, have led hedge funds to increase their combined net-long in WTI and Brent crude oil to 699k lots and within a few thousand lots from the previous two peaks in 2019 and 2020. While potentially signaling a risk of a short-term pullback, given current RSI’s at overbought levels, it is worth keeping in mind that the net-long peaked at close to 1.1 million lots back in 2018.
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