Macro: Sandcastle economics
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What drove the three-day rout in crude oil
Ole Hansen
Head of Commodity Strategy
Summary: The three-day 11% rout in Brent crude oil highlights the risk when speculative positions become too one-sided. Despite a rangebound market since November, the combination of backwardation and lower volatility helped drive a tripling of the net long held by hedge funds during this time. A long that is now seeing a forced reduction in response to a deteriorating technical and fundamental outlook
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Global Market Quick Take: Europe
Since our latest crude oil update where we highlighted the downside risks driven by the collapsing risk appetite, we have seen some considerable downside moves across growth and demand depending on commodities, from crude to copper and cotton. As the banking crisis which started last week in the US spread to Europe and Credit Suisse on Wednesday, the need to reduce across market exposure accelerated.
In terms of oil demand, we are currently seeing a widening gab Western nations and Asia, especially China which continues to recover from its extended lockdown period. In their latest oil market report OPEC lower its demand for forecast for OECD countries while raising its demand for non-OECD countries, including China and India. Overall, the group stuck with its call for global demand to rise by 2.3 million barrels a day this year to 101.9 million barrels a day. A projection that is being based on global growth of 2.6% this year, with China’s economy growing by 5.2% while the Eurozone and the US economies will be bumping along at much slower pace of 0.8% and 1.2% respectively.
The IEA followed up on Wednesday by saying that global oil stockpiles have risen to the highest in 18 months with Russia managing to maintain production of its sought after heavily discounted oil by refineries, especially in India and China. However, “It remains to be seen if there will be sufficient appetite for Russian oil products now that the price cap is in place or if its production will start to fall under the weight of sanctions,” the agency cautioned. The agency held onto expectations that global oil demand will increase by 2 million barrels a day this year, thereby surpassing pre-pandemic levels.
The three-day 11% rout in Brent crude oil highlights the risk when speculative positions become too one-sided. Despite a rangebound market since November, the combination of backwardation and lower volatility helped drive a tripling of the net long held by hedge funds during this time. In the week of March 7, the gross long reached a 16-mth high at 320k contracts while the gross short was cut to 22k contracts, a 12-year low. As the long/short ratio reached a four-year high at 14.5 there was a very limited short position left to absorb the sudden burst of long liquidation once the floodgates opened on Monday when the trendline support at $81.70.
The prompt month backwardation (indicating a tight market condition) at 44 cents has only suffered a small reduction from around 60 cents last week, indicating no significant change in underlying fundamentals. And unless the recession story gains further traction, we conclude this move was mostly driven by position squaring and that fresh buying will likely emerge once stability returns.
From a technical perspective, according to Kim Cramer, our technical analyst’s latest update there is no doubt that the breakdown has change the short-term technical outlook, potentially driving fresh short selling and continued long-liquidation from funds who normally enter and exit positions over several days. However, based on previous experiences, holding a short position when the market is in backwardation is often difficult and the full downside potential may not be met.
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