Commodities: West Texas Massacre

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06/16/2017 | 11:50 am
The downward spiral in oil prices continues. Despite numerous tailwinds, West Texas crude oil hit its lowest closing level of the year this week. Many oil analysts have been looking for firmer oil prices on the back of downward trending inventories this year coupled with promised output cuts by the Organization of Petroleum Exporting Countries (OPEC) and hopes for higher gasoline demand over the summer.

The first chart shows the Department of Energy’s weekly estimate of the change in crude oil inventories. Even with inventories tracking down, the surprise build in the week of June 2 accelerated the drop in oil prices after peaking in late May (second chart). Overall levels of U.S. commercial crude inventories, nevertheless, remain more than 100 million barrels above the five-year average. From these levels, weekly draws will need to average no less than -5000k barrels per week over the summer to eliminate the glut.





 

Graphically, despite wide swings in the West Texas oil price, the 2017 trend shows falling tops and falling bottoms. A classic down-trend channel.





 

The S&P Oil and Gas Exploration & Production Index, grouping the companies most sensitive to the change in oil prices, has been pricing in lower oil prices since December – despite the several “false start rallies” in West Texas crude oil. With oil prices below $40 barrel, almost all E&P companies will be operating at a loss. Even if prices of oil company stocks are getting attractive, it’s a tough trade to fight against this textbook downtrend.







For the moment, there is no way to sugar coat what is taking place in the oil space. This is a West Texas massacre. We have seen the S&P Energy index fall for five consecutive months (January to May 2017). Oil prices have seen sellers pile on after each rally this year. But investors know that when there is blood in the street, long-term buying opportunities are created.  We break down the near-term positive versus negative factors for the oil market below.

On the positive side, oil bulls can cite:

·         The Saudi and Russian oil ministers calling for $75/barrel oil by year end. Recall that these two countries control 1/3 of the world’s oil exports, so these actors’ words hold quite a bit of weight.  
·         The downward trending U.S. dollar.  As oil is denominated in USD, oil prices need to rise to maintain the real price of oil in a weak dollar environment.
·         Market sentiment is already very weak, a sign that oil bulls have largely thrown in the towel.
·         Many of the bearish factors that have led to the poor first half performance of the oilers are set to reverse in the second half of the year. Demand is typically stronger in the second half, which will especially be the case this year if Chinese demand holds up.

On the negative side, oil bears can cite:
·         The absence of any signs that shale producers are holding back on production, even in the face of falling prices.
·         U.S. stockpiles are still holding near historic highs even after several recent weekly declines. To close the oversupply, as mentioned above, we’d need to see a stretch of exceptional drawdowns.
·         A very ugly West Texas crude oil chart that continues to show technical deterioration.

Conclusion
While the trend in weekly inventory changes is bullish for oil prices, don’t expect to see higher West Texas prices until the oil glut begins to get resolved and OPEC production cuts kick in. Longer-term investors can start nibbling in the oilers; traders need to remain cautious with West Texas crude prices potentially targeting $40/barrel.







 

Owen Williams
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