Being long oil is a very “crowded trade,” but who’s on the other side of that trade, and what do they know that speculators don’t?
“Crowded trade” is an infamous phenomenon. It’s when traders are all betting on the same direction of a trade. But each trade must have someone else betting on the opposite direction. So who is on the other side of a “crowded trade?” And what do they know that these traders don’t?
And what happens when the traders in the “crowded trade” are all looking for an exit, and suddenly the entire psychology changes?
Oil markets may have reached that point, according to Dan Dicker, a 25-year veteran of the New York Mercantile Exchange where he traded crude oil, natural gas, unleaded gasoline, and heating oil futures contracts. In Oil & Energy Insider, he writes:
When I was standing shoulder to shoulder with all those other oil day traders on the floor of the NYMEX, once in a while I’d get a very funny feeling. All of a sudden, I’d realize that the position I’d built up for myself was largely shared by just about everyone around the ring – and I also sensed that every other trader had had the exact same realization.
That’d be a wary moment – staring around at each other like combatants in an old west quick draw. We’d all still be convinced still in our positions, of course. We, collectively, could be entirely right on the coming trend and just need some patience to all make some money. But we also knew that the first guy to flinch in panic could set off a complete avalanche of traders suddenly becoming less convinced and trying to get out.
I called this “the porthole effect”: The boat might or might not be sinking, and you couldn’t tell through the small hole that was available to you; but if one guy jumped into the porthole trying to escape, he was likely to cause a mob scene of panicked passengers all fighting to squeeze out of that entirely too small of an exit.
This is kind of what I’m seeing in the oil market today.
While “there is a lot to like” in the oil markets, there are also other dynamics at work. The Numbers Report of Oil & Energy Insider spells out some of them.
OPEC members have cut more than 1 million barrels per day (mb/d) in production. That’s less than their promised cuts of 1.2 mb/d made during their November meeting. The deal is further being undermined by some OPEC members, including Nigeria and Libya which are exempt from the deal:
- Libya has added 162,000 bpd since the deal was announced;
- Nigeria has added 12,000 bpd but might add a lot more (see below);
- Iran has brought back 110,000 bpd.
With those additions, net OPEC cuts are “closer to 800,000 bpd,” according to the Numbers Report. Plus, Libya and Nigeria are trying to restore more idled capacity.
Nigeria’s oil production plunged from 2.2 mb/d in 2015 to a low point of 1.4 mb/d in the summer of 2016 due to the attacks by militant groups on oil targets. Production has since edged up to only about 1.6 mb/d. The government is struggling to restore output. It has reinstated a program to pay militants to lay down their weapons. If this improves security, pipelines and export terminals could be repaired, and about 500,000 bpd could come back on line, which would crush much of the OPEC production cut.
The 11 non-OPEC oil producers, including Russia, that had agreed to cut production along with OPEC, have only delivered 40% of the promised cuts in January, according to two OPEC sources cited by Reuters on Friday. The sources in turn cited OPEC calculations based on data from the IEA. Part of the lack of compliance is said to be due to the phased implementation of the cuts by Russia.
In the US, the glut gets worse. Crude oil inventories surged by a near record 13.8 million barrels in the first week of February, after having already surged 29 million barrels in January – compared to the 10-year average increase of less than 13 million barrels.
Part of this surge is due to imports that had jumped as a result of OPEC ramping up production in December to front-run the production cuts starting in January.
At the same time, US gasoline stocks, at over 256 million barrels, have surged above the five-year average for this time of year.
And big money is flowing back into US oil production. Wall Street funded the shale oil boom. After oil prices had plunged, credit to the oil patch tightened and equity issuance collapsed. Now Wall Street is pouring money back into oil production. In January alone, drillers and oilfield service companies raised $6.64 billion in 13 different equity offerings, with much of the funding flowing into the Permian Basin. And the credit tap has been reopened.
So the fundamentals are mixed, as they say. Dan Dicker sees it this way:
And yet, everyone speculating on the price of oil, just like when I was standing in the pit, seems to be all in one direction – LONG – and staring at each other just as we did, wondering who, if anyone, would flinch.
For an oil market that has really done fairly little since the start of the year, we do seem to be reaching a tipping point, when a fairly sizable move is about to come in the crude market – either recognizing the higher prices that the fundamentals of a rebalancing market and OPEC compliance will bring, or the blow up that comes with traders who are all in the same boat, diving into the porthole en masse.
The big question: Who is on the other side of that crowded trade? Who are the entities that are taking these bets? Dicker:
They’re domestic producers, about to file quarterly reports, who’ve seen a greater than $50 crude price as a respite for all those rigs they’ve been adding over the first quarter this year – about 200 or so.
In other words, US producers are hedging their production by selling futures. So Dicker asks, “Are they necessarily more right than the speculators?”
History – or at least my long history in futures – says that they almost always are. In a battle between pure money on one side and commercial physical assets that are the underlying “currency” of the bet, the commercials almost always come out on top.
And Dicker, who remains bullish on the oil sector over the longer term, concludes that “if history is the judge,” there could be “a fairly sizable, and imminent, move down.”
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