Commodities

Are oil prices at risk of a “long squeeze”? – Commodity News

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Oil prices have had a good run so far in 2018. WTI rallied 6.5% in just the first month of the year, boosted by a softer US dollar and declining crude inventories in the US. However, recent developments suggest that the positive sentiment surrounding the energy market may be on thin ice right now, and a near-term correction should not be ruled out.

Oil is traded in US dollars. This implies that when the greenback depreciates, oil becomes more attractive to buy for investors using foreign currencies, which usually fuels demand for the liquid. This is probably one of the main reasons behind the latest rally in oil; the dollar index has declined 3.5% so far this year. Meanwhile, colder-than-usual weather across the United States helped to increase oil demand further, pushing down crude inventories. To top everything off, recent forecasts from institutions like the IMF revised global economic growth higher, raising expectations that demand for oil could strengthen further in coming years.

The “elephant in the room”, however, is how long it will take for US producers to begin ramping up their production, as prices remain elevated and their profit margins recover. Of course, any significant increase in US production would likely cap any further gains in oil prices, or even trigger a correction lower.

That was partially answered on Friday, after the Baker Hughes oil rig count data showed that the US added twelve rigs just in the past week, denting the optimism surrounding the energy market and putting investors on high alert that oil’s narrative could change soon. Indeed, comparing the rig count to WTI prices, one can clearly see that the rig count tends to follow prices, but with a lag of a few months. It’s already been almost three months since WTI broke above the $55/barrel zone and began rising, so a steady increase in rigs appears logical right about now.

Finally, the stretched-long market positioning in oil should not be overlooked. According to the latest CFTC data, speculative oil net-long positions are currently at a record high. This leaves oil prices exposed to a “long squeeze”. Given the extent of bullish bets in oil, any piece of news that is seen as harmful for prices could have a disproportionally large effect, sending prices lower much more violently than normal as many of the long bets are quickly closed.

Does this mean that a correction lower is on the cards for oil? That will probably depend on whether the signals of rising production continue to flash red in the coming weeks, meaning a sustained increase in the Baker Hughes rig count, as well as a build in US inventories, which have declined for ten consecutive weeks now. In case they do, WTI could very well edge lower and perhaps test the $60/barrel support territory. The performance of the US dollar will also be significant for the precious liquid. A potential recovery in the greenback would likely curb demand for oil, enhancing the argument for a correction.

On the flipside, should the dollar continue to collapse, or if the number of active US rigs does not increase in a material way, then oil prices could rebound. Prices may also see a lift from any unexpected supply disruptions in high-risk regions, or from speculation about a further extension of the OPEC-led supply cuts. In such a scenario, WTI may rise and target once again its recent highs near $66.60. An upside break of that zone could open the way for the psychological level of $70.