Hot money drove oil’s short rally that crashed in July
Oil prices have been on quite the roller coaster over the past two months, plunging from a pandemic-era high of US$75.25 per barrel in early July to US$62.32 in mid-august back to around US$68.50 on Thursday.
In late June, I highlighted some of the fundamental weaknesses that I thought were being obscured by oil’s steep price gains. I now believe the crude complex is healthier today than the highs of two months ago, and that the mid-july price rout was a necessary sentimental rationalization that gives us more headroom for crude’s next push higher.
IT’S COVID-19, STUPID
While it may sound like a tired analytical cop-out, oil prices collapsed in mid-july primarily because of a re-acceleration of the global virus case counts and the deterioration of crude’s reopening narrative momentum.
The fallback was the latest iteration of a cycle that has played out repeatedly over the past year: crude prices have been grinding structurally higher from depressed 2020 levels, with that steady rally getting supercharged in periods when global COVID cases are falling (January-february, May-june) and temporarily derailed — backslide followed by rangebound trading — when those cases begin to rise anew (March-april, July-august).
While the latest wave obviously slowed the oil demand recovery slightly — the International Energy Agency’s latest monthly report notes that that global oil demand fell back slightly (0.12 million barrels per day) in July, but only after surging 3.8 million bpd in June — investor myopia can be largely credited with aggressive price swings, both on the upside and on the way back down.
When COVID-19 case counts were bottoming, investors became overzealous and overbid crude on its central reopening narrative, pushing it higher than it deserved given lingering headwinds and the high likelihood of at least one more wave. When COVID-19 cases re-accelerate, that hot money floods out.
The current new case plateau, combined with rising vaccination rates means that we’re already likely past the point of peak Covid19-sentiment weight on oil prices and that these headwinds will become tailwinds if new case identification continues to reverse.
HOT MONEY, COLD FEET
Speculative sentiment toward crude oil — as measured by managed money positions in futures contracts — has eased off substantially since June. Net-long positions have fallen by more than a quarter, the equivalent of about 200 million paper barrels of crude, and the move was mostly driven by the liquidation of long positions than the establishment of fresh shorts. Funds likely saw great returns on those profit-taking decisions, with oil prices nearly doubling between late 2020 when said positions began to accumulate and when they started selling in early July 2021.
Net speculative positioning in combined Brent and WTI contracts is back to around levels last seen in August 2020, when crude was trading more than US$25 cheaper in the low-us$40s per barrel and futures contracts were still trading in contango territory. This hot money is far from the only driver of oil prices, but I typically look at it through the lens of it being the marginal crude buyer; those marginal buyers looked pretty tappedout a couple months ago, but after this sell-off it looks like they have much more headroom to help support crude on its next leg up.
OPEC+’S GRACIOUSLY SHORT MEETING
The Organization of the Petroleum Exporting Countries
and its allies agreed to stick to its hard-fought plan and continue adding 400,000 bpd of withheld oil back to the market each month. Rumours emerged in mid-august that the additional barrels could be delayed given waning prices, but those worries proved unfounded.
Media reports indicate the OPEC+ technical committee sees deficits through the end of 2021 sufficient to absorb incremental supply additions and a modest surplus (1.6-2.5 million bpd) in 2022 given demand trends, though that may change as global virus case counts decelerate.
Crude prices are healthier today than when we were testing pandemic-era highs only two months ago, benefiting from less dependence on speculative positioning and from increased certainty regarding OPEC+ production policy. The outlook remains dependent on the continued rollover of global COVID-19 case counts but we now have plenty of sentimental headroom for another sustained grind higher for prices should balances remain tight as OPEC+ anticipates through year-end.