Betting on the bears

17 July 2017
17 July 2017, Week 28, Issue 466

Raymond James has recently restated the case for a rise in oil prices, but its forecast relies on questionable assumptions about supply conditions and inventory levels, writes Jennifer DeLay

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WHAT: The financial services company has argued that “fake news” is keeping oil prices low.

WHY: Traders have supposedly overlooked or misinterpreted supply projections and US inventory data.

WHAT NEXT: Crude is likely to remain bearish, not least because Russia is losing confidence in OPEC’s ability to influence markets.

Oil market sentiment has been overwhelmingly bearish for the last few months, but Raymond James has continued to insist that crude prices still have room to grow. The financial services company restated its case in a note dated July 3, saying that most traders were so habituated to bearish talk that they were ignoring bullish signals. It also framed the argument in a manner designed to draw headlines, using US President Donald Trump’s remarks about “fake news” to describe this purported echo chamber.

“The recent collapse in oil prices was triggered by a breakdown in the technical charts but fuelled by the ‘negative feedback loop’ of bearish headlines that usually follow price declines,” the note said. “Some oil price headlines have been misleading or outright wrong, and they have distracted investors from what we believe is fundamentally a bullish overall picture.”

Among other things, Raymond James contended that traders were misinterpreting US inventory data from the US Department of Energy (DoE). It also argued that market players were overstating the threat of a supply glut stemming from factors such as the expansion of US shale development and the collapse of OPEC’s agreements with independent producers.

This critique is not without substance, as inventory data do contain hints that oil markets are in the process of rebalancing. Even so, Raymond James’ expectations of a shift in supply conditions supporting oil’s return to US$65 per barrel do not quite jibe with recent developments. In other words, the bears still appear to outweigh the bulls.

Inventory issues

In its note, the financial services company examined fluctuations in US crude stocks. It stated that inventory levels had dropped by nearly 300,000 bpd between March 1 and June 30, in contrast to the usual build of 180,000 bpd during this period. This is notable partly because the decline is even larger than that predicted by Raymond James’ own models and partly because it implies that global crude stocks, which typically amount to around three times US levels, might be down by as much as 1.2 million bpd, it said.

If these assumptions were to hold, they would point to a shift in supply conditions. Specifically, they would indicate that prices are poised to rise, since refiners will need more crude just to meet demand.

But this argument appears to be built on shaky ground. For one thing, its estimate of stock drawdowns includes withdrawals from the US Strategic Petroleum Reserve (SPR). And as Bloomberg noted in an analysis published on July 5, these were so unusually large during the March-June period that they magnified the extent of the departure from historical trends.

This, in turn, casts doubt on Raymond James’ assumption that global inventories tracked US levels as closely as they have done in the past. In other words, the case for a 1.2 million bpd aggregate drop in oil stocks is weak.

Supply side

The company did acknowledge this problem, saying that “this extrapolation [was] overly simplistic and fraught with potential regional inventory flow error”. It argued, though, that since the drawdowns had apparently been in excess of its global model, they would probably continue to unfold along the same lines. And since the global model projects further stock declines over the next nine months, it said, supplies are likely to tighten.

This reasoning is somewhat circular. It rests on the premise that the global model, despite its deficiencies, is accurate enough to guarantee the legitimacy of future projections, thereby obviating the need for revising the model to take said deficiencies into account.

Moreover, recent developments cast doubt on Raymond James’ scepticism about a possible supply overhang. Astenbeck Capital, an oil-focused hedge fund, said in a note dated July 3 that US unconventional oil operators were likely to rack up more gains in production. Because technological advances have pulled break-even prices down, it explained, US producers have been able to continue exploiting their assets even though world crude prices have remained low.

Additionally, Astenbeck said, oil demand has not grown as much as projected since the start of 2017. Consequently, OPEC’s attempts to rein in supplies have not had as much impact as anticipated last autumn, when the cartel struck an agreement with Russia and other unaffiliated producers. Instead, crude prices have not sustained the increases noted in the first quarter of this year.

Options dwindling

In theory, OPEC could overcome these short-term losses by marshalling its forces and stepping up co-operation with third parties. But in practice, it probably will not have the opportunity to do so on the same scale that it did in late 2016.

Moscow has signalled that it is losing confidence in the cartel. According to the Prime news agency, the Russian Ministry of Finance said in a draft outline of its budget, customs, tariff and tax policies for 2018-20 that OPEC’s attempts to control world oil prices were becoming less effective. Crude markets cannot remain bullish indefinitely, and efforts to regulate supplies have actually had the effect of moving prices back to previous set points, it said.

In short, Raymond James’ optimism appears to stem from unsupportable assumptions about inventory levels and supply conditions, and oil prices are not likely to gain much ground before the end of this year. Indeed, the market may remain quite bearish in 2018, especially if US shale developers continue to bring production costs down.

 

Edited by

Anna Kachkova

Editor

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