(John Kemp is a Reuters market analyst. The views expressed are his own)
* Chartbook: tmsnrt.rs/2TZZN0D
By John Kemp
LONDON, Feb 21 (Reuters) - Oil traders are becoming very bullish on the outlook for prices, betting that Saudi Arabia will do whatever it takes to tighten the market even if consumption growth slows, helped by U.S. sanctions on Iran and Venezuela.
Brent’s calendar spread for the second half of 2019 has surged into a backwardation of 90 cents per barrel, the strongest for more than three months and a huge swing from a 70 cent contango near the end of last year.
For many traders, spreads rather than spot prices are a better indicator of expected balance between production and consumption (“Price relations between July and September Wheat Futures at Chicago”, Working, 1933).
Backwardation implies many traders expect the market to be undersupplied in the second half of the year with a significant drawdown in global inventories of crude and fuels.
The current swing to backwardation is similar to previous shifts in market structure when OPEC and its allies reduced production in 2017 and the United States re-imposed sanctions on Iran in 2018.
Both of those shifts were accelerated and amplified by significant position-building in crude oil by hedge fund managers, and something similar is likely in 2019.
Hedge funds and other money managers have been net buyers of Brent crude futures and options in nine of the last 10 weeks with net purchases equivalent to 130 million barrels (tmsnrt.rs/2TZZN0D).
Fund managers have almost doubled their bullish position in Brent to 266 million barrels, up from just 136 million barrels in early December, according to position records published by ICE Futures Europe.
Position-building has been very similar to previous episodes, but total positions are still well below previous peaks of 500-600 million barrels, suggesting it could still have some way to run.
Like other financial traders, hedge funds and other money managers tend to concentrate their positions in nearby futures contracts where there is more liquidity.
Hedge fund buying is therefore lifting the price of nearby contracts and accelerating the shift into backwardation (just as fund selling depressed nearby contracts and accelerated the shift to contango in the fourth quarter).
Traders have become relatively bullish on oil even as they maintain a more defensive position in equities and bonds, suggesting oil prices are being lifted by idiosyncratic factors.
Brent has continued to march steadily into deeper backwardation even as the benchmark U.S. Treasury yield curve has remained close to flat and major U.S. equity indices have moved sideways.
Traders seem increasingly confident Saudi Arabia’s output cut coupled with U.S. sanctions on Iran and Venezuela will push the market into deficit, especially in the second half, when consumption is normally higher.
The market is expected to be undersupplied despite a slowdown in consumption growth this year and poor compliance with the production agreement by other countries in the enlarged OPEC+ group of exporters.
In effect, hedge fund managers are gambling on Saudi Arabia’s determination to tighten the market and lift prices plus a relatively tough sanctions policy from the White House to counteract weakness from other sources.
If the U.S. economy slows and the Federal Reserve responds by trimming interest rates, the resulting decline in the dollar would also be supportive for oil prices, provided the slowdown is not too deep or too long.
The investment narrative is drawing strong interest from fund buyers even as investors remain more neutral in other asset classes.
The principal risks are a deeper and more prolonged slowdown in global growth; a more dovish approach to sanctions from the White House; or renewed criticism about rising prices from the U.S. president.
The White House has so far been relatively quiet about rising oil prices, but that might change if they rise above $75, the level that provoked a flurry of presidential tweets in 2018.
Until then, oil traders seem convinced the oil market will continue to tighten.
- Saudi Arabia resumes familiar role as swing producer (Reuters, Feb. 20)
- Hedge funds accelerate oil buying (Reuters, Feb. 18)
- Oil price risks shift to upside (Reuters, Feb. 15)
- Venezuela sanctions leave oil market short of heavy crude (Reuters, Feb. 12) (Editing by David Evans)