The almost 10 percent nosedive in headline oil prices this week has many hallmarks of a shocking but short-lived slump, triggered by a confluence of external events and exacerbated by safety-seeking investors and momentum-chasing traders.
By Tuesday afternoon, the crowded race to the exit was winding down, with prices recovering from three-month lows as traders reassessed the factors they blamed for the worst slide in four months: Greece’s debt woes; China’s stock market meltdown; talks with Iran over its nuclear program; a stronger dollar; a rise in the number of U.S. oil rigs; a breach of key technical triggers.
Yet a deeper look at the market suggests an important and more lasting rethink may now be afoot: longer-term oil prices, normally less volatile and reactive than immediate delivery, have suffered an almost equally violent collapse, pushing crude prices for 2017 to below $60 a barrel for the first time ever.
If U.S. shale drillers – the world’s new ‘swing’ producers – can still turn a profit at below $60 a barrel, then the fall in long-dated oil prices may be rational. If not, as some bullish market analysts worry, then lower prices could be choking off new supplies the world may need as soon as next year.
“If you take the curve at face value, it appears to be saying that U.S. shale can grow … if WTI stays below $60 for three years. That doesn’t seem very likely,” Paul Horsnell, global head of commodities research at Standard Chartered, said, referring to West Texas Intermediate crude.
“One would guess that all those companies that had been holding back from cutting projects and jobs over the past few months are not going to hold on much longer, and another shakeout will start. And it probably won’t be long before U.S. rig counts start to dive again.”
Link to chart: link.reuters.com/tef25w
U.S. oil futures for December 2017 delivery have dropped by as much as $5 a barrel, or 8 percent, in the past two days, an even deeper retreat than last November when OPEC’s surprise decision to maintain oil output despite a global glut sent markets into a deepening tailspin.
The more liquid frontline prices for delivery in August this year have fallen only slightly further this week and are still several dollars above their trough from March. Longer-dated futures are plumbing contract lows, testing the break-even economics for U.S. shale oil drillers.
The cause of this unusual tumble is still a topic of debate.
Some link it to a future shift in fundamentals such as the expected boost in Iran’s oil exports next year. Others say it may reflect the realization that oil industry costs are falling faster than expected as activity slumps. A few wonder if it is an unusually large producer hedge, or a big macro-economy fund trade unwinding.
IRAN, RIGS OR…
Longer-term oil futures are normally insulated from the speculative, short-term fluctuations and factors that afflict immediate prices. Too illiquid to attract fast money, they tend to trade on more strategic themes, whether a long-term bet on prices or a corporation seeking to hedge its price risks.
Front-month oil futures have posted a daily change of more than $1 a barrel on 62 occasions this year, trading in a range of over $20; December 2017 has moved by that magnitude only 18 times, trading between $61 and $67 a barrel.
The fact that this week’s activity has affected both ends of the futures curve in nearly equal measure is unusual, says Credit Suisse analyst Jan Stuart.
“This isn’t a simple front-month correlation trade or a dip in demand,” he says. “This is investors who invest all along the curve picking up the ball and going home. That’s what this looks like.”
Some fundamental factors are also in play.
Negotiations over Iran’s nuclear program, which may conclude this week in Vienna, have increased the likelihood that a country that was once OPEC’s second-largest producer will ramp up exports as sanctions are eased – likely adding more supply to the market next year at the earliest.
Others pointed to the latest U.S. rig count data released last Thursday, showing the first increase in oil drilling since December. The addition 14 rigs was a bigger rise than expected.
The rise suggests that at $60 a barrel, “producers can ramp up activity given improved returns with costs down nearly 30 percent and producers increasingly comfortable at the current costs/revenue/funding mix,” Goldman Sachs, which is predicting a deeper and prolonged oil slump, said in a note on Monday.
A HEDGE TOO FAR?
Some suggested that the selloff, which began last week ahead of the U.S. Independence Day holiday, may have provoked reticent oil producers to hedge, locking in far-forward prices for fear they may fall much further.
Oil option volatility fell last month to its lowest level in seven months, making hedging relatively cheaper for drillers who had locked in only 15 percent of their 2016 prices, according analysts at Tudor, Pickering, Holt & Co.
The oil VIX index, a proxy for options pricing in the main oil ETF, has surged alongside oil prices in recent days, rising from 33.8 to over 42, its highest since mid-April, in a possible sign of increased demand to buy options protection.
Yet market sources saw little immediate evidence of a big hedge that could explain the price move.
Trading volumes in the December 2016 and 2017 WTI contracts, which were the fourth and fifth most-active in the market on Monday, was elevated, but not unusually so. The 2016 contract traded just over 35,000 lots, double the 30-day average but a hair less than on July 1, data show.
“We have not seen a lot of activity in the last 24-48 hours,” said John Saucer, vice president of research and analytics at Mobius Risk Group, which advises companies on hedging. “We saw a lot last month.”