Quarterly Outlook
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Chief Investment Strategist
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Crude oil: Production cuts drive short seller exodus
Ole Hansen
Head of Commodity Strategy
Summary: The energy sector has rising strongly this quarter with sentiment experiencing a major positive turnaround as aggressive voluntary production cuts from Saudi Arabia continues to tighten the market. However, the fact the bulk of recent aggressive fund buying in response to a +17% rally has been driven by short covering instead of fresh longs, show a current hesitancy about getting too extended. It highlights the risk when a rally is being driven by a political and economic movtivated production cut, and not a sustained rise in demand driven increased economic activity. With that in mind, we maintain our $80 to $90 price range forecast for the current quarter, unless the economic outlook counter to our expectations show signs of improving.
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The energy sector, excluding natural gas, has rising strongly this quarter with sentiment experiencing a major positive turnaround as aggressive voluntary production cuts from Saudi Arabia continues to tighten the market. In addition, concerns about the global economic outlook have yet to impact demand in any meaningful way, and together these two developments have seen WTI and Brent reach four-month highs.
Just like last year, when prices shot higher following the Russian invasion of Ukraine, the rally has been led by tight diesel markets which have sent prices for gas oil futures in London and Ultra-light Sulphur Diesel (ULSD) in New York surging to $123 and $131 dollars per barrel, the highest levels since January. In WTI crude oil, the premium the prompt futures contract, currently CLU3, commands over the next has reach a November high around 70 cents, and the tightness or backwardation of this magnitude has been adding to the bullish sentiment.
Crude oil production from the OPEC+ group of producers fell to a two-year low in July according to the latest Platts OPEC+ Survey carried out by S&P Global Commodity Insights. While OPEC pumped 27.34 million barrels/day, non-OPEC allies produced 13.1 million barrels/day, with the bulk of the reduction being driven by Saudi Arabia’s aggressive voluntary production cut which so far has been extended to include September. The one million barrel a day cut has seen the Kingdom’s production slump to a two year low just above 9 million barrels a day, some two million barrels below what it pumped last September. Ahead of their pledge to cut August exports, Russian production held steady, thereby overtaking Saudi Arabia’s position as the biggest OPEC+ producer.
At the beginning of June managed money accounts held a 231k contract combined net long in Brent and WTI, and apart from the March 2020 Covid-19 outbreak slump, this was the lowest belief in higher prices since 2014. The Saudi energy ministers' vocal threat to hurt speculators seems to have been successful after the mentioned production cut helped drive a six-week buying spree that according to the latest Commitment of Traders Report covering the week to August 1 helped lift the combined net long by 82% to 421,000 contracts or 421 million barrels. While the WTI contract has seen the biggest jump in net length, the main driver behind the overall change has been short covering with the Brent and WTI gross short down 116k contracts to 88k, a three-month low.
However, the fact the gross long has only risen by 74k contracts or 17% during the mentioned six-week period where prices rallied by more than 17%, in the process breaking several key technical levels, highlight a current hesitancy about getting too extended. Not least considering the rally has not been driven by rising demand but by a politically and economically motivated production cut which at best can be considered temporary. For that to change and prices move even higher, the global economic outlook needs to improve and with our CIO’s bold call for stagflation to emerge in the coming months, this according to our expectations looks increasingly unlikely. Potentially preventing Saudi Arabia from adding barrels back into the market while raising the risk of prices revisiting support, in Brent towards $82 and WTI towards $77.50.
In Brent, the key level of support can be found around the 200-day moving average, currently at $81.54, and while looking increasingly stretched the price is currently challenging to April high at $87.50 and while having enough momentum to break it may struggle to challenge, let alone break the January high at $89.
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