Saturday, May 28, 2016

Macro | Oil Rally - Not A Dead Cat Bounce

The recent rally in oil, which started with general risk asset rally in early February this year has been a solid one. This blog discussed about the bottoming out in oil and a potential come back in the past. It played out quite well (although it apparently surprised a few). Along with equities, it has initially benefited from the softening of Fed hike expectation. And then went on braving an increased Fed hawkishness. I discussed the policy expectation re-pricing, and also noted the potential decoupling in correlation. Nonetheless, the strength of the oil rally in the face of more than doubling of a June hike probability is remarkable. 

In some measure it has been a bit different than the earlier dead-cat-bounce rally we have seen last year around this time. Here is a chart tracking who made what from the oil price gyration for last couple of years in the (zero-sum) futures market (from CFTC reports).

As you see, apart from producers (who are supposed to be hedgers), the biggest gain in the oil sell-off in 2015 was captured by the swap dealers (large trading houses like BP and Shell and a few Financial Institutions still left in the business of commodities). Most of the pain went to presumably the CTA community and non-reportables (individual investors and smaller hedge funds). You would expect that - as most large trading houses have considerable advantages of information and physical stocks (even over large banks, many trading houses are trading arms of large producers), they are the people who should be in the know.

During the false rally last summer, those big players were still short and did not mind taking losses (which of course paid off in the second leg of the sell-off). This time around while most of the money seem to have gone to the CTA/ non-reportable communities, the big players are flat.

In this light, the recent interesting piece in WSJ is true on facts but perhaps paints a wrong picture of a rally fueled by dumb money. It is an expected bounce of an overly sold market, where smart money just stayed out, not actively betting against. This will last beyond the driving season with all probabilities.

I would not expect another leg of sell-off, nor a continued upward movement from here. While this rally cheered the economy-is-all-good signal from Fed, it is hard to keep it going. The still significant inventory, a possibly weakening OPEC, and the cost and operation structures of shale producers make it a long shot to take us back to 100 or even 70 oil. Over the past years, as the oil price tumbled, so did the breakeven for Shale. 

I think the real implications from this cycle in oil price are mostly two - firstly the conventional high-cost producers got a raw deal. The thing is, unlike shale, for traditional high-cost producers, it is easy to turn off the tap, but not so much to turn it on back again. That involves time and cost. The distribution of the gain and ruins from this price gyration will be uneven and shale producers may not be the most damaged lot when the dust settles.

Secondly, while few producers reduced output significantly, the most obvious victim of the sell-off and associated cost reduction was exploration. And this meager rally so far has done little to change that significantly. Most producers and service companies are now shifting from a strategy of hope to a strategy of low for long. But this also means an increased sensitivity of prices to the inventory levels (as future inventories are compromised). Unless we have settled down in to another recession by then, I expect another leg of this rally in medium term, in 2017 or 2018. When we feel the pinch.

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