Remember last year at this time when WTI crude oil had fallen from $60 down to $26? Instead of scooping up the cheap oil, most market pundits were bearish. Really bearish. Huge, hulking Kodiak brown bearish. Forecasts of oil falling to $20, and even $10 filled the headlines.
Into the decline, high yield investors puked out their energy related names, pushing high yield energy option adjust spreads to levels wider than the 2008 credit crisis!
At the time I remember anyone who suggested oil might rebound was an “idiot who plainly didn’t understand the fundamentals.” Well, nothing cures low prices like low prices, and much to the surprise of the chorus of energy bears, oil proceeded to rebound from $26 to $53.
Today all those prophets of doom have conveniently disappeared, and instead, speculators hold a record amount of net long positions. Yup, you read that right. In the space of a year, speculators have gone from insanely bearish to frighteningly bullish.
Some of the more astute observers might recognize the inconsistency in my argument that we have gone from peak bearishness to record bullishness over the past year. Wouldn’t net specs have been record short last year if that was the case? Yup, I am confused why there seems to be a secular trend towards larger and larger net speculative long positions. I don’t know if there was some sort of reclassification of the definition of speculator, or if there is some other extraneous factor affecting the data, but it seems unusual.
But I know a year ago, almost everyone was bearish. And as for today, it is pretty much the opposite. There is no doubt which way everyone is leaning.
Some of it has to do with speculation regarding Trump’s border tax.
From the always great Reuters energy reporter John Kemp:
LONDON, Jan 30 (Reuters) - Hedge funds seem to be quietly positioning for the possible imposition of a border tax adjustment on imports of crude oil into the United States. The principal impact of a border tax adjustment would be to raise the price of domestic crude compared with international grades such as Brent.
Hedge funds have started to anticipate the possibility of a tax being imposed by increasing their exposure to futures and options linked to WTI rather than Brent. In the two weeks between Jan. 10 and Jan. 24, hedge funds added 62 million barrels of extra long positions in WTI while cutting long positions in Brent by 6 million barrels. The increased exposure to WTI included 50 million barrels of extra long positions added in the week to Jan 17, the largest one-week increase for more than six years.
Hedge funds have been progressively adding to their net long position in both of the major crude benchmark grades since the middle of November. But bullish positioning in WTI has been rising much faster than Brent, according to an analysis of records published by regulators and exchanges.
Although some of the increased speculative positioning might be an attempt to front run a Trump border tax, net speculative long positions have increased across the board.
Trumphoria has convinced traders that wagering on crude oil rising is a great bet. The forecasted economic upswing, combined with a tax policy that might push up the price of oil, has encouraged traders to buy crude oil - by the supertanker full.
Colour me skeptical about Trump’s “great” economic plan. And make no mistake, the longer the markets remain excessively buoyant, the greater the risk the Federal Reserve will tighten too aggressively.
But my big worry is the US dollar. The price of crude oil is highly correlated to the US dollar.
Have a look at this chart of WTI crude vs. the US dollar (inverted) over the past decade:
The relationship is quite obvious. But what is most interesting is the recent breakdown. Have a look at the same chart over the past couple of years:
As with many correlations, Trump’s surprise win has thrown the traditional crude oil / US dollar correlation out the window. The US dollar has rallied, but instead of this causing the price of crude oil to sink, speculative buying has pushed it up to the top of the recent range.
All of these factors have combined to create a favourable risk reward trade on the short side.
With the Fed itching to dampen down the Trumphonian animal spirits, I am not optimistic the US dollar will decline anytime soon. Sure, when the Fed finally tightens enough to cause the next recession the US dollar might stop rising, but I think that is a few months away at least. And maybe the US dollar need not even rise for crude oil to decline. After all, if the US dollar treads water, the crude oil / US dollar relationship can re-couple with a lower price of crude.
In the mean time, speculators are overly optimistic about economic growth. They are positioned for everything going perfectly in Trump’s grand reflation.
Somehow they have also talked themselves into believing Trump’s policies will be bullish for oil prices. If anything, his beliefs more closely resemble Sarah Palin’s “drill baby drill.”
I don’t see how this all adds up to higher oil prices. Markets that have record net long speculative positions, priced for perfection, are a recipe for disaster.
I am shorting crude oil. I think it’s yet another market that is overly optimistic about Trump’s policies.
Thanks for reading,