This week at the Milken Institute Global Conference the question on everyone’s mind was: Which way is oil going? Hedge funds seem convinced oil is headed above $80/barrel, and they’re placing big bets to back up their conviction. Exchange data show long exposure to Brent crude oil through futures and options is at an all-time high, worth 265 million barrels – enough for three days of global consumption.
At the same time, oil producers have hedged more than 500 million Brent barrels in order to protect against further declines. Rex Tillerson, CEO of ExxonMobil, the world’s largest oil company, recently said the industry should expect lower prices for “at least a couple of years.” In order to comfort investors many energy companies have slashed capital expenditures.
According to Baker Hughes, the number of oil rigs operating in the United States has fallen 53% YTD to 703 – the fewest since 2010. And yet, despite the massive cutbacks, the oil supply keeps growing. US crude inventories stand at the highest level in 80 years and have now risen for 15 consecutive weeks.
Despite a 40% rally from the bottom in January the oil market seems impervious to developments in the supply/demand fundamentals. Instead, it appears as though the US dollar, which precipitated oil’s collapse last June, is still the biggest driver of prices. Unfortunately, oil investors are forced to become Fed watchers like the rest of us.
The market has now pushed back the timing of the Fed’s first hike to early 2016. While the US economy is showing signs of momentum, it’s incredibly difficult for the Fed to raise rates when the rest of the world is cutting. No fewer than 27 central banks around the world have eased monetary policy to some extent this year, notably China – the world’s second largest economy.
As long as the Fed seems hesitant to tighten there’s a good chance oil will move higher as USD weakens. However, Janet Yellen will inevitably have to face the music and raise rates for the first time since 2004. USD is likely to see a strong rally leading up to that announcement and oil will face some strong headwinds. It’s very telling that forward prices, which are less susceptible to fast money and a good gauge of future demand in the real economy, remain depressed. The December 2019 Brent oil contract has rallied a mere 5% from the lows. Oil looks like it’s improving but it’s too soon to say the bottom is in place.
