I’ve been saying for some time now that oil prices will reach the mid-$50s towards the end of the year, and the low $60s in the first quarter of 2017.
And now, the world’s largest financial players are catching on, making record moves to prepare for rising crude prices.
But that’s just the beginning…
It doesn’t even account for what happened to oil this morning.
Shorts on Oil Have Never Been Unwound This Fast
Through the end of last week, short positions on oil (bets that oil will go down) decreased by record amounts. In the face of an almost 25% rise in futures prices, more shorts were unwound than for any equivalent period since figures were first compiled a decade ago.
That’s great news for oil prices, and another signal that my oil price forecast is correct. But before I get that, let me first explain why shorts and other artificial manipulation is so important to the price of oil.
This manipulation is based on the relationship between “paper” and “wet” barrels – futures contracts in oil as contrasted to actual consignments of crude. The futures market was created to stabilize the market and remove pricing-control from the control of a few major producers to a wider market of investors.
This has largely been a success. Volatility still exists, but the cycles of instability are much shorter and smaller.
However, with the advent of even quicker computer-based trading abilities, shorting has become more and more important…
Shorts Can Be Good – But They Also Accelerate Existing Price Trends
When a market sector – especially one dealing with commodities – is moving up or down, traders always try to ride that movement to profits by running “paper trades.”
If the underlying commodity is drifting up, and futures are indicating that such a trade will continue (as I explained last Thursday, this situation is called “contango”), long positions tend to increase.
On the other hand, if prices are falling, as was common with oil until recently, short positions (“shorts”) are the rule.
The process of shorting oil futures is similar to shorting a stock. A trader takes a short position in oil by “borrowing” contracts from a broker and then immediately selling them at market. Later, the trader needs to go back into the market and buy the contract, returning it to the broker.
With oil futures usually standing for 1,000 barrels at a time, such shorts are not made by normal investors. But big institutional players do it all the time.
For example, let’s say oil is trading at $45 a barrel (about where it was this morning). That means that the contract that a short-selling trader “borrows” has an effective face value of $45,000. By immediately selling the contract, the short-seller makes that much money.
Then, if their guess that the price of oil will go down is correct, the trader can buy back the contract for less. Suppose oil falls to $42 per barrel, putting the face value of the contract the trader sold (for $45,000) at just $42,000.
The $3,000 difference is the profit made from the short.
Usually, shorts help to stabilize the market by bringing in investment that sees things differently than other market players.
These days, crude oil is much more important than just a (widely used) commodity. Given its fundamental connection to currency exchange rates (the vast majority of daily oil trades are denominated in U.S. dollars), oil has ended up being a global vehicle for stored value – much like currency or gold.
That makes the influence of shorts on crude oil much more pernicious.
During the protracted decline of oil prices from late 2014 until the beginning of this year, shorts tended to accelerate oil’s downward trajectory. I even developed an algorithm to determine what part of the decline was occasioned by shorts and other secondary derivatives.
But now, things are changing…
Traders with Shorts are Being “Squeezed” Out of Their Positions
We are now experiencing a movement in the other direction. As I noted last Thursday, oil prices are showing additional signs that a floor is building and a gradual movement up will take place.
That puts existing short-runners in a difficult spot. Because the only way for them to close their position is to buy contracts at the going rate, when the market turns against them, they risk losing a lot of money. In fact, there is theoretically no upper limit to how much you can lose on a short (as there is in theory no upper limit to the price of a stock or futures contract).
Now, this risk can be reduced by trading options at the same time, but the loss is still a loss.
If the trader thinks a price rise is just a momentary setback and will soon go away, the shorts can be “rolled over” into new ones, to extend the trade.
But if the market looks like it will move up or stabilize for a long time, the short position has to be closed as quickly as possible, to guard against even higher losses in the future. When a large number of short sellers close their positions at the same time by buying at market prices, the resulting jump in prices is called a “short squeeze.”
And this short squeeze is getting even tighter today…
This Morning Saw a Record Reduction in U.S. Oil Inventory
This morning, the Energy Information Administration (EIA) announced a dramatic drawdown from U.S. oil stockpiles (the real “wet” stuff) of more than 14 million barrels last week. That was more than 12 times what “experts” expected, and the largest drawdown in a single week seen in more than 17 years.
Expect any remaining short sellers to run for the exits.
Nonetheless, some perspective is in order. The rise in oil prices currently underway is more subdued than in the past. This will not be a quick move to $80 a barrel, and it won’t be a straight line, either.
Rather, I continue to hold to my forecasts of mid $50s per barrel in New York by late fourth quarter of this year and low $60s in the first quarter of 2017.
The recent short-squeeze and this morning’s storage drawdown are just the first step in that direction…
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