What's Holding Oil Up in Spite of Itself?

 | Feb 17, 2017 | 12:00 PM EST
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Oil looks ripe for a very big selloff. Record inventories. Record inventories in gasoline. Near-record inventories in distillates, which were at record inventories just the week before. Moreover, imports have dropped and exports, too. Refiner inputs down for five weeks in a row. Refiner inputs reflect refiner demand for crude. It's the quantities of crude that they "input" into their refineries to make product. Finally, and this is the big one, gasoline demand is down sharply. Looking at the four-week average of gasoline demand, it's down 8.5% year over year and that's even an improvement from an 11% year-over-year decline just a few at weeks ago.

Combine all this really bearish-looking data with the knowledge that speculators were holding a record net long position in West Texas Intermediate (WTI) crude futures as of Feb 7. Their net long position (total long open interest minus total short open interest) in crude on the NYMEX was 370,000 contracts.

These were the same guys who were selling like mad last May and before that, last January, when oil hit bottom. By the way, I called that bottom here. We'll get the new position data from the Commodity Futures Trading Commission (CFTC) after the close today, but it does look like there has been some liquidation in the past week. The CME reports that total crude oil open interest has fallen from 2.19 million a week ago last Tuesday (Feb. 7) to 2.13 million as of yesterday. A relatively small liquidation.

Even so, the selloff has been small potatoes, so it begs the question what's holding the oil market up? Could it be the story of OPEC price-cutting discipline? Good question, but is there really discipline? There was a report out yesterday that Kuwait, an important member of the group and obviously an important member in terms of compliance, was bragging about reaching output levels of 2.75 million barrels per day. That's well above their agreed-upon quota of 2.707 million barrels per day.

So, I ask again, what's holding the market up? It's a fair question because it seems like, with supplies at record levels and important members of OPEC cheating and the large spec long position, there should be one heck of a selloff, yet it's not happening.

If I were to speculate on what is holding the market up -- and I am going to -- I would say it's the inflation story. The inflation story is starting to sink in among investors and asset managers. Of course, I told you about the inflation story over a year ago. I said that inflation would start rising once the Fed hiked rates and that you should buy gold and commodities. That's been the trade that has outperformed all others.

However, no one looks at the fiscal flows and understands MMT (modern monetary theory) and has a trader's background as I do. Certainly not institutional asset managers. They're always late to the party and they always overstay.

The inflation story will pick up portfolio flows into commodities, oil being a very important component. We saw this in the infamous oil price run-up to $150 back in 2008. Even when the fundamentals back then probably didn't justify $100, they kept buying and buying and buying. It's the same phenomenon we see happening in stocks right now. Do you know who the largest longs are in the S&P futures? It's the institutional asset managers.

The way most asset manages work is that they decide, often by committee, that they need a certain percentage exposure to a particular asset class. That could be stocks, bonds, gold, whatever. It could be oil, too. Let's say they decide to have 2% of their asset holdings in oil or oil futures. So they buy, and as a result of their buying (because they all do the same thing) the price goes up.

Now that means they need to buy more to maintain that 2%. You see what happens? While they may have gotten into that asset on the basis of fundamentals (though late), maintaining their position means that they need to keep buying as prices rise, even though it has nothing to do with the fundamentals. They buy and buy and buy as the price goes up, and it's their buying that pushes the price up and then they need to buy more.

Eventually the fundamentals (reality) get so detached from price that the market crashes. Oil could be entering into one of these phases. If the price doesn't tumble soon, that's the only explanation I have, and it's probably the correct explanation. It means we could have one unreal oil price rally that completely will be divorced from the fundamentals. It also will drive oil very high along with inflation, and the dollar very low.

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