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  1. Home
  2. / Investing

Oil Specs Are All in and Long - Too Much Too Soon?

Oil is especially interesting as it is deemed the cheapest. Cheap is cheap for a reason.
By MALEEHA BENGALI
Jan 22, 2021 | 12:00 PM EST

Since the start of the year, all investors have been inundated by calls to buy the value stocks, namely Energy, Financials, Industrials - anything geared to the reopening and reflation trading theme. After the announcement of successful vaccines in November, these sectors have been on a one-way ticket up and pretty much recovered all of their losses of 2020 and then some. Of course in traditional style of chasing performance and upgrading numbers after they have already moved 40+%, all sell-side houses are now outright bulls of the oil price claiming $56-$60/bbl. Brent. Thank you Wall Street, we are already there! On top of that, every bank is also very pro-recovery and long the value trade, calling it "cheap". Going back 10 years these stocks have underperformed, so calling them cheap is not a difficult task, but after such a big move, is either outright gutsy or ignorant.

Oil is especially interesting as it is deemed the cheapest. Cheap is cheap for a reason. It all boils down to demand over supply balance and your investment horizon. It seems like there is no margin of error built in at all into the sector here now. We still have a tricky few quarters ahead of us before we can talk about the eventual recovery in 2H'21. Europe has been in strict lockdowns throughout the winter months and even China has been closing down after showing positive cases rising with over 29 million people locked down. We all know President Biden's campaign was built around the fear of coronavirus and the measures needed to be taken to be safe. These being right no doubt as the U.S. had been slow to take up masks and precaution at the very onset. But Biden erring on the side of caution, and limiting mobility can only mean the demand recovery is delayed.

Oil spec longs are now quite long in oil chasing the momentum from last year, not to mention the extra pre-emptive cuts of 1 mbpd of oil in February and March. In total, hedge funds and other money managers purchased the equivalent of 51 million barrels in all in the week to Jan. 12. It was the largest wave of buying for seven weeks and takes the total since the middle of November to 450 million barrels, according to ICE records. Funds hold a combined position in the main six contracts of up to 805 million barrels, and up from 356 million at the start of November. The highs of last year sat with a long of 970 million. It is important to remember oil was one of the worst hit commodities, and for good reason, given the direct hit to travel and jet fuel demand post lockdowns. It has come a long way to price most of the eventual recovery post the pandemic in the first few weeks of the year!

The same sell-side houses that have upgraded oil stocks, claim how cheap these stocks are as they have underperformed the oil price. One thing about cross asset correlation analysis is that one can never measure oil majors on purely technicals vs. the oil price. It has never worked properly. They never capture enough on the upside and always underperform on the downside. Equities by default are discounted instruments, so there is an inherent discount built in them. The only question is, how much is enough or too little? This is where the fun and mystery is.

Investing is all about assessing the risk vs. reward. If we seem to have priced in all the good news with zero chance of any delays or downside, it would not seem a viable investment. In addition, people always say they are happy for near term downside risk as they are "long term" investors. But make no mistake when stocks fall 20%, there is no "long term". With oil, it is not as though we have a shortage of supply. It is just being carefully manipulated and kept on the sidelines, waiting to come back. One has to ask oneself, what price would producers be incentivized to keep drilling and produce more. Certainly WTI prices above $50/bbl. is making it enticing enough.

With demand now falling post the initial reopening trade, and supply itching to come back, spec positioning elevated, risks look skewed to the downside.

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At the time of publication, Maleeha Bengali had no position in the securities mentioned.

TAGS: Commodities | Economic Data | Economy | Investing | Markets | Oil | Stocks | Trading

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