Crude healthier today than when prices were higher

Less dependence on hot money and more spec headroom for next move up

• It’s been a bumpy two months for crude prices, which fell by one-fifth from pandemic-era highs only to quickly retrace more than half those losses.

• The initial rout was driven by the reacceleration of global COVID case counts, accentuated by the liquidation of speculative long positions.

• While fundamentals have shifted with the virus, myopic investor sentiment moved further, faster—both on the way up and on the choppy ride back down.

• The past two months of oil price backsliding was both rational (prices had gotten ahead of themselves) and healthy (frees up positioning headroom for the next move higher)

• Oil prices look healthier today—slightly lower but with much more potential upside—than when they were precariously sitting at pandemic-era highs merely two months ago.

Oil prices have been on quite the roller coaster over the past two months, plunging from a pandemic-era high of $75.25 per barrel (bbl) in early-July to $62.32/bbl in mid-August back to around $69/bbl today.

My first newsletter on crude’s precarious rally in late-June—the publication of which coincided with the high-water mark for crude prices in 2021—highlighted some of the fundamental weaknesses that I thought were being obscured by oil’s steep price gains. This piece, in contrast, will outline why the crude complex is actually healthier today than when we were sitting at the highs of two months ago and why the mid-July price rout was a necessary sentimental rationalization that gives us more headroom for crude’s next push higher.

It’s COVID, Stupid

While it may sound like a tired analytical cop-out, oil prices collapsed in mid-July primarily because of a reacceleration of global COVID case counts and the deterioration of crude’s reopening narrative momentum. This fallback was the latest iteration of a cycle that has played out repeatedly over the past year: crude prices have been grinding structurally higher from depressed 2020 levels, with that steady rally getting supercharged in periods when global COVID cases are falling (January-February, May-June) and temporarily derailed—backslide followed by range-bound trading—when those cases begin to rise anew (March-April, July-August).

While this latest wave obviously slowed the oil demand recovery slightly—the latest IEA OMR notes that that global oil demand fell back slightly (0.12 MMbpd) in July, but only after surging 3.8 MMbpd in June—investor myopia can be largely credited with aggressive price swings, both on the upside and on the way back down. When COVID case counts were bottoming, investors became overzealous and overbid crude on its central reopening narrative, pushing it higher than it deserved given lingering headwinds and the high likelihood of at least one more COVID wave. When COVID cases reaccelerate, that hot money floods out.

The current COVID new case plateau combined with rising vaccination rates means that we’re already likely past the point of peak COVID-sentiment weight on oil prices and that these headwinds will become tailwinds if new case identification continues to reverse.

Hot Money, Cold Feet

Speculative sentiment toward crude oil—as measured by managed money positions in futures contracts—has eased off substantially since June. Net-long positions have fallen by more than a quarter, the equivalent of about 200 million paper barrels of crude, and the move was mostly driven by the liquidation of long positions than the establishment of fresh shorts. Funds likely saw great returns on those profit-taking decisions, with oil prices nearly doubling between late-2020 when said positions began to accumulate and when they started selling in early-July 2021.

Net speculative positioning in combined Brent and WTI contracts is back to around the levels last seen in August 2020, when crude was trading more than $25 cheaper in the low-$40s per barrel and futures contracts were still trading in contango territory. This hot money is far from the only driver of oil prices, but I typically look at it through the lens of it being the marginal crude buyer; those marginal buyers looked pretty tapped-out a couple months ago but after this selloff look like they have much more headroom to help support crude on its next leg up.

OPEC+ Rolls Forward Deal in Graciously Short Meeting

OPEC+ agreed to stick to its hard-fought plan and continue adding 400 kbpd of withheld oil back to the market each month. Rumours emerged in mid-August that the additional barrels could be delayed given waning prices, but [thankfully for the length of this write-up] those worries proved unfounded.

Media reports indicate that the OPEC+ technical committee sees continued deficits through the end of 2021 sufficient to absorbs incremental supply additions and a modest surplus (1.6-2.5 MMbpd) in 2022 given current demand trends, though that may change as global case counts continue to decelerate.

Crude prices are healthier today than they were when we were testing pandemic-era highs only two months ago, benefitting from less dependence on speculative positioning and from increased certainty regarding OPEC+ production policy. The outlook remains dependent on the continued rollover of global COVID case counts but we now have plenty of sentimental headroom for another sustained grind higher for prices should balances remain tight as OPEC+ anticipates through year-end.