By John Kemp
LONDON Oct 28 For all the bullish talk about tight supplies next year if the global economy skirts renewed recession, and occasional sharp short-covering rallies, benchmark oil prices are softening.
In the past six months, each of a series of sharp short-covering rallies has pushed the front-month Brent futures contract to peak at a lower level than the previous one: $127 on April 11, $126 on April 28, $121 on June 15, $120 on Aug. 1, $116 on Sept. 8, $114 on Oct. 14 and now $112 on Oct. 27.
Gradual subsidence in prices is not confined to nearby futures contracts. The same pattern of successively falling peaks is evident in the price of contracts for deferred delivery in Dec 2012 and Dec 2013 .
It stands in marked contrast to the continuous uptrend in prices through 2009 and 2010, which culminated in April 2011, in which each temporary peak was higher than the last (with one limited exception in the late spring of 2010).
Sustained downtrends have been rare since the great upsurge in oil prices started in 2003 ().
Prices have eased despite several potentially bullish factors: (1) reported tightness in the cash market evidenced by premiums for quality crude and steep backwardation in the Brent forward curve; (2) the Fed's commitment to keep interest rates lower for longer and attempt to pull down long-term rates; (3) rallying equities; (4) continued demand growth in Asia; and (5) warnings from prominent forecasters at major commodity banks about continued upside price risks from a tightening supply-demand balance in 2012.
Hedge funds and other money managers remain convinced oil prices will rise. The ratio of money managers with long positions in WTI-linked futures and options to those running short positions remains at three to one, according to data released by the U.S. Commodity Futures Trading Commission (CFTC) ().
For Brent futures and options, the long/short ratio is 1.77:1, according to Intercontinental Exchange (ICE), lower than earlier in the year but still bullish.
Physical traders are also bullish. "Bullish physical oil traders, who have been warning for months of a tightening market, have so far won the game against bearish macroeconomic hedge funds," as my colleague Javier Blas wrote in the Financial Times on Tuesday ("Swing in WTI price curve leaves oil traders reeling", Oct 25).
U.S. equity markets have also been doing well recently . But benchmark seaborne crude prices have been largely left on the sidelines during the relief rally.
DOWNTREND FOR NOW
It is not necessary to believe in either strong versions of the efficient markets hypothesis (EMH) or the forecasting power of technical analysis to perceive something structural has changed in current fundamentals or expectations about the future.
The downtrend started back in the late spring, long before there was an end in sight to the disruption of Libyan oil supplies and also before the markets began to fully appreciate the risks of a synchronised global slowdown.
The downtrend is probably due to a combination of factors: (a) expected resumption of Libyan oil exports; (b) cuts to projected global growth; (c) downward adjustments in forecast oil consumption; (d) liquidation of the record long positions in oil derivatives taken by money managers in late 2010 and early 2011; and (e) improved confidence in medium-term oil supplies as a result of tight oil and other technologies.
Market perceptions of ever-increasing supply shortages and escalating prices appear to have given way to greater confidence (complacency?) about the supply-demand outlook.
It is also possible market participants now perceive oil prices have reached a threshold or ceiling where further increases generate slower global growth and are therefore not sustainable except in the very short term, capping gains.
Nothing guarantees the market is right and that prices will not resume a sharp upward trajectory. Like other financial markets, commodity markets are notoriously fickle and inefficient at processing information. As one senior energy trader remarked: "The forward curve is not a forecast; it's what we bet against".
There have been plenty of times when the market has been wrong or over-reacted. Oil analysts may be proved right in warning that the market is far too complacent about the supply-demand situation next year and is under-pricing upside risk (for example in the options market).
But the price on the screen represents the balance of views among those willing to risk their money. For all the reported bullish comments around the market, talk of looming shortages, and fierce rallies, prices have been ebbing for six months.
If the market is even loosely efficient in processing information about current and expected supply, demand, inventories and spare capacity, the sustained downtrend indicates a significant change in the outlook that needs to be explained.