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Edward Bell - Senior Director, Market Economics
Published Date: 31 May 2020
The improvement in oil prices in the last month has been nothing short of dramatic. WTI front month futures ended May at USD 35.49/b, an 88% gain in a single month and the largest improvement in data going back to 1990. The increase in oil prices is all the more significant given then just barely one month ago oil futures closed negative for the first time ever. Brent’s rise has been less eye-watering than WTI but Brent front month futures still managed a near 40% gain for May.
The OPEC+ cuts are doing their job in restoring the oil market closer to balance but improving sentiment generally toward markets—particularly for risk assets like equities or highly trade-exposed currencies like the Australian dollar—is also helping to catalyze a turnaround in oil prices. Investors continue to extend net length in oil futures and options. Speculative net length in WTI has risen by more than 236k lots in the last eight weeks, presumably as investors have called a bottom in oil. Those additional net long positions have crowded the market, taking speculative net length to more than 13% of total open interest, near its highest levels in the past five years and compared with an average of 6.6% for 2019. Given that the economic impact of coronavirus is still very much in effect, the heavy one-way positioning of the market could prompt a sharp correction if economic activity is restricted again and oil prices react negatively. With oil market volatility still at elevated levels, futures and options positioning isn’t reflecting much downside risks: 25D risk reversals in front month WTI are pricing in—relatively—limited downside moves.
Economic data continues to show the grim toll of the coronavirus, particularly for consumers and the services sector, but there are some signs of tentative stabilization in industrial activity. China’s official manufacturing PMI fell in May but still managed to stay above 50. Meanwhile in the US core capital goods orders fell by “only” 7.4% in April, better than the 17% drop in headline durable goods orders.
The improvement in spot prices was matched by steady gains in the structure of the forward market. The excessive contango of the last few months appear to be behind the market thanks to a considerable drop in production—both from OPEC+ and others—and sentiment improving toward demand for the rest of the year. Oil consumption is in no way going to return to pre-coronavirus levels but the scale of demand destruction may be far less than the market initially feared. December time spreads continue to narrow their contango, if not necessarily in a straight line back to neutral.
Drilling activity in the US continues to decline although the pace of rigs coming out of services has tempered in recent weeks. Total oil focused rigs fell to 222 (down 567 y/y) last week and more than 90 rigs fewer than the trough in 2016. Oil markets may begin to price in a reaction on the part of shale producers to the improvement in spot prices but any impact on production would only be felt several months from now. Moreover, the priority for most US producers is to maintain liquidity rather than spend on new production.
Source: Bloomberg, Emirates NBD Research
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