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Going Short on Brent Futures Needs No Excuse

Gaurav Sharma
This article is more than 6 years old.

The global geopolitical landscape couldn’t be more complicated than it already is. There is a war in the Middle East engulfing Iraq. An international US-led coalition including Qatar, UAE and Saudi Arabia is hammering Islamic State, a terrorist outfit with wider ambitions of establishing a regional caliphate.

Meanwhile, Libyan oil production continues to stutter. Nigeria and other West African oil and gas prospection zones hit by the Ebola virus have their own catalog of troubles. The UK was until last week in danger of breaking-up had the Scots not voted against it. Several upstream and downstream facilities in wider Europe are undergoing seasonal maintenance. Yet the Brent front month futures contract for November delivery, a common proxy for oil prices on the world market, keeps slipping lower, trading below $97 per barrel at the time of writing this article.

And further it should slip, as supply-side analysts have been saying for better parts of 12 months. It was inherently frustrating to see rebuttals over the period from paper traders using the risk premium as a pretext and trumping supply-demand realities in the process. Some even confidently predicted that at least $10 worth of risk froth per barrel was something the market should get used to.

English: Oil Rig, Cromarty, Scotland (Photo credit: Wikipedia)

So, why is it dissipating now with a tacit acknowledgement in most trading circles that shorting Brent is the right call for the moment? First and foremost, Brent is currently suffering from risk fatigue. As Price Futures analyst Phil Flynn concurred with me last year, there was always an inherent danger of the market repeatedly recording the risk and simply pricing in that level by default should there be no reduction in tension. That has pretty much been the case since the initial Iranian Nuclear standoff and onset of the Libyan Civil War in 2012. Simply put, risk no longer weighs as heavy as it used to.

Secondly, there is clear evidence that not only is the US consuming less crude oil, but it is also importing less on the back rising domestic oil production. The country is unlikely to export oil over the medium term. However, by importing less, the US has created incremental barrels in the global supply pool. Exporters, especially West African ones, are diverting crude oil cargoes destined for the US to Asia, something which OPEC has also acknowledged.

Thirdly, OECD demand has been tepid while of late China's demand has been as erratic as its macroeconomic data. All of this has tilted the balance in favor of buyers as hedge funds found out over the summer.

Using the often abused ‘only way is long’ logic, back in June many hedge fund managers totally ignored the wider dynamic to collectively hold just short of 600 million paper barrels on their books. They were banking on backwardation when the Brent price was well into three figures.

However, intelligent buying by physical traders eyeing cargoes without firm buyers made contango set in. That left hedge funds with massive losses as the benchmark first slipped and then got stuck below $100. It felt great that ‘real traders’ taught speculators a simple lesson – you can only ignore the physical market up to a certain point. The lesson was duly learnt as net long positions for the Brent contract have been in general retreat since, according the ICE data.

In January, I forecast a Brent price range of US$90 to 105 for 2014 and will be sticking to an upper median of the said range. However, a floor of $95 or a dollar or two lower is very plausible at the moment and reflective of market reality. So there’s no excuse for not going short over the short-term. Yet, the current state of affairs won’t last into the winter.

For instance, after the maintenance season ends and capacity returns by the end of the year, it is to be expected that refineries will run real hard due to elevated levels of refining margins. According to Deutsche Bank this will improve crude demand by a substantial amount on the physical side and, in its view, help to support crude prices.

“Depending on how much product demand and pricing improve over this time frame, these could be potential factors that help to eliminate contango in the Brent crude oil term structure,” its analysts add.

Additionally, India is recording a mini-bounce in economic activity. China and wider Asian economies are expected to lend support. Calls are already afoot for OPEC to cut production, so what happens at its meeting in November could also influence Brent’s direction.

Factoring all of this in, and keeping a keen eye on the physical crude market, I’d say we’d be looking at a flattening of the Brent price just below or at $100 by December. If that were to happen, physical traders would have calmed a crazy benchmark.

