By Barani Krishnan
Hedge fund managers who rushed into crude oil longs only to see the rally stop at below $60 a barrel may have to wait till the second half for their payoff, renowned oil bull Andy Hall says.
“Patience is a virtue,” Hall, who runs the $2.3-billion oil-focused Astenbeck Capital Management hedge fund in Southport, Connecticut, said in a March 1 letter to his investors. “So far, however, the oil market is not showing much evidence of any explosion in demand.”
Crude oil prices hit 19-month highs in the first few days of 2017, continuing their surge from the end of last year, after the Organization of the Petroleum Exporting Countries pledged in November to cut supply to overcome a global glut.
But shortly after benchmark Brent soared above $58 barrel and U.S. West Texas Intermediate (WTI) crossed $55, the rally sputtered as rising U.S. drilling activity offset OPEC efforts to prop up the market. On March 3, Brent settled at about $55 and WTI around $53.
Despite the market’s retreat from the highs, hedge funds and other money managers haven’t let up in buying oil. Recent data from the U.S. Commodity Futures Trading Commission showed such speculators holding a record net long equivalent to nearly 1 billion barrels in both Brent and WTI valued at more than $52 billion, based on existing prices.
OPEC NEEDS MORE THAN 6 MONTHS TO DRAIN MARKET
For OPEC to drain the market of surplus oil, it needed to clear some 350 million barrels, Hall said in his letter.
“At a drawdown rate of 2 million barrels per day, it would disappear in 6 months,” he wrote, referring to the surplus. “However, given seasonality in supply, and especially demand, it is unlikely that rate can be achieved in the first half of this year.”
“By the same token, if the OPEC production cuts are maintained into the second half of 2017 – which is now a reasonable assumption – it would result in a very rapid stock drawdown in the latter part of the year,” he said in the letter, made available to 50 Park Investments by a hedge fund source industry who asked not to be identified because the information was private.
The Astenbeck letter was accompanied by a performance note that showed the hedge fund returned nearly 1 percent to its investors in February, an improvement after the 5 percent loss it suffered in January.
Hall said oil hasn’t hit $60 lately for several reasons.
Chief of them was the pre-November surge in OPEC oil production that had negated the output cuts carried out by the group, he said.
He also cited peak maintenance season for U.S. refineries now, which had reduced demand for crude, and some global inventory declines that could not be validated due to unreliable data.
“Observed oil inventories (and especially those in the U.S.) have continued to build even though OPEC has largely followed through on its pledges to trim output,” Hall wrote. “As a consequence, oil prices have been treading water, trapped in a relatively narrow range, certainly in comparison to the price action seen during the previous two years.”
“But we think it’s just a question of time before prices move higher. This will happen once the market sees unequivocal evidence of excess inventories being absorbed.”
While OPEC’s output cuts were initially expected to last only six months, recent statements by the cartel’s kingpin Saudi Arabia indicated this may be extended when the producer group meets in May, Hall said.
“The Saudis seem to be targeting $60 as a minimum price: not only do they want to boost their oil revenues to narrow the government budget deficit, they also want higher prices to underwrite the success of the forthcoming Saudi Aramco IPO,” Hall said, referring to the impending public float of the kingdom’s oil company.
WILL SHALE SPOIL THE PARTY?
Even so, he questioned whether U.S. shale oil producers will spoil the party for oil bulls.
“The question naturally arises whether a further recovery in prices would stimulate a self-defeating surge in activity. This is obviously something that needs to be monitored carefully.”
U.S. shale producers have added drilling rigs for seven weeks in a row since the start of February, bringing current rigs in operation to 609, the highest since October 2015, oil services firm Baker Hughes reported.
While higher rig numbers were negative to bull market psyche, Hall said his calculations showed U.S. crude production was likely to escalate in 2018 rather than this year. This was because of the roughly four months on average that it took to bring a well into production from the time it was spudded, along with the fact that peak production was possible a month or so after start up.
If U.S. crude output was poised to rise more in 2018, then prices would move from their current “contango” position, where forward delivery was pricier than nearby contracts, to a “backwardated” structure, where spot oil fetched a premium.
Shale drillers have profited from the contango position that allowed them to hedge future production at a premium to spot prices and subsidize competing supply. To move the market into backwardated structure, the inventory surplus had to be eliminated, Hall said.
“The Saudis and other key OPEC members recognize the desirability of moving the market into backwardation,” he added.
- Until inventories fall demonstrably, market will have difficulty adding to gains
- If contango stays, prices could be capped at $55/barrel levels
- If backwardation occurs by middle of year, mid $60 levels likely
By Barani Krishnan
NEW YORK, Feb 7 – Prominent oil bull Andy Hall posted a 5 percent loss at his hedge fund in January, telling his investors to brace for more market volatility under President Donald Trump and not expect hefty price gains in crude until OPEC supply cuts take effect.
” ‘May you live in interesting times’ is a blessing (or curse) supposedly attributed to the Chinese, which seems particularly apt as we enter the Year of the Rooster, ” Hall said in a Feb. 1 letter circulated to investors in his $2.3-billion Southport, Connecticut-based Astenbeck Capital Management.
“Things certainly appear to be getting interesting as the Trump Administration wastes no time in overturning apple carts both at home and abroad with the implementation of its policies,” Hall wrote.
Oil prices hit 19-month highs in the first few days of 2017, with benchmark Brent climbing to $58.37 a barrel and U.S. West Texas Intermediate (WTI) $55.24, before pulling back as rising U.S. drilling activity offset OPEC efforts to prop up the market. The market’s recoil since has tripped up Astenbeck, forcing the fund to post a 5 percent drop in January, its first monthly loss since October, according to a performance note accompanying Hall’s letter.
Astenbeck returned 8 percent in December to finish 2016 with a 26 percent gain, after a pledge to cut supply by the Organization of the Petroleum Exporting Countries and 11 non-OPEC producers helped crude prices double from lows hit earlier in the year. Astenbeck has only done better in 2009, when it posted a 28 percent profit as oil prices rallied powerfully that year from the lows of the financial crisis.
This month, oil has continued its decline, with Brent settling at $55.05 a barrel on Feb. 7 and WTI at $52.17 on renewed worry that supply was overtaking demand.
While OPEC had defied skeptics that it would cut output, the market needed proof of significant stockpile declines for further price gains, Hall said.
“Until inventories are falling demonstrably, the market will have difficulties adding to the gains made at the end of last year (absent some geopolitical event, the odds of which have probably shortened),” he wrote. “These cuts have yet to show up in the published inventory data — at least for the U.S. — which is what the majority of market participants pay attention to.”
For the week ended Jan. 27, U.S. crude stocks rose by 6.5-million barrels, far exceeding a 3.3-million barrel rise expected by analysts, government data showed. In contrast to that, a Reuters survey found OPEC had delivered by January on about 82 percent of its deal to lower supply by 1.16 million barrels per day (bpd).
Hall said production cuts by OPEC made in December and January will not be reflected in U.S. inventory data until February. “In fact, refinery turnarounds may delay a significant decline in U.S. inventories until the spring.”
With OPEC’s output remaining at about 1 million bpd lower than averaged in 2016, the cartel’s kingpin Saudi Arabia may not feel the need to extend production cuts beyond the intended duration of six months, he added.
If the market remains in “contango” — with spot oil trading at a discount to consignments meant for later delivery — prices could be capped at current levels of around $55 a barrel, Hall said.
“A deferred futures price for WTI below $60 is probably required to discourage excessive growth in U.S. oil production — at least until such time as OPEC spare capacity is exhausted.”
If “backwardation”, or the reverse to contango, occurs, mid-$60 levels were likely as the spot contract pushes above deferred months, Hall said. “Other things being equal, that should occur sometime toward the middle of next year.”
Hall said oil traders were also anxiously watching to see if the Trump Administration would go ahead with a border adjustment tax (BAT) which could make Brent hugely costlier versus WTI, causing a windfall for U.S. oil producers and exporters.
“A 5 percent tariff would add $2-$3 per barrel to the price of WTI relative to Brent, while a 10 percent tariff would add $4-$6 per barrel,” he wrote. “Depending on its final structure, a BAT could add as much as $15 per barrel to the relative value of WTI. Without a tariff, WTI should trade at a $1-$2 per barrel discount to Brent.”