Why Oil Prices Could Plunge Soon

crudeoilTyler Durden:   “Energy needs lower prices to maintain financial stress to finish the re-balancing process; otherwise, an oil price rally will prove self-defeating as it did last spring,” Goldman’s Jeffrey Currie recently wrote, on the outlook for crude going forward.

The rally off the lows has largely stemmed from the market’s hopes for an output freeze from Russia, the Saudis, and everyone else who isn’t Iran. Producers will meet in Doha next month to try and hammer out an agreement, but as we’ve documented exhaustively, the whole effort is farcical at best.

Moscow and Riyadh (among others) are already pumping at record levels, and it’s not at all clear why “freezing” output at all time highs is bullish. Indeed, as we noted last week, Russian crude exports are set to rise going forward. “The discussion is only about freezing production. And not exports,” Russian Energy Minister Alexander Novak told reporters earlier this month.

Throw in the fact that a recalcitrant Iran is in no mood to freeze anything now that international sanctions have finally been lifted and you have a decidedly bearish fundamental backdrop for crude, and that, in turn, should be expected to pressure the rest of the commodities complex which has for years struggled to deal with slumping Chinese demand and a global deflationary supply glut.

For their part, Barclays thinks the bullish sentiment around commodities could shift abruptly in the not so distant future, leading the “herd” straight off a cliff.

“Investors have been attracted to commodities as one of the best performing assets so far in 2016,” analyst Kevin Norrish begins. “However, in the absence of any concerted fundamental improvements, those returns are unlikely to be repeated in Q2, making commodities vulnerable to a wave of investor liquidation that we estimate could, in a worst case scenario, knock as much as 20- 25% from current price levels.”

Here’s more:

Given that recent price appreciation does not seem to be very well founded in improving fundamentals and that upward trends may prove difficult to sustain, the risk is growing that any setback will result in a rush for the exits that could again lead commodity prices to overshoot to the downside.

Key commodities markets such as oil and copper already face overhangs of excess production capacity and inventories, but also now face another obstacle in the recovery process, that of positioning which is now approaching bullish extremes.

Net flows into commodity investor products totaled over $20bn in January-February (the strongest start to a year since 2011), futures positioning in key markets such as copper and oil has switched rapidly from bearish to bullish extremes in a few short weeks and there is evidence of a surge in investment flows into Chinese commodity markets as well.

The risk for commodities is that investors seek to liquidate long positions quickly and in unison, with potentially highly negative consequences for prices. There are several reasons to believe that a short-term turning point for investor flows might be close.

First, the kind of commodity investment that is taking place currently is not the long-term buy- and-hold strategy for portfolio diversification and inflation protection that underpinned the huge inflows of the previous decade. It is much more short term and opportunistic, as is clear from the relatively short holding period for ETP buyers in oil. Many have been liquidating on the recent move up in prices, having held their positions for only 5-6 weeks.

Second, commodities are among the few assets that have generated a positive return in Q1 and, as quarter-end approaches, that may make investors keener than they would usually be to close out long positions and lock in profits.

Third, the risk rally set in place by the previous week’s more dovish-than-expected FOMC statement is already starting to fade, as several Fed policymakers came out last week with more hawkish statements. Part of the problem with recent Fed-driven risk rallies is that they most often result from a run of poor economic data usually for the US, though recent Fed comments suggest it is becoming increasingly conscious of the growth path in emerging markets as well. Unfortunately, that means that any commodity price gains that result tend to be transitory because they are not supported by any underlying improvement in demand fundamentals; that seems to be the case again this time.

“How bad could it get?,” Barclays asks? “A very simple analysis of the relationship between investor positioning and recent price movements in oil suggests the potential for a 20-25% move down in prices if positioning were to return to the average levels of the past few months. The potential downside in copper is similar,” the bank says, answering its own question.

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