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Longer dated Crude Oil futures see Spot prices peaking near $50 /barrel


May 18, 2016

     Three months ago, – on February 9th, – Goldman Sach’s <GS> analysts warned that the price of crude oil could drop to below $20 /barrel as part of a search for a price level that would bring the dynamic of supply and demand back into balance.

“With capacity to store oil exhausted in some places, prices may need to drop low enough to halt crude output that can no longer be stockpiled. Once you breach storage capacity, prices have to spike below cash costs because you have to shut in production almost immediately,” GS’s top analysts in commodities said in an interview with Bloomberg Television. “Volatility will surge and we wouldn’t be surprised if this market goes into the teens.”

     Texas Sweet crude oil, the benchmark, traded on the New York Mercantile Exchange <Nymex> was trading near $30 / barrel, when GS issued that dire warning, and two days later, oil prices would slump to a 12-year low at $26.50,

     However, three months later, on Monday, May 16th, GS told the markets that it had flipped its forecast on the crude oil market to slightly Bullish, but only after the price of Nymex crude oil had already rebounded by about $20 /barrel. Due to unforeseen supply disruptions, removing about 2-million barrels per day <bpd> from the oil market, the global supply /demand balance had flipped to a deficit sooner than analysts at Goldman Sachs, Morgan Stanley, Barclays Plc, and Bank of America Merrill Lynch, had expected.

    A decline in production driven by unexpected supply disruptions, as well as sustained demand, have resulted in a “sudden halt” to the output surplus, Goldman analysts wrote in a report dated May 15. Other analysts also noted that supply losses are leading oil prices higher. The unexpected outages caused by everything from wildfires in Canada to pipeline attacks in Nigeria will keep production below demand through the second half of this year. “The physical re-balancing of the oil market has finally started,” GS said. The bank raised its Nymex crude price forecast for the second half of 2016 to $50 /barrel and now sees oil at $60 by the end of 2017. The bank expects global demand to grow by 1.4 million barrels per day <bpd> in 2016, versus 1.2 million predicted previously.

     As such, the price of Texas Sweet crude oil rose as high as $48.95 / barrel on the New York Mercantile Exchange on the morning of May 18th. Front-month futures are up +82% from a 12-year low of $26.50 /barrel, where a “double bottom” pattern formed on Feb 11th and Jan 20th.

     However, a bombshell threat by the Federal Reserve, issued on May 19th, – telegraphing a +25-bps increase in the federal funds rate to 0.625%; at its upcoming June 14th meeting, blocked crude oil’s advance at around $49 /barrel – at least temporarily. A tighter Fed policy could give the US$ a lift in the foreign currency markets, which in turn, could trigger selling of US$ denominated commodities, such as crude oil in the world markets.

     In hindsight, investors in the energy markets would’ve been better off – ignoring the “fundamentals” or the causes of the market’s movement, and instead, should’ve focused on the price action of the longer dated Nymex oil contracts, such as for December 2016 and Dec ’17. In reality, the price and price action of commodities and the fundamentals are often in conflict with each other. Usually at the beginning of important turning points, the fundamentals do not explain or support what the market seems to be doing. It is at these critical times in the trend that these two approaches seem to differ the most.

    Usually they come back into sync at some point, but often – when it is too late for the trader to profit. One explanation for these seeming discrepancies is that market price tends to lead the known fundamentals. Stated another way, – the market price acts as a leading indicator of the fundamentals and or the conventional wisdom of the moment. While the known fundamentals have already been discounted and are already “in the market,” prices are now reacting to the unknown fundamentals. Some of the most dramatic market movements in history have begun with little or no perceived change in the fundamentals. By the time those changes became known, the new trend was well underway.

    Such was the case on Feb 11th, when the front month contract for Nymex crude oil fell to as low as $26.50 /barrel, while at the same time, the Dec ’16 contract, hit a low of $37 /barrel, and was clearly forecasting an eventual rebound in oil prices of +10.50 /barrel by year’s end. In hindsight, spot oil prices rebounded by as much as $22.50 /barrel to $49 /barrel on May 18th, while the longer dated Dec ’16 contract reached $50.75 /barrel. The narrowing of these price spreads suggests a slowdown in the advance of spot prices, and a possible plateau in pricing around $50 /barrel in the months ahead.

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