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Can Oil Regain Its Mojo After Bearish Turn?

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Oil market sentiment has reversed dramatically in the past week, with Brent plunging about $12 per barrel to under $70/bbl amid fears that a new coronavirus variant could slam demand. But a closer look reveals that risk capital has been draining from crude futures markets since October, making them more vulnerable to the Omicron rout. The recent coordinated release of strategic reserves by leading consumer nations helps explain some of the bearish turn, but speculators were making for the exits before that, having lost conviction that oil prices would continue rising to $90 or $100/bbl as some Wall Street banks had predicted. Banks and investment funds, the largest speculators, have been exiting bets on higher Brent prices each week since early October when Brent moved over $80/bbl. These long positions were down 25% from October peaksand are likely to show an even steeper fall when the data for this past week lands. The demand impact of Omicron remains unknown, while the coordinated release of oil from strategic reserves was a mostly symbolic and well-flagged affair in terms of supply. Back in early October, speculators had 395 million barrels of oil riding on higher Brent prices. That was down to 308 million bbl on Nov. 23, the latest available data show. That is the lowest volume since a year ago, when Brent was rising toward $50/bbl. Just before the pandemic started in early 2020, Brent long positions for managed money were close to 500,000 contracts, or 500 million bbl. Meanwhile, speculative positions on lower Brent prices have picked up 50% since early October and now cover 97 million bbl.

Speculators' power is most obvious in the front-month contract of oil futures, which has the most liquidity. When financial players bet on higher prices, they push up the oil price and exacerbate the notion that the physical market is tight, even though these funds have no intention of taking physical delivery. Some traders argue that the bullish narrative of recent times had overstretched the market like a rubber band. One analyst said signs were clear before last Friday that the tail was wagging the dog — that the paper market was dictating the price to the physical market, not the other way around. Speculators try to assess the value of oil a month or two in the future and put a price on events that have not yet happened. They saw a super-tight crude market. Consumer complaints about available supply and rising prices added to their bullish sentiment. Fuel switching away from expensive natural gas and rising jet fuel demand also contributed. By late October, speculative buying helped push front-month Brent to a premium of more than $5/bbl over loadings in six months. That premium has now deflated to less than $2. The swing in US benchmark West Texas Intermediate was even larger, with the prompt premium narrowing to less than $2/bbl from more than $7 a month ago. The premium for front-month Brent over the second month is now close to 40¢/bbl, compared to $1.35 a month ago.

On the face of it, the price collapse signals a drastically weakened outlook for winter fundamentals. The crude market was always going to be in surplus in the first half of 2022. But recent developments — Omicron, strategic stock releases, even the restart of Iran nuclear talks — forced some players to wake up to this fact. Still, product markets remain tight and product prices, led by diesel, are still expected to create significant volatility over the winter. Rising product prices would be a major catalyst for another crude rally, while Opec-plus still holds considerable power over prices through its supply management. On the other side, Omicron is a stark reminder that the world is not yet past the pandemic. The market was already facing an oil surplus in the first five months of 2022. Energy Intelligence puts that surplus at about 1.6 million barrels per day during that period, which includes softer pandemic demand and rising US oil output. But bulls can point to tight products markets and the sluggish ramp up in refining runs. If the world runs short on diesel, for instance, it could push Brent back to $80/bbl in no time. For now, uncertainty rules, which could keep significant risk capital in oil on the sidelines until some consensus on the market's direction is reached.

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