Is Oil Going Back Under $40?

• In recent weeks the oil market has seen negative sentiment drive prices lower based on expectations of heightened output (some of which have been realized) from recent problem areas including Canada, Nigeria and Libya while refining margins have collapsed and Brexit has added to macro/demand concerns. Over the last two months speculators have trimmed net length by 32 percent in NYMEX WTI and reduced net length in ICE Brent by 21 percent. During WTI’s rally from $26.05 to $51.67 many traders assumed that a gasoline demand boom and falling non-OPEC+Russia production would accelerate a clearing of the global crude supply overhang and lead to higher prices. Instead, traders are looking at a more negative macro picture, a global glut of gasoline is weighing on the entire complex and fear of another move into the $30s is gaining momentum.

• In our view, however, a protracted move below $40 for oil would probably require a sharp selloff in the EUR/USD (which is certainly possible, but could be difficult given the Fed’s unspoken mandate of keeping a harness on the $, more on that later) and could ultimately prove to be a good buying opportunity as the global daily supply surplus continues to shrink. High inventories aside, the market is still gradually moving towards balance and peak daily oversupply is behind us. According to the most recent IEA data, the peak in the oversupply cycle occurred in 2Q’15 at 2.2m and supply/demand will flip into deficit either in 2H’16 or 1H’17. The EIA and OPEC see similar trends believing that the market is moving towards balance before reaching a daily supply deficit next year. We would even view a market with a daily surplus of 500k bpd (a much more bearish assumption than any of the above forecasts) as a thin margin of error when the IEA sees 96-97m bpd of demand in 2H’16, production has yet to bottom in many parts of the world and massive geopolitical risks persist in Libya, Nigeria and Venezuela. More broadly, the budget stress shared by exporting nations, commercial producers and the odds of an OPEC supply cut would only increase if prices make another aggressive shift south.

• While we aren’t in the camp arguing for +$60 oil in 2016 based on the above trends, we do see trending market balance as limiting the downside risk for oil and would most likely look to own 35-25 delta $5-$10 wide call spreads with 4Q16 maturity, sell $35-$30 puts or own WTI structure such as WTI Z16/Z17 if an FX driven sub $40 crude oil move materializes in the coming weeks.


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