The Silent Drivers: How Technicals and Fundamentals Might Indicate The Next Oil Surge

Fundamental data suggests that crude oil might be poised for a short-term rally, regardless of escalating conflicts in the Middle East. Last week provided some promising data from both a market positioning and supply standpoint — two dynamics that rarely correlate. However, there's always a catch.

The Commitment of Traders report from last week showed that managed money — entities assisting retail traders with capital allocation via ETFs, mutual funds, or direct portfolio management — reduced their long positions significantly. Managed Money cut back their long positions by 42,000 contracts, indicating that the brief interest from retail investors dissipated rapidly. I emphasize this regularly: retail money flows are unpredictable. While they might trigger a short-term surge, such trends are often temporary. So, I concentrate on producer positioning.

Producers primarily utilize futures to hedge against their physical inventory. As prices rise, they typically expand their short positions to "lock in prices". This action is pivotal, as if producers refrain from committing capital to hedge their positions, a market gap proceeds. If, in the coming weeks, producers persistently increase their short positions, it could suggest two things:

• Producers are expanding supply in the market (more on that later).
• A scarcity of sour crude necessitates a shift from gasoline to diesel, heating oil, and jet fuel. This shift can lead to improved gasoline spreads, inducing a deflationary scenario for inflation, which is bullish for equities.

An uptick in producers' short futures positions signals potential new supply — generally a bearish indicator. However, this arrangement aligns understandably as geopolitical tensions could jeopardize inventory. Currently, the key risk is Iran, especially the Strait of Hormuz, which it controls. This strait is vital to global energy markets. Any hint of transportation disruptions or a complete blockade can inflate energy prices while simultaneously endangering energy producers' inventory. This would prompt them to diversify production strategies to mitigate risk.

One might assume that supply disruptions benefitting oil prices would be favorable for energy companies. However, the potential loss or delay of inventory adversely affects top-line growth, thereby curbing profitability. Last week, in fact, the Baker Hughes reported the first rise in operational oil rigs in the U.S., and Canada added 13 rigs, suggesting potential supply additions.

The recent scarcity of sour crude, resulting from OPEC+ actions, is evident in the energy complex. Despite being expensive to refine, heavier and sour crude remain crucial for diesel and heating oil production. Diesel significantly influences the transportation costs of consumer goods and continuously impacts inflation metrics like PPI, CPI, and PCE. Refiners might be adjusting their production blend to prioritize these byproducts, which currently offer higher margins, to cater to demand. Yet, this alteration also carries higher costs, which might stabilize prices for the moment. This shift may also counteract the gasoline oversupply. It's a delicate act of fulfilling market needs while also striving for maximum profitability.

The Technicals

The technical setup resembles a classic test and pullback. Efforts were made to elevate the price to $95 a barrel for WTI, but weak producer fundamentals combined with retail trader enthusiasm caused the trend to be short-lived. However, with the current pullback in crude, managed money withdrawing due to their inconsistency, and producers beginning to intervene, it seems we might be on the brink of a structurally sound price surge, Middle East escalations aside. An abundance of gasoline might stimulate demand.

Adjustments in byproduct supply for diesel and heating oil could also alleviate the transport industry's pressure, consequently reducing prices and, in turn, reigniting demand. All these elements hint at a resilient consumer, furthering the soft-landing narrative, potentially bolstering energy demand and driving prices upwards. While this intricate balance might seem perplexing, considering the potential chain of events, a hike in crude prices seems plausible in the coming weeks. Any weakening of these fundamental structures endangers this possibility. Hence, it's crucial to await the maturity of both technical and fundamental setups before acting. Something to keep your eye on.