From Producers To Traders: Dissecting The Complex Dynamics Of Today's Crude Oil Market As Prices Test $90

Crude oil has captured the attention of investors and traders over the last month due to supply constraints resulting from OPEC+ pressure. Additionally, domestic rig counts have driven crude oil to reach over $90. However, the prevailing question is its ability to maintain these current levels or even continue to some analysts' targets of over $100 a barrel in the not-so-distant future. Unfortunately, the technicals and even some market positioning may not support this thesis.

Fundamental Setup

The Commitment of Traders report (COT) provides valuable insight into the underlying positioning of large traders in the market. The main component that I monitor closely is the Producer category, which includes those who extract, refine, or distribute oil and its byproducts. Over the last several weeks, except for a small advance last week, producers have reduced their short positioning in the market. As oil demand grows, dealers typically increase their short position to hedge current inventory. This suggests a strong foundation for prices to maintain current levels and find support. Once we observe short positioning decreasing, it raises doubts about the demand side of the oil consumption equation. A reduction in demand should, all things being equal, result in price declines. The chart below shows the gradual reduction in short positioning from producers, indicated by the orange bar.

Another reason this rally might not sustain itself is the swift increase in long positions by Managed Money, depicted in the second chart below in blue. This category encompasses Commodity Trading Advisors, often called CTAs, and others who manage substantial portfolios. This influx implies that both institutional and retail investors are growing interested in crude oil markets. However, they can typically adjust their positioning quite quickly, unlike producers who mainly use these futures contracts to hedge inventory.

A similar setup emerged at the onset of the Russia/Ukraine conflict. Producers began to trim their short positions once oil touched $100 per barrel. Managed money continued to increase their long position in crude oil futures, propelling the momentum past $100 per barrel, even though open interest began to wane, and markets became relatively thin, thus creating additional volatility in the energy markets.

The "X" Factor

The drawdown in crude oil inventories from both the commercial stockpile and the SPR is widely recognized within the market. Integrated oil companies have cut onshore rig counts in the Permian basin and other regions, striving to align supply precisely with demand, causing crude oil futures to be in backwardation for nearly three years. However, a potential issue that may reveal vulnerabilities in the oil market isn't just refining capacity, but ensuring refiners possess the appropriate oil blends to meet demand in various markets.

Different types of oil exist in the market, each with its unique advantages and disadvantages. Depending on the oil's quality supplied, refiners might need to combine or "blend" different products in order to meet market byproduct demands. Without delving into extensive details, there are concerns that the cut in oil supply from OPEC+, particularly Saudi Arabia, may be affecting the refining process as the heavier, sour crude is in relatively short supply. This heavier oil, traditionally provided by OPEC+, is essential for producing diesel fuel and heating oil.

The Wrap UP

The reduction in supply could impact diesel and heating oil stockpiles, potentially keeping prices elevated, even as refineries adjust gasoline blends for the winter season. With colder temperatures, there's likely to be an increased demand for heating oil. Should these supply "bottlenecks" be addressed—whether through diplomatic or economic measures—it might prove difficult to sustain oil prices at these heightened levels without a significant driving factor.

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