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Reasons for Oil bearishness and pricing will continue to have downward pressure from here

Sunday 15th February '15

Reasons for oil bearishness
OPEC’s action unlikely to end US shale revolution

The only realistic way for oil to recover is if the Organization of the Petroleum Exporting Countries (OPEC) reverses its stance on bankrupting US shale oil producers in an effort to protect market share. Absent any such indication, OPEC’s previous willingness to take the hit at prices much lower than $50/BBL suggests the supply glut is unlikely to disappear quickly. The impact, if any, on US shale oil production also remains unclear. Ongoing improvements in horizontal drilling methods, and industry consolidation, means large producers are reaping benefits even as prices fall, and their ability to survive turmoil is improving. The US government also has a strong strategic interest in protecting the industry, and could still step in with tax breaks or subsidies if required. Altogether, OPEC’s actions will harm US producers and change their competitive landscape, as we are already seeing a sharp drop in the number of rigs drilling new wells, but are unlikely to affect aggregate US shale oil production materially. It may slow the growth trajectory, but it won’t reverse it.

China’s path of managed slowdown cools oil’s demand fundamentals 

China is now taking a different approach in managing its economy. It’s willingness to enforce more market discipline than in previous downturns means lacklustre industrial activity (see the subdued PMI readings since 2012) is unlikely to rebound to the degree that it reignites a new commodity super cycle. This discipline is effected through both monetary and fiscal restraints. Given the financial and operational gearing of the business economy remains high, China still needs to manage the slowdown to avoid a crash. With China’s new more disciplined, balanced approach, it is unlikely ever again to provide quite the level of stimulus to oil sentiment that it has in the last decade.
The premium China has put on the oil price is hard to quantify but ever since China’s acceleration in growth from 2001 to 2008, oil prices have risen sharply in both real and nominal terms. As shown in the chart below, even after adjusting for US core consumer prices, the real, inflation adjusted oil price is high when compared against the period since the adjustment of oil supply shocks caused by the 1979 oil crisis up until 2001, when China’s economy started its accelerated growth and instigated the boom phase of the commodity super cycle.

Speculative bullish unwinding not over yet
Despite the sharp falls in oil price to date, the unwinding of speculative bullish positions that has reinforced downward pressure since the summer of 2014 is probably not yet over. On NYMEX, the commodity futures exchange, some 324,000 WTI crude oil contracts are currently held as net long speculative positions; 12% of the open interest and much higher than historical standards (see chart below). If the net long positions fell by 200,000 contracts, i.e. back towards a more normal open interest level of 5%, there would be considerable further pressure on oil prices. At a time when the winter season would normally revive oil sentiment, such unwinding would blunt upside potential.

Short oil ETPs are efficient hedging tools in downward trending markets

Geared short ETPs tracking energy commodities have performed well recently. As shown in the chart below, a triple (3x) short ETP tracking WTI crude oil, such as BOOST WTI Oil 3x Short Daily ETP (3OIS), returned 167% (from 1 Dec 2014 to 30 Jan 2015) to investors. With WTI crude oil having fallen 28% over the same period, it demonstrates that geared short ETPs are an efficient way for investors to express a bearish conviction, or to build hedges that require less capital.

Boost has seen significant activity in trading volume as a result of the spiking volatility in commodity markets. Monthly trading since the second half of 2014 has risen exponentially, from $3 million in July to $160 million in January 2015 (see chart below) helping Boost’s AUM of OIL ETPs to grow to $42 million (as at 31 Jan 2015).
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