The end of 2016 markets performance was marked by a strong surge into year end. This of course includes the oil market, which benefited from an OPEC deal to reduce production and strong commitment from Saudi Arabia for further cuts. But now three reasons are creating a favourable risk/reward for shorting oil. Uncertainty regarding OPEC deal and US shale producers, speculator exuberance and complacent option market volatility.

Trade Details

My recommendation is to BUY April 2017 USO $12 strike puts, providing a compelling risk-reward. With the expectations of oil prices to touch in the $46/48 range ~$10 USO. The $12 strike and April expirey, allows us a longer time frame (88d) for the price move to play out, and only risks about 40 cents extrinsic value on the option value at Friday’s prices. I will be opening a portion of the position the coming week and another portion at any time oil reaches around $55 within two weeks. I will begin closing positions as the oil price falls below $50, subject to changes in market dynamics.

Market Complacency

The crude market is currently lodged between a tight floor and ceiling due to expectations of OPEC cuts and the prospect of a Shale restart above $55/$60. Coupled with the euphoria of the Trump trade, this has created a complacent market, cratering implied volatility and options pricing.

USO IV

Managed Money Exuberance

This week’s Commitment of Traders report showed a disaggregate increase in the net speculative positions to levels not seen since the oil downturn. As we can see by the shaded red region, a large portion of the change comes from shorts closing their position after the OPEC meeting, but also a meaningful increase in long positions. In most cases, a relative top in CFTC positioning report signaled a relative top in oil prices, as the capital which marginal buyers are able to speculate with decreases (since it’s been put up to purchase futures).

CFTC Oil

According to CFTC data, the difference between non-commercial and commercial positions has widened to it’s largest at 648.5k contracts vs 312k 1 year ago. This means more speculators are bullish and more producers are hedging, while refineries and other price takers are doing so at reduced rates.

Global Demand Dynamics

The OPEC deal focused on a significant cut in supply, but while all the talk was about supply, demand was growing at ~1% per year. While not sounding like a lot, it has contributed about ~1 million barrels/d of consumption globally. The steady demand growth has come from the likes of India and China, with large populations, high growth and industrialization/modernization as key themes of the respective governments.

Some upcoming headwinds which may dampen demand in the coming quarter or so could come from a number of places. I have listed a number of possible issues with links to further elaborate:

China

Chinese Oil Reserves nears capacity

Uncertainties around Chinese oil quota

China Property – Construction Cool down

India

Cash Crunch to dampen oil demand in Q1 /H1

Reduced Growth in India due to Cash Ban

Global Supply

OPEC reached a historic deal in late November, but the cut pledged by both OPEC and Non-OPEC members would only reduce oil production to early to mid-2016 production levels of 32.5 million barrels/day. Many of the Non-OPEC cuts are coming from unavoidable production declines. Besides press releases by Saudi Arabia and a few other OPEC member countries trumpeting the excessive level of cutting they have achieved, there is no tangible data available for OPEC production as we are still in January.

US Production

What we do know is that since mid-October US crude production has risen ~500k barrels/d according to weekly DOE data. This puts a dent in the 1.5 million barrel OPEC cut. While the sudden spike in crude prices over the last month or so, provided the opportunity to hedge 2017 production at high $50/barrel range for shale producers, likely reigniting rig activity.

Rigs & Inventories

US rigs have been steadily rising, and is it takes a number of weeks to deploy drilling rigs for new projects, we likely haven’t seen the end of the rig count increase. Rigs drilling in the Permian have more than doubled since their low in late April, rising from 134 to 281. Other basins have seen similar, albeit not as aggressive ramp up in production.

Inventories remain at seasonally high record levels, and with a higher gasoline price, sitting ~30% higher than last year, consumers have less incentive to increase their driving habits at the same rate as previous years.

But what about the OPEC cut in the first half of 2017?!

Well, according to the IEA, OPEC’s cut, if done to the specified extent will cause a global deficit of ~600k for the first half. Looking at just the US, which has less than 15% of the world’s crude oil storage (being generous here as global storage is just under 6B), the OPEC cut with full compliance would only trim about 100 million barrels, leaving the US sitting at about 400 million barrels ~50 million above the long term average. This is without factoring other regions which undoubtedly also have an oversupply problem.

Conclusion

While not a sure thing, oil prices on the balances are very likely to disappoint and head lower in the short to medium term. Key catalyst include an overstretched speculator position, possible OPEC deal non-compliance and US production continuing to surprise on the upside. The low volatility environment in both energy prices and across most financial markets have created an attractive option buying opportunity, and can also act as a cheaper portfolio hedge for a Trump trade unwind. I recommend to BUY puts on USO for April with a mid to high $40 oil price target.