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These Two New “Oil Records” Prove that Mid-$50s Oil is Almost Here

by | published September 8th, 2016

I’ve been saying for some time now that oil prices will reach the mid-$50s towards the end of the year, and the low $60s in the first quarter of 2017.

And now, the world’s largest financial players are catching on, making record moves to prepare for rising crude prices.

But that’s just the beginning…

It doesn’t even account for what happened to oil this morning.

We haven’t seen this in 17 years…

Shorts on Oil Have Never Been Unwound This Fast

Through the end of last week, short positions on oil (bets that oil will go down) decreased by record amounts. In the face of an almost 25% rise in futures prices, more shorts were unwound than for any equivalent period since figures were first compiled a decade ago.

That’s great news for oil prices, and another signal that my oil price forecast is correct. But before I get that, let me first explain why shorts and other artificial manipulation is so important to the price of oil.

This manipulation is based on the relationship between “paper” and “wet” barrels – futures contracts in oil as contrasted to actual consignments of crude. The futures market was created to stabilize the market and remove pricing-control from the control of a few major producers to a wider market of investors.

This has largely been a success. Volatility still exists, but the cycles of instability are much shorter and smaller.

However, with the advent of even quicker computer-based trading abilities, shorting has become more and more important…

Shorts Can Be Good – But They Also Accelerate Existing Price Trends

When a market sector – especially one dealing with commodities – is moving up or down, traders always try to ride that movement to profits by running “paper trades.”

If the underlying commodity is drifting up, and futures are indicating that such a trade will continue (as I explained last Thursday, this situation is called “contango”), long positions tend to increase.

On the other hand, if prices are falling, as was common with oil until recently, short positions (“shorts”) are the rule.

The process of shorting oil futures is similar to shorting a stock. A trader takes a short position in oil by “borrowing” contracts from a broker and then immediately selling them at market. Later, the trader needs to go back into the market and buy the contract, returning it to the broker.

With oil futures usually standing for 1,000 barrels at a time, such shorts are not made by normal investors. But big institutional players do it all the time.

For example, let’s say oil is trading at $45 a barrel (about where it was this morning). That means that the contract that a short-selling trader “borrows” has an effective face value of $45,000. By immediately selling the contract, the short-seller makes that much money.

Then, if their guess that the price of oil will go down is correct, the trader can buy back the contract for less. Suppose oil falls to $42 per barrel, putting the face value of the contract the trader sold (for $45,000) at just $42,000.

The $3,000 difference is the profit made from the short.

Usually, shorts help to stabilize the market by bringing in investment that sees things differently than other market players.

These days, crude oil is much more important than just a (widely used) commodity. Given its fundamental connection to currency exchange rates (the vast majority of daily oil trades are denominated in U.S. dollars), oil has ended up being a global vehicle for stored value – much like currency or gold.

That makes the influence of shorts on crude oil much more pernicious.

During the protracted decline of oil prices from late 2014 until the beginning of this year, shorts tended to accelerate oil’s downward trajectory. I even developed an algorithm to determine what part of the decline was occasioned by shorts and other secondary derivatives.

But now, things are changing…

Traders with Shorts are Being “Squeezed” Out of Their Positions

We are now experiencing a movement in the other direction. As I noted last Thursday, oil prices are showing additional signs that a floor is building and a gradual movement up will take place.

That puts existing short-runners in a difficult spot. Because the only way for them to close their position is to buy contracts at the going rate, when the market turns against them, they risk losing a lot of money. In fact, there is theoretically no upper limit to how much you can lose on a short (as there is in theory no upper limit to the price of a stock or futures contract).

Now, this risk can be reduced by trading options at the same time, but the loss is still a loss.

If the trader thinks a price rise is just a momentary setback and will soon go away, the shorts can be “rolled over” into new ones, to extend the trade.

But if the market looks like it will move up or stabilize for a long time, the short position has to be closed as quickly as possible, to guard against even higher losses in the future. When a large number of short sellers close their positions at the same time by buying at market prices, the resulting jump in prices is called a “short squeeze.”

And this short squeeze is getting even tighter today…

This Morning Saw a Record Reduction in U.S. Oil Inventory

This morning, the Energy Information Administration (EIA) announced a dramatic drawdown from U.S. oil stockpiles (the real “wet” stuff) of more than 14 million barrels last week. That was more than 12 times what “experts” expected, and the largest drawdown in a single week seen in more than 17 years.

Expect any remaining short sellers to run for the exits.

Nonetheless, some perspective is in order. The rise in oil prices currently underway is more subdued than in the past. This will not be a quick move to $80 a barrel, and it won’t be a straight line, either.

Rather, I continue to hold to my forecasts of mid $50s per barrel in New York by late fourth quarter of this year and low $60s in the first quarter of 2017.

The recent short-squeeze and this morning’s storage drawdown are just the first step in that direction…

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  1. Lonnie Prescott
    September 8th, 2016 at 19:36 | #1

    I am in high hopes of oil prices rising.
    I am so ready to get back to work !!
    Will keep close watch on the oil news.
    Praying for Better Days Ahead.

  2. Lee Marsh
    September 8th, 2016 at 19:57 | #2

    In your article you refer to the 12 to 14 million barrel drawdown of oil inventory last week, however, you did not explain the reason for the drawdown. Could you explain the reason for the drawdown? I doubt that it was caused by the “peak” driving season. Was it caused by a temporary slow down of vessel shipments due to the recent hurricane or was it caused by some other factor? Thank you.

  3. Jd lenderts
    September 8th, 2016 at 21:28 | #3

    thanks for the explanation, i wondered why my 5800 shares of chk went up $.94 today., Awesome!

  4. Jonas Gumaelius
    September 9th, 2016 at 07:03 | #4

    Regarding EIA stock figures released yesterday, Sept 8th, please note that dramatically lower imported crude during the reported week amounting to abt 12.9 million BBLs “explain” most of the 14.5 million fall in total crude oil stocks.

  5. Joseph Maxwell
    September 10th, 2016 at 20:49 | #5

    We are in the beginning of a 206 year Solar Cycle with the start of a 30 year cooling period referred to by solar physicist as a “grand minimum”. During the next 30 years the sun reduces its activity resulting in significant global temperature reductions of historic proportions that can produce major ill effects worldwide. The history of when this happened 200+ years ago tells us there were more earthquakes, volcano eruptions and crop failures. To find out more about this contact John L. Casey, director of the Space and Science Research Center in Orlando, Florida.

  6. Steffen
    September 11th, 2016 at 10:10 | #6

    What would happen to oil stocks if the US dollar looses its status by the. end of this month

  7. September 11th, 2016 at 20:20 | #7

    Great insight

  8. Nisar Mahmood
    September 17th, 2016 at 22:50 | #8

    Is crude bottomed ??

  9. September 24th, 2016 at 01:03 | #9

    Some how I feel we’re going to get screwed again,
    And the one that may get into office doesn’t want
    To see our hard working oil workers to make money, heaven forbid. And she doesn’t want them to get their Iives back, so that’s one reason I vote for Trump. I believe he’s not gonna play around!
    If theirs money to be made, damnit, we’re gonna make it! Of course Hillary won’t be around anyway
    It won’t look good on her resume if she wins the presidency and then goes to prison! Oil should be up around $80-$90 right now!

  10. September 25th, 2016 at 21:14 | #10

    The world is awash in oil we could start burning it today and never run out.
    Major players, Iran, Russia, and any of the Opec nations will love to take your money as you invest in higher and higher market prices all the while deflation will strike oil and you won’t be able to give it away. If the players try to screw the world, the world will screw them. And that is exactly the way the free Marketeers want it. With their inside knowledge, they will steal from their, Mothers and Grandmothers. Oh yeah and tell them there is no money left for Social Security. Nice group of people!!!!!

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