Post-OPEC, What's the Contrarian Take on Crude Oil?

COT large speculators are at their largest net long position on crude oil since 1986

by Bernie Schaeffer |

Published on Dec 26, 2016 at 9:00 AM
Updated on Dec 26, 2016 at 9:00 AM

The following is a reprint of the market commentary from the January 2017 edition of The Option Advisor, published on December 22. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- click here.

Major headlines for crude oil have bookended calendar year 2016: first, the prolonged price collapse that culminated in February's dozen-year low for spot crude of $26.05 per barrel; and more recently, the Nov. 30 OPEC decision to implement cuts equivalent to roughly 1% of global production. To say the reaction to the OPEC move was enthusiastic is underselling it by several orders of magnitude. Crude futures rallied more than 9% the day the news broke, and -- as of this writing -- have advanced a total of 16.3% since the Nov. 29 close.

Adding an exclamation point to this price breakout is the Dec. 13 Commitments of Traders (COT) report from the U.S. Commodity Futures Trading Commission, which showed the "large speculators" group of investors holding their largest net long position ever in crude oil (with data going back to 1986). The 480,689 net long open positions outstripped the previous high-water mark of 479,739 from June 2014, which occurred around the same time that crude prices were peaking at $107.73 per barrel.

After that June 2014 extreme in the net long holdings of large speculators, crude prices went on to fall by more than 50% through the end of that year, eventually settling 2014 at $53.27 per barrel. In the interest of providing some historical context, the average "anytime" performance for crude over a roughly six-month period (126 trading days), since 1986, is a gain of 5%. Looking out one year (252 trading days) from that COT peak, crude prices were down by 43%, severely lagging their average anytime one-year return of a 9% advance. And, aside from a minor lift during the second quarter of 2015, that decline in crude prices continued essentially unabated until the aforementioned February 2016 bottom.

It seems a likely bet that these unusually bullish investors are responding to the headline-grabbing (and admittedly, very rare) OPEC output cut, but one wonders if they've caught wind of the Baker Hughes rig count report, which showed -- as of Dec. 9 -- the largest weekly increase in U.S. oil and gas rig counts since May 2002 (and which, as of the Dec. 16 update, had logged increased rig counts for 22 of the last 24 weeks). And perhaps they're unconcerned that the incoming administration seems unlikely to take any steps to inhibit domestic energy production, from a regulatory standpoint.

In stark contrast to COT's unprecedentedly bullish crop of large speculators, the financial media has all but sounded the death knell for crude oil. On Dec. 20 alone, readers of Barron's were treated to the headline, "Get Ready for the Great Oil Bust of 2017," while Bloomberg ran with "Big Utility Sees Pathway to $10 Oil."

These conflicting sentiment signals warrant a close reading of the technicals, for which we'll refer to the accompanying chart of the United States Oil Fund (USO). Despite the gloom-and-doom headlines above, USO is enjoying a minor winning streak above its 320-day moving average, which capped the October highs, and is also trading north of several other key moving averages -- including its 40-day, 80-day, and 200-day. The recent strength in USO has also solidified its move above a trendline connecting a series of lower highs from the June peak. And as of its Dec. 22 close at $11.46, USO is currently trading near its year-to-date breakeven of $11 (top pane), which could be a key level on any pullbacks.

On the other hand, just overhead is $11.94, which represents 150% of the fund's Feb. 10 closing low, and which marked USO's exact intraday peak on Dec. 12 -- the first trading day after non-OPEC countries agreed to production cuts. And this looming resistance isn't the only caveat for prospective USO bulls. Additionally, an argument for more meaningful upside from here must also assume that COT large speculators are playing the role of "smart money," despite having served as a near-perfect contrarian sell signal around the 2014 price peak. And then, of course, traders must also contend with the very structure of the fund itself.

As an exchange-traded product tied to spot crude prices, USO is one of the more accessible vehicles for the typical investor looking to trade a directional move in oil. What makes USO less accessible for the "average Joe" is the fact that a successful trade requires not only an accurate prediction on the share price direction, but also on the term structure of oil futures. When futures are in contango, USO is selling shorter-term, lower-priced oil futures to buy longer-term, higher-priced oil futures, which negatively impacts assets. Conversely, backwardation can be a tailwind -- though taking advantage of this positive catalyst requires one to anticipate (and anticipate correctly) fluctuations in the relationship between the distinct oil futures contracts from which USO derives its value.

Given the sensitivity of crude oil prices to a variety of factors -- investor risk appetite, inflation, interest rates, economic data, geopolitical conflicts, and so on -- the ability to make such a forecast with a degree of accuracy exceeding that of a coin flip likely falls outside the purview of the typical investor. (Though if you were to develop a system for doing so, we imagine you'd have no trouble finding any number of major airlines willing to pay up for access to your methodology.)

It's understandable that the big news headlines and strong sentiment signals for USO -- not to mention the nearby presence of some significant price levels on the chart, and short-term implied volatility levels hovering near annual lows -- might hold some appeal for speculative players. But the deeply conflicting nature of the sentiment and technical signs for USO, combined with the added challenge of trading an instrument whose value is derived in part from the vagaries of crude's term structure, suggests the "correct" USO trade right now is no trade at all.

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