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What Happens After Mean Reversion?

Author: Brynne Kelly (w/Lee Taylor technical levels)

In recent history, a dip in WTI futures prices below the $40 level has signaled a 'buy' for those that believe in mean reversion. Such dips in price have been associated with large spikes in implied volatility, followed by fairly long periods of contracted volatility as futures prices stabilize. This was the case after the financial crisis in 2008/2009, as well as after the oil market collapse in 2015.

Well, here we are again in 2020, this time the result of a global pandemic. Except this time the volatility spike was even greater than those seen in the past (to show it on the chart below would ruin historical granularity!) as oil prices dove below $40 into negative territory (continuous month-2 Nymex WTI=black line, CBOE Crude Oil Volatility Index=purple line below).

Extreme moves attract market participants with the possibility of 'mean reversion'. In recent history, this has generally happened when oil prices move below $40 and oil volatility (index) is above 60. The global pandemic brought in sellers at a frantic pace as they had to unwind long positions. This drove implied volatility to record highs, which drew in the mean reversion traders looking for oil prices to move higher and implied volatility to move lower. Of course there is still a high degree of uncertainty in the supply/demand picture, but it's now more about nuance.

Regardless of oil price levels, a recovery from historic lows leaves room for profit-taking above the $40 level. We are starting to see this reflected in net money manager open interest (blue line = net money manager[MM] open interest, black line = continuous month-1 WTI futures).

The only unique thing to notice on the chart above is that money manager net positioning has typically mirrored outright movements in prices. Since March, money managers were able to change directions without immediately impacting outright prices. They have been able to get long while prices continue to move lower and reduce that length while prices move higher.

Profit taking usually is targeted in the front few contracts on the board that have the most open interest. This is where most outright price players hold positions - in the most liquid months. The price action of the Q4 2020 strip vs future calendar strips last week confirms that market participants are ever-so-slightly beginning to abandon their length in the front relative to the back (green line vs all other lines).

Of course, last week we had an epic push/pull of supply/demand (production shut-in's vs refinery shut-in's) due to the two storms that hit the US Gulf coast (Marco and Laura). The BSEE had reported on Friday that almost 85% of US Gulf of Mexico production was shut-in. By Sunday, this figure was reduced to just under 70%.

On the demand side, we had refinery shut-in's ahead of the storm. These were initially reported at around 2.3 million barrels/day, but are sure to be lower than that come Monday.

The current situation is very perplexing. It is one of profit-taking in the front due to the rebound of historic lows vs the expectation that oil investment has lost traction, which will lead to tighter supplies in the future. All of this against a back-drop of forced capacity reductions (by OPEC+). One could argue that the future has never been more uncertain than it is now. However commodities, including energy, always seem to require the spot market to lead. We live in times where the spot market is assumed to not reflect future conditions.

These are times when one should take advantage of herd mentality in spreads. Spread markets take their cues from current conditions, yet also require a closer look. For example, one month calendar spreads in WTI are saying two things at the same time. Calendar spreads have moved from backwardation to contango. Contango markets usually exist to encourage storage while also recognizing the costs associated with storing a product. In normal markets this 'storage cost' reflects not only the actual cost of physical storage but also the cost of money. It can be ironic to have a contango market in times when it is thought that there is too much in storage. The phrase 'super-contango' has been thrown out there to describe times when there is simply no use for molecules today or when inventories have reached maximum levels and there is simply no place to store another molecule. We saw 'super-contango' in April of this year.

But, what does contango mean in today's environment? Why is the market paying to accumulate barrels? Is the current market one that is 'normal' that simply pays a regular rate of return to producers that reflects the time value of money? It reminds me of the 1990's when I began trading oil and it was described to me that 'oil markets are always in contango because it costs money to store oil'. Have we come full circle, and oil is merely reflecting the simple cost to store oil in its curve structure? Or does the market have it all wrong? Below is the current shape of the WTI futures curve as of the 8/28/20 Nymex settlement (aka, contango).

A contango structure acknowledges a non-renewable resource (a natural substance that is not replenished with the speed at which it is consumed. It is a finite resource). Minerals like gold and silver have a contango market structure unless there is a problem with storage (too little or too much).

Here is what the above contango structure looks like when expressed as one-month calendar spreads.

This is definite 'herd mentality'. Either it's 'everyone in contango' or it's 'everyone in backwardation'. But, the herd is separating. Some of the spreads in the back (Oct/Nov, Nov/Dec 2021) are flirting with pre-pandemic levels. The risk/reward in buying back spreads seems good right now. It's a bet on a tighter supply/demand shock in the future due to reduced production because of anemic capital expenditures.

It's the crux of the market right now. A question that is more important than outright price direction. Simply put, are we paying producers to generate and store molecules now for the future because we think we will need them more in the future because it's a 'normal' market? Or are we falsely encouraging today's production with the promise of higher prices in the future because we think production will fall short in the future?

If the answer is that we think production will fall short in the future, the market will eventually flip to backwardation.


Weekly Changes

The EIA reported a total petroleum inventory DRAW of 9.70_million barrels for the week ending August 21, 2020. Commercial Crude oil inventories posted a weekly DRAW of 4.80.

Year-to-date, total Inventory additions stand at a BUILD of 118.90 million barrels (vs 128.60 last week). We have made meaningful progress in drawing down from record levels over the last several weeks.

Commercial Inventory levels of Crude Oil (ex-SPR) and Refined Products remain elevated compared to prior years, with distillate inventories being the most worrisome ahead of the winter heating season.


Lee Taylor - Technical Levels (to return next week)

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