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Oil Prices Are Set For A Major Pullback Soon

From Nick Cunningham: In the days leading up to the implementation of the OPEC deal, investors continue to remain bullish on oil prices.

Hedge funds and money managers have snapped up bets on higher oil prices at a torrid pace, wagering that crude will rise as OPEC slashes production. The net-long positions are now at their highest level in more than two and a half years, with investors repeatedly breaking new net-long highs in the waning days of December. For the week ending on December 27, investors added more bullish positions, marking the seventh consecutive week of increases, the longest streak since early 2014.

“We have a very confident positioning here,” Tim Evans, an energy analyst at Citi Futures Perspective told Bloomberg in an interview. “There’s plenty of hope that prices are supported and move higher and very little fear that compliance will be poor and prices will drop.” WTI closed out the year above $53 per barrel and Brent ended close to $57.

But while the markets are highly optimistic about rising oil prices, they risk overplaying their hand. Net-long bets have built up to such a degree that traders have increased the danger of a snap back in the other direction. Bets on oil futures tend to go in waves, with trading patterns resembling a roller coaster. A bout of good news causes long bets to rise. Once they are overdone or the market gets slapped with some bearish news, investors liquidate long positions and scramble for the exit. Shorts then come out in full force. A run of shorts builds up until that trend also looks like it has gone too far, with the emergence of market tightness or some geopolitical risk ending the bear run.

In other words, net-long bets could be on the crest of a wave, with the risk of a return to a more net-short market structure rising by the day. And each weekly build up in net-long positions only increases those odds. All that is needed is a spark, such as news that U.S. shale production is surging faster than expected or that OPEC is not complying with the November deal as closely as promised.

That puts the month of February in the spotlight, as that will be when the first bits of production data are published from OPEC. The data won’t paint a full picture, however, as OPEC members are only required to cut their six-month average down to the targeted levels. They are not required to cut to the full extent immediately this month. As such, the data may not reflect sharp decreases in output. That should not be taken as a sign of cheating, since they can cut deeper in subsequent months and still adhere to the deal. Nevertheless, headline figures about OPEC production exceeding the promised levels could spark a downturn in prices. Media hype and market psychology are always at play.

For now though, investors remain optimistic about a bullish 2017, and not just for oil, but for a wide cross section of commodities. “You began to see stimulus spending in China, along with monetary policy designed to bolster demand and growth. And also, you began to see pickup in economic activity in the U.S., suggesting that commodity prices would be bottoming and gaining,” Quincy Krosby, a market strategist with Prudential Financial Inc., told Bloomberg. Krosby says that commodities are now “a very attractive asset class.”

That is a remarkable turnaround from the past several years, which saw falling prices for most commodities, including coal, copper, nickel, and of course, oil and gas. The decade-long commodity super-cycle, fueled by explosive growth in China and loose monetary policy from the Federal Reserve, ended more or less in 2011, leading to several years of oversupply and weak prices. Oil defied that downturn, with prices remaining at high levels. That is, until 2014. Since then there have been few bright spots anywhere in the commodity space.

The year did close out in positive territory for commodities, however, raising speculation that commodity prices are once again on the upswing. The Bloomberg Commodity Index, which tracks prices for 22 different commodities, gained 11 percent in 2016. Oil posted the largest prices gains in seven years, rising 52 percent, although, that figure is not as impressive as it seems at first glance, given that the baseline used to calculate such a number was the sub-$30 oil hit early on in the year.

Nevertheless, investors are more optimistic than they have been in years that prices will continue to rise. “What a difference a year makes,” Phil Flynn, senior market analyst at Price Futures Group, said in an interview with Bloomberg. The market is now “probably the most optimistic we are looking going into a new year in energy in many, many years,” he added.

But being too optimistic on oil, which has been notoriously fickle, could carry risk. Speculative bets could unwind just as fast as they accumulated.

United States Oil Fund LP (ETF) (NYSE:USO) rose $0.25 (+2.13%) to $11.98 in premarket trading Tuesday. In 2016, USO gained 6.55%, versus a 10.78% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #2 of 123 ETFs in the Commodity ETFs category.

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