Why We Could See A Larger Short-Covering Rally in Oil

Over the past couple of weeks, oil markets have been marred by a storm of top-down macroeconomic fears that fed momentum-following algorithms, resulting in an extended oil price fall exacerbated by a final stage of gamma hedging by banks.

The overwhelming bearishness among money managers took positioning in crude oil and oil products to the most bearish extreme since the start of the Global Financial Crisis (GFC) in 2008.

As expected, a big oil price selloff ensued: front-month Brent crashed to $68.68 per barrel (bbl) intra-day on 10 September, the lowest price since 2 December 2021. Whereas oil prices have rebounded some $5/bbl in the week since, commodity analysts at Standard Chartered have pointed out that this is a fairly limited bounce given the extremes in speculative positioning, and warrants a larger short-covering rally.

Regarding the near-term oil price trajectory, StanChart has conceded that obtaining a clear short-term directional signal from fundamentals is almost impossible in such a dislocated market, with the group’s machine-learning tool SCORPIO recently thrown out of whack and making fairly inaccurate oil price predictions. However, StanChart points out several key bullish drivers.

First off, there is no supply glut, with September on track to become the tightest month of the year due to seasonal demand strength and supply outages in Libya, as well as the U.S. Gulf. StanChart has predicted that Libyan oil might take longer-than-expected to return to the markets. Two weeks ago, oil prices fell after the former governor of Libya’s central bank suggested that an agreement with Tripoli and Benghazi authorities that would restore full oil exports was Imminent.

Back then, StanChart argued that the nuances of the negotiations were significantly more complicated than market commentary had implied. Well, little substantive progress has been made after two rounds of negotiations, with the experts reporting that Libyan crude oil exports clocked in at 550 kb/d, roughly half the pre-crisis level of about 1.2 million barrels per day (mb/d). StanChart sees the reduction in output lasting significantly longer than the market is currently expecting, suggesting that the market has got ahead of itself in pricing the immediate resolution of an actually unresolved crisis.

Second, no supply glut is likely in at least Q4-2024 and H1-2025 if OPEC+ producers keep to their commitments. Last week, StanChart reported that oil markets are overlooking the imminent removal of even more barrels from the markets in the coming months. Back in July, Russia, Iraq and Kazakhstan submitted their compensation plans to the OPEC Secretariat for overproduced crude volumes for the first six months of 2024. According to OPEC, the entire over-produced volumes will be fully compensated for over the next 15 months through September 2025, with Russia ‘paying back’ a cumulative 480 kb/d, Iraq 1,184 kb/d and Kazakhstan 620 kb/d.

According to StanChart, the compensatory output cuts by the three OPEC members work out to a combined 370 kb/d reduction in October, and then an amount varying between 162 kb/d and 206 kb/d for November 2024 through to September 2025. StanChart has worked out that adding the compensation schedule to the recently announced reduction in targets due to delaying the implementation of tapering will result in OPEC production clocking in at 530 kb/d lower in Q4-2024; 540 kb/d lower in Q1 and Q2-2025 and 560 kb/d lower in Q3-2025, if all commitments are kept.

StanChart has argued that the market’s current assumption that there will be no compensation reduction is wrong because it’s highly unlikely that other OPEC+ countries would take it lightly. StanChart says Saudi Arabia, in particular, is unlikely to accept any further backsliding on promises made by the overproducers, noting that the high-profile visits to Iraq and Kazakhstan by the OPEC Secretary General, Haitham al Ghais suggests that OPEC intends to follow up on the promised cuts.

“I received strong assurances that Iraq continues to be fully committed to the DoC’s ongoing market stabilization efforts. During this visit, Iraq presented clear and determined steps to compensate for overproduced volumes and gave assurances that it would achieve full conformity going forward, ”al Ghais said after visiting Baghdad.

In yet another bullish catalyst, the latest weekly data by the U.S. Energy Information Administration (EIA) reveals that crude inventories at WTI’s pricing point at Cushing, Oklahoma, fell for the fifth successive week and for the ninth week in the past 10. Crude inventories  fell 1.7 mb w/w to a 10-month low of 24.69 mb, and are now 11.25 mb below the five-year average.