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February 14, 2018

Oil market review: Why prices should fall further?

Oil market review: Why prices should fall further?

Trump’s tax reform will not only leave marked footprint on corporate profits but also pose a big threat to the oil market.

Recall that in December last year, Donald Trump and Republican party successfully pushed the bill featured with massive tax cuts. Its too early to say what will be the precise impact on corporate earnings and social welfare. But the distinguishing thing is that sharp increase in oil production followed the Republican’s victory. The output boost can be attributed to mere coincidence but for oil traders it was completely unexpected outcome.

According to the Wood Mackenzie note, Trump’s law will result in $200 billion increase in capital assets for oil explorers. The sector’s stability will be improved with a combination of corporate tax rates, pass-through rates and accelerated expensing of capital costs adding 19 percent to post-tax profit or $190.4 billion. Together with the rebound of prices for crude oil it means surge in profitability, encouraging producers to step up drilling activity. further attracting investment capital towards the sector.

Recall that in December the US Energy Department expected that the country’s daily output will average 10.02M barrels. In January the agency made a sharp upgrade to their projections – up by 600K barrels a day. Latest report anticipates that average output will rise to 10.6M b/d topping at 11M b/d when the year is out. Markets were completely taken by surprise, although numerous warnings has been wired predicting such outcome.

Post factum take on this case is easy, but it is clear for me that if taxes decrease the cost of production falls as well. Marginal revenue productivity (change in Total revenue / change in production factor) increases as well as margin productivity (change in Q / change in production factor) what logically leads to increase in production and capital investments. With the recently lifted ban on exports of US crude oil this open doors of cheaper US oil flowing into the world market, pushing it back into oversupply zone whatever OPEC efforts are.

Hedge funds rushed to cut their long positions on crude oil. But is it too late?

As of February 6, hedge funds had 512.9K long and 40.2 short oil contracts. Net long positions averaged 472,8K contracts, declining by 23.2K contracts or 2% in the week ending on February 6. For the same period priced retreated by 2%.

Recent slump in prices did not lead to a decrease in short positions on the part of the largest market participants. Spread between the short and the long among top 4 traders of the New York Mercantile Exchange is 3.7 percentage points, which is the biggest difference since November 22, 2016. However, that time they wagered on the growth of “black gold».

Last week prices plunged more than 6% and it is not yet clear whether hedge funds could get rid of their long positions fast. Sluggish response in next COT data, i.e. the change in net long positions smaller than recent price drop pose threat for the oil market, as traders can renew liquidation of longs pressuring prices further. The prices bounced from key support at $60, but its likely to witness an attempt to break through this level as long-term fundamentals look gloomy for the market.

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