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Three Factors That Could End The Oil Rally

oil rig

The bullish forces helping to push crude benchmarks up to their highest levels in years could be running into trouble.

There is a confluence of factors that conspired to push Brent above $70 and WTI to $66, but several of those could be coming to an end.

The post, Three Factors That Could End The Oil Rally, was first published on OilPrice.com.

First, the dramatic weakening of the U.S. dollar over the past year, and especially over the past two months, has buoyed oil prices. Because oil is denominated in dollars, a weaker greenback helps lift demand – and thus, prices – for crude. The dollar’s role in driving the oil price was punctuated last week when Secretary of Treasury Steven Mnuchin offered some support for a weak dollar, comments he had to somewhat walk back. Oil prices surged after Mnuchin’s comments raised speculation about a change in the U.S.’s preference for a strong-dollar policy.

The steep decline of the dollar took a breather on Monday, which removed some bullish momentum from crude benchmark prices. Meanwhile, Iran’s oil minister expressed concern about oil prices rising too high, and Baker Hughes reported a large increase in the rig count, pushing prices down. During midday trading, WTI was down more than 1.25 percent and Brent was off a similar amount.

If the dollar begins to regain ground, it could kneecap the oil price rally. “Further pronounced strength in the greenback could threaten crude’s recent mojo,” Baird Equity Research analysts said in a research note.

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Arguably the largest factor fueling the rally over the past two months has been the substantial drawdown of oil inventories. That too may soon run its course. Forecasters such as the IEA and OPEC have long predicted that inventories would begin rising again in the first half of this year. Thus far in 2018, the markets seemed to have derived some confidence from the past few weeks of drawdowns, perhaps overlooking the prospect of a return to storage increases.

There could soon be a reckoning. Last week offered some early signs that the inventory builds could be upon us. API reported a surprise build of 4.75 million barrels for the week ending on January 17, a report that was offset by the slight drawdown from the EIA. However, a growing number of market watchers are expecting crude stocks to start rising in the near future.

“That’s the biggest reason why you are seeing pressure on crude — it’s a function of the reverse correlation to the dollar,” Bob Yawger, director of futures at Mizuho Securities USA Inc., told Bloomberg. “There is the expectation among a sizeable amount of the energy space that there will be a storage build for the first time in eleven weeks.”

Finally, another important driver of higher oil prices in the past few months has been the speculative positions staked out by hedge funds and other money managers. I have repeatedly cited this phenomenon as a serious short-term bearish threat to prices, but so far the bullish bets have continued to climb.

However, the overwhelmingly one-sided positioning from major investors has not gone away. In fact, hedge funds and other money managers continued to break new records for the volume of bullish bets on crude oil.

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If investors start unraveling some of these bullish positions, crude prices could see a sudden and sharp selloff. “Considerable correction potential has meanwhile built up for all these energy sources — which may provoke a marked price correction at any time,” Commerzbank said in a note, referring the extraordinary buildup in speculative positions.

The unwinding of bullish bets could accelerate if a series of worrying headlines emerge. It isn’t inconceivable that EIA weekly reports in the next few weeks start to show ongoing gains in U.S. oil production, while simultaneously reporting a rebound in inventories. That is particularly true if refineries start to cycle down or go offline for some maintenance, as is typical before warmer months. Up until now, the inventory declines have helped distract from U.S. shale growth.

To be sure, there are plenty of reasons why oil prices could continue to rise. OPEC compliance remains high. Deeper unexpected outages from Venezuela, Libya and/or Nigeria are entirely possible. Demand is still strong.

But the increase in oil prices in recent months has been turbocharged by a weaker dollar, falling inventories and speculative bets on rising prices. If those factors disappear, the oil price rally will face a test.

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