Why It Makes Sense To Short Oil

In a dealing room, making bad calls is a fact of life. I don’t care how smart you are or think you are, no trader has ever been 100% correct in their reads on a market. Understanding that, accepting when you are wrong, and then cutting and moving on are essential traits if you are to survive for any length of time. It follows from that that the worst thing a trader can do is to double down on a bad call.

Averaging losers and “trading with conviction” may look admirable in movies and the like but for every success story that comes from doing that there a few hundred tragedies.

So, given all that and in the knowledge that one half of the hedged trade that I suggested here last week was to short crude, and understanding that since I made that call the main WTI contract, CL, is around twenty percent higher, the one thing I shouldn’t do this week is think about shorting crude.

But I just can’t help myself.

Don’t get me wrong, I completely understand that the massive cuts in U.S. output will have an effect and that that effect will probably be being felt most just as demand begins to recover. There are good reasons to believe that the spike in price that causes could be nearly as sensational as the drop that preceded it. I just can’t see how that future dynamic can lead to further price increases over the next couple of weeks.

As many people realized for the first time a couple of weeks ago when the May WTI contract dropped into negative territory, Cl is not just a trading instrument. It is a deliverable contract for many industry users. When, as was very much the case then, supply exceeds demand, the oil delivered has to be stored. As a result, storage capacity and pricing can be a big influence on oil’s price as a contract nears its settlement date.

The price of the front-end June contract (CLM20) is currently reflecting the big cuts in supply and an expectation that demand will be returning soon. That is right and logical, but the problem that caused such chaos as the May contract expired hasn’t gone away. In fact, according to the EIA data, total U.S. crude inventories have increased by 13.6 million barrels over the weeks since all that drama.

Futures pricing is, by definition, about expectations (the clue is in the name), but even if the assumptions behind the recent rally are correct it is hard to see a lot of upside as CLM20 nears expiration when there is still so much crude stored around the country.

The assumptions on the supply side that are driving prices higher right now are certainly supported by data. There has already been a massive decline in the rig count and this afternoon’s numbers are expected to take the number of active rigs in America to new lows. That has a big impact on where we will be in the future, but unless there is enough demand to eat into the existing glut, that won’t make much difference to the short-term storage issue.

On the demand side, things aren’t as clear-cut. I hope and pray that things go smoothly as some states begin to reopen, but there is a chance that it is just too soon. If so and coronavirus cases spike, that anticipation of big increases in demand disappears and oil will collapse again. Even if the worst-case scenario doesn’t unfold though, reopening is a gradual process and it is hard to imagine that gasoline demand will be robust enough initially to allow for a further jump in crude over the next two weeks.

So, as much as it is against my number one rule to revisit a losing trade or view too quickly, I can’t get away from the logical assumption that a short bias in crude over the next couple of weeks just makes sense. Of course, that could be wrong too, but if it is, I will just cut and think again (again)!