Barron's: Why Oil is Cruising for a Bruising

By SIMON CONSTABLE

Here's a puzzle: The U.S. is producing the most crude oil in decades, domestic stockpiles are at record highs, yet oil prices are near $100 barrel. What's keeping prices aloft?

The first piece of the puzzle is the way the U.S. prices its oil. The U.S. benchmark, known as West Texas Intermediate, or WTI, is based on delivery at a storage hub in Cushing, Okla. How much oil is stored in Cushing affects the price. At the moment, inventories of oil across the U.S. are at their highest going back to 1982, but Cushing has seen a steady drop since a new pipeline linking the hub to refineries along the Gulf Coast opened earlier this year.

The Cushing hub is "running on fumes," according to Société Générale, giving the appearance of tight supplies, and leading prices higher.

Another boost is from money managers, including hedge funds diving into the futures market. Financial firms betting on higher prices outnumbered those betting on a slide by 322,788 futures contracts as of April 22, almost double the number a year ago, according to the U.S. Commodity Futures Trading Commission.

There's more. The U.S. oil benchmark is also tracking global crude prices, which have been elevated by tensions between Russia and Ukraine. The threat of more-intense hostilities and the possibility of a supply outage will likely keep Brent crude, the global benchmark, higher until the situation is resolved, wrote Commerzbank in a recent report. Russia is the second-largest oil exporter after Saudi Arabia, and investors are concerned that Western sanctions in response to Moscow's encroachment on Ukraine could hinder the flow of crude.

Currently, WTI trades about $9 below Brent. U.S. oil prices settled Friday at $99.76 a barrel, up 1.4% for the year.

BUT THAT'S ONLY THE story so far. Analysts see plenty of reasons for oil prices to slide in the weeks ahead. Oil inventories are piling up in the South as several Gulf Coast refineries have temporarily shut down for maintenance, writes Michael Cohen, an analyst at Barclays in New York. Oil continues to flow to the Gulf Coast because it fetches a higher price there—that's the so-called Light Louisiana Sweet, or LLS—than it does in Cushing. But Cohen says transportation costs from Cushing to the Gulf Coast also add $3 to $4 a barrel.

However, the buildup of supplies on the Gulf Coast has started to weigh on the LLS price, and that will bring it closer to the U.S. benchmark price, Cohen says. As prices near parity, it makes less economic sense to send crude from Cushing to the Gulf Coast, which will help supplies at Cushing rebuild. When Cushing's stockpiles grow, WTI prices are likely to soften.

A threat to prices is also "posed by a potential wave of hedge-fund liquidation of existing long positions," Cohen wrote in March, referring to bets on higher prices. If hedge funds do dump a substantial part of those bets, $10 to $15 would be wiped off the price of a barrel, he wrote.

Finally, when the Ukraine crisis abates, Brent prices are likely to retreat, and with that, WTI prices may fall as well.

"It could be a while," but eventually prices should capitulate, says Michael Wittner, a global head of oil research at Société Générale in a recent research report. 

See original story here.