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Oil's Most Likely Direction Is Down – Barron's

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DJ Commodity Index

Oil’s recent rally has run out of steam, and the path of least resistance continues to be lower for the beleaguered market.

U.S. oil futures have encountered resistance at the $50-a-barrel level, and face a deluge of challenges in breaking above the current range. While bullish storage signals have lifted prices more than 14% since oil fell into a bear market in June, analysts and traders are skeptical that they will rise much further.

One problem is a lack of confidence in the Organization of Petroleum Exporting Countries, which, along with several producers outside the cartel, had hoped to boost prices by curbing output by a total 1.8 million barrels a day.

However, prices have recently been trading close to or below levels seen right before the deal was made in the last months of 2016.

Light, sweet crude for September delivery settled on Friday at $48.82 a barrel on the New York Mercantile Exchange, down 1.5% for the week. A popular exchange-traded fund that tracks oil prices, the United States Oil USO 0.8072653884964682% United States Oil Fund LP U.S.: NYSE Arca 9.99 0.08 0.8072653884964682% /Date(1502499600001-0500)/ Volume (Delayed 15m) : 14805321 AFTER HOURS 9.95 -0.04 -0.4004004004004004% Volume (Delayed 15m) : 94881 P/E Ratio N/A Market Cap N/A Dividend Yield N/A Rev. per Employee N/A More quote details and news » fund (ticker: USO) is down more than 14% year to date.

Countering OPEC’s efforts to mitigate a global supply glut, U.S. shale companies ramped up production in response to the initial price jump, locking in higher future prices and restarting wells. Meanwhile, compliance among OPEC members has been slipping, as official July data showed total production rising.

“OPEC hasn’t been able to do 100% compliance,” says Tariq Zahir, managing member of commodity trading advisor Tyche Capital Advisors. “Once we go a few months from now, I wouldn’t be surprised to see other countries cheat…or even pull out of the deal.”

In May, the global cartel agreed to extend the deal through March 2018, but prices sold off as traders looked for longer or deeper cuts to combat shale’s rise. The speed at which shale drillers responded to higher prices took many industry watchers by surprise, and continues to unnerve some investors as they watch for increases in production data and the U.S. rig count.

In its short-term energy outlook report, the U.S. Energy Information Administration forecast that U.S. crude-oil production will average 9.9 million barrels per day in 2018, an all-time record. The last production record set was in 1970, at 9.6 million barrels per day.

“What this year shows is that the supply elasticity of U.S. production is very high,” says Robert Boslego, managing director of Boslego Risk Services in Santa Barbara, Calif., who put on short positions in oil futures after OPEC’s meeting in May. “Its whole strategy of just reducing production to get prices higher is really a failed strategy,” he adds.

Analysts have also warned that a move above $50 a barrel could increase hedging by U.S. producers, which sell future barrels when oil climbs to guarantee prices and revenue. In a report on Monday, Citi research analysts said producers have already added to crude hedges as U.S. prices have approached $50.

“The most important litmus test is, will crude be able to clear $50,” says John Saucer, vice president of research and analysis at Mobius Risk Group. Prices have “much more to do with how much hedging is being done” than OPEC right now, he added.

On Wednesday, the U.S. Energy Information Administration reported that crude inventories fell for the sixth week in a row, down 6.5 million barrels in the week ended on Aug. 4. However, an unexpected rise in gasoline stockpiles put a damper on the good news. The amount of gasoline in storage rose by 3.4 million barrels in the week ended on Aug. 4, raising concerns about slowing demand even as drivers hit the road for summer vacations and travel.

Speculative investors have started returning to the market in recent weeks. According to data from the Commodity Futures Trading Commission, bullish bets outnumbered bearish bets by 280,109 contracts in the week ended on Aug. 8, down slightly after reaching the highest net long position since April in the previous week.

However, analysts and OPEC noted that the positioning change has mostly been investors covering short positions, rather than adding bullish bets.

Bearish sentiment has been quick to take over oil prices, after speculators built up net bullish bets to a record position and got burned in the first half of the year. If doubts start to permeate the market again, investors unwinding bullish bets could lead to another steep and sudden drop for oil.

Stephanie Yang covers commodities for The Wall Street Journal.

Email: editors@barrons.com

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