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scott barlow

Monday's sharp decline in crude prices might just be a temporary correction from frothy, overly optimistic market conditions but the expert view remains that investors should not look for significant upside in the sector for 2017.

The Commodity Futures Trading Commission releases weekly statistics showing the futures positions of speculative investors, largely hedge funds. Using these statistics, the first chart below tracks the net hedge fund position – futures holdings betting on a rising crude price minus contracts that would benefit from a decline – and compares this with the West Texas intermediate crude price.

A rising line on the chart indicates more bullish than bearish bets on oil, so it's clear that hedge funds are now more bullish on the commodity price since the big slide from $106 (U.S.) per barrel that began in July of 2014.

This optimism contrasts with the consensus forecast on oil prices for 2017. According to Bloomberg data, analysts are expecting WTI to average $58 in the fourth quarter of the year. This is down from estimates of $60 in the summer of 2016, and only about $5 from current levels.

The extent of speculative optimism in the futures market, combined with recent price weakness and forecasts of limited upside for the oil price, suggest that hedge funds have gotten ahead of themselves and could be "caught long." If this is the case, investors should expect increased volatility in crude markets as some of the bullish positions are unwound.

Goldman Sachs analyst Damien Courvalin is among the many who believe that gains for the oil price will be limited by rising U.S. production. He writes: "Our base case forecast leaves us only forecasting moderate upside from current prices . … U.S. shale activity has picked up strongly, with the U.S. horizontal oil rig count at a 13-month high, and we expect U.S. shale producers to continue to ramp up activity at current price levels."

The second chart illustrates this phenomenon. The number of active U.S. oil rigs has increased from a low of 316 in May, 2016, to the current 529. The number of rigs follows the oil price with a lag, so we can expect U.S. oil production to continue to climb, partially offsetting the effects of the production cuts by OPEC.

The U.S.-based Energy Information Agency predicts that oil demand and supply will balance in late 2017. Until then, however, glut conditions remain. U.S. crude inventories at the primary facility in Cushing, Okla., finished 2016 higher by 5.2 per cent relative to December, 2015.