In 2013, when shale oil was in its relative infancy, Saudi oil minister Khalid al-Falih asked reporters to stop asking him questions about shale oil. “Leave us alone and leave all these issues. We had enough of shale oil and talks of shale. Please talk about anything else,” he snapped in response to a question about OPEC’s response to shale. Looking at 2017, accelerating US production failed to derail the crude oil rally. Thanks to strong global growth and OPEC’s supply cuts, crude oil demand far outpaced supply. Unsurprisingly, 2017 was a good year for the commodity. Al-Falih’s comments accurately reflect the exasperation of many speculators in response to the chorus of warnings regarding US shale. In short: “shale supply is growing, so what!”

The problem is twofold: Firstly, supply growth has accelerated to the point of catching up with demand growth. Historically, this has foreshadowed crude oil bear markets. Secondly, speculator enthusiasm is at bullish extremes based on a variety of different metrics. Today, going long crude oil has become a global consensus idea just as the fundamentals driving the rally have become weaker. While underlying fundamentals can still push prices higher, the bullish case for crude is getting stretched.

Crude oil fundamentals matter

One of the biggest believers in the shale oil revolution is the International Energy Agency, an intergovernmental organization focused on the world’s energy markets. While naysayers have frequently pointed out infrastructure bottlenecks as an impediment to shale supply, recent (unaudited) US production figures suggests that the industry is overcoming this issue. If data from the US Energy Information Administration is to be trusted, the US is now the world’s second-largest energy producer, with production at 10.25m barrels per day. This is higher than the previous record for US crude production from 1970. Given crude’s sharp fall after the release, it appears that the data has a good degree of credibility. While infrastructure issues remain, the US energy industry is investing aggressively in response. According to a recent study by US energy industry executives, an astounding $50b of new crude oil-related investment projects (in Texas alone) were launched after the US lifted its export ban in 2015. This week’s EIA figures confirm that these investments are yielding fruit. An overview of crude oil demand versus supply growth is shown below:

Estimates call for supply to overtake demand in 2018

(Click on image to enlarge)

Source: IEA Oil Market Report, OPEC supply estimates from US EIA

As can be seen above, crude oil demand growth is still ahead of supply growth based on the IEA’s latest Oil Market Report. In the first quarter of 2018, the IEA projects supply growth to overtake demand growth. While actual supply in 2017 averaged 0.4%, the IEA projects 2018 growth to accelerate to 1.8%. The biggest driver of new supply is projected to come from North American shale, while OPEC is expected to maintain its existing supply limits. Turning to demand, growth is expected to decelerate from an average of 1.6% in 2017 to 1.4% in 2018. Based on the estimates, the main culprit for decelerating demand in 2018 is slower growth in developed countries.

Historically, changes in demand versus supply growth have accurately foreshadowed bull and bear markets. Looking at the graph above, crude oil entered a bear market once supply growth surged above demand growth in early 2014. On the other hand, the current bull market was driven by collapsing supply growth in early 2016. Based on the IEA’s estimates, another big flip is set to appear shortly.

Bullish sentiment looks fairly excessive

Beyond fundamentals, we have been warning that speculator positioning in futures and options markets looks increasingly one-sided. Since we first flagged extended positioning back in early November, speculator positions have grown by a significant degree.

We typically flag positioning as a risk when net speculator positions are two standard deviations above historical trailing averages (that is, when z-scores are greater than two). Since open interest in crude oil futures and options have increased in the last two years (driven by producer hedging demand), it also helps to look at net positions as a proportion of open interest. According to both gauges, long crude oil is at a bullish extreme. This is shown below:

Extreme on all counts

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Source: CFTC,MarketsNow

Looking at net speculator positions compared to trailing twelve month averages, the latest z-score is +2.5x. In other words, the position is two and a half standard deviations above historical averages. This is above our threshold and suggests that positioning is at a bullish extreme.

Looking at net long positions as a proportion of total open interest, the position represents 22.6% of the total open interest based on the last Commitments of Traders report. Looking at historical data from the past few years, this is also an extreme. Net crude oil positions are seldom higher than 20% of the total open interest.

Fundamentals and sentiment signal a less energetic bull market

All in all, the fundamentals driving crude oil and speculator sentiment raise several warning signs. While it’s too early to call a bear market for the commodity, buying crude oil given today’s dynamics seems like a risky trade with fairly limited upside. Once the supply starts growing faster than demand, the big money will be made in shorting crude oil.