Nuance is dead

Published at 15:37 16 Nov 2018 by

Please note that, owing to the Thanksgiving holiday, there will be no Macro Digest next week. 

When positions are being liquidated, there is no such thing as nuance. And this week the oil market was capitulating, as evidenced by the three-standard deviation jump in volatility, one of the largest on record. Thus, it did not matter that the Saudis were trying to signal an intent to cut production. Perhaps more importantly, even if the oil market had not been capitulating, traders are now hard pressed to give Riyadh any benefit of the doubt. This summer’s policy reversal and subsequent production surge, regardless of whether it was necessary or not, has left a scar, and the market will now only react to Saudi deeds, not words. If anything, given the recent surge in US production, the cloud now hanging over the upcoming OPEC meeting (Russia has said that it “prefers” not to cut), and most importantly the market’s crisis of confidence in Saudi decision-making, the parallels to 2014 are starting to grow. The closer we get to the OPEC meeting, the more the comparisons will grow. One thing is clear, however, if OPEC+ does not cut production, the Q1 19 stockbuild will be sizeable, and all the hard work of the past two years will be undone, meaning the market will return to a world where oil is $50 per barrel, if not lower. It would be an inauspicious start to the new cooperation framework agreement that is expected to be finalised in Vienna. Indeed, it would leave the leaders of this enterprise, Saudi Arabia and Russia, without credibility. After all, what would be the purpose of a producers’ body if not to bring stability to the oil market.

The gamma vortex
As crude had already been selling for the last several weeks (see Macro digest: Widespread panic, 9 November 2018), the shock for investors this week came less from the direction for crude than the velocity and intensity of the selling. Almost always, when oil moves big, it moves by more than anyone expects, and this week was no exception.

To be sure, the selling pressure, which has been there since Trump started to hint that his Iran waivers were forthcoming, was intensified by funds liquidating crude positions, caught in a cross-asset trade involving both crude and natural gas. It was the spike in natural gas (for more details, see E-mail alert: Push it to the limit (trading): Henry Hub flirts with five-handle pricing, 14 November 2018), which saw several contracts go limit up, that triggered the selling in crude this week. Those that were short natural gas and long oil were forced to liquidate their positions in oil in order to buy back their shorts in gas. And once the selling in oil accelerated, it began to cascade and became self-reinforcing as swap dealers that had sold hedges to producers and sovereigns alike raced to cover those positions by selling futures, propelling negative gamma—as oil prices fell, swap dealers had to sell more futures, which drove prices lower, forcing them to sell even more. Rinse and repeat. While the moves in natural gas and in oil were both driven by positioning, the move in natural gas was triggered by fundamentals (yes…it’s cold), whereas the move in oil was not. Though painful, it does feel like this past week was the final capitulation by the 2018 longs for crude.

Fig 1: Nat Gas vs WTI, % change from 15 Oct Fig 2: Oil vol ETF vs Crude, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Now what?
It’s clear that the oil market has given up on the bullish narrative that drove the price rally this year—the market no longer believes that Trump will squeeze Iran if doing so risks overtightening the oil market and spiking oil prices higher. Perhaps more importantly, as a consequence of the Khashoggi murder investigation, the market also believes that the Saudis would not dare defy Trump on oil prices, thus their statements on production cuts are unreliable. As such, there is now growing belief that even if the Saudis need higher prices to generate more revenue, they will not be able to do so, because Trump wants lower oil prices. This is why, when Trump tweeted early this week that OPEC should not cut production to prop up prices, oil prices fell. The problem right now for OPEC is that because the market is convinced that Trump has the Saudis over a barrel, traders cannot take Saudi comments about cutting production at face value. Up until OPEC agrees formally to cut production on 6 December, and the market actually sees this translating into lower inventories (especially in the most visible centres, such as the US), the risk is too great that the night before the OPEC meeting, Donald Trump will force Crown Prince Muhammed bin Salman (MbS) to back down.

Drama queens
Meanwhile, the comments from Russian President Vladimir Putin this week with regards to potential production cuts were not exactly reassuring. Putin said that “the fact that the cooperation (with OPEC) is needed is obvious and we will cooperate”, adding that he liked a $70 per barrel oil price. That is not exactly an enthusiastic endorsement of production cuts. The reality is that at every single meeting since Algiers in 2016, the Russians have been drama queens. Each meeting has centred on the possibility that Russia would pull out of the agreement. Given Vladimir Vladimirovich’s comments, it is possible that Russia is perhaps again preparing to put on a show ahead of the December meeting. If history is any guide, then the Russians will, at the last minute, agree as they have done in the past. But the realities are vastly changed today, with Brent in the $60s rather than the $40s or $50s. Russian commitment to cut is not guaranteed. The urgency for Russia to support a production cut is not as obvious as it was two years ago.

This begs the question of whether the Saudis would unilaterally cut if Russia is not on board, something the Saudis have refused to do so far. But if the Kingdom has any designs on keeping oil prices north of $60 per barrel, let alone over $70, then it will most certainly have to do so (even if the Saudis do not publicly announce it) should Russia decline to participate in the cuts.

While the Saudi energy minister has said that December nominations are 0.5 mb/d lower than November, it looks like Saudi Arabia’s November exports will be very large at roughly 8 mb/d, with the figure somewhat exaggerated by some loadings delayed from end-October by poor weather. This means that December nominations are being cut from a ridiculously high base. Saudi exports arriving in the US, according to EIA data, were 1.45 mb/d last week, a large w/w jump. This brings the four-week average of exports to the US to roughly 1.2 mb/d, which is some 0.5 mb/d higher than at the start of the year. If it intends to keep inventories in check, Saudi Arabia has its work cut out for it.

Much as the Saudis increased production in May and June at the behest of the Trump administration, so too it will now have to cut production in order to help balance the market, regardless of whether Russia joins or not. But in the meantime, perhaps a lower oil price going into the meeting will focus a few minds. 

Breaking up is hard
Much of the uncertainty with the regards to the Kingdom’s policy-making has to do with its relationship with the US, which is much more ambiguous in the aftermath of the Khashoggi murder. For all the tweets from Trump about OPEC and oil prices, Trump is trying very hard to shield MbS from the incident. Even so, it is clear that the US establishment is not going to sweep this under the rug. This week, the Treasury department designated and sanctioned 17 Saudis for their roles in the murder of Jamal Khashoggi, including Saud al Qahtani, a long-time advisor to the royal court and a friend of MbS. Notably, the Treasury department stated that the US “continues to diligently work to ascertain all of the facts and will hold accountable each of those we find responsible", so further sanctions could still follow. Congress, for its part, continues to mobilise and is likely to pursue different avenues of legislation. In short, the relationship between the US and Saudi is becoming more complicated.

There are also complications within the Trump administration itself. Earlier this week, National Security Advisor John Bolton said that the audio recordings that have surfaced clearly show that MbS is not implicated in the Khashoggi affair. However, State Department spokeswoman Heather Nauert, when asked about Bolton’s comments, refused to endorse his assessment and stated directly that Secretary of State Mike Pompeo had yet to hear the recordings himself. Moreover, she added that the US will continue its own line of investigation regardless of what findings the Saudis present.

Finally, it’s worth noting that Trump this week appointed John Abizaid as the US ambassador to Saudi Arabia, a post that has remained vacant throughout his presidency. The joke has been that there is no need to appoint a US ambassador to Riyadh as Trump’s son-in-law Jared Kushner was the de facto ambassador. It appears this is no longer the case. Very slowly and very quietly, the US is keeping the Saudi royal at arm’s length while it continues to negotiate with Turkey for an amicable way out of this.

And this is why it’s increasingly difficult to handicap how Trump will react to Saudi efforts to boost oil prices by cutting production in December, let alone how Saudi Arabia will react to the blowback from Trump. Breaking up is certainly hard to do. And while for now the Trump administration and the Saudis are not getting divorced, MbS is most definitely sleeping on the couch the next time he visits the White House.

The ghosts of Vienna (Thanksgiving edition)
But where does that leave the oil market? Right now, the main question that needs to be answered is whether the oil market will be oversupplied or undersupplied in 2019. OPEC and the IEA released their latest forecasts and both agencies are showing that there needs to be a cut. The IEA, with its 0.6 mb/d ‘miscellaneous to balance’ plug, is hard to take seriously. But the OPEC secretariat’s balances are revealing. First, even in the OPEC balance, the Q4 18 call on OPEC is 33.05 mb/d. According to OPEC’s secondary sources, October production was 32.9 mb/d, suggesting that the oil market is undersupplied by 0.15 mb/d. This number also includes Iranian production at 3.3 mb/d, though we know that from October to November, and even into December, Iranian exports will go down substantially, forcing it to cut production. This is not an overwhelmingly bearish balance.

The problem really begins to manifest itself in Q1 19 if Saudi Arabia and other producers fail to rein in production. Just extending October’s production level of 32.9 mb/d according to secondary sources, in Q1 19, OPEC has a call on OPEC of roughly 31.23 mb/d, which implies a stock build of 1.6 mb/d, or 144 mb. The last time that stocks built by that much was in Q1 15, just after the infamous Thanksgiving 2014 OPEC meeting at which the Saudis refused to cut production as other members were unwilling to join in, preferring instead to let prices do the work.

Perhaps most ominously, inventory adjustments in the US are starting to look a little like 2014 and 2015. After falling at a historic pace in 2017, this year, inventories in the US have taken a far more worrying trajectory and the year-to-date change in US crude stocks is looking eerily similar to 2014. Moreover, Saudi crude exports to the US have been steadily tracking higher, up by some 0.5 mb/d since the start of the year. These trends are enough to call into question Saudi Arabia’s commitment to keeping inventories at or near the five-year average. Traders are already terrified that the oil market is going back in time. In the past, we have always advocated looking at what Saudi Arabia does and not what it says. Well…what it is doing is pushing the market into oversupply.

Fig 3: YTD change US crude stocks, mb Fig 4: Saudi exports to US, ytd mb/d
Source: EIA, Energy Aspects Source: EIA, Energy Aspects

The Outlook
Brent: Despite a pop late in the week, Brent timespreads remain under pressure. The contango in Brent is extending further out along the curve, though it is not yet deepening to carry. Forties has remained weak, but Urals in Europe has rebounded, driven largely by expectations for lower export volumes for the grade in December coupled with lower exports from Iran due to sanctions. Refinery margins across Europe continue to improve, with Brent cracking margins and Singapore topping margins at multi-year seasonal highs. Low inventories and strong margins have never marked the start of a bear market.

WTI: With Cushing stocks rising by 13.1 mb over the past eight weeks, the outlook for WTI and Cushing balances is worsening. We have revised our November and December forecasts and now expect builds of 4.4 mb and 0.6 mb respectively for November and December. The lower builds in December are due to hefty outflows on Seaway and Marketlink given all arbs from Cushing to the USGC have been wide open. It is very likely that Cushing ends 2018 with stocks close to 40 mb, some 8 mb higher than we had initially expected over the summer. This sets up for very bearish H1 19 Cushing balances, with no new additional outlet for the hub but more local production still set to flow into Cushing. Moreover, a heavy refinery maintenance schedule on the USGC (+0.15 mb/d y/y) over Q1 19 (0.53 mb/d in January, 1 mb/d in February, and 0.55 mb/d in March) will likely weigh on outbound arbs from the hub during those months, exacerbating the builds. The only relief (albeit not until Q2 19) could come in the form of a Marketlink expansion (after its 9 November binding open season), possibly by just above 0.1 mb/d, as this could prevent tank tops in Cushing next summer. Without Marketlink, the writing is on the wall for WTI timespreads and WTI-Brent spreads, with Cushing effectively landlocked once again (for more details see Data review: US Department of Energy review, 15 November 2018).

fig 5: Brent cracking margins, $/b Fig 6: WTI Mar-Apr spread, $/b
Source: Energy Aspects Source: Bloomberg, Energy Aspects

Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)

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