Donald Trump seems to be caught in a time warp. Or perhaps he is suffering from muscle memory in his brain from the countless Wall Street Journal op-eds he read during the 1980s. Because thinking from that era would appear to be fuelling his policy imperatives this year: Iran is bad, interest rates are too high, taxes need cutting and oil prices are too high. In many ways, he is delivering the Reagan redux that he promised on the campaign trail, just without the credibility of a seasoned actor.
In this context, there is at least a little method to some of the madness on the President’s Twitter feed—pushing the Saudis to lower oil prices, bullying Powell to lower interest rates, and obviously keeping the pressure on Iran. But all of these interventions by the commander-in-chief are creating all sorts of distortions, as much in terms of setting expectations for the market than anything. Literally, Trump’s tweets are telling the market which stocks to short, whether oil prices will go up or down, if the Fed will hike interest rates, and whether trade with China can stabilise or not.
As such, the market is now building up great expectations on outcomes: for a trade breakthrough at the G20 meeting to stabilise the dollar; for a deal to cut production at the OPEC meeting to support oil prices; and for a ‘dovish hike’ at the Fed meeting in December to support, well, everything. The next three weeks will be meaningful for market participants, especially given how much traders have struggled to preserve any gains this year. With so many asset classes in the red this year, many traders are hoping that if they get the next three weeks ‘right’, December could make their year. But, there is a risk that the market could be disappointed on all three counts.
You can’t handle the truth
Of the three great expectations, the OPEC meeting possibly presents the biggest risk of disappointment. Much of the discussion in the oil market currently surrounds the size of the cut which will be agreed next week, with almost no consideration that there is still a significant risk that there could actually be no agreement reached next week (see E-mail alert: Announcing an OPEC cut will be even harder than agreeing one, 29 November 2018). Indeed, the reality is that this meeting, perhaps more than any other we have covered, is extremely steeped in politics—and, in particular, Saudi politics—and so is less to do with fundamentals.
Saudi Arabia clearly understands that failing to secure a deal next week to cut production will result in lower prices, perhaps substantially so. But the intertwining of US-Saudi relations with oil policy is preventing the Saudis from overtly doing what needs to be done. As other producers sense the lack of conviction in the Kingdom, the chances of a botched meeting rise.
That being said, Saudi Arabia and its allies will quietly and discretely cut output, as they do not want a rerun of 2014 when inventories surged to record levels. Despite the constraints on their ability to conduct policy, the Kingdom does not want to push the oil market into oversupply, swell inventories or engage in a market-share war about market share. However, messaging this will be complicated. The market may take time to be convinced of the Kingdom’s conviction, or worse, may choose to test its resolve. We certainly expect heightened volatility in the coming weeks and months due to the opacity of Saudi communication of its oil policy to the market.
Events next week may be further complicated by the rising strains between the US and Russia. President Trump cancelled his scheduled meeting with President Putin at the G20, citing the rising tension in Ukraine. Russian Deputy Foreign Affairs Minister Sergei Ryabkov in Argentina before the meeting linked the issues of oil prices, US sanctions and Ukraine, stating that Russia wants a smoother, predictable oil price, saying ‘nobody is interested in price jumps, in a fast hike and then a nosedive’, which was a not-so-veiled shot at the Saudis. He added that ‘when the US is fighting Russia as a key global oil and gas supplier, when they are trying to complicate conditions for our exports and take pleasure in doing so, any talks [on cooperation between OPEC+ and the US] may be difficult’. A deal is not a given next week.
Fed: Algos gone wild!
Meanwhile, the market exuberance early in the week over Fed Chairman Jay Powell’s speech could be premature and was probably more related to headline-chasing algos than anything. But very clearly, the Powell speech on Wednesday triggered a dollar sell-off and stock rally, though we would note that the bond market did not react. If anything, both the Powell speech and the minutes of the November meeting released on Thursday reinforced our belief that the Fed is not done yet. We think there could be two or maybe even three rate hikes after December, though the market is only pricing in only one more hike before summer 2019.
|Fig 1: US stocks vs Bonds||Fig 2: The Powell put?|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
Both Powell’s speech and the meeting minutes reinforced our view that the Fed remains highly data-dependent—and by data, we do not mean the S&P 500. If labour and inflation metrics remain consistent, then the Fed will be forced to hike rates regardless of what is happening to the stock market. The comment that got the market excited was ‘rates are just below the broad range of estimates of the level that would be neutral’. To us, this was a statement of fact rather than one of intent. Sort of like when I told my doctor that my weight is ‘below the broad range of estimates of the level that would be healthy’. But the point here is that Powell was simply stating a fact—that the broad range of estimates for the level that would be neutral is 2.5-3.5% right now, while the target range for the Fed is currently 2.00-2.25%, which is just under the range. But Powell said nothing to suggest that he or the majority of the FOMC think they will need to stop at the bottom of the range after they hike in December. That means we are still some three hikes away from getting to the middle of the range. The metric for the Fed chair, much to Trump’s chagrin, is not the stock market, but rather GDP, employment and inflation. If anything, the message from Powell and the meeting minutes were extremely consistent with what Fed officials have been highlighting for months now—that they are data-dependent, that there remains a risk of overtightening and so there is no set path of rate hikes, especially given a less certain economic outlook. That remains the case.
Another thing we noted from the Fed minutes that suggests that more than one rate hike is coming was the use of the plural in the minutes—'almost all participants reaffirmed the view that further gradual increases in the target range for the federal funds rate would likely be consistent with sustaining the Committee's objectives of maximum employment and price stability’. The minutes went on saying ‘however, a few participants, while viewing further gradual increases in the target range of the federal funds rate as likely to be appropriate, expressed uncertainty about the timing of such increases’. Both sentences clearly referenced ‘increases’ suggesting more than one. Certainly, the equity rebound off these headlines has been impressive. Equities into early next week will be impacted by what happens at the G20. A positive outcome on trade would see equity markets rally and let traders worry about the rate trajectory later. But we would push back against a growing expectation that the Fed has shifted stance and that a ‘dovish’ hike is now forthcoming in December.
G20: Hope springs eternal
News reports this week confirmed our note from 5 November (see E-mail alert: A limited US-China trade agreement likely at the G20; Chinese imports of US crude to resume, 5 November 2018) that the US and China were working hard to introduce a ‘framework’ that will stop the escalatory tit-for-tat tariff escalation between the two countries. While the market is hoping for a breakthrough, instead it will likely get something short of a deal, but rather agreement to see if the two sides can broker a deal. At a minimum, a positive outcome here would be avoiding further escalation in tariffs on the part of the US, although due to Trump’s temperament this would still be subject to change without notice.
While the market wants to have some certainty on trade in 2019, the G20 meeting is unlikely to deliver it in full. We see three possible outcomes this weekend. First, there is still a chance that no deal is reached, an outcome to which we would assign the lowest odds. If Trump and Xi are going to meet, there will be at least a minimum of deliverables to bring back. If they did not think there were positives to take from this meeting, a meeting between the two simply would not happen. Second, and perhaps consistent with Trump’s tone so far, there could be a default to ‘constructive ambiguity’, which would be akin to some progress in talks without any firm commitments beyond to continue talking. It could simply be acknowledging that there is still something worth talking about. The third and final outcome, which we would argue is a best-case outcome (as we do not expect a comprehensive deal given the significance of the issues outstanding), would be some commitment to suspend the next wave of tariffs (i.e. at the 25% set to begin on 1 January, but no additional new tariffs) for some period of time—say, three to six months. In exchange, China would agree to some volume of imports of certain US commodities, likely soybean, crude and possibly LNG. In our view, the first outcome would be decisively negative, the second more neutral, while the last option would be outright bullish for the US and Chinese equity markets.
|Fig 3: China PMI vs US durable goods, y/y||Fig 4: China vs US equities|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
Don’t call it a comeback
Outside of these three major events that the market is focussed on, perhaps the most important broader development is the continued blowback from the Khashoggi affair. From day one, the Saudis have been miscalculating the fallout of the Khashoggi murder at every step. But this week may have brought home some of those new realities. The US Senate voted 63-37 this week in favour of allowing floor debate on S.J.Res.54, the ‘joint resolution to direct the removal of United States Armed Forces from hostilities in the Republic of Yemen that have not been authorised by Congress introduced by Bernie Sanders with Senators Chris Murphy (D-CT), Mike Lee (R-UT), and 14 other co-sponsors. The Senate voted against the bill back in February, but since the Khashoggi murder it has now become an important vehicle for those in Congress opposed to the Saudi leadership.
All 49 Democrats in the Senate backed the resolution and were joined by 14 Republicans, including Senate Foreign Relations Committee chair Bob Corker (R-TN), in a rare show of bipartisanship. The Senate vote may create a new opening for action in the House. But the focus in coming days will be on the Senate, where there will still be a struggle to secure approval for the Sanders resolution. The measure faces significant procedural hurdles and could be restructured and amended before a final vote takes place. It was the threat to include specific provisions related to Crown Prince Muhammed bin Salman (MbS) that spurred the White House to wheel out Secretary of Defense Jim Mattis and Secretary of State Mike Pompeo to try and stave off a vote. Lindsey Graham is demanding a full intelligence briefing directly from the Director of National Intelligence, a request that would take 35-40 days to prepare, buying some time, although that is unlikely to assuage a Congress that has seemingly made up its mind on MbS, whether there is a smoking gun or not.
Pick your poison
The choices for Mbs going forward are not easy. Either break with Trump and risk losing protection from the full brunt of congressional measures, wherever they may lead. Or alternatively, keep oil prices low, which will be difficult given the increasing importance of a domestic patronage network if MbS wants to stay in power. Unlike in 2014, when Saudi Arabia decided not to cut output in the face of structural shifts in market fundamentals—slowdown in demand growth, rise in US shale production and the return of production to the market from many disrupted countries—the Kingdom’s current fiscal buffers are thinner and the prospects for its economy and private sector are weaker. At the same time government spending keeps rising, which implies that Saudi Arabia needs a higher oil price. Moreover, today’s credit environment is extremely challenging overall, but especially for Saudi Arabia. Rates are higher than in 2014, while the political backdrop both domestically and internationally has also been transformed and many market participants have doubts about whether Saudi Arabia can isolate political factors from its oil output decisions. All that is happening increases the degree of risk for holders of Saudi debt and so accessing debt markets will be more expensive now than in 2014.
The question of course is still why Donald Trump remains obsessed with ‘low oil prices’. Because by every measure, prices are already low. For the first time since July 2017, the national average price of gasoline is lower y/y. Moreover, that y/y gap will continue to widen regardless of what crude prices do as gasoline weakness continues. The argument that the President wants lower prices as a tax break to his constituents rings hollow, because gasoline prices are already low by most measures. There must be another reason.
One possibility is that Trump is trying to force the Saudis to ‘really’ bring down oil prices, which is what he had wanted this summer, instead of the tepid effort they made to keep them from rising. Trump may want low oil prices so that he can effectively achieve the ‘maximum sanctions possible’ against Iran that he had wished to do this summer, but without spiking oil prices. Let’s face it, the waffle on waivers from the Trump administration was not because of a change of heart on Iran, but rather because the White House panicked that oil prices were on the verge of surging higher. This theory would imply a more aggressive posture on Iran sometime in H1 19. Time can only tell.
Brent: The swiftness with which the Brent crude curve shifted from backwardation to contango in just over a month has been almost as impressive as the 30% drop in the flat price over the same timeframe. North Sea grades remain weak as the Atlantic basin is still awash in light sweet crudes. Contributing to the weakness, the disruption to the Buzzard oil field since last week means that the Forties grade has become much lighter and less sulphurous, which in such a weak naphtha market is bearish for Dated Brent (see our E-mail alert: Buzzard outage curtails North sea production, but not bullish for Dated as it makes Forties lighter, 29 November 2018). With record arrivals of US cargoes in November and hefty volumes expected in December, there is no shortage of light sweet crude in the region. Unless a deficit is created, either via a prolonged production outage or an OPEC cut, we expect the contango to persist. While not yet in full carry (which would require roughly 50 cents a month, six months out along the curve), each week we move closer to that level. The contango has now extended along entire curve, with most of the curve now below $65 per barrel.
|Fig 5: Brent crude curve, $/b||Fig 6: US crude stocks, ytd mb|
|Source: Bloomberg, Energy Aspects||Source: EIA, Energy Aspects|
WTI: Like Brent, the WTI curve has also shifted into full contango, though the curve is much flatter than in Brent, with carry even further away. The entirety of the WTI curve is now below $54 per barrel. Even with a draw expected in December, the US is set to enter 2019 with bloated crude stocks and we expect builds of over 100 mb across 2019 amid fairly flat runs and higher crude production.
With the deluge of crude headed to the crossroads of Oklahoma from the Permian, Rockies and local production growth, we have begun to see large incremental inflows into Cushing. The start-up of pipelines such as Sunrise and the expansion of Pony Express are blatantly bearish for Cushing balances, as these works will result in a net rise in inflows to the hub. The pressure on Cushing stocks will have major implications on WTI-Brent spreads in 2019, affecting how wide they could go. There are two major developments that will be key drivers for the spread. The first is in H1 19. With no new planned pipelines out of the hub, there is little relief from the builds, which implies a further widening in WTI-Brent spreads. One risk to this forecast, however, is the potential for incremental flows on Marketlink, which has recently announced an open season for additional space on the line. Another risk to wide spreads would be a major fall in flat price. But assuming Brent recovers if OPEC+ manages to cut production, the infrastructure constraints out of Cushing could cause the hub to disconnect once again. This would cause WTI-Brent to blow out, possibly to -$15 or more. The second inflection point will be in H2 19, once additional Permian pipelines come online. These pipes will likely steal barrels from Cushing, sending them to the USGC directly, as committed space on the new pipes will outnumber the amount of new production expected to come online in the Permian by nearly 0.8 mb/d (when comparing exit rate 2018 versus 2019 growth). In this scenario, we could see pressure taken off the hub and spreads could again narrow. But a lot of the trajectory for Cushing balances depends on the US production growth profile, given the recent price collapse.
Many US producers will be setting their budgets in the coming weeks and it is very likely that companies will pivot cautiously, especially with many still unhedged for 2019. One way or another, shale growth must slow—the world is simply too oversupplied with light ends, and refineries are increasingly struggling to make the products in demand with the crude available. For more details please see our Data review: US Department of Energy, 28 November 2018.
Yasser Elguindi, Energy Market Strategist
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