Gamma said knock you out

Published at 15:41 11 Jan 2019 by . Last edited 17:08 11 Jan 2019.

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After the dramatic capitulation in risk assets in December, many started 2019 assuming the worst. Thus, the reversal in risk assets seen at the start of the new year has been a surprise for many. While much of the initial move off of the bottom on 24 December 2018 was technically driven, the follow-through rally has been fuelled by two important shifts in perception in the market to start this new year: the belief by traders that there is now a ‘Powell put’ that will lead the Fed to reverse course and become accommodative; and the belief that enough progress is being made in theUS-China trade talks to deliver a positive outcome on 1 March, the expiry of the 90-day truce talks. Given that these two issues were important drivers of the weakness in late 2018, this would effectively mean that the narrative has shifted. That is the perception anyways.

Oil has also had a dramatic reversal of fortune—following a roughly 40% capitulation in prompt crude prices in Q4 18, oil has surged by 20% off its 24 December low, on very little fundamental news at all (more on this below). Paradoxically, part of the reason for the sharp crude rally is the same driver responsible for the dramatic fall in prices in Q4 18—gamma. To be honest, not since the Defiant left Deep Space Nine has there been this much interest in the gamma quadrant. But amid all the volatility, and the late December negativity, the market may have also missed an important signal from the Arabian Peninsula for 2019—in late December Saudi Arabia released its annual budget, which (according to our analysis) implies an average target production level of 10.2 mb/d over the balance of 2019 at a price of around $80 per barrel.

Shhh…don’t talk about price
This is significant for two reasons. The first is obvious: $80 Brent is some $20 per barrel higher than actual prices when the budget was released, and at a time of intense bearish sentiment in the market amid fears of a looming recession driving all asset prices lower. Clearly the Saudis signalled that they remain constructive on oil demand and specifically demand for their crude and the overall health of the global economy, though they recognise that some risks remain. Second, the implied 10.2 mb/d average Saudi production level is significantly lower than the roughly 10.6 mb/d we have built into our balances for H2 19 (we assume 10.3 mb/d for H1 19). Even with higher OPEC and Saudi production (as we have not rolled forward the OPEC deal), we are already registering crude draws for Q2 19 and Q3 19 with an average price forecast of $72 for Brent in Q3 19 (for more details please see Perspectives: Not for the fainthearted, 7 January 2019, in which you’ll find our new balances). Should Saudi Arabia actually keep production at 10.2 mb/d for the balance of 2019, then this would materially tighten our balances and would push Q4 19 into draws too.

The fact that the next OPEC meeting has been scheduled for April was very tactical as well, and also underscores the fact that the Saudis need to lock up the production strategy very early in the year. Indeed, Saudi Arabia was very keen to hold a meeting in April as opposed to June, not just because of Ramadan (in May), but also because in April the market will still be trading June physical barrels, and the existing agreement expires at the end of June. Thus, Saudi Arabia wants to ensure that any changes for H2 19 get locked in by April so that nominations for July and August are not affected.

We have noted on several occasions that, given all the political challenges currently facing the Saudi leadership, there is tremendous pressure on the oil ministry to deliver a higher oil price in 2019. Aside from the expanding patronage network that King Salman must now satisfy to smooth over some of the political missteps of 2018, the reality is that foreign direct investment in the Kingdom has dried up in the aftermath of the Khashoggi affair, and there is some capital flight from the Kingdom, to the extent that authorities are allowing it to happen. Revenue generation is going to come at a premium, and the release of the Saudi budget is perhaps the clearest expression yet that the Kingdom intends to try and achieve higher prices, even if it is limited in its ability to signal this to the market. Indeed, reading the Saudi tea leaves in 2019 will be very important given the limitations on talking directly about price due to the political pressure being applied by President Trump and his desire for lower oil prices.

For prices to average $80 for the balance of 2019, then oil prices either need to rally very quickly, or they will need to average over $80 in H2 19 in order for Saudi to reach its target. The macro backdrop may help in the very near term, but given the lingering negativity on global growth, this is a narrative that the broader oil market may struggle to embrace initially. So, the Saudis may need some help.

The gamma quadrant
The oil rally to start the year is very much technical and position driven, rather than any shift in fundamentals. Much of the oil market is still licking its wounds from the shocking 40% Q4 18 capitulation, as much because of the speed with which prices fell as the size of the decline. Brent fell by some 20% over a three-week period in November and saw three separate $5-intraday reversals over that time period.

To be sure, the selling pressure, which had been there since Trump’s early-October hints that Iran waivers would be 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, which saw several contracts go limit up, that triggered the panic selling in crude. Funds 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. (for more details see Macro Digest: Nuance is dead, 16 November 2018). 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. Meanwhile, as prices cascaded lower, it triggered stops for CTAs who sold roughly 600,000 lots over a three-month span, as they went from max long (roughly 300,000 lots) to max short (roughly 300,000 lots). All these things conspired to accelerate the selling in crude. The triggers for the sell-off may have been fundamental, but the velocity was driven by technicals and positioning.

While positioning data are lagged due to the US government shutdown, the gross short position in crude swelled to roughly 490,000 lots in mid-December, while the combined gross long for WTI and Brent collapsed to roughly 850,000 lots (as of 18 December, when CFTC stopped updating the data).

Fig 1: Combined crude gross shorts, k lots Fig 2: Combined crude gross longs, k lots
Source: CFTC, Energy Aspects Source: CFTC, Energy Aspects

To a large extent, what has happened at the start of this year is the same as the Q4 18 sell-off, but in reverse. As prices unexpectedly started to rally (we have now rallied some 20% since the 24 December low), those in the market that sold futures on the way down to cover the options they had sold to producers, as well as CTAs that sold futures are now having to buy back their short positions.

While these forces might not be as violent as in Q4 18, given that the short position that has to be bought back is not nearly as big as the long position that had to be liquidated last October and November, the reality is that, much like in Q4 18, positions could get squeezed, forcing liquidation, but in this case, of shorts. Thus, should prices continue to trend higher, the gains would accelerate very quickly due to these technical factors.

WTI producer hedges from $45 per barrel to $60 per barrel experienced a similar phenomenon and all those dealers that sold futures to cover for the short exposure will likely have to buy back those shorts. There is very large put open interest at the anchor strikes: $55 and $60 for WTI, $65 and $70 for Brent (see Fig 3 & 4).

Fig 3: Nymex WTI put open int by strike, k lots Fig 4: Ice Brent put open int by strike, k lots
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

We think this was most clearly visible just this past week following the release of the US DOE inventory report. On Tuesday night (8 January), Brent breached $60 and WTI $50, which triggered strong buying on Wednesday despite decidedly bearish inventory data released that day. We have also noted in the past week or so, much like in Q4 18 when there were sellers on the close each day, there have been buyers scooping up futures into the crude close. Our soundings indicate that the next big pressure price is around $63 Brent for the CTAs. If breached, this could also trigger another bout of buying and it could push crude back into the high $60s much faster than perhaps anyone (including us) was anticipating.

Research from several banks has suggested that CTAs have completely bought back their shorts, but it is not clear to us that this is the case. CTAs sold futures at different price points along the way. So, while they have bought back their shorts at $60, there are still short positions at higher prices points ($63 for Brent and $52 for WTI being the levels we hear the most). Thus, if prices do continue to rally, they will be forced to buy back those shorts.

We have always believed that the sell-off in risk assets in Q4 18 was overdone, as crude and different components of the equity market (i.e. autos, banks, construction) were all trading as if we are fast approaching a recession. For crude in particular, we understood that the selling was not fundamentally driven. While there was an argument for oil prices to be below $80, we did not believe sub-$65 Brent to be fundamentally justified. Moreover, in the case of WTI, sub-$50 is unsustainable for US producers.

A surge in prices now will make things difficult going forward. For US producers it will provide a lifeline, and perhaps lead to another surge in production in H2 19, although it’s not yet clear whether that would happen or not, especially with key Permian pipelines delayed. But, part of the reason why there was a perceived pivot by the Fed was because the consensus now strongly believes inflation risks to be fully contained, with even some of the deflation doves beginning to chirp again. Should equities and oil both rally in the next month or two, they may be sow the seeds of their own undoing.

Powell says yanni, market hears laurel
For oil to continue to rally, it will need some follow-through from broader risk sentiment. Recent comments from US Fed Chair Powell on 4 January and 10 January have led many in the equity and bond markets to believe that that the Fed would pause its rate hike cycle, with some even beginning to price in the possibility that the Fed would flip to an accommodative stance in 2019. This is an incredible reversal in sentiment from a market that was ranting in November that the Fed was overtightening. But Powell’s comments that the Fed could afford to be patient, in essence to watch and wait, has been translated by many in the market to mean that additional rate hikes and/or balance sheet reduction were not on autopilot, and fed this perception of a ‘Powell put’. It was this perception of a dovish pivot from Powell that allowed global equities to extend the new year rally, boosting the S&P to one of its best starts to the year, sent bond prices tumbling and helped extend oil price gains for nine straight sessions at the time of writing, with Brent back above $60 and WTI above $50. The US dollar is near the lower end of its recent ranges against the euro and sterling, while the Canadian and Australian dollars have extended their recent gains. The yen is also softer. It would seem that risk is most certainly back on. Again, that at least is the perception.

Fig 5: Crude ($/b) vs Equities ($) Fig 6: S&P vs moving averages, $
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

But we are struck that the Fed Chairman really hasn’t said much that is different to his statements in December—the Fed remains highly data dependent, there is no pre-set path, and it can remain patient. Sandwiched between the two Powell speeches was the release of the FOMC minutes, which many have taken as further proof of a more dovish Fed. And to be sure, the debate among FOMC members was a lot more diverse than a unanimous rate hike last month might suggest. But the reality is that while the Fed is indeed taking downside risks on board, those downside risks were heavily centred on financial conditions rather than actual growth, though not exclusively. And with increased perception by inflation doves that China and the global slowdown presents deflationary risks, the risk now is that the Fed does not do enough to protect from the right-hand tail risks, difficult as they may be to see at the moment. Cyclical bear markets do have bear market rallies, and in some cases, those can be powerful. The momentum for higher equities is building, and unless or until something forces the Fed to change its tune, its unlikely to do so. The next couple of weeks could see the equity rally continue to run.

Ultimately, this rally in risk assets is predicated on a rather unstable narrative. And the problem here is that equity bulls risk cannibalising their own narrative—the more equities rally, the more comfort level and room that the Fed will create for hiking rates and reducing the balance sheet. Clearly, unless and until the narrative shifts again, risk assets can and probably will continue to trade on technical factors, which at the moment point higher. We do not see the Fed cutting rates again or suspending its balance sheet reduction unless stocks fall a lot lower. But there is literally zero upside to the Fed communicating that explicitly right now. So, in the meantime, the Fed is unlikely to get in the way of this market perception, as reflected by Powell’s follow-up comments and the FOMC minutes. Fed officials will publicly proclaim that they do not care about equity prices, only financial conditions and their impact on the growth/inflation outlook, but in the end, it comes back to equities.

If so, then the set-up for equities could be pretty strong, so long as growth doesn't collapse, which is what the markets were pricing until last Friday. In this way, it becomes reflexive—if you get a modest slowdown, the Fed steps back and equities bounce higher. If the combination of higher stocks/higher oil prices pushes surveys higher (which is possible if this rally extends for the next month or more), and the hard data particularly for consumers hold up, and so long as inflation doesn't rocket higher (while unlikely, we must concede this is not a 0% possibility), you get good growth. So, recession fears recede as does a Fed that is intentionally going to go slow for now at least. And should we also get the inevitable papered-over 'solution' to the US-China trade war, the market will get a nice jolt of stimulus.

All of which is not to say that there are no risks. The government shutdown is unprecedented and is likely to have negative effects for the economy, depending on how much longer it lasts. Chairman Powell conceded in his comments that an extended shutdown would begin to creep in the data rather quickly. Powell acknowledged that financial markets are expressing concern about risks, with his principal worry being global growth, even as the US economy continues to grow. All of this suggests that the Q4 18 sell-off had become over extended; and again, bear markets can still rally, as it seems they will on this occasion…at least until the narrative flips again.

The Outlook
Brent: After a long period of weakness, physical markets in the Atlantic basin have finally started to see some signs of life. Chinese and European refiners have bought WAF barrels, eliminating much of the overhang that existed. This has in turn helped to support Brent spreads. Considering the 40% price collapse in Q4 18, both spreads and differentials have been holding up rather well. And, while Brent spreads have been in a contango, it has been and remains shallow. OPEC cuts are beginning to bite, while low oil prices will keep a lid on US production growth. The supply uncertainties that were the catalyst for the sell-off in H2 18 are beginning to stabilise. But the risks now lie on the demand side. The large and difficult to quantify downside risks from the US-China trade war are starting to hit corporate earnings. China is undoubtedly the biggest concern, especially given the weakness in the latest economic data. The government is taking measures to put a floor under growth, but this will take time. In the meantime, if equities should continue to rally on this perception of a Powell put, it will help support oil flat price, and there is risk in the near term that should prices rally, gamma will catapult prices back towards $70 per barrel much sooner than anyone was prepared for.

Fig 7: Brent vs dec red dec, $/b Fig 8: Dec Wti-Brent spread, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

WTI: US petroleum stocks surged to close out the year, driven higher by very large product builds on the back of extremely high refinery runs. There are always wild swings at the end and the start of each year, so although it is too soon to draw clear conclusions, it looks as though it will be difficult to sustain crude rallies if products continue to build at the current pace.

Reductions in Venezuelan supplies and the coordinated supply constraints in Canada have lent support to North American sour markets, while OPEC+ supply cuts are boosting sour prices across the Atlantic basin. Significantly, Saudi Arabia continues to aggressively price its crude, and other OPEC members are following Aramco’s lead. January loadings from Middle Eastern OPEC members to the US are measly so far at less than 0.5 mb/d and loading programmes suggest that total loadings from Saudi Arabia and Iraq in January and February could be at record lows of 1 mb/d, or just below. Meanwhile, the prompt time structure in Mars has shifted from contango to backwardation, with LLS shifting even more powerfully. We would note that this tightening is occurring despite looming turnarounds, which are biased towards sour crude refineries in the USGC.

WTI timespreads remain weak as Cushing has continued to build, some 6.9 mb over the last seven weeks with no slowdown in builds forecasted in the near future. Indeed, December 2018 builds came in at 3.7 mb, higher than we expected. Yet, the Dec-19 vs Dec-20 spread has bounced hard off the lows, more or less tracking the move in flat price and there is some debate creeping in over just how much Cushing stocks will build in H1 19 if US production actually slows, especially with arbs from Canada completely shut following the rally in Canadian prices recently. While we expect Cushing stocks to rise to 55 mb by the end of March and continue building through most of Q2 19, putting pressure on WTI-Brent, given the vast amount of shorts in the WTI market, short covering in the WTI-Brent spread in the near term that narrows the March spread above -$7 per barrel cannot be ruled out, especially if March Brent expires weak (although right now, that seems unlikely).

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

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