The Trump doctrine

Published at 16:13 17 May 2019 by . Last edited 11:18 22 Aug 2019.

Oil fundamentals and geopolitics trumped the trade war this week as oil prices outperformed equities to finish the week higher despite the breakdown in the US-China trade talks at the end of last week and fears of a protracted trade war weighing on sentiment. Crude oil prices showed great resilience. Even when negative news prompted a sell-off, Brent managed to bounce off its 50-day moving average the six times it was tested. Moreover, though volatility did spike early on in the week, the surge in the VIX got nowhere near the levels of February 2018, when panic selling ensued. If anything, after initially selling off last week after the US reimposed tariffs on Chinese goods, equities have been rallying ever since, but it has been crude which has been taking the lead among risk assets, up now in the month to date as physical fundamentals continue to tighten. Notably, oil prices have risen even as the dollar has remained well bid since the start of the year. Technically, Brent has managed to bounce back up into the up-channel established since the December 2018 low, and technicians are eyeing a decisive close above $72.66 per barrel which would clear a pathway higher, with first resistance around $77 per barrel.

Fig 1: Risk asset quarter to date % change Fig 2: Brent vs 50 day moving average, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Game of drones
Geopolitics has certainly helped to support the crude market and there has been plenty for the market to digest in the last week. In the wake of the US announcing it will no longer issue waivers to buyers of Iranian crude, we have been expecting to see Iran’s proxies become more active across the region and the market this week got a first real taste of what is likely to come. First came reports early in the week that four tankers had been attacked at the port of Fujairah in an act the Saudi energy minister called terrorism, but the UAE and others continue to describe as sabotage. Two of the tankers were Saudi owned. The damage was very focused in execution—enough to sideline the tankers for repairs, but not enough to render them junk or cause them to sink. There are still very limited details regarding this incident, with Saudi and Emirati officials not disclosing much as their investigation is ongoing.

The second incident was an explosive-laden drone attack on two pumping stations on the East-West pipeline northwest of Riyadh in Saudi Arabia. Iran-allied Houthi rebels in Yemen claimed responsibility for the attack. The Kingdom also denounced it as an act of terrorism. While damage was limited and the pipeline restarted the next day, the attacks on the Saudi oil industry drove home the message to traders that the Kingdom is vulnerable.

In the wake of these two incidents and other intelligence, the Trump administration ordered a partial withdrawal of its diplomats from Iraq, as Washington warned of heightened threats from Iran-backed Shiite militias. Germany has also suspended its training operations in Iraq, and the UK has now raised the threat level for all UK forces and diplomats in Iraq and has started contingency planning in case the UK decides it has to remove personnel from Iraq, Saudi Arabia, Kuwait or Qatar. Iran has denied all of the allegations and has accused the Trump administration of staging these events to try and pull Iran into a war with the US and its regional allies.

Three weeks ago, we noted that Iran would likely respond in an asymmetric way. We noted that ‘Iran can activate the Houthis to become active against vessels in the Red Sea again, and it could also conduct or direct covert operations and industrial sabotage. To be sure, we can expect Iran’s proxies to become more active in targeting US, Saudi and Israeli assets across the region’ (see Macro Digest:One step forward, two steps back, 26 April 2019). If Tehran’s goal was to simply send a message to the West and its allies that it has ways to retaliate and that any escalation will come at a cost, well then mission accomplished.

It is hard to believe that these two attacks happening within days of each other was a coincidence. Both the port of Fujairah and the East-West pipeline are part the Saudi/UAE contingency planning in the event that Iran were to shut the Strait of Hormuz in retaliation to US sanctions. While Iran has not left any fingerprints, it clearly had a hand in both of these incidents, with a very specific message in mind. This was a not-so-subtle nudge to the Saudis and the Emiratis to let them know that their continued support of US sanctions would have consequences. As one source noted, this was not quite like waking up to find a horse’s head in bed with you, but rather more like getting a finger in the mail from the mafia.

Fig 3: Oman diff to Dubai, $/b Fig 4: Dubai M1-M2 spread, #/b
Source: Argus Media Group, Energy Aspects Source: Argus Media Group, Energy Aspects

All of these incidents, coupled with US announcements of military deployments to the region, are conjuring up memories of the run-up to the 2003 Iraq war for many, when the neocons trumped up linkages between Saddam Hussain and Osama bin Laden to justify a US invasion. And, while there are risks of overreach here on both sides, some of the fears of war are a bit overblown. The only thing which could remotely qualify as ‘parallel’ between Iraq in 2003 and Iran in 2019 is the universe in which Donald Trump lives. In 2003, Saddam was thought to have weapons of mass destruction (WMD) by most intelligence agencies (not just the US) and there was bipartisan (even popular) support for action in the wake of 9/11, while President George W. Bush was talking about spreading democracy to the region. Building an international coalition to oust Saddam Hussein, while not easy, was feasible. None of those dynamics exist today. Creating a similar coalition today would be virtually impossible.

Moreover, there is growing distance between President Trump and his National Security Advisor John Bolton. Deploying carrier groups and leaking war plans is just this administration’s Iran version of fire and fury. While Trump and Bolton absolutely agree on the need for maximum pressure on Iran, they have very different outcomes in mind as a result of this tactic. There is no doubt that Bolton wants maximum pressure to either facilitate regime change by choking the Islamic republic economically or by goading the Iranians into doing something that would elicit a crisis and a US response that will ultimately lead to regime change. Trump, meanwhile, views just about everything within the context of leverage, and so believes he is being clever in trying to put maximum pressure on the Iranians in order to have leverage when they ultimately get to the negotiating table. Of course, the difficulty here is that from Iran’s perspective, there is no table to go to given Pompeo’s list of 12 preconditions for normalising relations or, as the Iranians call it, ‘surrender’. When Trump says to the Iranians ‘call me’, most recently by giving the Swiss president his digits to pass on to Tehran, he means it. This is Trump’s way to circumvent Bolton’s harsh rhetoric. There is no serious opening for negotiations unless there is a softening of Pompeo’s regional demands, but it is unclear if Trump understands that while he is playing checkers, the Iranians are playing chess.

And for all the warmongering, the US president has actually been extremely conservative when it comes to the actual use of force, with one pinprick operation in Syria the only time he has authorised an outright use of force over and above operations initiated by his predecessor. Moreover, Trump has taken every opportunity to reduce the number of troops abroad when he can, even when this flies in the face of Pentagon recommendations. This not a president who wants a shooting war. As if to emphasise the point, the New York Times this week reported that the president directly informed the acting defense secretary that he does not want war with Iran.

But to quote Mick Jagger (sorry Gene Simmons), you can’t always get what you want. Right now, the party with the most to gain from dragging the US and Iran into a direct confrontation is probably Saudi Arabia. The escalation in tension across the region over the past week is very real, and even if no one wants to get into a war, stuff happens. The Trump doctrine appears to be "squeeze and hope". Trump has tried to squeeze Venezuela, China and North Korea in the hope this would be enough to trigger meaningful concessions and change. Unfortunately, it has not worked out with any of the three countries, and more importantly, it is clear the administration has no 'plan B' in place. The worry is that this failed squeeze and hope strategy pushes the administration into an even more hard-line position. As a result, we expect geopolitical risks to extend well into H2 19.

The Jeddah JMMC
The OPEC+ committee that monitors the progress of production curbs will meet on Sunday (19 May) in Jeddah, Saudi Arabia. For weeks now, Saudi Arabia has signalled that while it will fill any supply gap as a result of the sanctions on Iran, it is in no hurry to ramp up production or exports and will certainly not pre-empt the Iranian losses in a repeat of the mistakes made last year. If anything, all the soundings from Riyadh are that the job is not yet finished, and they are already introducing the notion that the five-year average for stocks is not the best metric for deciding whether the market is oversupplied or undersupplied. This is meaningful because this month the IEA reported that OECD stocks had dipped below the five-year average in March (although had moved back higher in April as per preliminary data). But again, this only underscores to us the defensive posture that the Saudis are taking.

The big wild card will be the position of the Russians going into this meeting. After being quite vocal for some weeks, the Russians have gone awfully quiet ever since the contamination of the Druzhba pipeline became known publicly. It could be that Russia is going to be more conservative regarding its ability to ramp up production in H2 19 given the Druzhba pipeline will take months to clean up, in turn curtailing production. Any hint that Russia appears to be in no hurry to increase production would be a surprise for the market, which still believes that Russia is itching to raise output. On balance, we still believe that the market expects OPEC+ to green-light higher production for H2 19 at the June meeting. Indeed, most balances have Saudi production significantly higher in H2 19. A straight rollover of the existing agreement through end-2019 is something that is not even remotely priced in at the moment. However, if prices should remain around current levels for the next few weeks and going into the June OPEC meeting, there is a much higher chance that Saudi Arabia and Russia agree to extend the current agreement through end-year than is currently expected by the market. Regardless, we expect this weekend in Jeddah to be non-controversial, with ministers putting off any major decisions until the June OPEC meeting, which is still some five weeks away, and as it is currently too early to commit to any policy changes.

The Outlook
Brent: Timespreads continue to tighten as, on top of all the other sanctions-related losses the global supply chain is having to contend with, North Sea outages are also on the rise. With Ekofisk undergoing maintenance for most of June and now several unplanned outages at Norwegian and UK fields, Forties differentials have rallied to a five-year high and Brent CFDs are solidly backwardated. This is, of course, happening just as buying interest from Asia is picking up. The problem now is that physical crude has raced well ahead of products and, as a result, margins are getting squeezed in Asia and Europe. Moreover, with the crude shortages caused by the Druzhba pipeline outage, inland European refiners are now starting to cut runs. This may create some confusion in the coming weeks as some will point to weakening margins as a bearish signal. However, the margin squeeze is entirely a function of strong crude. With OPEC set to keeping the market tight, refiners will be forced to keep runs in check, which will tighten the products market. But this means margins will recover quickly, dragging crude up again. Crude has outperformed equities so far this year, and that should continue into Q3 19. While there is no doubt that some of the geopolitical noise in the last month has attracted some buyers, that is still the noise . The signal is the continued tightening fundamentals. And the reality here is that crude fundamentals will remain tight and IMO 2020 means refiners will need to run, even if runs stay subdued in the near term. US production is not growing nearly as strongly as some continue to believe—it is growing, but it is not overwhelming the market—while most of non-OPEC outside of North America is underperforming relative to expectations regarding production (particularly Brazil and Mexico). We expect stocks to draw meaningfully in both in Q2 19 and Q3 19. This is just the start of the strong crude market, not the end, even if spreads pause for the time being.

Fig 5: Wti-Brent spread, $/b Fig 6: Prompt benchmark spreads, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

: US crude stocks built this week despite a surge in exports and refineries raising runs by 0.27 mb/d w/w, though higher imports probably offset much of that. But for the second consecutive week, the adjustment factor swung violently again, from -0.9 mb/d in last week’s data to +0.8 mb/d in this week’s data, a swing of 1.7 mb/d, which dwarfs any of the weekly changes in imports, exports or refinery runs. With the Houston Ship Channel disrupted for much of this week following a barge collision, next week’s data will likely also show another wild swing. Cushing stocks built by more than the consensus and this continues a trend of higher stockbuilds this month. This should continue to weigh on WTI spreads until new pipelines begin to reconnect the US Midcon with the rest of world in H2 19. As such, we expect to continue to see WTI-Brent spreads weaken in the coming weeks and months, but expect to see a sharp reversal once these pipelines go into service. While US crude exports are currently running below expectations, despite this week’s increase, the export market has to be the home for incremental US crude production going forward in order to balance the US market. However, the Trump administration’s decision to enact another $200 billion-worth of tariffs on Chinese goods last Friday (10 May) may throw a spanner in the works. China backed almost entirely away from US crude imports once trade tensions began last year, ceasing all US imports from August 2018 to February, except for intermittent loading activity in December 2018, according to EIA data. Prior to the trade war, China had stepped up its imports of US crude, buying 0.36 mb/d on average between September 2017 and July 2018, with a peak of 0.51 mb/d in June 2018. Should China back away from US exports again, its unclear that Europe, which appears to have been reaching its limits of US light crude intake in 2018, can take much more. Should China walk away from US crude, then it is very likely that Permian producers will have to discount their crudes in order to move their barrels by enticing refiners outside the USGC to take more US light crude (see Data Review: US Department of Energy, 15 May 2019).

Products: Margins are getting squeezed again, with simple margins getting whacked. In Q1 19, it was complex refining that was getting squeezed while simple margins rose, but now the reverse is in effect. However, a big part of the squeeze in margins this time is related more to strong crude rather than weak products. In fact, in the past two months, distillate has rebounded while gasoline has recovered from the extreme low levels from Q4 18 into Q1 19. We would expect to see margins pick up in the coming weeks as we anticipate continued strength in gasoil. The difficulty will remain with gasoline, however, especially as refinery runs ramp higher. Gasoline is tight at the moment primarily because of the lack of octane, which may not necessarily translate into stronger margins for simple refiners. So, though RBOB prices should stay firm through the summer, this may not necessarily translate into stronger margins for all refiners. But ultimately, it is diesel that will drive margins in H2 19 and, right now, diesel is coming off the lows of the last few weeks and starting to see some seasonal strength. Should refinery runs remain seasonally low, this is bullish diesel going forward. We expect this slump in margins to be short-lived.

Fig 7: Urals diffs vs Margins, $/b Fig 8: Dubai Hydroskimming margins, $/b

Source: Argus Media Group, Refinitive,
Energy Aspects

Source: Refinitiv, Energy Aspects

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


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