In a bit of a delayed reaction to last week’s China tariffs announcement, the market this week has finally started to absorb that the dispute between Washington and Beijing is about much more than just the trade imbalance between the two countries. Coupled with weakening PMIs in Japan, Europe and the US, risk assets all fell on the week as traders took a defensive posture.
For crude oil, however, the weakness in the flat price feels especially acute as the sell-off defies ever stronger crude fundamentals. The gulf between the physical oil market and Brent and WTI futures prices keeps widening. Supply tightness keeps pushing crude timespreads and differentials higher, while macro funds keep driving the flat price lower on concerns that the economy is slowing and headed for a recession, especially as the US-China trade war escalates, just as supply is about to increase in H2 19 on surging US production and OPEC+ offsetting the losses from sanctions on Iran and Venezuela. That’s the thinking anyway.
|Fig 1: US Risk assets mtd change||Fig 2: Brent vs prompt spread, $/b|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
Do fundamentals matter?
Some of these fears are justified, while others are partly driven by a desire to backfill a narrative to explain a price move that is still quite frankly difficult to rationalise. With CTAs clearly liquidating length as sell targets were triggered when oil prices started to fall this week, at least for now, flows are trumping fundamentals in the futures market.
Some of the demand fears are clearly worth flagging given the shaky state of the economy—weakness in petchem margins in Asia and Europe, coupled with the weak agricultural distillate demand in PADD 2 due to the flooding are worth watching closely. Some continue to point to softening refining margins, though we still believe that this is as much a function of crude strength as it is about product weakness, though there are few signs of outright strength in any of the product markets we cover. Even the strength in gasoline is more of an octane shortage than spiking demand growth. Additionally, even with US runs effectively flat for the last three weeks, product stocks in the US have built, against expectations. These are all warning flags that need to be watched, but the jury is still out, especially given our already cautious demand growth forecast for 2019. Moreover, we still believe that margins are in a bottoming process.
Supply fears, meanwhile, revolve around the perception that US production is surging and that Saudi Arabia and Russia will suddenly flood the market with oil. The perception of surging US production appears to be driven more by surprise US stockbuilds over recent weeks (albeit largely propane and ‘other oils’) rather than any hard data point. The steep sell-off in US producer stocks only reinforces this view—if crude is selling off due to the idea of surging US output, then investors would of course punish US producers for destroying shareholder value despite promises of capital discipline in recent earnings calls. To us, US production is rising but not surging—certainly not to August and September 2018 levels based on the frac spread count, the rig count and other high frequency data. Stockbuilds have been largely driven by US refiners struggling to return from works but holding crude as they prepare to raise runs at a time when sour crudes are hard to come by.
|Fig 3: US crude production, mb/d||Fig 4: US prod index vs WTI, mtd % change|
|Source: EIA, Energy Aspects||Source: Bloomberg, Energy Aspects|
As for OPEC, Saudi Arabia will not let stocks rocket as they did in H2 18, let alone allow them to hit the disastrous highs of 2015–16. Saudi efforts are focused on bringing inventories down to levels that will allow them to manage the markets in the short and medium term, and while they may increase marginally in H2 19 if, and only if, refiners ask for more of their expensively priced oil, it will only be in modest amounts. There will be no flood.
Still, regardless of our scepticism, the above views do appear to be the prevailing crude narrative, and it will be down to the data to prove or disprove them. In a week that saw triple-digit crude spreads in both Brent and Dubai, and a WTI curve flirting with backwardation, flat price crude has sold off by roughly $5 per barrel. Last week we noted that one of these is wrong. For now, flows are trumping fundamentals.
Risks are far more balanced
The problem right now is that these two competing narratives, tight supply and weak demand, risk influencing policy decisions that will create even more distortions going forward. For OPEC, the signal from the futures price collapse could not be clearer. The market is telling OPEC that it doesn’t want or need more crude oil in H2 19, partly on the assumption US shale will grow by 1 mb/d by December and, in any case, because the world will probably be in a recession that might force OPEC to actually cut production rather than increase (what a time to be alive). How OPEC responds to this price weakness is hard to say. The group wants to be a responsible steward of the oil market and to ensure that customers are adequately supplied, but weaker prices put even further financial pressure on the Saudis at a time when their costs are rising due to attacks on their infrastructure and the continued militarisation of the region. Our balances already assume large increases in Saudi and Russian production across H2 19, back to record levels by Q4 19, and yet we are still registering large draws in Q3 19. The longer oil prices remain subdued heading into the OPEC meeting, the greater the risk that the Saudis will defer responding to tightening fundamentals and overtighten the crude market in H2 19. This is true even though the Saudis will be under extreme pressure from the US to fill supply holes dug by sanctions on Venezuela and Iran.
Is the Fed behind the curve again?
On the demand side, there is also a fear that the US Fed is again behind the curve. Like in December 2018, when it hiked rates even as markets were melting, there are renewed worries that the Fed remains obsessed with inflation when perhaps it should be worried about deflationary pressures as China devalues its currency and global economic growth hits serious headwinds from the trade war escalation.
Markets had been hoping the Fed would shift to cutting rates, but hopes were dashed on 1 May when the Fed said:
“The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes."
It was specifically the use of the word “patience” and the explicit mention of the symmetry of inflationary outcomes either side of 2% that led the market to reprice some of those expectations for a rate cut. Since then, as hope of a trade deal evaporated, the market began to price in at least one rate cut and possibly two by year-end.
But the reality is that were there to be a material demand capitulation, due to the trade war or anything else, the Fed would very likely cut 100 basis points before year-end. The question is: how much pain must the Fed see before it begins to pivot again? We had a similar dynamic in October/November 2018—the market was getting bearish, but the Fed was still not there and hiked in December 2018 before eventually being forced to pivot in early January.
|Fig 5: Rate probabilities Dec 19 Fed meeting||Fig 6: Rate probabilities Dec 19 Fed Meeting|
|Source: CME, Energy Aspects||Source: CME, Energy Aspects|
Right now, though some physical crude markets have come off their highs, they remain tighter than they’ve been for years—and yes, we can say that with a straight face—while product markets are showing signs of stress. If the March-April demand softness is more than a seasonal swoon, it will be difficult to hit our price forecasts later this year, and we may need to revise our price assumptions. But these are still just yellow flags of interest. Whether they morph into red flags (of despair) will depend on several drivers in the coming months: how OPEC responds when it meets in around a month if prices remain lower; how quickly the Fed pivots to an easing bias; resolution/exacerbation of the US-China trade war, and at what point the US and China accelerate stimulus packages to mitigate the row’s impact. Of course, all this is happening against the backdrop of an IMO transition that will begin in Q3 19 which is expected to generate 2 mb/d of incremental diesel demand.
It is also worth reinforcing here that our demand numbers were already quite pedestrian given that we had already assumed a much higher oil price than consensus in 2019 and a slowdown in growth given the protracted nature of the conflict between the US and China. With demand growth projected at just 1.0-1.1 mb/d in 2019, we are hard pressed to mark demand down even further, absent a significant downside catalyst. Only once in the last quarter century has demand growth actually contracted and that was in 2009 after the global financial crisis—demand was flat in 2008 and fell by 0.9 mb/d in 2009 as global trade was brought to a standstill. This was such an extreme event given the collapse in credit and the impact it had on all global trade. Even if we assume that tariffs will escalate and lead to a trade slowdown, it most certainly will not lead to the type of cliff diving seen amid distressed credit markets in 2008-09. Even in 2014, when the economy was sputtering given the massive post-crisis debt deleveraging and three straight years of +$100 oil, demand still grew by 1 mb/d, despite much weaker economic growth than today. We are not implying that there aren’t challenges to growth, which will clearly slow from its 1.4 mb/d per year average over the past five years. But the market is still acting as if financial Armageddon is about to destroy demand and see it contract for the first time in over a decade. We are not there yet.
|Fig 7: Global demand growth, mb/d||Fig 8: P2 runs (mb/d) vs diesel stocks (mb)|
|Source: Energy Aspects||Source: EIA, Energy Aspects|
The challenges cited above are more medium term in nature. But in the very near term, it is unlikely that flat price will rally unless and until this narrative is picked apart, which can only begin to happen once US stocks draw. At a minimum, US draws would mean that US production is being absorbed (regardless of what rate it is growing at). Secondly, given how low imports are, draws would also likely mean that runs are ramping higher, suggesting that margins are conducive to higher runs, thus partially alleviating some of the concern on the demand front. The problem is that we might still see another couple of weeks of builds in the US, which will continue to reinforce these narratives. Ultimately, we do believe that fundamentals will trump flows. Right now, the crude fundamentals are very clear. Product fundamentals may need a bit more clarity in the coming weeks, however.
Trump: It’s my way or the Huawei
It should now be very clear that the dispute between the US and China is more than just about a trade imbalance. While the Trump administration has tried to soften the rhetoric over the past year by spinning a very positive story as the negotiations progressed, Stephen Bannon has in the last two weeks ripped the veil off any mystery over what exactly the administration is trying to do and what is at stake. Bannon claims that the US is in an “economic war with China in which it is futile to compromise”. Moreover, he added, whatever emerges won’t be a trade deal. It will be a temporary truce in a years-long economic and strategic war with China. Bannon may no longer be in the Whitehouse, but he remains the ideological god father of many who remain, and his views reflect much of the thinking within the administration. These are very clear lines in the sand for the US, and any delusions that this could be fixed by the Chinese buying some soybeans has been tossed out the window. Xi Jinping’s visit this week to one of the largest suppliers of rare earths—natural elements used for military and civilian uses—in China (and the world) was a stark reminder of the America’s dependence on China for their production: the US imports nearly 80% of its rare earth minerals from China. This was not a run of the mill photo op. The gloves have come off, and both sides are firing shots across the boughs.
A major stumbling block in the negotiations was the US insisting that China effectively rewrite the laws to protect intellectual property among other things. Specifically, there are two Chinese laws that the US negotiators are focused on: the National Intelligence Law, and the Anti-Spyware Law that require Chinese firms to support and assist state intelligence and security agencies.
Recognising the sensitivity around this, the founder of Huawei, Ren Zhengfei, this past January, said “No law requires any company in China to install mandatory back doors” referring to giving officials a key to unlock data on devices or networks. He continued with “I personally would never harm the interest of my customers and me, and my company would not answer to such requests.” The sanctions slapped on Huawei by the US this week suggest that negotiators were not persuaded.
The collapse of the US-China trade talks earlier this month, followed by President Trump’s decision to blacklist Huawei Technologies, highlight the deep gulf between the two countries. Moreover, as the rhetoric on both sides is increasingly combative and nationalistic, ‘win-win’ diplomatic solutions will be out of reach. To be sure, a meeting between Trump and Xi in late June, on the side lines of the G-20 summit in Osaka, is still possible, but it is highly unlikely to deliver a deal. Negotiations will resume and, now that both sides have ‘shown their cards’, substantive and direct talks can begin to limit any fallout. China is hunkering down for a protracted struggle with the US. Meanwhile, the US believes it is defending itself against an existential threat, one that will erode its global competitive advantage. And Xi is not going to cave in to US demands, as his domestic constituents would not allow it. Immovable force meets unstoppable object.
Brent: Last week, we noted that after having rallied so hard for so long, some physical differentials and timespreads were due for a correction as run cuts (mainly in Asia) and unplanned outages would weigh on prompt demand. However, both Brent and Dubai prompt spreads continue to tighten, even as some crude differentials have eased up. Barring a major demand problem, as runs return in both regions, crude stocks will draw. The severity of the supply losses means that downside to physical crude is likely limited, and it would take a massive demand shock to loosen crude fundamentals. If anything, Dated Brent continues to remain strong even in the face of growing European run cuts as Chinese buying seems to have allegedly picked up, in turn forcing Brent spreads to bounce back after a small correction earlier in the week. With WTI still lagging, the arb continues to widen approaching double digits, a trend we see continuing in the near term.
|Fig 9: Ytd change in US crude stocks, mb||Fig 10: US crude exports, mb/d|
|Source: EIA Energy Aspects||Source: Census Bureau, Energy Aspects|
WTI: The market has been gripped by the surprise build in petroleum stocks in the US over recent weeks, in particular product stocks building despite largely flat US crude runs. But even so, the build in crude stocks seems curious given the tightness in the seaborne market and the fact that USGC crude pricing continues to strengthen. Exports have come off, averaging just over 2.6 mb/d in Q2 19 so far (based on quarterly EIA data), versus 2.75 mb/d in Q1 19 (final Census Bureau data). And with production also starting to rise following a disappointing Q1 19, crude stocks have built by 27 mb since the start of April versus the five-year average build of 5.6 mb. With China shying away from US crudes following the ratcheting up in the US-China trade war and instead turning to the North Sea, until US runs rise materially, crude stocks may continue to rise in the near term across the US and at Cushing
Yet, despite the builds, most USGC crudes are in varying degrees of backwardation (MEH, LLS and Mars). But the backwardation in Brent and Dubai are way steeper and once again, like last August and September, they are telling us that they world is screaming for barrels. Yet US crude exports are likely lower than they were in Q1 19, and US stocks are building, even as refinery runs in the US remain low. Why? The market has assumed that its because US crude production is surging higher than most realise. But as we have said before there are any number of reasons why stocks could be building. Even if it is production that is the culprit, one possibility is that the quality of the crude being produced in the US at the moment is so light that its struggling to find a home, especially when the US is still in a low run environment. Clarity on this issue will be paramount in determining whether the crude market is over or under supplied in the coming months. Anecdotally, we hear that exports for June are picking up again, but the global market does not seem to suggest that a deluge of US crude is about to hit it. But if US exports underwhelm even when the world is crying for crude, we clearly have a quality problem at hand.
Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)