Published at 13:12 14 Jun 2019 by . Last edited 11:18 22 Aug 2019.

Global markets are at a crossroads with three significant pivot points in the coming two weeks for the oil market and more broadly for general risk appetite. Next week, the US Fed meets to discuss policy and markets continue to price in higher odds of a rate cut. The week after, OPEC is scheduled to meet on 25 June (more on this below) to decide on output policy (Russia is insisting OPEC+ meet the first week of July). After that, the G20 will meet in Osaka [on 28-29 June] and the US will decide whether to extend tariffs on Chinese goods or call another ceasefire to allow negotiations to resume. The outcomes from all these meetings will go a long way towards setting the tone for H2 19.

OPEC plus or minus?
For oil, much of the macro community believes it is 2014 all over again. The feeling is that US supply is surging (it’s not) just as the global economy is slowing (which it is) and OPEC is a shambles (to be determined). All of which is further reinforced by the fact that US inventories have leapt, counter-seasonally, by some 95 mb since the middle of March. Of course, 51 mb of that is ’other oils’, as well as a 20 mb build in propane, and crude built by 46 mb, while the remaining products drew close to 17 mb. But additionally, the adjustment factor over that period has averaged roughly 0.55 mb/d, which translates to 40 mb of builds. With such a large adjustment factor, there is clearly a problem with the reporting, which is driving the idea of surging US production. But there could be many reasons, aside from production, why the adjustment factor is so large (see Date Review: Department of Energy, 12 Jun 2019). US output is certainly growing, but we do not believe it is surging; instead, this is a reporting anomaly that will take time to fix. But in the meantime, with US runs so low, so long as the adjustment factor remains high, stockbuilds are likely to persist, further reinforcing the oversupply narrative in the spec community even though physical crude markets are tight by any definition.

Fig 1: Brent crude prices, $/barrel Fig 2: US crude stocks, mb
Source: Bloomberg, Energy Aspects Source: EIA, Energy Aspects

For OPEC, the surge in US crude stocks must be disappointing. The whole purpose, if unstated, of the OPEC and Saudi strategy of cutting its exports to the USGC was to slash US crude stocks. For a while it worked, as there has traditionally been a strong correlation between deliveries of Saudi crude into the USGC and inventories. However, this relationship has broken down—even with Saudi exports to the US at historic lows, US crude stocks have swelled. For the Saudis, and for OPEC, this will require a rethink of the broader strategy. If continued supply management is no longer having an outsized impact on visible stock levels, and thus price, then what’s the point? While effective in 2016 and 2017, this strategy has been less effective in 2019. If Saudi Arabia is unable to lift oil revenues by lowering volume to push up prices, then it may have to consider other options.

Fig 3: Saudi exports to US-4 wk avg, mb/d Fig 4: Saudi exports to US vs US crude stocks
Source: EIA, Energy Aspects Source: EIA, Energy Aspects

Mission not accomplished
Crude rallies are being sold rather than dips being bought, despite the physical crude structure remaining well bid. Crude flat price is effectively trading as if there is a full-blown recession underway. The message to ministers could not be clearer—additional OPEC crude is not only unnecessary but unwanted because shale is growing like gangbusters and we are probably in a recession or, if we aren’t already, then we will be by Q4 19.

OPEC is now in a very tough spot, especially with Russia insisting that the OPEC+ meeting take place on 4 July, some 10 days after the 25 June OPEC meeting. Saudi officials are working hard to make sure there is only one meeting, but Iran has been refusing to agree to changing the date to the first week of July. Just 10 days out from the scheduled OPEC meeting, there has as yet been no confirmation that it will go ahead on that date. We have been expecting that there will be two meetings: the OPEC meeting on 25 June and the OPEC+ meeting on 4 July. Although, if the market must wait until 4 July for Russia’s decision, then what is the point (other than setting the OPEC Secretariat budget for the coming fiscal year) of meeting on 25 June? If ever there was a time to replace the meeting with a simple WhatsApp group chat to agree an official statement it would be this month.

With time running out, the options for OPEC are limited. Most of the OPEC members have agreed to move the OPEC meeting to the first week of July with the exception of Iran. Should lobbying efforts fail, and Iran insists on having the OPEC meeting on 25 June, then the OPEC+ meeting will still take place on 4 July, leaving a 10 day gap between the decisions. The majority would still prefer to move the OPEC meeting to the first week of July and are lobbying Iran heavily to agree. Hopefully this can be agreed before 25 June.

While the market may try to find implications for policy from all this, it is important to highlight that the disagreements regarding the timing of the OPEC meeting are purely political divisions between Iran and Saudi Arabia and do not reflect a disagreement over policy within OPEC or between OPEC and Russia. Whether the OPEC meeting takes place on 25 June or the first week of July, we still think a rollover of the existing agreement to year end the most likely outcome and that Russia and Saudi Arabia remain firmly committed to cooperation.

Powell to the people
Next week, the Fed will also meet to discuss policy. Markets rebounded in recent weeks as Fed officials offered reassurance that they will be much quicker to cut rates if there are increasing signs of an economic slowdown, and explicitly cited the uncertainties of tariff escalation on global growth. This is an important linkage that had been missing, and perhaps is also reinforcing the administration’s hard line on China in its negotiations. Unlike last year, it appears that the Fed has got Trump’s back.

But the market may be getting ahead of itself as it is now pricing in at least two cuts, perhaps three, before year-end, and forward pricing has historically tended to under-price actual Fed moves. Yet the Fed’s commitments to ease further have been qualified, meaning that the Fed is prepared to ease ‘if conditions warrant’, suggesting that current conditions do not warrant.

There are a few out there expecting to see a Fed cut as early as next week, but most of the market pricing is looking more towards September, although July could be in play too. The Fed is unlikely to pre-empt a deterioration in the economy, and with so much uncertainty surrounding the G20 meeting, the Fed may prefer to save its ammo for later in case US-China relations worsen.

But the Fed doesn’t have to cut to send dovish signals. In lieu of a cut, we would expect it to continue to reinforce its readiness to move more quickly than it has in the past…if conditions warrant. While much of the Street has been revising forecasts to include more rate cuts by year-end, we note that UBS and Goldman Sachs remain the most notable holdouts (both expect no change in rates this year). All of this is to say that it is not yet a given that the Fed will cut, unless you think the economy continues to weaken.

Fatter tail risk to US-China than maybe the market realises
And then finally, the G20 meeting is building some great expectations for a grand US-China bargain, something we still think is unlikely. In fact, given the strong equity market performance, the dovish tilt by the Fed and bipartisan support for a tough stance on China, Trump may in fact see a window of opportunity to squeeze China even further. While much of the conventional wisdom has been that Trump has six months to get a deal done and thus will bend over backwards to ensure he gets one, the flip side of that same coin also holds true. Trump has six months to be aggressive with the Chinese before his re-election campaign begins in earnest. His constituents have been willing to give him a lot of leeway politically on the impact of tariff battles, because he insists they give him leverage in negotiating better trade deals. But those deals have not materialised and the only tangible result of Trump’s efforts thus far has been the pain associated with his policies. If that doesn’t change soon, support for tariffs will fade very quickly heading into the election cycle (for more details see E-mail alert: US-China: Tails in the mirror may be fatter than they appear, 13 June 2019).

The Outlook
Brent: While prompt timespreads have come off significantly from their highs, they remain 80 cents backward. There was a time when an 80-cent backwardation in the prompt would have been meaningful. But not today. Despite continued strength in the physical markets, flat price continues to sell off. Meanwhile, the correlation between equities and crude has weakened even further with equities generally buoyed for most of the week while crude was selling, until the attacks on the two ships in the Gulf of Oman provided a brief pause in this divergence. The oil market is woefully complacent about the risk to shipping in the Strait of Hormuz. Insurance premiums are rising, even if freight rates remain weak, given all the production cuts out of OPEC (see E-mail alert: Tanker attacks near Strait of Hormuz raises security of supply risks, 13 June 2019). But back in the 1980s we had a similar phenomenon emerge—the now infamous tanker wars, when both Iran and Iraq began targeting each other’s tankers during their protracted conflict. Back then 30 countries had ships damaged by either Iran or Iraq. Eventually, the US agreed to reflag Kuwaiti tankers under the US flag, and the US Navy ultimately created safe corridors through which these tankers could pass. While the direct targeting of tankers did not halt the flow of oil (a feat that would be even harder today given the redundancies in the pipeline systems of Saudi Arabia and the UAE), it did manage to slow the pace of exports and increased costs significantly, thought this was primarily absorbed by the US Navy. Iran has repeatedly said that it would not be the only country to go to zero if it got hit by sanctions. It is unclear whether it has the capacity, let alone the wherewithal, to follow through on these threats.

WTI: This remains by far the most confounding oil market in memory. For now, everyone’s forecast for the adjustment factor in the weekly DOE report is as important as their forecasts for refinery runs or imports or exports. As absurd as it may sound, this is the truth. The weekly DOE inventory report, more so than usual, has turned into a crapshoot. If the error factor turns negative (or corrects lower) this month, crude stocks will fall back to seasonal averages. But in the meantime, the reality is that US refinery runs are still very low on a seasonal basis and have underperformed relative to expectations. And, more worryingly, while principal product stocks have drawn, they have not done so to the extent one would expect given the very low level of runs. The real question in our mind remains, regardless of the adjustment factor, why would US crude exports stagnate in April and May if there was strong demand abroad, and low runs in the US. Why would crude go into inventory rather than be exported? With USGC crude differentials so strong, it does not make sense that US inventories would be rising and exports falling, when stocks in the rest of the world were falling. Without knowing the quality of the crude going into inventory, it is hard to determine whether the crude market is over or undersupplied. However, the strength in physical crude prices suggests that the stockbuilds are not necessarily crude that is widely desired.

Fig 5: Brent ($/b) vs S&P 500 Index Fig 6: Ytd change in US petroleum stocks, mb
Source: Bloomberg, Energy Aspects Source: EIA, Energy Aspects

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

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