Controlling the narrative

Published at 14:44 4 Oct 2019 by . Last edited 15:56 4 Oct 2019.

How risk assets trade over the next few months may depend on who controls ‘the narrative’ over three critical issues for the market—Saudi production, the US economy and impeachment proceedings against Donald Trump. First, the Saudi’s narrative that ‘everything is normal’ is of prime importance to the country’s leadership, not just politically as the global crude supplier of last resort but also for the IPO of Saudi Aramco. The market has not yet questioned this narrative but may do so in Q4 19, when the balances are set to materially tighten.

Meanwhile, for the US Fed, the narrative that US economic growth is slowing but not stalling is key to the central bank’s characterization of its recent rate cuts as a mid-cycle adjustment rather than the start of a new easing cycle. But a dollar shortage and contracting manufacturing data will test the perception of whether the US economy is just slowing or about to fall off a cliff.

And finally, for Donald Trump, his political survival may well depend on whether he or the Democrats control the narrative on the evolving impeachment saga. The more time Trump spends shouting about Ukraine, corruption and ‘crazy Democrat obsessions’, the less he must defend a teetering economy, a disastrous foreign policy (Venezuela, Iran and China), and deteriorating trade relationships.

Reliable, secure, dependable
‘Normal’ is the word that we hear Saudi officials state most often publicly when describing the state of the Saudi oil industry in the wake of the attack on Abqaiq. The Saudi oil minister this week confirmed that the country’s oil production is back up to 9.8 mb/d while capacity is at 11.3 mb/d, and they expect to reach their full 12 mb/d of capacity in November.

Much of Saudi Arabia’s soft power derives from its claim to be the global shock absorber in the oil market due to its spare capacity. For the Saudis, this is about their place in the world, not just production revenue. Prince Abdulaziz, speaking this week at the Russian Energy Week being held in Moscow, noted ‘[we were able] to overcome this unprecedented challenge in the world, proving that Saudi Arabia will remain the world's reliable, secure and dependable oil supplier’.

But it is also clear that the Saudis are cutting a lot of corners to achieve this ‘new normal’. Supplies to market are not the same as production and while we do not doubt that Saudi Arabia has moved heaven and earth to meet its customer commitments, there are some lingering inconsistencies in the market which are leading to questions over whether things are indeed ‘back to normal’ as the Saudis say. For example, we continue to hear from industry and market sources that several Asian customers, such as Japanese buyers, have been told that there is still no Arab Light or Arab Extra Light for October, and that only Arab Medium and Arab Heavy are available. These buyers are having to find light crude from other producers instead.

Moreover, the recently released Saudi OSPs for Asia were very strong, implying that the Saudis are trying to disincentivise buyers from nominating more of their crude. And finally, Saudi refinery runs remain at least 0.5 mb/d below pre-Abqaiq attack levels. All of which suggests that things are not yet normal.

Of course, should prices continue to fall between now and the December OPEC meeting, there may be a desire for less rather than more production anyway. OPEC output cuts are perhaps one way to hide any persistent problems at Abqaiq. With a couple months to go until the OPEC meeting, it is early to speculate. But should prices continue to fall, the clamour in the market for cuts will rise and this may be an easy way for Saudi Arabia to quietly restore Abqaiq while paying heed to the market’s needs.

Fig 1: Saudi Arab Light OSP to Asia, $/b Fig 2: US crude stocks, mb
Source: MEES, Argus Media Group, Energy Aspects Source: EIA, Energy Aspects

So, the question is how much further can oil prices fall? Though many fear a repeat of last year’s price collapse, there are some very stark differences. First and foremost is positioning. This time last year, the market was max long oil, whereas today, the market is likely on balance short. CTAs are predisposed to selling rallies, and the hedge funds which remain bearish global growth are averse to taking the long side when oil demand remains so weak, regardless of the supply-side tightening. Second, OPEC production was on an upswing this time last year, driven by Saudi Arabia. But this year, Saudi Arabia is helping to tighten the crude market. Last year, crude stocks built in the US in Q4 18, and while we do expect a modest build this month, we expect big draws over November and December, meaning US crude stocks are likely to show a net draw in Q4 19. And finally, the two big differences to last year are that prices are not nearly as high as they were and US crude production growth rates are not as high as they were a year ago, with the latter looking set to disappoint market expectations rather than beat them.

Fig 3: Brent seasonal price, $/b Fig 4: Combined crude non-commercial net positions, K lots
Source: Bloomberg, Energy Aspects Source: CFTC, ICE, Energy Aspects

The downside for oil is much more limited this year than last year given we expect the supply side to remain severely tight in the coming quarters, even if demand does disappoint. But with the US economic data beginning to weaken materially, focus will be on whether equities, which despite the global slowdown remain only 5% off their all-time highs, can remain impervious to all these headwinds.

Fed plumbing
For much of the last two years, the US economy seemed impervious to the global slowdown in manufacturing as US consumer optimism appeared unbounded. This optimism was dented this week as ISM data confirmed that the US manufacturing sector is slowing materially. For the Fed, however, the question remains whether the US economy is merely slowing or if it is stalling. With 2019 growth still pegged at close to 2.25%, the Fed continues to make the case that the US economy is slowing but not collapsing.

Of course, it is important to remember that at this time last year, the consensus in the Fed was that there were likely to be two more rate hikes in 2018 and three more in 2019. That consensus fell apart by the end of 2018, forcing an abrupt about-face from Fed Chair Jay Powell.

As a further indication that the narrative is falling apart, a spike in the repo rate has spooked investors. The Fed began offering repo loans two weeks ago after a shortage of cash in the financial system forced companies to scramble for overnight funding and prompted the Fed to make its reserves available for loan to the US banking system. One reason for the tightening liquidity is that a big chunk of new Treasury debt settled into the marketplace just as cash was being sucked out by quarterly tax payments companies needed to send to the government. Rather suddenly, there was not enough cash for those who needed it. The Fed basically made reserves available for borrowing to balance that mismatch. Whether this is a short-term blip or the start of a longer-term liquidity squeeze remains to be seen.

But both the slowdown in manufacturing and the repo spike could not come at a worse time as the US and China are set to continue their trade negotiations. On the surface, both China and Trump have every incentive for a partial deal, and consensus seems to believe that at least an interim deal will emerge. As we have written before, we still think the goal is to reach an understanding culminating in a Trump-Xi summit in November in Santiago, Chile, at the APEC conference (for details see Macro Digest: Cart before the horse, 13 September 2019).

Fig 5: US manufacturing indices, seasonally adjusted Fig 6: US vs China manufacturing PMIs
Source: ISM, Energy Aspects Source: Markit, ISM, Energy Aspects

Are Democrats handing Trump the 2020 election?
Though the odds of Trump being impeached have doubled in the last week, according to several prominent betting sites, the reality is that any impeachment will ultimately depend on who controls the narrative leading up to the US presidential election in 2020. Impeachment is a political rather than a legal act, and thus President Trump will only be impeached if Republicans in the senate allow it. The Trump campaign has decided it can do two things by flipping the focus and attention to Joe Biden. First, it muddies the water about the legality/morality of Trump’s interactions with Ukraine. But perhaps more importantly, it also undermines Biden and boosts the prospects for Elizabeth Warren. Trump’s political operatives think that Warren, like Hillary Clinton, is the only woman with effectively no chance of victory in 2020 as they believe they will be able to hammer her as being a socialist. Moreover, Trump’s advisors believe that the public will not support impeachment over the Ukraine allegations as there is, as yet, no proof of explicitly illegal acts, even if its morality is increasingly in question. Regardless, Trump would much rather be talking about ‘crazy Democrats with their Trump conspiracy obsessions’ than the sinking economy, the collapse in manufacturing activity, the trade war or his failed foreign policy (North Korea, Iran and Venezuela). Diverting attention away from those issues is his best chance to win the 2020 election.

Nancy Pelosi, the speaker of the House of Representatives, understood this from the beginning and thus resisted the temptation to launch an impeachment inquiry over any of the various foreign election interference Beltway dramas. More important for Pelosi was to secure the Democrat’s gains in the House from the 2018 election and buttress the freshman class from ‘purple’ districts in swing states. However, when several members of this freshman class, many of them with military and national security backgrounds, supported impeachment, Pelosi was unable to fend off the majority in the Democrat caucus.

Ultimately, who controls this narrative may be the most important outcome for risk assets going forward. Trump will provide an endless and non-stop barrage of claims that Biden and his son are corrupt and the Democrats have it in for the president. For the Democrats, if they cannot prove any illegality, they will at least have to prove that what Trump did was un-American, selfish and went against the national interest. While many Democrats believe they have a smoking gun, Republicans insist there is not one. And ultimately impeachment is not so much about your enemies, but about your friends. Just ask Nixon. Our feeling is that the longer this drags on, the more it will hurt the Democrats and help Trump. If you thought the last two yeas were a circus, you ain’t seen nothin' yet.

The Outlook
Brent: Saudi Aramco’s efforts have offset the worst from the Abqaiq attack. Through a combination of destocking, starving domestic refineries and buying spot cargoes, the Saudis have made sure there is no prompt shortage of crude, even if some refiners did not get the exact grade of crude they wanted. With no clear immediate shortage in the market, it is perhaps understandable that front month oil prices have come under pressure as the threat to prompt crude deliveries recedes. At the same time, prompt spreads and differentials remain strong, highlighting the lingering tightness in the physical market. But with spare capacity in doubt for the foreseeable future, it is hard to argue that the back end of the crude curve should be so weak. The Dec-20–Dec-21 Brent spread is nearing parity, while the prompt Dec-red-Dec spread is closer to $3.00 per barrel backward. The repairs in Saudi Arabia are likely to mean that spare capacity will be at a minimum for a long time to come, even as US production growth slows in the coming quarters. If anything, the risks to supply are rising not falling further along the curve. We still maintain that the back end of the curve is grossly mispriced.

Fig 7: Brent Dec - Dec spreads, $/b Fig 8: WTI Mar - Apr spread, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

WTI: Crude stocks in the US built on the week as refinery runs dropped, especially in PADD 3, and higher exports have not yet registered in the weekly data. We have noted over the past few weeks that there could be headwinds to WTI timespreads due to refinery maintenance and, more recently, the surge in freight costs last week after the US Treasury imposed secondary sanctions on six Chinese companies, which we suspect could hurt US exports in the near term. The jump in freight requires USGC differentials to discount or crude grades in the east to surge—both of which have occurred to keep barrels flowing east—just as USGC turnarounds are about to rise and as new Permian pipelines deliver additional supplies to the shore. However, we expect this period of price weakness for US grades to be limited. The 0.9 mb/d Gray Oak pipeline will begin its linefill in Q4 19. Thus, any dip in Q1 20 WTI timespreads will continue to attract entry points for the long side and USGC grades should be supported once refinery maintenance ends in mid-November (see Data review: US Department of Energy, 2 October 2019).

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

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