For many oil traders, the end of calendar year 2019 in two weeks cannot come soon enough. It has been an incredibly challenging year with crude flat price, spreads and energy equities, seemingly moving in different directions. Crude spreads and differentials are reflecting extreme tightness in physical crude supply. Flat price expresses deep concerns among traders over economic and thus oil demand growth. And the collapse in energy equities reflects the growing investor apathy towards the sector, due to extreme uncertainty on both supply and demand but also somewhat irrational concerns over an energy transition which, in our view, is only just beginning and will take decades to complete. Energy’s share of the S&P 500 is now at an all-time low. Much like with tobacco and coal, the investor class has decided that energy is toxic.
But those analogies with tobacco and coal are apt because after a period of collective upturning of noses, investors started to look at cash flow and ultimately held their collective noses and returned to those once shunned industries. Will the same happen to the oil companies? We think this is a question of when, not if.
|Fig 1: S&P energy sub-index weighting vs S&P 500||Fig 2: S&P sub sector performance, % change|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
In our view, we are approaching an inflection point as the outlooks for supply and demand come into better focus as we look into 2020. Supply will remain tight as OPEC will strive to keep inventories from building, and demand is not nearly as bad as some fear. It will not take that much to once again pique the interest of equity investors in the energy sector, especially as many will again be chasing yields. The exodus from energy should be near complete.
The supply side of the oil market is going to remain tight due to OPEC’s commitment to keep inventories in check and keep the crude structure in backwardation. Saudi Arabia is very keen to establish a $60 per barrel near-term floor for Brent and is prepared to defend it. Unlike in the last two years, when US production was surging, OPEC should have less difficulty in doing so because US shale growth is now in a structural slowdown and decline rates in conventional production outside North America continue to accelerate (note it is important to look at net production growth rather than gross additions in Brazil, Norway, Angola and other countries).
Johan Sverdrup and Liza are the last of the non-OPEC mega-projects, and from 2021 onwards, we have no new big projects on the books. Thus, should demand continue to grow at roughly 1 mb/d each year, OPEC will increasingly be asked to bridge the gap between supply and demand. This need should start from H2 20. And while sanctions on Iran could at some point be reversed, there will be room to absorb Iranian barrels in 2021 onwards. Venezuela’s problems are a bit more structural and would take years to reverse, but the market should be able to absorb the supply if it becomes available. The alternative is that oil prices will have to rise materially in order to reignite activity in the Permian and allow for activity in shorter-cycle conventional crude to also restart.
But that is really a story for 2021 and beyond. More near term, we think there is a case to be made for crude to remain constructive even with an ambiguous liquids balance in 2020. While much of the macro world has hated crude oil, those sentiments can change rather quickly. But only if the global economy is truly at a turning point. To answer that question, we must first understand why we are where we are to begin with.
|Fig 3: Brent vs US dollar index||Fig 4: US risk assets|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
If you ain’t first, you’re last
When looking at most of the macro economic data, it feels like much of the world hit a proverbial brick wall in January 2018, as Trump’s America First policy segmented the global economy. A dollar rally began in earnest in early 2018 because of these policies. In particular, the imposition of tariffs (while it is debatable whether they are actually helping American manufacturers and the US economy), were undoubtedly siphoning off growth from the rest of the world. In early 2018, the subsequent repricing of risk triggered the massive volatility spike which signalled distress.
Equity, credit and commodity markets traded nervously in October and November 2018 before entering full-on riot mode when the Fed failed to ratify the growing certainty in the mind of the market that both an early end to balance sheet run-off and cuts to the Fed funds rate were necessary to offset rapidly rising recession risks. Spooked by the market pandemonium in the second half of December 2018, the Fed undertook a rhetorical 180 degree turn as soon as the calendar turned to 2019, with abnormally tight messaging discipline across the board and regional Fed presidents, beginning with a high-profile panel appearance by Fed Chair Jay Powell on 4 January. Repeated reiteration of the view by the Fed that the economy was ‘in a good place’ but that the Fed stood ready ‘to act appropriately, as always’, Fed members signalled in unison that the hiking cycle was effectively over and that it would not hesitate to ease policy if the tightening in financial conditions saw any transmission into the real economy.
While this approach was effective in tightening credit spreads and sending equity indices to new highs by early spring, the haphazard use of trade threats by the White House threatened to undo the stabilisation the Fed brought to financial markets. The threat to use punitive tariffs over the immigration dispute with Mexico in early May led to the subsequent shift in monetary policy, as the Fed sought to avoid repeating its December 2018 messaging debacle by signalling both an imminent interest rate cut and an early end to balance sheet run-off at the June Federal Open Market Committee (FOMC) meeting.
The markets proved none too happy when Powell suggested that the July rate cut was part of a smaller ‘mid-cycle adjustment’ rather than the onset of a sustained cutting cycle, but once again the see-saw between the Fed and market expectations was overwhelmed by developments on the trade front. The renewed imposition of tariffs on all imports from China were a greater catalyst for the very sloppy markets of August than the Fed, which after all was starting to deliver on market expectations albeit at a slower pace and lesser scope than had been hoped for. With economic data in the US holding up reasonably well, particularly in the labour market/household sector and the interest-sensitive residential real estate market, financial markets did not end up challenging the Fed's go-slow approach, especially as the White House walked back some of the more extreme threats against Chinese imports.
The buck stops here
Though Trump continues to argue that the strong dollar is impeding his policies, the reality is quite the opposite. The dollar strength we are currently seeing is a symptom rather than the cause of global instability. And for the dollar to ease, growth expectations in the rest of the world must rise relative to the US, as that is the only thing which will trigger outflows. If growth is indeed bottoming in Europe, then we could see a bit of a dollar sell-off there. But with negative real interest rates in the Eurozone and Japan and highly negative growth differentials still in favour of the US, it is hard to see a sustained slowdown in capital flows into the US unless something happens to the growth outlook here. Much of the rest of G10 FX vs the USD—think AUD, NZD and even CAD—are beholden to the trade outlook and if we do not get a full-fledged resolution there, it is hard to argue we will see a huge range breakout in the USD. In emerging markets, real interest rates in all but a few countries (Mexico, Russia, Turkey) are now zero or negative and many countries are paying the price for recent economic mismanagement (countries in Latin America, and South Africa).
The big issue going forward, unlike in 2016, is that monetary policy is pushing on a string. The Fed has some conventional space to easy policy but is loath to use it unless it senses that recession risks are growing acutely (in the real economy, not just in stock market pricing). The European Central Bank and Bank of Japan have largely exhausted the proactive stimulus that can be provided. The costs of negative policy rates in jurisdictions that have chosen to blow through the zero lower bound are increasingly apparent.
Thus, while the stimulative settings put in place by major central banks globally should remain supportive of asset prices in 2020, there is no reason to think that central banks alone will provide the next leg up. Indeed, if further central bank action becomes warranted, it will likely only occur after stocks have dropped sharply, credit spreads have widened, commodities have fallen, and the dollar has rallied. That said, as long as no new shocks occur and no organic slowdown in the US economy crops up, crude should benefit from an incrementally stronger global growth outlook, with a tailwind of a flip in sentiment to boot.
Brent: The Brent crude curve continues to tighten with the backwardation steepening further out the curve. There is some risk of spreads correcting as indicative margins continue to show weakness, but the outlook for spreads remains constructive. OPEC’s decision to cut production belies a market that believes it needs more supply rather than less. But the OPEC decision should be enough to eliminate seasonal Q1 20 crude stockbuilds and push them to draws of 0.7 mb/d, overtightening an already tight physical market and removing downside for crude prices. Prompt Brent backwardation is hovering around $1.00 per barrel, and we expect the strength in Brent and Dubai to continue following this decision.
WTI: Much like Brent, the WTI curve is moving into steep backwardation, albeit with a lag. We expect Cushing stockdraws of 7.4 mb during December, taking year-end stocks to 35.5 mb. But as flows on the Basin pipeline fall more substantially, we expect stronger draws during January and February 2020. However, with planned works at Ponca City and Coffeyville refineries during March 2020 and the start of Northern Tier refinery maintenance pushing more barrels to Cushing, we expect a build of 2 mb during March, taking end–Q1 20 Cushing stocks to 30.2 mb before draws resume during Q2 20. By the end of Q2 20, we expect stocks to hit around 22–24 mb, which will send at least one of the Q2 20 WTI spreads into strong backwardation.
|Fig 5: Average year to date US ref runs, mb/d||Fig 6: Benchmark prompt spreads, $/b|
|Source: EIA, Energy Aspects||Source: Bloomberg, Energy Aspects|
Head of Macro Energy
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