Don’t kid yourself. It doesn’t matter who you are or what you’re trading, it’s all about oil these days.
If you don’t buy that, then have a look at the carnage that unfolded in January. Sure, some of it was attributable to the hangover from the first Fed hike in nearly a decade and the market was also a bit jittery over China’s move to adopt a trade-weighted index for the yuan in December, but crude’s dramatic plunge into the 20s was the driving force behind the turmoil.
Some would argue that when you strip out all the noise, the rather inauspicious start to 2016 was attributable to the fact that market participants have finally lost faith in central bankers. While that’s probably true, it’s important to remember that the main reason the market seems to have lost faith in the primacy of monetary policy is that eight years and trillions in asset purchases have failed to ignite inflation and growth. If you had to pick one factor to blame for the deflationary impulse that persists across the globe what would it be? That’s right: the protracted slump in crude prices.
When you look at the bounce of the February lows, one thing should stick out: it coincided with a sharp rally in oil.
Long story short: if you’re a trader or a stock picker, you may indeed be able to identify a handful of idiosyncratic opportunities around earnings or one-off events, but generally speaking, you should mind oil and the dollar (there’s obviously an inverse relationship there).
With that in mind, I wanted to highlight OPEC’s monthly report (released on Friday).
Needless to say, the narrative around oil now centers on the extent to which OPEC still has the ability to dictate prices. The consensus seems to be that the cartel is dead. Between US shale, the Canadian oil sands, and Russia, the market simply isn’t monopolistic any longer conventional wisdom holds. That, pundits say, is why Saudi Arabia is embarking on an ambitious drive to restructure and diversify its economy.
A more nuanced take recognizes that Saudi Arabia isn’t exactly a victim of the plunge in oil. Rather, they engineered it in late 2014. Sure, they have lost control of things since then, but it’s hard to say that the cartel no longer has pricing power when it was in fact the Saudis who triggered the plunge in the first place. It stands to reason then, that although the train may have left the tracks (so to speak) temporarily, the cartel hasn’t entirely lost its ability to move the market.
On Friday, OPEC said production outside the cartel is set to fall by 740,000 b/d this year. That’s 10,000 b/d less than last month’s estimate. Here’s the language from the report:
“Non-OPEC supply for 2016 is forecast to contract by 0.74 mb/d, indicating a downward revision of 10 tb/d compared with a month earlier, to average 56.40 mb/d due to lower expectations for crude oil production from China, Brazil, India and Vietnam, which outweighs total upward revisions in the UK and Russia. The first decline in US oil production – following the shale boom in North America and deferring of major new projects due to reduced cash flow in 2016 after global oil prices fell – has been the main reason for a contraction in the current year. Non-OPEC oil supply in 2016 is subject to many uncertainties from economical and technical, to geopolitical.”
Zeroing in on US production, the report says the economics no longer make sense for US producers who, as everyone is now acutely aware, have relied for years on capital markets to plug funding gaps (nearly the entire space is cash flow negative):
“Between 2016 and 2018, the industry is expected to invest around US$40 billion per year in exploration and appraisal, less than half its investments during 2012 to 2014. Many pre-final investment decisions (FID) for projects have been deferred over the past year as the economics are no longer justifiable under the current oil price environment. Companies seeking to remain cash-flow positive are likely to continue to cut investments, leading to further project delays or cancellations. For instance, just for the case of the US, oil output is expected to contract by 430 tb/d this year, following strong growth in the previous two years.”
Overall, the monthly report reads much like the commentary we’ve seen out of the sellside lately. There’s the obligatory references to creeping demand growth and falling non-OPEC supply, but at the end of the day, the fundamentals are what they are.
For instance, the cartel notes that “US production has fallen by 281,000 b/d, while the Baker Hughes rig count registered a drop to 332 active rigs by month end, compared with 679 a year ago [and] outside the US, there have been consistent signs of declines in non-OPEC production.” That, the report says, “should likely flip the global oil market into a net deficit in 2017.”
Nevertheless, OPEC admits that “not much has fundamentally changed as the oversupply remains and global oil inventories are at record highs.”
Further, it’s worth noting that whether or not the market “flips into a net deficit” is largely dependent upon whether Saudi Aramco decides to ramp to capacity. The following graphic from Credit Suisse illustrates this point nicely:
And then there’s the X-factor: the USD.
OPEC notes that “the oil market was buoyed by a weaker US dollar, following US Federal Reserve and Bank of Japan decisions to stay put on monetary policy.” As discussed earlier this week, it’s not clear how long the Bank of Japan will be willing to stand pat (i.e. acquiesce to the weak dollar regime tacitly agreed at February’s G-20 meeting) in the face of a strengthening yen. Indeed, Goldman sees the USD strengthening against the JPY going forward and although they’re more cautious on the outlook for euro weakness, Mario Draghi seems ever more willing to think outside the box when it comes to unorthodox policy.
If the ECB moves into stocks and the Fed hikes in September (don’t bet on June), then you can expect the vast policy divergence to drive dollar strength against the EUR as well.
If the dollar soars, one important tailwind for crude will disappear.
The takeaway here is that if you’re trading equities, you can’t afford to be oblivious to what’s going on in the oil market. That’s the “crude” reality.
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