Fear Reduction Across Asset Classes Behind Oil Price Rally
Make no mistake, despite plenty of attribution otherwise, the March rally in oil prices has had little to do with a change in oil supply and demand fundamentals. Just as the twin downward price spikes in January and February were engendered by Macro-level demand concerns, the relief we’ve seen in March can be primarily attributed to the dissipation of fear by investors across a wide swath of emerging markets, currencies, high-yield credits, equities markets and indeed oil prices.
Twin Oil Price Drops (Fear) and Current Rally
Source: CME Group
A quick examination of the following chart on the implied volatility embedded in oil price options (a quite reliable proxy for investor fear) clearly illustrates the drop from a peak of 80% to 45%:
Front Month WTI Oil Option Implied Volatility Returns to Earth
Source: Bloomberg Professional
We established a roadmap to recovery in “Oil Prices – Price Discovery Spurs Widespread Declarations of Oilmageddon” that included:
- Flattening Forward Curve – which is a prerequisite for the removal of economic incentive to store oil
- Evidence of Inventory Draws – visible proof of a change in supply/demand
- A major development in the Syrian War that enables the Saudi’s to lead a production cut from OPEC
- Resolution of the China Growth Question, most likely expressed in the Renminbi exchange market
We concluded that true bottom would only be evident after the fact, and likely coincide with several of the above major indicators. Our following review suggests that the only takeaway one might make of the recent rally in oil prices is that generic marketplace fear has subsided. We are still waiting for macro and fundamental confirmation.
Forward Curve Has Not Flattened
As seen in the following chart, the forward curve has flattened a bit, but we are still in a strong contango. Front month WTI trades more than $6 below 12-month WTI. While this is an improvement from the nearly $10 discount mid-February, it is still well above the level necessary to encourage the unwinding of storage arbitrage. Thus, despite the bullish change in absolute price levels, the term structure of oil prices is not signaling any kind of change in the supply-demand balance.
Forward Contango Relaxes (12 Month WTI vs Front Month WTI)
Source: Bloomberg Professional
Inventories have not drawn down
To date, we have not seen any evidence of inventory draws, which is not surprising given the normal seasonality of refinery demand. We have not even seen a statistically meaningful (three data points) deceleration in the rate of inventory builds yet. Thus, this rally is purely anticipatory, as there is nothing tangible to point to as having changed.
Total Crude Oil and Petroleum Products (Excl. SPR) Inventories
Source: US Energy Information Administration (EIA)
Is the Announcement of a Russian Troop Reduction from Syria a Valid Signal?
The recent announcement of Russia’s intention to reduce combat troops in Syria is a bit of a geopolitical quandary.
On the one hand, taken together with meetings held between Russian and Saudi oil officials (an improved dialog at a minimum), and the dubious announcement of a potential OPEC production freeze (again, a positive signal of Russian and Saudi dialog, at the expense of Iran), one might start to build a case that this is a potentially giant step forward in the conflict. Clearly a Russian drawdown will increase pressure on the Syrian Government to agree to a timeline for Assad’s departure, which is hard to misinterpret as anything but an overture (dare we say capitulation?) from the Russian’s to the Saudi’s and the West at large.
Russia Plays Master Shell Game In Syria
On the other hand, given the history of little green men in the Crimea conflict, it’s hard to take any proclamation at face value. Furthermore, Russia’s role in Syria, and a potential rapprochement with the Saudi’s are but one of the prerequisites for Saudi reconsideration of its market share strategy vis a vis OPEC. The Iranian test launch of ballistic missiles raises the stakes once again, and there are so many conflicting agenda’s in Syria, a definitive physical signal would be preferred to unilateral proclamation.
China’s Growth Far from Resolved
China’s February foreign trade was much weaker than expected, with export and import growth at -25.4% yoy and -13.8% yoy, respectively. Perhaps it’s a fluke associated with the timing of the Chinese New Year, but there’s no discernable change in the trajectory of the Yuan Renminbi, which is consolidating extreme weakness versus the Dollar seen in August, December and January. The world craves clarity on China’s new growth profile. Is this a transformative maturation, or have the sins of empty cement cities come home to roost?
Chinese Yuan Consolidating, Not Reversing Weakening Trend
The ECB, the BOJ and Fed have all become more accommodative, with the Fed just yesterday holding rates steady and indicating just two rate hikes in 2016. The consistency of policy movement most likely belies the widespread reduction of fear underlying the oil rally. Nevertheless, Western monetary policy alone will not be able to counter the loss of Chinese growth if indeed that economy has fallen off the rails.
With respect to our roadmap to recovery, we have not seen anything concrete that one could say even remotely resolves the China Growth Question.
Technical Trend Up, Capital Markets Open, But Danger Lurks
Short-term technical momentum has turned positive. Capital markets, especially equity markets for oil producers, have opened. Debt rating agencies now have lower price decks than the term curve, suggesting the incessant rain of downgrades will diminish. Pressure on commercial banks re-evaluating their commodity-backed borrowing bases will not be as extreme as it seemed just a month ago.
Optimistic soothsayers have called “Bottom”, and we have seen a surge in our own energy finance deal flow, both domestic and international. That said, we have no confirmation on three out of our four recovery markers, and one that is questionable at best. Thus, we are skeptical of the rally insofar as the emotional tides of fear are not a variable we are comfortable speculating on.
For sophisticated institutional investors (we are not offering any specific investment advice) that heeded our thoughts on using near-term volatility to fund longer-term volatility purchases in crude, as illustrated in the following chart, that window has closed.
Comparison of Front Month WTI Implied Volatility to 12-Month WTI Implied Volatility
Source: Bloomberg Professional
We are still quite fond of longer-term volatility outright (just not funded by short-term vol). Structurally, we do not subscribe to a scenario of the oil market simply rebalancing. Our experience has led us to believe there’s a basic incompatibility between the intrinsic time lags of real-world global capital development financing and the instantaneous PNL’s of financial asset management. Inevitably, supply and demand get thrown out of whack.
Given the enormous overhang of insolvent debt finance, our thesis that US Shale is going to squeeze out some higher-risk conventional development, and the impact of budget cuts in 2015/6 on 2018-2020 growth and beyond, it’s clear that a balanced future scenario, with resultant lower price volatility, would only happen by sheer accident.
If anything, the probability of surprise has increased.
Central bank policy is having diminishing effects on economic growth, leading to more desperate fiscal and political measures and greater popular dissatisfaction. A polarizing Syrian civil war is exacerbating global religious, ethnic, geopolitical and financial divisions. A dramatic power shift has Chinese leaders embracing anti-corruption efforts as its battle cry; meanwhile they have not been able to formulate a plan to correct historical capital allocation errors, nor stimulate balanced growth for the future. Unfortunately, this narrative has too many parallels to the periods before the world wars of last century. Let’s hope we all have the sense to avoid repeating mistakes of the past.