Macro | Oil Rally - Not A Dead Cat Bounce

The recent rally in oil, which started with general risk asset rally in early February this year has been a solid one. This blog discussed about the bottoming out in oil and a potential come back in the past. It played out quite well (although it apparently surprised a few). Along with equities, it has initially benefited from the softening of Fed hike expectation. And then went on braving an increased Fed hawkishness. I discussed the policy expectation re-pricing, and also noted the potential decoupling in correlation. Nonetheless, the strength of the oil rally in the face of more than doubling of a June hike probability is remarkable. 

In some measure it has been a bit different than the earlier dead-cat-bounce rally we have seen last year around this time. Here is a chart tracking who made what from the oil price gyration for last couple of years in the (zero-sum) futures market (from CFTC reports).

As you see, apart from producers (who are supposed to be hedgers), the biggest gain in the oil sell-off in 2015 was captured by the swap dealers (large trading houses like BP and Shell and a few Financial Institutions still left in the business of commodities). Most of the pain went to presumably the CTA community and non-reportables (individual investors and smaller hedge funds). You would expect that - as most large trading houses have considerable advantages of information and physical stocks (even over large banks, many trading houses are trading arms of large producers), they are the people who should be in the know.

During the false rally last summer, those big players were still short and did not mind taking losses (which of course paid off in the second leg of the sell-off). This time around while most of the money seem to have gone to the CTA/ non-reportable communities, the big players are flat.

In this light, the recent interesting piece in WSJ is true on facts but perhaps paints a wrong picture of a rally fueled by dumb money. It is an expected bounce of an overly sold market, where smart money just stayed out, not actively betting against. This will last beyond the driving season with all probabilities.

I would not expect another leg of sell-off, nor a continued upward movement from here. While this rally cheered the economy-is-all-good signal from Fed, it is hard to keep it going. The still significant inventory, a possibly weakening OPEC, and the cost and operation structures of shale producers make it a long shot to take us back to 100 or even 70 oil. Over the past years, as the oil price tumbled, so did the breakeven for Shale. 

I think the real implications from this cycle in oil price are mostly two - firstly the conventional high-cost producers got a raw deal. The thing is, unlike shale, for traditional high-cost producers, it is easy to turn off the tap, but not so much to turn it on back again. That involves time and cost. The distribution of the gain and ruins from this price gyration will be uneven and shale producers may not be the most damaged lot when the dust settles.

Secondly, while few producers reduced output significantly, the most obvious victim of the sell-off and associated cost reduction was exploration. And this meager rally so far has done little to change that significantly. Most producers and service companies are now shifting from a strategy of hope to a strategy of low for long. But this also means an increased sensitivity of prices to the inventory levels (as future inventories are compromised). Unless we have settled down in to another recession by then, I expect another leg of this rally in medium term, in 2017 or 2018. When we feel the pinch.

Macro: From Peak Oil to Trough Oil?

How low we can go from here

Well here are two completely opposite perspective - to $20 (surplus argument) or to above $100 (geopolitical argument). The first one is standard, the second is kinda fat-tail argument (it can happen, but it is less like a probability and more like an uncertainty. Difficult to trade on). Then of course you have the click-bait articles like this and a long term official version of $80. Opinions apart, let's try to get a perspective from the available data. Here is a chart that juxtaposes the current built up inventory vs the marginal supply curve against price.

The inventory is indeed large (left chart). OECD inventory is 60+ days of consumption against IEA recommendation of 30 days stockpile. OECD estimates are mostly reasonable (but sometimes you doubt them). On top there is a much larger than usual oil "At Sea". The rest are running not a particularly high inventory (but at the same time those numbers are very wild estimates).

Chart 2 is my approximate total marginal production curve, see below sources. It basically says at a given price of oil, how much of world oil production achieves breakeven. It shows a very large supply drop around USD 20, and ramp up above USD 50 (red line is 2014 demand at approximately 92.5 mbpd). Of course this can change temporarily based on producer's reaction. But a physicist would say from the curve itself, that oil is at a stable equilibrium and going nowhere. All trades technical here, nothing macro yet. But build longs below USD 30. The supply drop is too sharp to wait for (or ever reach) USD 20.

Also the there is a fundamental difference between shale production and the low cost OPEC production (apart from the cost of production of course!). In case of shale, the variable cost is relatively much larger. Unlike conventional oil field, the cost of exploration and operation set up is relatively much lower. This makes shale production kind of "on the tap". This, and the fact the production curve looks like the way it is, and the built-up of inventory together make the case for a macro-driven sustainable price rise from here any time soon quite unlikely.

Note the last chart is based on production cost, and excludes building in exploration cost, so probably the range is on the higher side. Balancing this impact on oil price, is the ever-increasing cost effectiveness of alternative energy sources. Now add to this your own opinion about global demand for the medium term, and draw your own equilibrium oil price.

Happy new year.

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Source: see here, here, here and here, for example

Five things I do not believe in...

But have no evidence to the contrary. Yet.

1. That the dealers are running zero corporate bond inventories
2. That China shorts is going to make money for investors (UPDATE: At least not in macro shorts. Possibly in selective equity shorts. There seems to be a fissure within the old and the new economy in China)
3. That the next crisis (whenever that happens) will mean a dollar rally (against euro) (UPDATE: See this, although I think it misses the point. It is about in what currencies global assets and liabilities are funded)
4. That migration crisis is just another one for Europe
5. That we have reached the peak Geo-political crisis (think about power balance in post-oil scarcity world)

2015: Points to Ponder

As you gear up for the year end, here a list of things and points for the next year. To mull over, without any iota of attempts to forecast!

1. Oil: from peak-oil to freak oil. And how the story unfold will be driving a lot in 2015. IMF Direct (the blog from IMF) had a very interesting piece on this recently. They estimate unexpected lower demand can account for only 20% to 35% of the price drop. And they find little evidence of financialization. In this context what is surprising is the speed of adjustment. For 2015 most analysts maintain gloomy forecasts for oil. Perhaps rightly so. But a lot of that comes from forecast of continued lower demand from China and Europe. Given the lower contribution of demand in the price change (as above), and the still volatile geopolitics of a large part on the supply side, the question remains what if there is a strong come back of oil price in 2015? It will mostly reverse what we have seen in 2014. The hysteresis loss will be for new investments in oil sector with renewed long term risk assessment; and in Europe, especially if the ECB had not gone through with the QE by then.

2. Russia: very much related to above. Will they get out of it? yes if the oil price bounces back. What if it does not. That is the hard part to speculate. On the face of it Russia does not look particularly bad on economic parameters. Yes, the inflation is running a bit high, and the GDP has slowed down. But they have been there before. The missing links are current account weakness, ruble appreciation reversal, and the possibility of capital flight. Krugman explains the first two of them here. The last part is the hardest to explain and quantify. See here, for example. And in my opinion this is the most crucial make-or-break factor. Russia will survive in the short run if the oligarchs have a lot to lose otherwise, and if Putin survives.

3. Wage growth: That will shape the Fed policy to a large extent. We have already seen some encouraging trends. 2014 has been a great year for job growth in the US. 2015 might as well be a good (perhaps not great) year for wage growth. If that is supported by lower oil price, it is good. If that coincides with a sudden rise in oil price, that can spook the market and push up break-evens and rates.

4. Housing: One of the weakest part of the so far good enough recovery of the US, is the contribution of housing to the investment component and hence the economy. The flow of funds from the Fed has consistently shown continued deleveraging in mortgages while consumer credit picked up. The higher mortgage rates and increasing prices did not help it either. Historically the contribution of housing to GDP is near record low. And that to me seems like a lot of upside in 2015.

5. Europe: If we have a Grexit start of the year (or even a panic towards that), that will greatly ease Draghi's case for an all-out QE. European equities missed out a lot compared to elsewhere, and can benefit from both improved earnings and re-rating. As I mentioned before, I think people are unusually bearish on Europe now (just like they were unusually bullish a while back). If you think the US equities are done with most of the run, and Abenomics not really working for Japan, and missed out the Chinese rally and now scared of the EM, you do not have much choice. On the rates side, a lot of the curve flattening has been driven by global influence and a re-pricing of the long end. I do not think the rates market is nowhere near as confident of a QE as most analysts are. The European swap markets now looks hardly any different from Japan. And with much much better upside.

6. Abenomics: And speaking of Japan, which I frankly do not understand much, all I say I do not see Abenomics working. The problem with that is if Abenomics does not work, the challenge for the subsequent governments will be progressively humongous. What are the odds that we will stop to see the yen rallying in a global panic? And what are the odds we will actually see yen selling off in a panic? I will keep rolling my yen shorts. In good times or bad.

7. China: Perhaps most discussed. One good thing about China for traders and investors is that China, with its mighty central bank and strong command control hardly produces any large surprise for the markets. (Of course the antithesis is that when the surprise does come it will be huge and bad, but somehow I do not buy in to that yet). With the rally belying the economy, the central bank and policies will be in the driving seat.

8. The bull run in India: I am a believer. Well for one, the benefits of the large oil re-pricing on India is still totally lost in the panic about EM. In fact India has been a net importer of non-agri commodities. So recent secular weakness is a huge bonanza if they sustain. In terms of valuation it may not be cheap, but much scope remains for earning improvements. 

9. Return of volatility: A sustained period of low vol can be policy driven (when the central bankers become sellers of vols), or it can be just a phase of a complex system. Because low vols just happen some times. FX has already seen some uptick in vols. And yes, commodities of course. May be time for the rest.

10. What else: move away from rotation to diversification? a policy-driven liquidity crisis? year of the frontier markets? crisis in Europe? middle-east mayhem? HY melt-down? comeback from the UK? Wide open. As always.

Best wishes and a happy new year

Freak Oil - Long Term Perspective

A long term look at crude oil price. And some fresh perspective.

Note the high correlation between bonds and oil price (correlation approx 90% on monthly differences)

And in spite the recent crash, oil still trades near all time high in terms of beer!!

The Most Important Thing Now

Today's BoJ move sets up the tone for the rest of the year (discounting ECB, at max we can get a hint at balance sheet target). Overall, starts a new leg in carry trade and long end out-performance and general out-performance of risky assets. I would say, including European peripheries. Even if you point out risky assets are already very risky, there is not much trigger left for the rest of the year.

Now, the most important question remains. That is the price of crude.

This is not only about headline inflation, it plays an important role by pass-through effect on the core as well, plus help shape the future expectation. 

Till at least the first quarter of 2015, the best rates traders will be the best oil traders!

But there are many unanswered questions - why WTI is in backwardation, while Brent strongly contago. And how much of this represents supply and demand, and how much is carry trade. How the currently cartel will react. And what really is the break-even for US shale. Oversupply, or lack of demand, or just god damn positioning.

Points to ponder!

[EDIT 05-Nov-2014]: Ok, WTI slipped back to contago now. So one less puzzle that is.