The trend in oil prices is clearly up. We maintain that the price recovery to the current $45-$50 per barrel range is less about improving fundamentals and more about improving investor sentiment. Our perspective remains that the exacerbated fall from November 2015 thru January 2016 was a Macro-fear-induced panic about demand, with no suitable fundamental counter argument in the form of coordinated Opec supply cuts, or observable inventory build moderation able to gain traction. With time, the fear subsided, and pricing has been able to overcome even the heretofore impregnable negative outcome of a failed OPEC meeting held in Doha.
Inventories are now peaking with normal seasonality amplified by the fires in Canada and production outages in Nigeria. The outages are of a magnitude that even Goldman Sachs felt compelled to adjust their near-term oil price outlook. While the media characterized this move as a bear throwing in the towel and therefore a bullish endorsement, our interpretation was less constructive, noting that the near-term increase in Goldman's projections was completely offset by a reduction in future price assumptions. In layman's terms from a former publishing analyst, a giant "slide to the right" more indicative of a true up of projections to the reality of the screen than any grand change in outlook.
Nevertheless, the prospect of positive statistical newsflow (post Memorial Day weekly DOE inventory draws) supporting the upward trend in oil price has some traders giddy with enthusiasm. We would simply note that if the market could shrug off as bearish a fundamental datapoint as Doha, then it follows that positive inventory data points would do little to offset a reversal in Macro sentiment.
Returning to the roadmap we published in “Oil Prices - Price Discovery Spurs Widespread Declarations of Oilmageddon” (11 Feb 2016), the upward trend in current oil pricing has not yet been confirmed by a majority of our milestones. Thus, we still prefer non-directional, long volatility investments for liquid traders and cautious, positive yielding (free cash flow supported) underlying assets for private equity, credit and industry buyers. [This is not specific investment advice]. In fact, now is a great time for everyone to revisit their hedging strategy.
The roadmap indicators with commentary follow:
- 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
1. Flattening Forward Curve (Almost!)
There has been flattening of the forward curve, but it has not yet become uneconomic to store oil, which will be the case if we can reach and sustain backwardation. In fact, physical differentials suggest the curve is actually weaker than the screen.
2. Evidence of Inventory Draws (Coming, but not quite yet)
While normal seasonality should create draws in inventories, the seasonal trend has not yet started, as illustrated in this EIA graph:
Given normal demand seasonality, combined with large one-off production outages and the expected declines in production in US onshore and elsewhere resulting from lower drilling activity, visible declines should be evident in the third and fourth quarter of 2016.
3. A major development in the Syrian War (Nothing Good Here)
Unfortunately, the war in Syria continues on. While one can point to a tangible divergence between Russian and Iranian interests lately, and at least a somewhat more accommodating, less visceral Saudi-Russian dialog, the Saudi-Iranian dispute rages unabated.
If anything, direct competition in the oil market has increased (see Reuters article, "Iran cuts crude prices vs Saudis, Iraq in market share fight"). The latest pricing moves by Iran represent "the largest discount to Saudi and Iraqi oil since 2007" (Oil&Gas 360 "Iran Reignites Middle East Price War" 18 May 2016).
The fact that the market has ignored the failure in Doha has robbed the Saudi's of verbal credibility in the oil markets, blunting the efficacy of wielding oil prices as a weapon. That suggests the Saudi's will either have to reassert their dominance by implementing physical production increases, or face prolonged market-share battles with the Iranians while they find alternative, perhaps kinetic, means to achieve their political goals. In the meantime, technical traders beware the seduction of positive momentum - as it has never proven wise to position oneself against the Saudi's.
4. Resolution of the China Growth Question (Still a big unknown)
Chinese monetary stimulus may have again kicked the can down the street, delaying the day of reckoning for widespread misallocation of capital once again. But conventional financial modeling does little to illuminate the outcome of the chaotic interaction between the (positive) accelerated urbanization of a massive population against the (negative) collective emotional fear of the collapse of excessive capital leverage backing uneconomic assets. In the meantime, the dollar remains the most reliable real-time indicator of the trajectory of capital flows.
While mathematical correlations between the dollar and oil prices are inconsistent, reflecting the ebb and flow of Macro influence relative to Fundamentals, Technicals and Mechanical factors, during large dollar moves a clear negative correlation exists.
This negative correlation is perhaps what continues to keep us from getting too enthusiastic about the current upward trend in oil price, and in particular drives the attractiveness of volatility strategies at this point in the cycle. The dollar may spike again should the Federal Reserve move forward with a rate hike this summer. The Brexit vote and potential repercussions await. The negative interest rate policies of several central banks are producing what could only be described as bizarre reactions leading to very unpredictable and unsustainable money flows. The only thing that we are certain of is that the docile, low volatility period post QE2 from 2012-2014 is gone, and the future holds potential for major change.
Thus, flexibility, agility and embedded optionality remain the most attractive attributes of any potential oil-related investment. Financial leverage and directional risk are dangerous and should be controlled to the greatest extent possible.
We look forward to working with institutional investors, oil companies and commodity traders who need to reexamine their approach to mitigating commodity price risk - obviously, given the number of bankruptcies in the oil patch, most approaches were just plain wrong.
Matt Epstein leads Aremet Energy Consulting, an independent advisory boutique based in Greenwich, Connecticut. With over 20 years experience as an energy specialist, Mr. Epstein is regularly engaged by oil companies, investment managers and commodity traders for assistance managing commodity price volatility, and for innovative financial structuring solutions. Follow his regular commentary here.