2016 Recovery Hopes Deferred; Macro-Outlook Grows More Tenuous
From a trough in late January 2016 through a peak in early June, oil prices were in a hopeful uptrend supported by seasonal demand trends and a temporary respite from macro-economic fears that marked the close of 2015. Many analysts spoke of a "rebalancing" of supply and demand that was to spur large inventory draws in the second half of 2016. However, reports from the IEA and OPEC this past week have dispelled the notion of a second-half 2016 recovery, and the new hope is for visible improvement by mid-to-late 2017.
Disciplined adherence to our roadmap to recovery as described in “Oil Prices - Price Discovery Spurs Widespread Declarations of Oilmageddon” (LinkedIn Pulse, 11 Feb 2016), prevented positive price action from coloring our view of the fundamental outlook. The roadmap specifically included four signposts (see summary insert to right), designed to gauge contemporaneous and objective confirmation that recovery was in fact at hand. We revisited the signposts in our monthly commentary, and for every month from March through our last article in July, the signposts had universally failed to confirm market optimism.
Embrace Volatility as the New Normal
Despite significant skepticism in the prevailing analytical dialog, our prescription for both industry and financial participants has not been to aggressively sell-short (position for significant and lasting price declines), but rather, to embrace higher price volatility as the new norm. Indeed, the latter part of July was marked by a spike in realized volatility (departure from mean), expressed as a rapid 15% price decline followed immediately by a 23% rise in early August. The moves were each 12 sessions, or 16 days long, as seen in the following chart:
While industry and fundamental participants may have been whipsawed by the price action (labeled 0 to 1, and 1 to 2 on the chart below), the duration (at 16 days each) and sequential persistence (# of days in a row down/red or up/green) were sufficient to reward almost all technical/algorithmic systems.
Subsequently, the following three moves (down, up and then down again; 2 to 3, 3 to 4, and 4 to 5, respectively) have been both shorter in duration (falling to 13, 6 and 6 # of days), smaller in amplitude (difference from high to low, falling to 12%, 11% and 9%) and less persistent (as measured by sequential red or green bars). This decreasing triangle, often interpreted by technical analysts as a wave (as in Elliott Wave) or flag, is characterized by a decrease in near-term volatility, and suggests a consolidation of pricing. High-frequency traders are typically the only ones nimble enough to exploit the mini-trends, as industry, fundamental and even many trend-following participants tend to view the price action as choppy and trendless.
Importantly, this consolidating pattern is emerging under both more robust trading volumes (owing to increased participation following summer holidays) and greater fundamental newsflow (with a flurry of macroeconomic and industry specific news flow this past week in the form of IEA, OPEC, EIA reports and data on both US and Chinese economic activity). In this context, oil price consolidation does not represent growing consensus, nor a lack of catalysts. Rather, we interpret consolidation as the manifestation of investor paralysis and confusion. It seems the world is now waiting to see how the US Federal Reserve will actually proceed with monetary policy (as opposed to talking about it), and how the global financial markets will react.
Maintain Long-Volatility Positioning
We chose not to publish in August, because frankly, there was no change to our interpretation of either the market, or the best way to position for the future. Our roadmap signposts remain negative, offering no confirmation of a recovery. Technical analysis suggests that a new trend will emerge in the form of a breakout from the consolidating triangle before the end of October. In an absolute sense, we'd rather be short than long as we see a little chance of meaningful inventory drawdowns, and a growing probability of a resurgence of macro-demand related fear. That said, the US Federal Reserve is stuck weighing the radically divergent needs of the domestic economy (relatively strong), the global economy (relatively weak) and the political economy (thunderstorms ahead in the form of the US Presidential election). Thus, uncertainty is likely to grow, and the best position is to embrace longer-term volatility as the most attractive investment opportunity in both real and financial assets.
The Inevitable Train Wreck
Over the medium term, two giant economic factors will collide, and like cross-current waves in the ocean, it remains to be seen if these factors combine to increase, decrease or cancel each other out with respect to the absolute level of oil prices.
On the supply side, the billions of dollars that have been cut from oil capital spending budgets will inevitably result in an inability of supply to keep up with demand growth. The near-term prospect of supply shortfalls will continue to be muted by record OPEC production (spurred largely by intensified Saudi-Iran rivalry), the potential return of offline production from Libya and Nigeria, the startup of Kashagan, and the consistent increase in North American shale new drills and DUC completions. Inevitably, however, under any consistent long-term demand growth scenario, medium term supply will fail to keep up.
On the demand side, 30 years of falling global interest rates and inflation are reaching their mathematical end. More recently, the past decade of near continuous monetization of poor credit decisions and excessive fiscal stimulus has brought the dual realities of negative interest rates and continuous deflation to the forefront. Although August economic data from China is encouraging, given China's overall aggregate debt levels and established track record of poor capital allocation, the continuous failure of Japanese economic stimulus, and the ultimate prospect of Brexit-related European demand dislocation, the US consumer looks like the only viable party capable of breaking the deflationary global outlook. The US Federal Reserve has to finely balance the need to maintain growth in the US, reintroduce the expectation of higher interest rates as a mechanism to break unbridled financial asset inflation, and simultaneously not derail the fragile state of global economic growth. The probability of perfect execution is not high in our estimation. Thus, the risk of a global demand contraction - across everything, not just oil - remains a material possibility.
As these two macro-factors tug in opposite directions, an eventual supply drop that pushes oil pricing higher versus a potential demand meltdown that pushes oil prices lower, we believe the best way to manage the outcomes is by staying long positive-yielding, medium-term volatility strategies.
Details on construction and execution of these strategies for both institutional investors and oil companies are available via consultation. Please contact us here.
Aremet Energy Consulting - Unconventional Insights
We have over 20 year's experience navigating oil and gas prices as well as public and private investment opportunities across the petroleum-based energy sector (Upstream, Midstream, Downstream and Marketing).
Our most unconventional insights include:
"Oil companies have been mislead into pursuing ineffective and overpriced hedging strategies."
"Oil markets do not trend toward equilibrium. Balanced markets only happen by accident, and disequilibrium is the norm."
"The real cost of debt (including bankruptcy risk) for companies exposed to commodity prices is far higher than advertised, leading to poor capital allocation decisions and sub-optimal strategy execution."
About the author
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.
© 2016 Matt Epstein, All rights reserved