The Oil Market's Far-Reaching Implications

By Stephen Innes

Oil Markets

OPEC meeting in Abu Dhabi

WTI futures are up over 1.2% and Brent + 1% this morning. Saudi Arabia has stepped in front of the oil market bears, proactively announcing they will reduce supply by .5 million barrels per day in December. Khalid al-Falih told reporters that "Saudi Aramco's (ARMCO) customer crude oil nominations would fall by 500,000 bpd in December versus November due to seasonally lower demand", but "There is no consensus yet among oil producers about cutting production". This announcement comes on the back of the joint statement Friday that that Saudi Arabia and Iraq will work together to stabilise prices.

Oil markets are the hottest topic on the Street, as the recent slide in prices are having far-reaching implications across all asset classes.

Over the weekend, the Joint Ministerial Monitoring Committee (JMMC) of the OPEC+ met in Abu Dhabi as growing frictions amongst members intensified with Iran calling for an end to the JMMC and its offshoot, the Joint Technical Committee (JTC). And there are even rumours that King Abdullah Petroleum Studies and Research Center (a Saudi think tank) is role-playing scenarios if Saudi Arabia exited the producers group.

And while supply cuts topped the agenda, the JMMC does not set policy but will establish the groundwork for the full members OPEC meeting in early December.

Oil prices above $80 are never welcome by OPEC customers, and that seems to be a similar consensus among OPEC+ and US producers. However, producers are concerned that the latest selling frenzy could see Brent oil reach $60 or below. So, it's in OPEC's best interest to tame the current supply glut, primarily since they intended to bring in the production cut in December. But with the prompt markets overflowing with light and sweet grades, something must give, and OPEC solution seems the most viable outcome. Where oil prices are headed next will depend on the producers, but with Russia not fully supporting a production cut, things could get a little testy approaching the December meeting.

However, producers may get some breathing space from falling prices over the next few weeks, as demand from refineries will pick up after returning from their annually scheduled maintenance period. Anticipated demand could rise by as much as 1.5 million barrels per day by year end.

OPEC Shale Shocker

Baker Hughes reported US energy firms added oil rigs despite oil futures plummeting and US inventories skyrocketing. Drillers added 12 oil rigs in the week to November 9, bringing the total count to 886, the highest level since March 2015. A bit odd when this metric is an indicator of future supply, which tells me the industry has few - if any - worries about demand for oil breaking down anytime soon. But one thing that is abundantly clear, OPEC is in for a shale shocker, as US crude production increased to a record 11.6 million barrels per day and will cross the 12 million threshold next year.

But at $70 Brent, are we really in a Bear market? Yes and no.

Technically speaking, we are in a bear market as defined as a 20% decline from a market peak.

Indeed, a record 10-day losing streak has everyone panicking, while causing a high-speed reassessment of the state of global oil supplies. Taking into account that OPEC has revised down its short-term global demand outlook for three months in a row, the forecast does look bleak

In reality, this is a supply glut, but it's unlikely Asia's unquenchable demand for oil is about to dry up anytime, soon so prices could base. Plus, as we've seen in the past, OPEC and allies have been able to stabilise prices during supply surplus, which will undoubtedly happen this time around, leaving traders to speculate on the timing for production cuts to occur.

Nonetheless, the consumer will get an early Christmas gift at the pumps, as supply glut is expected to extend into year end.

Oil falls 1 Percent, U.S. crude on longest losing streak since 1984 - Reuters. "What a difference a month makes," said Michael Tran, commodity strategist at RBC Capital Markets.

Were Iran sanctions expected to be a game changer?

For a short term, they were going to be, until market supply caught up. I recall having this exact conversation a few months ago with a local Energy Editor, where we both humorously concluded there would be a massive run-up in prices until a few weeks before Iran sanctions take hold, only for the reality check to set in when the market realises Saudi Arabia converted the shortfall into a surplus.

Trump waivers affect

Well, a funny thing happened - Saudi Arabia and Russia increased production starting way back in June, while the US's unofficial oil minister, Donald Trump, may have orchestrated probably one of the best sleight-of-hand tricks in some time. He effectively drove prices lower by offering up far more Iran sanction waivers than expected, catching the producers and traders alike completely wrong-footed, while effectively correcting oil prices back to the perceived Brent $65-75 sweet spot. Remember, these taps can be turned off as quickly as they were turned on.

Never one to miss out on a press op, Trump said during a press conference on Wednesday, "We're going to let some of the oil go out to these countries that do need it because I don't want to drive the oil prices up to $100 or $150 a barrel, which could happen very easily." Trump argued that prices have "come down very substantially" recently "because of me." (Source: CNN) He does have a point, though.

Fact Box: The Knowns and unknowns of US Iran oil sanction waivers: Reuters

G-10 Currency Markets

FOMC is messaging the same signals - gradual increases coming, certainly no dovishness. This leaves the USD firm and EUR back towards the critical 1.1300 level. Trading the dollar has been a bit of an oddity of sorts in the past few weeks, completely ignoring the strong US economic data, while focusing on a highly improbable Fed pause. But with the US economy firing on all cylinders, while there are growing concerns that global growth has peaked, this points to a favourable dollar outcome heading into year end.

Euro

The USD has traded very well last week, but I don't think this has so much to do with the FOMC as it is about the euro's ugly duckling persona around Italy risk. After all, there was hardly a change in the FOMC, and a December hike was always the market's base-case scenario. With that in mind, the move to 1.1300 was a bit quicker than expected, and while there some definite carry appeal into the USD by G-10 standards, the movement does feel a bit overdone.

Japanese Yen

The dollar was rallying everywhere yesterday but not so much in USDJPY, suggesting that market positions are a tad long and the equity markets' risk overhang is now weighing on traders' sentiment. The dips remain shallow, however, suggesting that a convincing push above 114.50 is still in the tea leaves, but a possible escalation in risk aversion around US-China trade war is keeping new buyers cautious.

Australian Dollar

Not unexpectedly, the Aussie dollar came under fire from a lacklustre policy statement (SOMP), but with the stronger USD and China factory inflation wobble, G-10 traders were noticeably increasing their short Aussie China proxy bets on Friday. So, the Australian dollar appears headed for a near-term test of the critical .7200 level. It's been a tough grind shorting the AUD lately, but China risk looks poor and RBA a tad delusional, which is usually a right combination for an AUDUSD sell-off. But given the steady outperforming data in New Zealand, selling AUDNZD does look equally attractive.

China's far-reaching influence

Flagging growth in China revived global growth concerns, naturally, pressuring EM Asia and triggering a global equity market sell-off. But the diverging comprehensive global growth narrative should continue to favour broader USD gains. Specifically, it was Friday's China factory gate inflation wobble that is weighing on global equities and commodities alike. With manufacturing activity in China expected to recede further, it should dampen price pressure on commodity markets and will continue to weigh on global growth prospects.

But adding more fuel to the equity sell-off was President Trump's trade adviser Peter Navarro criticised Wall Street executives and accused Chinese President Xi Jinping - without mentioning him by name - of failing to live up to highly publicised trade deals. (Source: WSJ)

Indeed, the fear of escalating trade war is coming back to haunt investors yet again.

As I've been harping to anyone that was buying into the post-midterms equity markets rally, curb your enthusiasm, as we're by no means out of the woods on the US-China trade story. Don't expect a resolution to pop out of thin air given the great trade divide. And with neither party willing to blink, we could be dealing with trade woes throughout 2019 and into 2020.

In recent months, the Chinese authorities have responded to signs of slower growth in parts of the economy and a more challenging outlook by easing financial conditions in some ways. However, the effect of the current round of policy easing has been relatively small, as I suspect overt easing could cause unwanted sell-off in the yuan. As well, easing policies have been very targeted given that China remains committed to deleveraging - well, at least during this current cycle to avoid re-leveraging (borrowing this from the RBA). So, by all accounts, for the Aussie bulls counting on more stimulus efforts from the PBoC monetary policies, they may be much less bullish for Australia than past efforts.

Australia Markets

ASX

Benign US political gridlock, in my view, indicates no softening in US trade war stance, in fact, I think an emboldened President Trump with the backing of House Democrats, who are just as hawkish on that front, should continue to play out negatively for regional and local Australian markets. And if we factor in the expected slow burn on China economic data as the drag from US tariffs takes hold, even more so after China's front-loading capacity diminishes, we should see continued pressure on commodity prices and more sustained pressure on commodity constituents on the ASX.

Asia Markets

The stronger USD effectively tightens financial conditions in Asia, suggesting that the longer the dollar remain in favour, the higher the likelihood for growth slowing next year. With US yields on the rise again, bearish sentiment is permeating local bond and equity markets.

Asia Currencies

While the massive drop in oil prices will take some pressure off oil-importing deficit countries like IDR and INR, any hope for a reconciliation of US-China trade tensions is far too premature.

Indonesian Rupiah

The USDIDR caught a significant downdraft last week as oil prices collapsed. While the outlook for oil remains bearish, OPEC discussion will need to be monitored.

Chinese Yuan

With China's current account surplus evaporating, US-China monetary policy divergence and China terms of trade expected to weaken, USDCNH higher should be the path of least resistance.

Malaysian Ringgit

The Malaysian ringgit is expected to struggle on some fronts. Traders are increasingly pricing in greater BNM versus Fed policy divergence, which makes Friday's Q3 GDP print so incredibly crucial for the ringgit - even more so with the BNM striking a dovish chord. On the optimistic side of the equation, we could get a reprieve, as the GST should have boosted consumption. Tax relief has some forecasters looking at Q3 GDP to rebound from 4.5 % in Q2 to 5.1%. However, I think this would only be mildly positive for the ringgit, but a miss below 5% would persuade a quicker move to the critical USDMYR 4.20 level.

US markets

The USD will have a plethora of items to anchor itself to this week, and given the strong economic performance in this year's data, we should expect another good week for the dollar.

With the Fed's November meeting in the rear-view mirror, it's time for the markets to come back to reality. We know with a high degree of certainty the Feds will raise interest rates in December for the fourth time in 2018, but that doesn't mean it's time to bring out the snooze pillow. Specifically, Fed Chair Powell's Wednesday discussion with Dallas Fed President Kaplan (non-voter/neutral bias) will be significant, as the discussion will likely fill in some blanks from what amounted to a scanty FOMC statement. But those looking for anything other than Powell to expound that the Fed policy is a "gradual" path of policy normalisation, yes higher US interest rates on a data-dependent basis, need to wake up and smell the coffee. For Fed Chair Jay Powell, I suspect "Red October" is still a movie and not a big enough concern that should cause the Fed to stop raising interest rates. After all, isn't part of "raising interest rates a prudent move when market valuations become a source of concern" (Janet Yellen; Source: CNBC)

But funnies aside, apparently the FOMC is little concerned with tightening in financial conditions triggered by a stronger USD and lower equity markets. It's not a case of ignoring weakness in equities during October or the rapid tightening of financial conditions; these conditions have not shown up in US data as an economic drag. But more important for market participants, Chair Jay Powell has made it abundantly clear that the Fed will be entirely data-dependent despite some concerns that the desire to normalise interest rates blinds the Fed.

Wednesday's US CPI release will be the week's main event. The market is expecting a strong inflation print after going through a recent soft patch in consumer prices (+0.4% forecast vs. +0.1% previously) and core (+0.3% vs. 0.1%). While a downside miss won't necessarily keep the Fed from hiking in December, a softer inflation profile will keep market expectations very low with regard to returning US rates to Neutral (3%) and could quash all those discussions about the Fed meandering into restrictive territory.

Thursday's retail sales data will also share some of that spotlight, but given robust consumer confidence and a healthy jobs market, one can only assume the US consumers will have their purse strings loosened. But this print could provide substantial guidance as to what to expect for the rest of Q4 as we head into the spendthrift holiday season.

For equity markets, keep in mind November 15 will be the last day for hedge fund investors to notify managers to exit their positions before the end of the year (45-day withdrawal turnaround). My best guess is with a considerable tail risk from the Trump-Xi November G-20 meeting along with tight funding conditions entering year end, which will likely see more pressure on equity markets, we could see more downward persuasion on US equities this week strictly from a year-end profit-taking perspective. Of course, fund managers who have extremely bullish views heading into the year end might warehouse positions expecting to sell them back to clients at higher valuations next year. However, "If history is any guide, the rush for the exits will be swift and accelerate. Clients have already pulled $11.1 billion even before funds fell into the red for the year." (Source: Bloomberg)

On US interest rates front, still firmly planted in the bear camp and expect UST 10-year yields to test 3.50%. Even with congressional gridlock, interest continues to point higher given the strong chance of bipartisan agreement on infrastructure investment - this despite the congressional divide reducing the likelihood for additional fiscal stimulus. While there's an outside chance we could see other economic stimulus policy adjustments, the odds remain well below the Mendoza line. But let's not make a meal of it - the prospect for additional tax cuts, given the massive US budget deficit, was creating huge divisions among the Republican party, and these policies were no shoe-in. So, it's very unclear if Washington gridlock marks a significant shift on that front for 2019.

As for the funding crunch theory, in currency markets, the US$ year-end turn funding pressures has been a factor for the past few weeks, which has been pressing long-dated 2-month tenors into expensive territory (cash funding and FX swaps into early January).

Gold Markets

All that glitters isn't gold. With the Fed on track for a December rate hike and the dollar looking likely to hold a bid into year-end, the odds for gold to test $1150 over the next few months seem more likely than a test of $1250. There is little to no safe haven appeal, and the US leading indicators remain robust, suggesting the US services-based economy is firing on all cylinders and that the Fed will stay on track.

The University of Michigan Survey and PPI came in above expectations, signalling that consumer confidence remains strong. All that chatter about a Fed pause in 2019 is far too untimely, suggesting that considering the economic growth slowdown around the globe, the USD should remain in good standing from a growth differential perspective, which could tarnish gold's appeal heading into year end. Indeed, higher US interest rates and a stronger USD are flashing red for gold investors.

An opinion piece on Oil

The fear of missing out (FOMO) is a widespread disease that afflicts even the cagiest of traders. The perfect example was the latest ramp on oil prices and the subsequent collapse since early October (-21%). FOMO was getting driven by a theoretical supply crunch from Venezuela and Iran as the US imposed sanctions came. But this all occurred on the backdrop of a rising US dollar and moderating global growth (PMIs).

Historically, the USD and comprehensive PMI index have a very tight correlation with oil prices, and at the peak of the oil ramp, the correlation metric suggested oil prices were 30%+ overvalued (as per Deutsche Bank data). So, as more significant than expected US Iranian waivers came into play, which in my view was little more than US intervention in oil markets to reduce price pressure heading into the midterm election, all while OPEC, Russia and US had been raising production, the market was caught completely wrong-footed. Now, as the market shifts to the slowing global narrative, it could be argued using that same USD/PMI index correlation to oil metric, that the market is still 10% overvalued (Deutsche Bank).

So, what does this mean? It means OPEC will look to cap production and ensure that Brent remains in the happy $65-75 price range. Funny how we closed the week right on top $70 on the prompt Brent contract.