OPEC Agreement and Inventory Draws - Bullish October for Oil Prices
We did not expect the September 28th preliminary verbal agreement by OPEC to limit production, primarily because we did not think the Saudi’s and Iranians had actually started speaking, much less cooperating, on anything. Thankfully, we expressed our negative fundamental bias using long-volatility positioning, which is not a directional bet, so a sharp rise in pricing actually benefited the position, as did the subsequent fall. We see no reason to change that positioning now, given uncertain policy implications following the US election, and our assessment of no better than equal probability for meaningful OPEC action at the end of November.
Bullish OPEC and EIA Inventory Data in October completely reverse in November
The OPEC proclamation was significant enough for us to tally a confirmation on point #3 “cooperation at OPEC” of our “Roadmap To Recovery” (11 Feb 2016). The large subsequent draws in US inventories (as reported by the EIA) during October almost inspired us to check off another bullish box (i.e. #2 Evidence of inventory draws), but our tracking of shipping volumes, OPEC production, and global inventories did not support the move. For convenience, the roadmap is summarized below:
Flattening curve - which is a prerequisite for the removal of economic incentive to store oil
Evidence of inventory draws - combined petroleum inventory reductions need to exceed seasonality to confirm a true change in supply-demand balance
A major development in the Syrian War that enables Saudi and Iran to put aside differences to permit cooperation at OPEC
Resolution of the China Growth question, most likely expressed in a stabilization of the Renminbi market
Enthusiasm - Divergence From Reality
Although potentially two of our confirmatory indicators flashed positive by mid-October, the persistence and deepening of the forward contango, together with a resumption of the decline in the Yuan vs the US Dollar prevented us from switching our stance. Those indicators remain firmly negative today.
Weakness in global physical pricing differentials, together with the growing contango of the forward term structure of both WTI and Brent crude futures and swaps, indicates that the supply-demand balance has indeed been diverging from popular market dialog of rebalancing. In fact, things have not been improving, but deteriorating.
Timespread Contango Deepens
Entire Forward Curve Steepens
Further evidence of growing volumes of crude-in-transit (thank you Clipper Data, Genscape and Bloomberg Professional) together with a surge in OPEC production (blue chart below by John Kemp of Reuters - @JKempEnergy on twitter) were also divergent indicators. From a trading perspective, it was only a question of when those volumes would show up in the EIA weekly estimates.
Surging OPEC production
In addition, the breakdown of the Yuan (weak versus the US Dollar), together with falling Chinese FX reserves, continues to signal material capital flight from China, a clear indicator that growth is not where it is supposed to be.
Yuan Weak / Dollar Strong
Chinese FX Reserves Falling
Thus, as we progress through November, there is a real possibility that we have to uncheck the two positive developments we tallied in October. The EIA inventories have reversed course and snapped back where they were prior to the various disruptions and temporary drop in imports. OPEC’s verbal pronouncement is now being put to the test of actual action, and the actors have all been producing and shipping as much oil and refined product as possible.
A Silver Lining?
There may be a silver lining. The recent US presidential election has several analysts anticipating a more aggressive fiscal stance from the new administration. Rising government spending with an expected Fed Funds interest rate increase in December has precipitated a major bond sell off. In a Macro context, rising interest rates, a surging dollar and speculative flows in industrial commodities such as Iron Ore and Aluminum, may actually be constructive to the global narrative.
Surging Industrial Metals Pricing
If in fact the US is able to lift inflation and growth expectations on a global basis, the cycle of deflation and falling interest rates may have a chance of being broken. Ultimately, this would be a great long-term bullish indicator for oil prices, as it would delay or put to rest fears about the impact of deflation on global demand and consumption.
Unfortunately, it is far too early to embrace the potential long-term benefit of breaking the deflation cycle. It would take more than a year's worth of global economic data to truly prove that thesis as valid. In the immediate future, uncertainty reigns - supporting long volatility positioning as the best investment strategy available.
The forthcoming OPEC meeting is quite uncertain. On the one hand, for credibility reasons, Saudi has to make something happen. On the other, recent acrimony has driven the Kingdom to withdraw support in the form of direct oil supply to Egypt, usually a key Sunni ally in its struggle with the Persian Shiite powers and their Russian allies. To us, this unusual move signals that something ugly and turbulent is stirring just under the surface, out of the focus of popular media. The only conclusion we are able to draw is that it would be prudent to avoid getting caught flat-footed going into the OPEC meeting and beyond.
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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.
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