Back to a Macro-Driven Market
We have been advocating strategies that thrive during increased volatility all year long precisely because oil-price discovery has recently been more vulnerable to influence from macro-economic factors than specific, industry-fundamental micro, mechanical, or technical factors.
This is not always the case, and following the multi-year period of very low-volatility, very micro-fundamental, basin-by-basin, news-flow-driven markets post global financial crisis, this Macro market is most certainly confusing and disorienting for many of our clients.
Rather than repeat ourselves at length, we do suggest a quick read of our earlier work, specifically these articles, for a comprehensive review of our methodology, viewpoint and positioning recommendations. Last month's article is particularly timely:
Brexit is very serious, and should not be underestimated
We have seen some analysis attempt to quantify the impact of Brexit on oil demand by comparing UK oil demand to global demand. At approximately 1.5 million barrels per day of UK demand out of 94 million barrels per day of total global demand, or 1.6% of the overall market, even a monstrous 20% drop in UK demand (about 300,000 bpd) would probably not tip the apple cart. Furthermore, when one considers a minimal two-year implementation tail for actual separation, it's tempting to dismiss Brexit as potentially insignificant. But, that is not the right way to approach this rubik's cube.
Remember the Thai Baht?
We remember very clearly in the leadup of the Long Term Capital / Asian Contagion downturn of 1998 that the same type of direct, demand-impact math was being used to suggest that the collapse of the Thai Baht would not impact oil prices. The analysts at that time were technically right, the Baht was not directly responsible for meaningful drop in physical demand for oil. Nevertheless, a sequence of events followed, economic damage compounded, and ultimately, oil prices subsequently cratered.
In the same way, the impact of Brexit on oil prices is not just about the direct, economic impact of potentially reduced physical oil demand from the UK, or even the EU. Brexit is a visible manifestation of fear and uncertainty, for what else could motivate a population to vote so clearly against its own self-interest? Call it a fallen domino, or the death of the canary in the mine; Brexit is more than a one-off political referendum.
Brexit is a visible manifestation of fear and uncertainty, for what else could motivate a population to vote so clearly against its own self-interest?
Fear and uncertainty increase the value of tail-risk insurance
We expect continuing alarm in the media following the surprise Brexit vote to be amplified by the US presidential election cycle. Headlines proclaiming the end of globalization, the genesis of a global depression, and a widespread political rejection of the status quo will likely spew forth over the coming weeks and months. It's possible a hedge fund or bank will implode, most likely scapegoated to unauthorized trading, when in fact it was more likely the inability of most VAR models to capture the explosion in currency market volatility following the vote.
Furthermore, years of aggressive post global financial crisis monetary policy, resulting in low (and in the case of Germany, Japan and Switzerland, negative) interest rates, have eliminated the future flexibility of relatively sober central bankers to offset any damage created by their more politically exposed fiscal counterparts.
Although we remain skeptical about the absolute probability of any of these specific scenario's achieving fruition, it is clear that the probability of extremely negative outcomes is not zero, and that it has risen as a result of Brexit. Thus, the value of out-of-the money options (tail-risk insurance), should respond positively.
Oil Price - The Trend is No Longer Up
Technical models were already being challenged prior to Brexit, and today's price action should result in many registering broken momentum. The prevailing trend in oil prices is no longer up.
Inventories are still very high
The large inventories that magnified fear earlier this year have not been meaningfully worked down, despite promising demand and production data. Inventories this high will not offer any comfort to fundamental investors seeking to resist the deteriorating Macro environment. The Macro-Beast awakens; fundamental, technicals, and mechanical arguments for higher prices will be swept away.
Forward Curve Contango Persists - No Incentive to Reduce Inventories
The forward curves in both WTI and Brent remain stuck in contango, whereby the front is cheaper than the back. This market structure does not confirm the improving fundamental sentiment reflected in both the financial futures flat price rise, and in the equity market strength of oil and gas producers and service companies. While the absolute forward price has no better predictive value than the current price, term structure does determine the real-world economics of physical storage. A market in contango has no incentive to draw down inventories. That suggests that improvement in fundamental sentiment was more sentiment than fundamental. Moreover, in the second chart following, it is clear that physical market spreads confirm the financial market contango, and that demand, while strong, is not sufficient to deplete the bloated inventory overhang.
Physical Market for Brent Confirms Financial Market Contango
Rig Counts have Stopped Falling
The rebound in Brent and WTI benchmarks above $50 may also have prematurely encouraged some producers to selectively start drilling again. While we have not seen a meaningful change in pressure pumping prices or utilization to signal a true increase in activity, certainly one can surmise that a rising rig count at least signifies that spending is no longer falling. Exclusive of any impact from Brexit, that is yet one more reason to be skeptical of recent consensus calls for a continuing recovery.
Brexit - that's why we "hedge"
We recommend that oil companies, oil field service companies, resource management companies and private-equity-backed entities call us immediately to discuss hedging strategy.
Hedging is not about selling forward contracts to lock in cash flow. In fact, hedging is a term so bastardized, we should really avoid it if possible, and frame the discussion around commodity-price-risk management strategies. Semantics aside, the goal of a well thought out program should be to create competitive advantage, and to preserve optionality. If that's not what your explicit goal is, then your hedging strategy is not very robust.
Likewise, more liquid investors should tread lightly on directional bets, irrespective of the price action today. It's far more reliable to construct a portfolio of positive yielding instruments that more than cover the cost of long-OTM-volatility optionality. We can help hedge funds, distressed debt investors, and institutional investors navigate this market.
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.