Author: Rebekah Stovall

Weekly Energy Update (November 5, 2020)

Posted on by Rebekah Stovall

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Here is an updated crude oil price chart.  After dipping below the $37.00/$42.00 range, prices have returned to that band.  A key reason is that OPEC+ is considering additional production restrictions.

(Source: Barchart.com)

Commercial crude oil inventories fell 8.0 mb when a 2.0 mb build was expected.  The SPR declined 0.2 mb; since peaking at 656.1 mb in July, the SPR has drawn 16.7 mb.  Given levels in April, we expect that another 5.7 mb will be withdrawn as this oil was placed in the SPR for temporary storage.  Taking the SPR into account, storage fell 8.2 mb.  The data was affected by tropical activity again this week as Hurricane Zeta disrupted oil flows.

In the details, U.S. crude oil production fell 0.6 mbpd to 10.5 mbpd.  Exports fell 1.2 mbpd, while imports declined 0.6 mbpd.  Refining activity rose 0.7%.  Tropical activity continues, with Tropical Storm Eta expected to pass over Cuba this weekend.  Although we expect the oil regions of the GoM to be unaffected, it will likely disrupt shipping, thus affecting next week’s import and export data.  We do expect tropical activity to wind down as we approach Thanksgiving.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data showed a large decline in crude oil stockpiles, which is contraseasonal.  Inventories are approaching their second seasonal peak.  Thus, after next week, we would expect a steady slide in oil inventories.

Based on our oil inventory/price model, fair value is $45.43; using the euro/price model, fair value is $62.50.  The combined model, a broader analysis of the oil price, generates a fair value of $53.20.  The wide divergence continues between the EUR and oil inventory models.  However, current oil prices are below all three measures of fair value, suggesting that oil prices are likely undervalued.

Gasoline inventories are approaching their autumn seasonal trough.  Next week, the low is usually made and then stockpiles rise steadily into Valentine’s Day.  This rise can be a bearish factor for crude oil prices as it has the potential to reduce refining margins.

(Sources: DOE, CIM)

As the energy world continues to think about reducing carbon output, the “once and future fuel,” hydrogen, is again making headlines.  We first looked at hydrogen back in the 1990s when interest in fuel cells rose.  There are some really attractive elements to hydrogen as a fuel.  Fuel cells are nearly pollution-free.  Hydrogen is a really light fuel and very efficient.  But, creating hydrogen is an issue.  There are generally two sources of hydrogen—water or a hydrocarbon (natural gas or coal).  Separating the oxygen from the hydrogen from water takes a lot of energy, so if the energy is not “green,” the environmental improvement is much less.  We would expect more interest on fuel cells and hydrogen in the coming years as countries try to figure out how to achieve a reduction in carbon emissions without crippling economic growth.

Last week, we discussed the rise in natural gas prices, which has allowed natural gas-focused firms to outperform oil-concentrated ones.  One of the factors helping gas is exports.  LNG exports to Europe have been improving.

However, these flows are now facing increased scrutiny by European regulators.  For years, natural gas was seen as the “good fuel”; its carbon footprint is less than coal or oil.  But, methane leaks from natural gas wells are common and methane is a potent greenhouse gas.  Accordingly, EU regulators are closely examining the impact from LNG and thus exports are at risk.  France has actually moved to ban U.S. LNG due to the lack of well head methane control.  The U.S. is arguing against France’s decision and we await any trade retaliation.  If the pressure continues, we would expect U.S. natural gas firms to take additional steps to control well leakages to win back EU business.

Japan announced it intends to be carbon neutral by 2050.  The narrative is that Japan will achieve this goal through solar and wind.  We suspect it will have to take another look at nuclear if this goal is to be achieved.  Japan has been replacing nuclear capacity with coal due to the Fukushima disaster but maintaining that trend and meeting this carbon goal are incompatible.

In our WEU report from October 16, we noted that energy stocks are underperforming not only overall equities but even crude oil prices.  Part of the reason for this divergence has been that energy scores low on ESG—Environment, Social, and Governance—investing.  Although we take a rather dim view of ESG,[1] there is no doubt the investing style has become quite popular.  It is very possible that the underperformance of energy stocks is tied to the onset of ESG investing.  In response, the Energy sector is looking to improve its ESG profile.  For example, Baker-Hughes (BKR, USD 15.32) announced it will be Compact Carbon Capture, a privately held firm engaged in, well, what its name says.  Although carbon capture technology is relatively new, it could be critical to maintaining climate stability.  The fact that energy companies are investing in the technology suggests they are taking account of climate change.

Another problem?  Although shale oil production has clearly led to a rapid rise in U.S. oil production, it has done so with little benefit to investors.  The industry has tended to consume capital and has mostly survived in a low interest rate environment.  The remaining firms are now seeking to improve their position with Wall Street, mostly through mergers.  It remains to be seen if the industry can return to favor among investors.

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[1] Definitions are loose; there is an element of virtue signaling in the process and appears to be more about marketing than real impact.

Weekly Geopolitical Report – Of Pirates and Computer Hackers (November 2, 2020)

Posted on by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA | PDF

It’s now been more than a quarter century since the first nefarious behavior was observed on the internet.  There have been countless news reports about computer hacks, stolen data, ransom scams, misinformation aimed at manipulating elections, and the like.  Many of us have had to change our passwords and sign up for free credit monitoring after a service provider suffered a digital breach.  We’ve probably all seen how businesses have been forced to up their game and adopt stronger computer security, just like they lock their doors against common burglars.

But what if common burglars aren’t necessarily the best model for thinking about hackers?  Some of the hackers who threaten our personal data or the sensitive systems of our companies and public institutions certainly are “lone wolves,” but in this report, we’ll show that another model for understanding today’s hackers can be found in the pirates who prowled the Spanish Main from the 1500s to the 1700s.  We’ll look at what some hackers have in common with those pirates and what it means for digital security.  As always, we’ll wrap up with a discussion of potential investment ramifications.

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Asset Allocation Weekly (October 30, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

Many investment managers think of “foreign equities” as one big, monolithic asset class and leave it at that.  When setting a portfolio’s asset allocation strategy, many simply assign a certain percentage to the asset class and implement it by investing in a broad international index fund.  Here at Confluence, we go a step further by identifying individual countries that may be attractive based on our analysis of their geopolitical power, economic performance, social developments, and financial dynamics.  We think the current negotiations for a post-Brexit trade deal between the European Union and the United Kingdom offer especially rich insights into the relative power and prospects of the various EU member states and the U.K.  Our analysis suggests the EU’s Central European members and the U.K. may be especially well placed to outperform economically in the coming years.

At first glance, the EU would seem to have immense leverage in the post-Brexit trade talks because its exports to the U.K. make up only a small part of its total trade and economic activity.  In theory, the EU could easily walk away from the negotiations and accept any trade barriers that would snap into place under a “hard Brexit.”  In contrast, the U.K. would stand to lose a huge chunk of its exports and economic activity, which would supposedly force it to make significant concessions.  To illustrate, the chart below shows that only about 6.0% of the EU’s merchandise exports went to the U.K. in 2019 (the red line in the chart).  For Ireland and a few other big EU members, the U.K. represented as much as 10.3% of exports (the blue columns), but no EU member came close to the U.K.’s dependence on cross-Channel trade.  Fully 46.0% of the U.K.’s foreign merchandise sales went to the EU (the gold line).

Despite the EU’s apparent negotiating advantage, however, all indications are that the U.K. is holding its own in the talks.  Last week, for example, a British threat to walk away from the negotiations brought the EU back to the table with promises that it would be willing to compromise on the remaining issues of fisheries and corporate subsidies.  A close look at the following graph suggests why the EU may have less leverage than expected.  The red line in this graph shows that, on average, EU members’ exports to the U.K. represent only 2.2% of their gross domestic product (GDP).  The gold line shows that the U.K.’s exports to the EU represent fully 7.6% of its GDP.  But the key story is revealed by the blue columns, which show each individual EU member’s merchandise exports to the U.K. as a share of its GDP.  Besides the obvious dependency of close neighbors like Ireland, Belgium, and the Netherlands, what’s notable is that the Central European states like Slovakia, the Czech Republic, Poland, and Hungary are also unusually dependent on shipments to the U.K.

The Central Europeans clearly have a strong interest in maintaining close EU trade ties with the U.K.  The Poles and Hungarians have also recently been at odds with the EU leadership over what some see as their authoritarian political and judicial policies.  In other words, even if the EU leadership in Brussels would prefer to play tough with the U.K. and risk a hard Brexit, the Central Europeans would probably oppose the move.  But do the Central Europeans really have the power to thwart Brussels?  The answer is “yes.”  The reason is that most major EU decisions ultimately need to be approved by all member states.  The Central Europeans have leverage over Brussels because they can threaten to withhold their approval for major legislation, budgets, trade deals, and the like, whether they’re related to the issue at hand or not.  The EU negotiators therefore have to be cognizant of the Central Europeans’ interests and likely can’t risk being so tough on the U.K. that a trade deal falls apart.

More broadly, the need for unanimous decisions means the EU as a bloc will continue to be hamstrung politically.  Indeed, former European Commissioner Romano Prodi recently said in an interview that, “Europe’s enemy is unanimity. . . In this moment I’m pessimistic about [change.]  Unanimity will go on in the major issues, at least in the foreseeable period of time, unless there will be a quick realization that this will kill Europe.”  On a more positive note, however, these dynamics suggest the Central Europeans will continue to use their leverage to win economic and political concessions from Brussels.  Meanwhile, the U.K. and other countries negotiating with the EU on various issues will probably learn that they can exact concessions by “playing the Central European card.”  In sum, these political dynamics suggest the U.K. could well end up with a favorable post-Brexit trade deal and the Central Europeans will likely be able to protect their economic interests fairly well in the coming years, making both more attractive investment destinations than would otherwise be the case.

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Business Cycle Report (October 29, 2020)

Posted on by Rebekah Stovall

by Thomas Wash | PDF

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis.  Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.

In September, the diffusion index rose further above contraction territory, signaling that the economy remains on track to expand in Q3. Financial markets were weaker as equities dipped and the yield spreads were roughly unchanged. Meanwhile, the labor market continues to show signs of improvement as firm hires remain strong. However, the lack of progress on additional fiscal stimulus continues to weigh on growth expectations as concerns over slowing consumer spending continue to mount. As a result, four out of the 11 indicators are in contraction territory. The reading for September rose from +0.0909 to +0.1515, above the recovery signal of -0.100.

The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index is currently providing about six months of lead time for a contraction and five months of lead time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing and refer to our Glossary of Charts at the back of this report for a description of each chart and what it measures. A chart title listed in red indicates that indicator is signaling recession.

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Weekly Energy Update (October 29, 2020)

Posted on by Rebekah Stovall

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Here is an updated crude oil price chart.  Prices remain rangebound but are testing the lower boundary of the range.

(Source: Barchart.com)

Commercial crude oil inventories rose 4.3 mb when a 1.5 mb build was expected.  The SPR declined 0.7 mb; since peaking at 656.1 mb in July, the SPR has drawn 17.2 mb.  Given levels in April, we expect that another 4.4 mb will be withdrawn as this oil was placed in the SPR for temporary storage.  Taking the SPR into account, storage rose 3.7 mb.

In the details, U.S. crude oil production rose 1.2 mbpd to 11.0 mbpd.  Exports rose 0.4 mbpd, while imports also increased 0.5 mbpd.  Refining activity rose 1.7%.  The data suggest a return to normal after a few weeks of hurricane disruptions, although we are dealing with another this week, Hurricane Zeta.  The hurricane season traditionally ends on Halloween and Zeta doesn’t appear to be strong enough to cause a significant decline in production.  Thus, we should be close to finished with the effects of tropical activity.

(Source: Barchart.com)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data showed a build in crude oil stockpiles, which is the normal seasonal pattern.  Inventories tend to make their second seasonal peak about mid-November.  We are approaching the period where inventories tend to decline into year’s end.

Based on our oil inventory/price model, fair value is $42.84; using the euro/price model, fair value is $62.70.  The combined model, a broader analysis of the oil price, generates a fair value of $51.92.  The wide divergence continues between the EUR and oil inventory models.  However, current oil prices are below all three measures of fair value, suggesting that oil prices are likely undervalued.

Last week, we noted that distillate inventories had declined.  They did so again this week.  But what caught our attention this week has been the recovery in distillate demand.  This rise may be more due to home heating inventory building, but it may also be a “ground level” indication that the economy is improving.  Consumption is near the five-year average.

(Sources: DOE, CIM)

Oil prices have been under pressure recently due to the return of Libyan production.  Weak global oil demand has made prices especially sensitive to supply news.  Russia, in light of these concerns, has indicated it plans on delaying an expected OPEC+ production increase.  Meanwhile, on the geopolitical front, Iraq is facing increasing scrutiny for facilitating Iranian sanctions evasion.  The U.S. has sanctioned the Iranian oil ministry and the state oil company along with other Iranian nationals.

With U.S. elections next week, political tensions are elevated.  At the last debate, VP Biden suggested he supported moving away from oil production.  This is part of the party’s platform, but it was surprising he would say it in a debate.  In the short run, the comment won’t help in  Texas or, more critically, Pennsylvania.

Natural gas prices have been rising since late July and have been holding steadily above $3.000 per MMBTU.

(Source: Barchart.com)

The bullish fundamental factor that is lifting prices is a decline in production.

This chart shows the rolling 12-month level of supply (production + net imports) compared to the same measure for domestic consumption.  Supply has been declining for two reasons; first, the sharp decline in oil prices has led to a drop in oil production that has reduced associated natural gas production that is part of the drilling process.  Second, net imports are negative.

The expansion of LNG and pipeline sales to Mexico, along with a drop in gross imports, has led to the positive trade balance (negative net imports mean positive exports).

Unfortunately, inventory levels are elevated as we move into winter.

This model seasonally adjusts the level of inventories; when the lower line is above zero, storage levels are higher than normal.

If we combine the level of output, the balance between supply and consumption, and the level of inventories, fair value for natural gas is $2.14 per MMBTU.  To justify current prices, inventory levels would need to decline by nearly 450 bcf on a seasonally adjusted basis.  Since inventories are poised to decline on a seasonal basis starting in November, stockpiles must fall much faster than normal for prices to be maintained, implying winter demand will need to be robust.  Given the winter forecast, that isn’t likely, so prices are vulnerable to a pullback into 2021.

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Weekly Geopolitical Report – The Election of 1876: Part II (October 26, 2020)

Posted on by Rebekah Stovall

by Bill O’Grady | PDF

Last week, we outlined the history of the presidential election of 1876.  This election was disputed and required a special commission to resolve.  This week, we will begin with a discussion of our current procedure for electing presidents and the impact of partisanship on the existing environment.  We will use last week’s historical foundation to compare and contrast the 1876 election to the current turmoil and offer insights on how the 2020 election might unfold.  We will also examine the international implications of an uncertain election; in other words, what could happen if the world’s hegemon doesn’t have a clear commander in chief?  As always, we will conclude with market ramifications.

The Current Procedure
One of the strengths of democracies is their ability to adapt.  Authoritarian regimes tend to ossify over time, which often undermines them and eventually leads to their downfall.  At the same time, while democracies do show they can change, it doesn’t mean it’s pleasant to watch.

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