The Market
Over the past quarter, oil prices have ranged from a low of around $56 to a high of $66 per barrel.
Prices remain elevated, supported by OPEC production discipline and solid global oil demand.
Prices and Inventories
Inventory levels remain elevated but have clearly declined from last year’s peak.
The Market
Oil prices have recovered strongly from the mid-summer lows. It appears we are establishing a new trading range between $55 and $60 per barrel.
This recovery was mostly caused by a steady decline in U.S. domestic crude oil inventories, a weak dollar and OPEC output discipline. We expect OPEC to maintain output restrictions until the Saudis price their partial IPO of Saudi Aramco sometime in 2018.
The Market
Oil prices peaked in March around $55 per barrel. There have been a series of lower highs and lower lows, as shown by the lines on the chart.
This obvious downtrend has led to a general bearish tone to the market. We don’t necessarily share that level of pessimism; as we will show below, dollar weakness and falling inventories are supportive for oil prices. On the other hand, there are legitimate concerns that Saudis may reverse production restrictions after next year’s initial public offering for Saudi Aramco.
[Posted: 9:30 AM EDT] Welcome to Super Thursday!
Today, there is a slew of geopolitical events that may have an impact on global markets. In Europe, the ECB will hold a press conference about current and future policy decisions. In the U.S., former FBI Director James Comey testifies to the Senate Committee about Trump’s influence in the Russia investigation. In the U.K., there are parliamentary elections to decide the prime minister.
The ECB has decided to hold rates at their current levels and maintain the current level of quantitative easing. Prior to the press conference, the ECB released a statement that left out the mention of possibly lowering interest rates in the future. The market has interpreted this as a signal that the ECB is willing to exit the stimulus program. As mentioned yesterday, the ECB has cut its inflation forecast and revised its GDP forecast higher. During the press conference, Mario Draghi added that he expects monetary policy to remain the same for an extended period of time, even after the stimulus program ends. He went on to say that increased momentum in the Eurozone economy shows that risks to the global outlook were broadly balanced, but the momentum has not translated into stronger inflation dynamics. Draghi warned that global macroeconomic developments still present downside risk and that the ECB is prepared to increase asset purchases if the outlook were to become less favorable or financial conditions become inconsistent. After the press conference, the euro depreciated against the dollar.
With the release of former FBI Director Comey’s statement that Trump asked him to “lift the cloud” of the investigation by publically stating that Trump was not personally under investigation, Comey’s testimony today could prove to be a bit anti-climactic. The primary market worry would be that enough information will emerge to further distract the Trump administration from other goals. We do note that Senate GOP leaders are looking at a health care bill; reports suggest that McConnell will give it a few weeks and, if nothing is done, tax issues will be taken up. Tax cuts are what the market is mostly concerned over so if the Senate can move forward then it probably means equities will at least hold at current levels.
The other major item today is the British election. Polls are scattered, with some late polls showing a dead heat, while others show a 10% lead for the Tories. Our expectation is a Conservative win but no major pickup in seats and thus no expanded mandate. This isn’t a great outcome but it probably doesn’t move the financial markets.
U.S. crude oil inventories unexpectedly rose 3.3 mb compared to market expectations of a 3.5 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have been declining. We note that, as part of an Obama era agreement, there was a 1.7 mb sale of oil out of the Strategic Petroleum Reserve. This is part of a $375.4 mm sale (or 8.0 mb) done, in part, to pay for modernization of the SPR facilities. International agreements require that OECD nations hold 90 days of imports in storage. Due to falling imports, the current coverage is near 140 days. Taking that into account, the build was a less ominous 1.7 mb.
As the seasonal chart below shows, inventories are usually well into the seasonal withdrawal period. This year, that process began early. Although the actual level of stockpiles remains quite high, we are seeing stock declines at a rather rapid pace. Assuming a similar drop from this year’s peak of 566.5 mb at the end of March, we will end up at 505 mb by late September. In fact, current inventory levels have already declined more than the seasonal trough, which is supportive. As a result, last week’s rise is something of an anomaly; we would not be surprised to see declines resume next week.
Based on inventories alone, oil prices are overvalued with the fair value price of $37.17. Meanwhile, the EUR/WTI model generates a fair value of $53.24. Together (which is a more sound methodology), fair value is $47.34, meaning that current prices are below fair value. Inventory levels remain a drag on prices but the oil market seems to be ignoring the impact of dollar weakness. Our position has been that oil prices are in a range between $45 and $55 per barrel and, accordingly, oil is attractive at current levels. The worries about OPEC shattering over Qatar appear to us to be misplaced. The cartel has managed to maintain relations with members at war before. A bigger risk is that a conflict develops that disrupts flows. It’s not highly likely, but it is more likely than OPEC expanding output based on tensions with Qatar.
[Posted: 9:30 AM EDT] The Federal Reserve did just about what we expected; it did acknowledge Q1 economic weakness but expressed no serious concern about slowdown, suggesting that it isn’t all that concerned about future growth. We note that fed funds futures are placing the odds of a 25 bps rate hike at the June meeting at 90%, up from the low 81% level before the meeting statement. As long as economic data remains stable, it looks like a second hike is coming in June.
The House is planning to vote on a replacement bill for the ACA; the vote is expected to be close. Usually, the leadership of the House won’t bring an important bill to a vote if they are not reasonably confident of the outcome. If the bill passes, it probably won’t become law in its current form as it is highly unlikely the Senate will pass it without major changes. However, if it fails to pass the House, it will be a defeat of sorts for the White House and perhaps raise concerns that the president is incapable of shepherding anything through Congress. That outcome might undermine hopes of infrastructure spending and tax cuts.
SOS Tillerson gave a speech yesterday at the State Department laying out the administration’s vision for foreign policy. He suggested that the U.S. has been “too accommodating” to emerging nations and allies and “things have gotten out of balance.” We can see the logic of this statement. The U.S. has been unusually generous for a hegemon on two fronts. First, for the most part, we have single-handedly enforced peace in the world’s three “hot zones” of Europe, the Far East and the Middle East by putting troops and bases in these regions. More importantly, we have taken over the security of Europe and Japan, removing the long-standing tensions that led to two world wars in Europe and the constant tensions between China and Japan. We essentially did the same thing in the Middle East. This policy has been quite costly in terms of “blood and treasure,” although we would argue that the costs were worth it since we didn’t fight WWIII. However, without question, much of the world has enjoyed a “free ride” at the expense of American taxpayers and soldiers.
Second, the other element of hegemony has been to provide the reserve currency, which has led to persistent trade deficits and allowed a model of development designed to boost investment and exports, funded by domestic saving. This topic is under discussion currently in our four-part Weekly Geopolitical Report series. By being the global importer of last resort, we have bolstered global growth. However, the cost to Americans has been a gutting of the middle class that has become clearly evident in the political turmoil observed over the past three elections.
What Tillerson didn’t do was explain how the “rebalancing” is going to occur. Would it be through a reduction of the trade deficit by forcing foreign firms to source production in the U.S., sort of a “tribute” paid to America for access to the dollar? Would it be by forcing allies to pay more for their own defense? If allies pay more, can we still control them? What if Germany rearms and decides to collect bad Greek debt by taking a few islands?
We can see the need for changes to American hegemonic policy. However, a clear path isn’t obvious; in fact, it’s fraught with risk. We are already seeing the results of “thawing” the frozen conflict in the Middle East. The territorial integrities of both Syria and Iraq are mostly broken and we don’t know what will replace them. Islamic State was the first attempt; that wasn’t such a great outcome. An adjustment is necessary. We believe the policies used since WWII have probably become politically impossible to maintain, but it isn’t known what can effectively replace those policies. Until they are replaced, uncertainty will remain elevated.
U.S. crude oil inventories fell 0.9 mb compared to market expectations of a 3.3 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have started the seasonal withdrawal phase. We also note that, as part of an Obama-era agreement, there was a 1.5 mb sale of oil out of the Strategic Petroleum Reserve. This is part of a $375.4 mm sale (or 8.0 mb) done, in part, to pay for modernization of the SPR facilities. International agreements require that OECD nations hold 90 days’ worth of imports in storage. Due to falling imports, the current coverage is near 140 days. Taking that into account, the draw would have been 2.4 mb, roughly in line with expectations.
As the seasonal chart below shows, inventories are near their seasonal peak and should begin falling as rising refinery operations lower stockpiles. This week’s decline rise puts us further below normal. Although inventories remain high, this seasonal level is consistent with July, meaning that we may be on the way to an easing of the inventory overhang. Last year, we saw a 45 mb draw from the April peak. Assuming a similar drop from this year’s peak of 566.5 mb at the end of March, we will end up at 520 mb by late September. Assuming a $1.09 EUR and using the model discussed below, fair value is $44.15 for oil prices. Thus, we would need to see a much larger drop to justify current prices.
Based on inventories alone, oil prices are overvalued with the fair value price of $31.03. Meanwhile, the EUR/WTI model generates a fair value of $41.57. Together (which is a more sound methodology), fair value is $37.68, meaning that current prices are well above fair value. To a great extent, it appears that the oil market has already discounted a drop in inventory levels and a weaker dollar.
[Posted: 9:30 AM EDT] The euphoria surrounding the election of President Trump appears to be waning. Although the sentiment polls remain elevated, we note the fixed income markets are clearly showing some jitters.
This chart shows the two-year/10-year Treasury spread. Although the curve is steeper than it was prior to the election, it has been flattening rather rapidly recently. If this isn’t arrested soon, worries over the economy will increase and likely weigh on risk assets.
There were massive protests in Venezuela yesterday as those opposed to President Maduro braved security officials and the irregular Maduro forces armed by the president to call for elections and democratic reforms. At least seven people died. More rallies are expected today. Oil production appears to be down to 2.0 mbpd; the country was traditionally a 3.0 mbpd producer. Unrest there is a minor, but supportive factor, for crude oil prices.
U.S. crude oil inventories fell 1.0 mb compared to market expectations of a 1.7 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high.
As the seasonal chart below shows, inventories are near their seasonal peak and should begin falling as rising refinery operations lower stockpiles. This week’s decline puts us further below normal. Although inventories remain high, this seasonal level is consistent with July, meaning that we may be on the way to an easing of the inventory overhang.
Based on inventories alone, oil prices are overvalued with the fair value price of $29.65. Meanwhile, the EUR/WTI model generates a fair value of $40.35. Together (which is a more sound methodology), fair value is $36.43, meaning that current prices are well above fair value.
Yesterday, oil prices fell sharply, with the rise in gasoline inventories cited as the catalyst. Although gasoline inventories usually decline from their February peaks, the pace of the decline is reaching its nadir and stockpiles normally stabilize through the summer.
This chart shows gasoline inventories. The five-year average shows the seasonal pattern; however, this year’s data is closely tracking last year. If this pattern continues, we will see mostly steady inventory levels until late July. That isn’t necessarily bad news for oil prices but it isn’t supportive, either.
Saudi Arabia is pressing OPEC to extend its production cuts and there are reports that the cartel is going along with it. This is the factor keeping prices higher. At the same time, rising U.S. production is taking share away from OPEC. As we have stated before, the oil market is being supported by what we would describe as epic “window dressing” in front of the Saudi Aramco IPO next year.
A secondary factor helping U.S. oil production, beyond OPEC propping up oil prices, is lower yields on junk bonds.
Since 2011, the correlation is a respectable -55% between the two series, with yields leading production by eight months. Obviously, oil prices play a larger role but the combination of higher oil prices and a favorable financing environment will tend to support higher U.S. production. Although higher U.S. output may be modestly negative for oil prices, it is supportive for U.S.-oriented oil producers…at least until the Saudis decide to retake market share.
The Market
Since December, oil prices have been ranging between $48 and $55 per barrel.
Prices and Inventories
Inventory levels remain elevated, reaching historic highs.
In the above charts, the one on the left shows the long-term inventory situation, while the chart on the right shows a 12-year history. Normal inventories would be below 400 mb, so stockpiles remain elevated.
[Posted: 9:30 AM EST] We are seeing a bit of weakness this morning in equities but this looks mostly like a normal market pause. The dollar is lower despite growing talk that the Fed is moving to raise rates. Not only did Chair Yellen signal that hikes are coming, but Boston FRB President Rosengren, a long-time dove, is calling for three hikes this year. The most likely reason for the dollar weakness is that Chair Yellen expressed opposition to the border adjustment tax. The opposition to this tax is growing and there is rising speculation that corporate tax reform won’t include this provision. If true, that removes an element of dollar support.
The turmoil coming out of Washington is relentless. Vociferous leaks continue out of the intelligence apparatus, the White House appears in disarray and Congress looks to begin investigations. All these things would seem to undermine confidence for investors, consumers and businesses. However, that couldn’t be further from what we are seeing. The economic data is improving and the survey data is strengthening. Today’s evidence comes from the business outlook survey from the Philadelphia FRB (see below). The numbers were more than double the forecast and the trend in the data suggests growing optimism.
Some of this improvement appears to be simply organic. After nearly eight years of slow growth, we are finally starting to see some animal spirits return to the economy and markets. At the same time, hopes for regulatory relief and fiscal stimulus are supporting sentiment. Progress on these fronts may slow if the president becomes mired in scandal and investigations. On the other hand, Congressional Republicans may simply forge ahead with traditional GOP policy positions, which should be supportive for equities.
We are closely monitoring the issues and concerns coming out of D.C. We do think they are important but, for now, they are not enough to derail an improving economy and earnings. As long as the political problems don’t affect the economy, earnings and the progress of favorable policy, these issues are noise.
[Posted: 9:30 AM EST] One of the political factors we watch with a new president is the management of political capital. Political capital is essentially the goodwill, the mandate, which comes from winning an election. Although not a hard and fast figure, it does appear to exist, can be depleted and has a “sell-by date.” In general, by the 18th month of the first term, the capital is exhausted even if it isn’t spent. By that time, Congress is gearing up for the midterm elections and the president’s goals and aspirations become secondary to the desire for reelection.
Essentially, it’s all about first understanding the strength of the mandate and “spending” it wisely. In my recollection, no president is perfect in this area. In the sweep of the moment, it’s easy for a president to think he can do more than he is actually able and to get distracted by side issues that consume more time, effort and political capital than the issues warrant. It’s also critically important for a president to understand the environment. All Democratic Party presidents pine for the expansion of health care; Republicans for entitlement changes. Attempting to achieve these changes tends to consume a lot of political capital and it’s hard to get much else accomplished.
President Trump is something of an enigma. It is difficult to measure how much political capital he has given the size of his popular vote. At the same time, he is so unconventional that he may have more than normal. However, history would suggest his capital isn’t infinite and it probably remains perishable. This means that we have to closely watch the allocation of political capital to policy and personnel.
After the November election, both the right-wing populists and the center-right establishment had their wish lists and both seemed to believe most of their goals would be fulfilled. Financial markets clearly believed that tax reform and rate reductions were coming and regulatory rollbacks were likely. Equity markets rallied, interest rates rose and the dollar jumped. At the same time, the right-wing populists were expecting immigration reform, infrastructure spending and trade restrictions. Trump is clearly trying to satisfy both constituencies while also trying to fill positions to build an administration. Our concern is that he is experiencing a significant “capital burn.” At some point, he is going to have to start choosing his battles more carefully to conserve his political capital and accomplish his goals. We suspect this is going to require some degree of discipline that, at this juncture, seems to be lacking. Without discipline, he stands to disappoint both wings of his constituency due to ineffective management and opposition from Democrats.
Here is an indicator that may offer some insight into the concept of political capital.
This chart shows the implied yield from the Eurodollar futures contract, two years advanced. Essentially, it’s the market’s estimate of what three-month LIBOR will be in two years. Note that the yield soared after the election, jumping nearly 90 bps in the first few weeks after November 9. We believe the rate jumped on expectations that Trump’s fiscal stimulus would boost the economy and lead to tighter monetary policy. However, we are starting to see the implied rate pull back, suggesting the financial markets are reassessing just how much he will be able to accomplish.
If our analysis is correct, the implied rate should rise if Trump’s policy goals begin to accelerate. This is especially true if tax cuts and fiscal spending are implemented. That would also lift long-duration Treasury yields and the dollar. However, if the implied yield continues to fall, it would suggest the financial markets are discounting less stimulus and slower policy tightening. This could lead to lower long-duration Treasury yields and dollar weakness.