2018 saw a brutal swing in sentiment that has left the oil market with a nasty hang over into year-end.
The latest move lower has sparked industry concern, however, sentiment remains surprisingly bullish and the start of 2019 will be critical to set the tone.
Few major market participants have been left unscathed by the uptick in oil price volatility:
Oil producers are hedged but well below year ago levels; market makers such as banks, were hit by “negative gamma” as oil prices crossed through put strikes subsequently sold to producers; Investors were caught off guard by the magnitude and the swiftness of the sell-off in prices and spike in volatility; while trade houses suffered from a lack of trading opportunities outside of physical arbs in the US. Overall, 2018 was a year to forget for most in the oil market.
Where to from here and what are the signals we are monitoring for oil producers in 2019?
Brent’s 5-year chart below is interesting as it shows the swing in market perceptions as participants attempted to grapple with major fundamental shifts: the rise of US production and exports, Venezuela production declines, CAPEX underinvestment, electric vehicles, IMO 2020, Iran sanctions, waivers and geopolitics, recently ignited uncertainty in Saudi Arabia and President Trump’s “explosive” Tweets.
- Brent opened Jan 2018 at $66.50/bbl (dashed vertical line), rose over $20/bbl to peak during the 1st week of October at $86.74/bbl. Oil producers, at that point, were restricted in hedging through swaps and collars by credit and fears of oil going to $100/bbl as consumers pushed backend oil prices higher on themselves (consumer volumes were at a multi-year record).
- The end of year brought a sudden and brutal selloff triggered by President Trump surprise U-turn on Iran sanctions, deeply damaging bullish sentiment.
- Brent prices accelerated lower as long positions suddenly found themselves in a funnel effect for exit, triggering the $62.50 – $67.50/bbl “short-gamma” producer strikes, which seemed so distant only two short weeks prior.
- Momentum/model driven selling started piling in as models based on moving averages flashed sell signals (oval circle below). Brent finally ends the year with a $50/bbl handle and enter 2019 with a nasty hang over.
The proposition to be short is not as exciting at current prices as the trend appears near exhaustion: divergence occurring (green circle) and charts are flashing oversold conditions (white circle).
Several idiosyncratic factors affected oil markets this year until macro sentiment turned negative. At that point, there was no differentiation between assets classes: oil (white line), US high yield (red line), US equities (blue line) down hard, all in synch as correlation spiked.
To halt the selling in oil, we are going to have to see some sort of improvement in the physical market that investors can grab onto. Ideally, a flip from front-end contango (blue line below) to backwardation would send a signal that “things are improving”.
Saudi cuts its US exports (white and pink lines below) and a resumption in China oil imports from the US (yellow line) would offer some respite for the paper market. At the very least, it could improve the most visible inventory data (weekly DOEs), which could send a positive signal to the paper market.
OPEC+ announced production cuts in December were an unsuccessful attempt to halt the oil price selloff. Let us be clear, this was not aimed to push prices higher. Unlike 2017 production cuts, the most recent OPEC press release lacked cohesiveness (with Qatar leaving the cartel). The absence of Central Bank language “whatever it takes” to reduce inventories below the 5-year average OECD stock levels (an observable metric) demonstrated that the OPEC+ cut also lacked conviction.
The issue for the oil market is in the light end of the crude slate. Saudi Arabia and OPEC will have to cut light barrels if it wants to make a dent in stocks and sentiment – it would be good “bang for the buck” but a big ask as we have never seen OPEC do this in the past.
Consensus demand forecasts (IEA, OPEC and EIA monthly estimates) for both 2018 and 2019 have been revised lower since mid-2018. Macro concerns ranging from US-China trade wars, Brexit to Central Bank tightening have blurred the outlook for oil demand growth in 2019. With oil demand growth forecasts at 1.4mb/d and above long-term trend growth, market participants will be looking for confirmation that the global economy remains strong.
Total oil stocks dipped below the 5-year average in the 1H 2018 but have since recovered and are currently about the same as this time 1-year ago. The cushion in total oil stocks (crude + products) will continue to grow in Q1 2019 as OPEC+ production cuts take time to work its way through the system and refineries undergo seasonal maintenance.
Surprisingly, the greater cushion in oil inventories may turn to be a bullish indicator in 2019 as it may embolden President Trump to get tougher on Iran by not issuing waivers to consumers of Iranian barrels.
What we are watching:
In oil it will be major outages from “barrels at risk” regions such as Libya, Venezuela, Nigeria, Angola, KRG pipeline and Kuwait neutral zone restart. Geopolitics in the Middle East, especially with regards to US policy and relations with Iran and Saudi Arabia. Africa could also play an important role with an election in Nigeria in February 2019.
On the macro side we are watching US equities (whether or not major indices dip into “bear market” territory), Central Bank tightening and the impact on credit markets as the ECB joins the US Fed in unwinding quantitative easing.
Most important on the radar though, will be developments on the US-China trade war as this will impact diesel and crude oil demand growth directly.
Volatility levels across asset classes has remained elevated since late October 2018. In combination with a highly charged geopolitical environment, unpredictable tweets/policies from US President Trump and the onset of a significant spec change from the International Maritime Organization, the outlook for the oil market looks set to be very choppy with hedging set to play an important role in managing volatility.
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