October 12, 2015

The crude oil rally has further room to go to the upside

Commentary by Robert Balan, Chief Market Strategist

"The Shanghai Composite Index jumped by 3 percent Thursday, easing fears of a downturn there. For oil, this is of central importance. China has been full of contradictions in recent times. Despite apparent slower GDP growth — by some measures as low as 3.5 percent in July — oil demand has proved astoundingly robust.”

Steven Kopits, managing director, Princeton Energy Advisors

Over the past five trading days, investors in the energy sector have been rewarded with a major rally. By close of Friday October 9th, the Nymex WTI front contract has risen by 8.98% for the week, Brent by 9.40%, and Diapason Commodities Energy Index® by 7.04%. The energy sector’s outperformance over other assets has been substantial: for instance, it has bested the S&P Index which has posted a 3.17% gain over the same period, on closing basis. This is the second time that the energy sector has delivered such a performance – the first one being the rally from March to May which delivered 40.20% gains before falling to new lows. Will this time be different?

To see if this rally finally found legs, we will look at the drivers of this rally and the factors which could change the previous dynamic. First, we look at the oil futures' term structure. In the case of WTI crude oil, the significant changes in the past two months has been mainly seen in the front end of the curve. Relative to just two months ago, the contracts through the end-2017 and early-2018 are significantly higher – the back end of the curve contracts have fallen rather than risen in sync with the front-end. This is a clear indication of tighter supply working its way into the system, which is not at all surprising given the sharp decline in rig counts in the US and elsewhere. But there is something curious about the behaviour of the later dated contracts – they have not gone up; there was no follow through from the rise in end-2017 and early-2018 futures. Admittedly, these later dated contracts are thinly traded, but for us it shows lack of market conviction that the oil price is going to be significantly higher in the next five years than where it is today. Nonetheless, it is also true that the long end of the oil curve is prone to inaccuracies as to its projections of future price levels in absolute terms. Case in point: the position of the oil curve at the end of October last year when the market was blindsided after assuming that $80 per barrel was a solid WTI price floor.

What has changed from a future expectation for prices at the $80 floor price at long end of the curve a year ago to a $60 range being the expected price ceiling today? The expectations of a year ago clearly defied logic given very low cost money worldwide that was encouraging free-wheeling drilling. A supply glut was in the making, and ironically, it was a condition known to all major market participants, both buyers and sellers. But there was almost unshakeable faith that Saudi Arabia would take the hit in clearing the accumulating glut in supplies. However, the Saudi's said no, and instead further flooded the market so as to solve the problem of the undisciplined frackers once and for all. The flat curve at the end of October 2014 collapsed. We all know what happened afterwards: rig counts fell drastically, and after an agonizing wait, US shale production started to fall in earnest, and will likely fall further as a new sequence of events is set to reverse some or most of the effects of the original trigger. This explains in large part the rise in the front-end today, and the flat-to-falling curve in the later dated contracts. For oil investors, there is still no visibility as to what happens next after the market balances in 2016. There are several reasons for this expectation.

The US Dollar also plays a role in the market's conviction that the later dated contracts will underperform. Falling oil prices tend to strengthen the US Dollar because of the narrower trade deficit that ensues due to the smaller oil import bill. Sharply higher US oil production was therefore a contributory as to why the US Dollar was stronger over the past two years, and it is not coincidence that the US Dollar outperformance occurred at the height of the shale oil bonanza. But the US Dollar could also be impacted positively by other monetary and fiscal policies, and the investors' universe adopts the meme that US Dollar strength is a given over the medium-term at least, as the Fed continues to talk about initiating a policy hike regime. If that eventually proves true, then the flatter curve at the long end may indeed have some merit. However, the US Dollar may be topping out. Going forward, the US Dollar may not be the all-dominant factor that it was in crude oil price determination in the past several quarters. The advantages it used to have in policy rate divergence, in growth spreads and in inflation coefficients against other developed nations are all gone. The first chart of the week below shows how those factors look like today.

Actually, the prime movers of the US currency have a global flavour – stronger global growth weakens the US Dollar, as the US capital account deteriorates due to US capital flows. Conveniently, the US current account shows the way for capital account to go 3 quarters later – and the deficit has been rising for some time and has shown signs of widening further, to the future detriment of the US Dollar. When the capital account goes, the US Dollar goes too. This is the dynamic: every time the current account deficit of the world's reserve currency issuer (the US) widens, the global economy picks up correspondingly as a consequence of the liquidity thus provided. A stronger global economy-ex US always weakens the US currency, as US capital looks for opportunities elsewhere. Those elements should put negative pressure on the US Dollar. And of course, it looks like there will be no sustained policy rate tightening from the Federal Reserve, even if a rate hike commences in 2015, which is increasingly looking unlikely. Assuming that a hike does happen this year, up to three rate hikes have already been built-in into US financial conditions which have already tightened accordingly, and were also already baked-in the present US Dollar valuation. The takeaway from all these is that the US Dollar will be hard-pressed to rally further under current conditions. Going forward, oil prices will therefore be impacted mostly by oil's fundamentals which are looking more positive each day.

What fundamentals should we focus on from here?

We name a few: (1) the impending forward supply collapse brought on by cuts in capex, $240 billion so far (2) higher decline rates in shale production, (3) more egregious re-financing hurdles (lower access to capital through re-determinations/ higher default rates and bankruptcies), (4) global oil demand has been resilient, and actually growing – the highest in the past 5 years at over +1.8mmb.d in 2015 ytd led by gasoline – and we also see oil demand into 2016 remaining in the 1.2-1.3mmbd yoy level and as such, rebalancing the global supply-overhang very quickly, (5) elevated oil-geopolitical risks – with Russia’s entry into the Syrian civil war arena, and (6) current market structures are indicating higher prices medium-term. We believe that the current rally is part of an initial phase from $55-60/bbl WTI into December, and then at $65-70 into the end of Q1 2016. We think that the situation still needs more time to curb excess supply and force-out the higher marginal producers, and that may take place during the period up to Q1 of 2016. This second chart of the week below shows how the process may look — our model illustrating how inventory may behave over the next few months. The vast majority of the supply and inventory declines will really start to materialise, we feel, from 3Q 2016 but the hyperbolic move will likely kick in 1H 2017 – as OPEC/Non-OPEC supply tends to a combined flat, versus demand increasing +1.3-1.4mmb/d yoy. This is the compounding effect that will rapidly rebalance the market; we view that the real draws could kick-in from middle of 3Q 2016 but they may also kick-in in 2Q 2017 by over 1.2mmb/d.

The decisive way we see the oil market balance is a transition from high levels of crude inventories, which will decline as refiners increase runs, which will naturally reduce in supply as US/Non-OPEC crude production declines. This initial phase will result in a collapse in margins, which will force refiners to draw down on product inventories and back-out crude. A classic oil up-trend market happens when despite negative margins, crude remains bid – this was seen in 1999/2000 and 2009 – both post-crises. We may see those conditions again in 2017.

Commodities and Economic Highlights
Commentary by Robert Balan, Chief Market Strategist

Zinc prices jump as Glencore announced output cuts, adding to the market deficit

Zinc prices last week after Glencore, the world's largest miner of the metal, announced production cuts equivalent to around 4% of the world's total annual supply, as part of its corporate restructuring. Glencore is the world's biggest miner of the industrial metal. This announcement followed earlier statements attributed to Glencore that the company cut will its annual zinc production by 500,000 metric tons, including closing its Lady Loretta mine in Australia and Iscaycruz mine in Peru.

The zinc nearby futures price at the London Metal Exchange rose 6.7% to $1,775/ton. Lead, which is mined as a co-product of zinc, rose 4.5% to $1,748.50/ton. The sharp recovery in zinc prices follows a steady decline to a five-year low of $1,601.50/ton on Sept. 28. The zinc sell-off ignored a slight deficit in the metal. Glencore's supply cuts will tighten the market significantly, even assuming that demand will stay flat, which we believe is not the case. The total global zinc supply of zinc is around; the global market deficit is estimated at circa 150,000 tons this year before Glencore's announcement. After implementation of those cuts, the deficit will widen significantly as demand for zinc is expected to stabilize over the following years.

The longer-term positive outlook for prices is not in doubt. With time, production is expected to fall below market demand, as aging mines are scheduled to shutter sequentially. Mining companies also need higher prices to justify the cost of developing new sources of metal. With the recent decline in zinc prices, capital allocation for new mines and expansion of existing ones were either scrapped or halted. As an example, Glencore which has zinc operations across Australia, Kazakhstan and South America, said it would be better to keep the zinc ores in the ground until market prices improve. In addition to closing the two mines mentioned above, Glencore will also curtail operation at George Fisher and McArthur River in Australia, and reduce production at its various sites in Kazakhstan.

Zinc is primarily used for steel coatings, but zinc is used in the manufacture of many products such as car tires and sunscreen, and has few substitutes. The global market for the metal is estimated at 13-million-ton-a-year. Glencore forecast fourth-quarter zinc production to fall by about 100,000 tons. The company said it was upbeat on the longer-run prospects for zinc and lead prices. Glencore was also which critical of other mining companies, especially producers of iron ore, which continue to dig up increasing volumes of the metal resource even as a global glut develops. The price of zinc is closely linked with the global price of steel. China consumes nearly half of total global zinc production. The weak economic outlook in China has undercut zinc and other base metals prices in the past two years. Chinese steel-producers, the largest in the world, have added to the issues facing zinc after they increased their overseas sales as China's production has begun to outpace domestic demand.

Divergence between physical and paper silver is driving the Gold-Silver ratio lower

Evidence is plentiful that an up-trend market in physical silver (and gold) is now underway. At the end of Q3 (September 30th), US silver coin demand reached very high levels and mints literally could not keep up with the demand, and had to ration the coins. Even so, in the past 4 months alone, a record 18.59 million ounces worth of Silver Eagle coins were bought by investors. Many bullion analysts are comparing the current situation to the 2008 shortage of silver coins. But the scope of the shortage is larger this time around — the US mint had already produced 3 times as many Silver Eagles as in 2008, but still could not cope up with the demand.

A news report on September 30 described the situation: "The global silver-coin market is in the grips of an unprecedented supply squeeze, forcing some mints to ration sales and step up overtime while sending U.S. buyers racing abroad to fulfil a sudden surge in demand." Reuters also quoted Roy Friedman, vice president of sales and trading at Manfra, Tordella & Brookes, one of the biggest U.S. wholesale coin dealers, who said he could not recall seeing a squeeze in supplies of North American silver coins spilling over to coins made in Austria and the U.K. to the degree seen this year.

We are also seeing the same degree of physical gold buying frenzy in China and India, and at a lesser degree in the US. The disparity in the US domestic situation where investors are favouring physical silver to physical gold is causing the Gold-Silver ratio to decline significantly in the past few weeks. The record demand for silver coins has boosted premiums on all bullion products significantly higher — most of the largest premium spikes being seen on pre-1965 90% silver coins. These premium increases on silver represent real gains in value for holders of the physical metal.

Silver physical premiums are also larger than those seen in physical gold, which may explain why the Gold-Silver ratio is collapsing. There is less of a market tightness issue for gold bullion products. Gold coin supply is mostly keeping up with demand – gold bullion and coin buying is also surging. Sales of Gold American Eagles increased to 397,000 ounces in Q3 2015, from 127,000 ounces bought in Q2. Impressive as it was, the purchases of silver coins at higher premiums will likely continue for some time, and this should weigh on the Gold-Silver ratio.

The current behaviour of the Gold-Silver ratio is of great interest to us because it can be used as a risk-on, risk off indicator, or a cyclical versus defensive measure. Crossing the two metals this way basically strips out the precious component, and what remains in the resultant ratio is the relative attractiveness of defensive assets versus cyclical assets. A rising ratio tends to show that defensive assets are more attractive than cyclical assets, i.e., the gold price is rising faster than the price of silver. The inverse suggests the opposite: a falling ratio suggests that defensive assets are falling out of favour, and that cyclical assets are coming into the forefront. The ratio also has one useful trait, that it tends to lead changes in the US Dollar trends. When the ratio is rising, the US Dollar trend tends to go higher, and vice versa.

The Gold-Silver ratio has been falling since late August, and that has coincided with the rise in the price of major commodities – crude oil, copper and major base metals, as examples. The peak of the Gold-Silver ratio also coincided with the August trough of major equity markets, S&P 500 for one, and even China's Shanghai stock index. As long as the ratio keeps on falling, we expect the financial markets to stay on a risk-on mode as well, and that should be positive for commodity prices in general.

Charts of the week: EA-US difference in inflation and GDP growth; Gasoline demand and production vs. oil inventory, and our inventory model

For the full version of the Diapason Commodities and Markets Focus report, please contact info@diapason-cm.com

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Last update on January 12, 2015