The Fed obeyed the old folk wisdom saying about March – It came in like a Lion and went out like a Lamb. Janet Yellen has once again confused financial markets by contradicting everything that she and her compatriots had said the week before about interest rates. She suddenly turned dovish. Jim Cramer, the energetic host of “Mad Money”, quipped, “She fooled us, again, or maybe we are just choosing to be fooled?"
When 2015 closed, the Fed’s long-awaited interest rate normalization process had finally begun. They also telegraphed to the market that four more changes were on tap for 2016, sending the dollar into a tizzy and disrupting trading positions across the globe. The latest news reveals once more how quickly things can change, when a central bank changes its collective mind. Forex analysts for banks and hedge funds have been feverishly changing their forecasts for 2016 and tumbling over one another, trying to get their new figures published and out the door.
The fundamental drivers for price action in 2016 were supposed to be the Fed’s normalization process, China, Europe, and the deflationary aspect of commodity prices. Concern had already been focused on the latter issue, but the press had moved on to berating China, after oil prices seemingly formed a bottom and roared back with a rally to beat the band. Chinese officials scoffed at reports that its banking system was on the verge of collapse, and oil prices retreated. Was the rally nothing but short covering?
In a blink of an eye, the market is transfixed again on oil prices
Oil prices hit the $40 watermark, while the Loonie strengthened to the tune of 800 pips. Fortunes are made on just such movements, but it appears that the rally has fizzled. Oil dipped this morning below $37, and the cry on the street is that we are headed for the twenties again. Basic fundamentals in the industry have not changed. Yes, there was a rumor that a few OPEC members were discussing a production freeze, or even cutbacks, but that notion went nowhere. What was all the ruckus about?
For whatever the reason, inflation targets and our ability to hit them has become, like it or not, the newly accepted barometer for determining if central banking policy is really producing positive economic results. GDP growth has taken a back seat in the bus of economic affairs, so to speak. Within that context, deflation is the outright enemy of mankind, although I cannot think of one household that has not reveled in lower prices at the gas pump. The above chart attempts to put oil prices and inflation on equal footing.
As much as there appears to be a strong correlation at times, economists reject the notion out of hand. As many state, inflation expectations are supposed to revert to a mean average over time, the simple idea that a central banker’s true objective is to guide the domestic ship of state towards an acceptable inflation target. Oil prices are not supposed to revert to a mean. They are guided by supply and demand forces in the market, as well as by inflation and the strength of the U.S. dollar. The conclusion that inflation expectations are rising and pulling oil prices up by their bootstraps is illusory. There have to be other reasons for the recent rally and pullback.
There have not been definitive improvements in oilrig counts, storage facility inventories, production deliveries, or even gasoline usage to justify this recent rally. In cases like these, the logical culprits are typically general perceptions and the emotional responses that follow. A few industry analysts fastened onto the recent monthly candlesticks that formed when oil prices hit $26. A similar formation had occurred back in 2009 when another bottom was established. Favorable forecasts suddenly followed, and investors grabbed onto the opportunity of a lifetime to ride oil all the way up to triple digits. As you might expect, shorts were squeezed. A brief rally ensued, and then a reverse occurred, once the market realized that nothing fundamentally had changed.
The bottom pickers quickly changed their arguments, as well. The word became that fundamentals were at least pointing in the right direction. Imports and gasoline demand remained elevated. Refineries were “going all out”. Inventories seemed to have stabilized. When the market heard there might be ongoing discussions between major and minor OPEC members concerning a possible production freeze, as misguided as it was, the fuse was lit for take off. The oil price rocket, however, barely achieved lift off before gravity returned. Are oil prices just establishing a new floor of support or are they preparing for another deep dive?
What is the latest thinking on the near-term direction of oil prices?
There are still two divided camps on this issue. One side argues profusely that a bottom has definitely formed, while the second group posits vociferously that down is the only way to go, at least for the months ahead. No consensus is coalescing at present, but that does not stop the shouting and screaming from the rooftops. There is money to be made in newsletter subscriptions, if you can claim to have made the right predictions first, before the herd tramples over you to fund its positions.
The Downward Naysayer Opinion: The primary point made in the initial debate is that when Saudi Arabia, Venezuela, Qatar, and Russia alerted the press that a potential production freeze might truly be in the works, there was no firm agreement and no discussion about future cuts. Iran was already ready to amp up its production, as well. The rally, plain and simple, was based on a rumor and should never have happened. Secondly, oilrig counts peaked at 1,600 in mid-2014, but have subsequently fallen precipitously down below 400. Everyone and their grandmother have predicted that supply would suffer, but production just keeps rolling along. Why is this? Newer technologies have allowed oil producers to get more from less. The rigs that have shut down were more than likely the inefficient ones that needed upgrading. Thirdly, even if oil prices surged to $40 to $50, the breakeven point for most North American facilities, the fracking community would come to life and flood the market once again. Lastly, if gasoline production is up, it is in preparation for the summer seasonal push. All in all, this bump is temporary by nature. The basic supply glut problem is still with us, and oil prices could hit the low twenties under this scenario.
The Upward Optimist Opinion: On the opposite side of the equation is a group of highly touted “sages” that have been respected in the past and already have large newsletter subscription bases. These analysts counter that the current data is misleading because it is derived from a model with data that is months old at best. The so-called glut is overstated from their perspective, as well. They also believe that Saudi Arabia is actually moving behind the scenes to bring about the much rumored “freeze”, since flooding the market with crude is not in its best interest. The possibility of a short squeeze is, therefore, imminent. Under this scenario, macroeconomic headwinds are also less formidable. China will not explode. Talk of a recession in the United States in 2016 is premature. Many analysts are reading the current tea leaves of leading indicators and forecasting a bump in 2017, but oil demand should not decline in the near term. If anything, political tensions should rise in the Middle East, followed by a ramp up in oil prices. The camp favoring this opinion sees $60 oil by yearend.
Are there any other considerations to take into account?
It is easy to side with the naysayers, since many of the positions on the optimistic side must be taken on faith that the so-called “Gods of Oil” have got it right. The problem is that these experts have been wrong as many or more times than they have been correct. They just shout about their successes and ignore their shortcomings. One key statistic that is missing is how profitable the industry was during the first quarter. It will soon be earning season, and you may want to focus on such companies as BP (LON:BP), Royal Dutch Shell (LON:RDSa), and Exxon (NYSE:XOM) to see how they are performing and what guidance they put forth for the balance of 2016.
The IMF is also puzzled as to why there has not been a bigger boost for the global economy from lower oil prices. One spokesperson for the Fund noted, “Since June 2014 oil prices have dropped about 65 percent in U.S. dollar terms (about $70) as growth has progressively slowed across a broad range of countries. Even taking into account the 20 percent dollar appreciation during this period (in nominal effective terms), the decline in oil prices in local currency has been on average over $60. This outcome has puzzled many observers including us at the Fund, who had believed that oil-price declines would be a net plus for the world economy, obviously hurting exporters but delivering more-than-offsetting gains to importers.”
The USD actually weakened by roughly 3.5% over this last quarter, a boon for global conglomerates that report their foreign earnings in U.S. dollars. This depreciation may have also helped in the rally to a small degree, but the dip was anticipated due to the actions of the Fed. This weakness may soon reverse itself, when the next normalization rate hike occurs in June.
Bigger problems, however, lurk with emerging market countries and shale producers that are deep in debt. Venezuela and Brazil are heavily dependent on their oil exports and have suffered. Many banks loaned cheap money to shale producers that have been hanging on by their fingernails, waiting for a price rise to push their cash flow into positive territory. These problems do not have quick, nor easy, solutions.
Concluding Remarks
Will we see another rally in oil prices? If you look to the futures market and oil prices one year out, you could jump to the conclusion that something has got to give. There is a “contango” in the price curve, indicating that traders are willing to pay more in the future than now for oil, but the how and when are up for speculation. The situation calls for more volatility in the near term, until the fundamentals get sorted out. From a forex perspective, the Aussie and the Loonie have appreciated roughly 5.5% over the past three months, so the world of commodities may be changing after all.
Stay tuned, and stay cautious!
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