The Weekend Edition # 113 - A note about oil
Market Recap: Bullish Flows; A note about oil; On soft landing and rate cuts
Welcome to another issue of the Weekend Edition.
Thank you to all who’ve read and welcome to all the new subscribers this week!
Here’s what we cover:
Market Recap - Bullish Flows
Macro - A note about oil
The Week Ahead - Economic & Earnings Calendars
Closing Thoughts - On soft landings and rate cuts
Let’s dive in ⬇️
Market Recap - Nov 20 - Nov 24, 2023
Another bullish week for the markets and this time driven by quite a lot of macro data. The inflation numbers for the US were a major catalyst, coming in much softer than expected, proving everyone's estimates wrong.
The market is now pricing in a soft landing and rate cuts. Add to that a decline in oil prices and you have situation where the bullish positioning in the market has resumed. There are some discussions of tax loss harvesting, which is where people take a loss on the stocks that are down to offset against profits, in order to have a lower tax bill. It's hard to say how this turns out.
On the one hand, you likely still have quite a bit of losses in single stocks that have not recovered as much against profits from the mega cap tech stocks. On the other hand, a lot of the tax loss harvesting may have taken place last year and therefore, we may see a lower level this year. We also have a situation where this year saw more people trade options and the broader indices / ETFs.
The investor mindset seems to have become shorter term now and we're seeing that in market moves. There may still be some rally left but 4500 remains quite a key level and we may see the year ending around this level. We do have conflicting views from some of the banks that suggest we could see stock drop at the end of the year.
We saw flows come in positive for equities last week but we did see some outflows in treasuries for the first time since Feb 2023. We don't think this is the end of higher rates and there is likely some steepening in the curve left.
We also saw one of the highest weeks for buybacks, last week.
Next week is shorter for the US markets, with Thursday off for Thanksgiving and Friday a half day. So liquidity is likely to be poor with higher volatility magnifying moves. We also have Nvidia earnings next week on Tuesday, and that may bring some fireworks.
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Macro - A note about Oil
I'd thought about writing about Oil this weekend, even before the so-called breaking announcement that Russia and Saudi Arabia would consider extending production cuts. We'd already talked about this last weekend and during the week so it shouldn't come as a surprise that when they hold their JMMC on Nov 26, there's a chance we get that extension of production cuts. The question is however, will they increase their production cuts?
Some mysterious source suggests that there may be an additional 1 million barrel per day (bpd) production cut. This would mean a total cut of ~4.6m bpd (2.3m bpd were voluntary cuts by OPEC+ adding to that 1m bpd cut by Saudi Arabia and 0.3m bpd cut by Russia).
The FT is suggesting that this anger over the situation in Gaza and the Middle East trying to get the attention of the US to stop the conflict or do something. I don't partake in politics but, this seems a little over the top.
The bigger concern is perhaps the decline in the price of oil. While our initial estimates say that Saudi Arabia wants to see the price of Brent at $80 per barrel. But more recent estimates suggest that with the new initiatives under the Public Investment Fund (PIF), this could be as high as $100 per barrel for Brent. With an average price differential of about $5, this would mean $95 per barrel on WTI (American) crude.
What's driving the price decline in oil?
Last week, Bloomberg reported that WTI had officially entered a bear market, dropping -22% from it's recent peak. I won't call it a bear market but, yes we're just at about -20%, after the 4% recovery in price on Friday.
There's a confluence of factors that drove the price of oil. But, before we discuss that, we should note that this recent spike was sudden, and driven by the geopolitical situation in the Middle East. Take that out, and WTI should be somewhere between $74 to $78 per barrel, given the OPEC+ price cuts.
We see the recent drop driven by:
Poor refinery margins
The overarching view is that the US is slowing down and Oil is pricing in a recession. Partially true. The recent PMI, ISM data, industrial production and manufacturing data, all point towards lower output and activity, which in turn, means lower usage of oil in manufacturing and transportation (to transport the goods).
Poor Refinery Margins and Runs
The third quarter saw lower gasoline prices driven by lower usage. Gasoline demand has fallen below 2020 levels, according to EIA, while the supply of product had increased. This meant record levels of refinery margins. When crude oil is refined, to produce gasoline, the difference between the price of crude (input cost) and the price of gasoline (output price) is the margin. With higher margins, companies will obviously want to refine more crude.
However, in October, refinery margins collapsed as the price of crude spiked while gasoline prices remained low. The fourth quarter estimates now show a lower throughput of crude oil to refineries. The issue is not limited to the US however, as recent news suggests that China is also considering cutting refinery runs because of poorer margins.
While seasonally supply is usually higher during this period, the forecast shows a higher level of production for the US, Brazil and Guyana, coming in better than expected. Third quarter production has also been better than expected.
In fact, overall crude production in the US has been significantly higher than prior years and the view is that now we will have inventory build into the end of the year.
Despite all these issues, refinery margins still remain above the 5-year average and with the gasoline stocks now gradually tightening, it's only a matter of time before we see inventories at the lower end of the spectrum and crude draws coming in higher-than-expected. The EIA expects Q4 worldwide supply to be higher than consumption by 200,000 barrels per day, which is leading to lower oil prices. However, potential changes from OPEC+ and the consumption situation could very well reverse oil prices higher.
The Week Ahead - Calendars
US Earnings Calendar
US Economic Calendar in Eastern Time (Source: Trading Economics)
Closing Thoughts - On soft landings and rate cuts
The narrative has now shifted to one of soft landings and rate cuts for next year, with the Fed Fund Futures pricing in the first cut in May 2024. We still think this is too early given that there is a risk that inflation may not go down as quickly as expected. While we've seen great progress in inflation thus far, coming close to the 2% level may prove more challenging than expected.
But three meetings ago, the Fed Chair did mention that they would likely cut rates before the 2% inflation target is reached if they believe the trend will continue down and that would likely be in July 2024.
We all know however, that the Fed continues to have a credibility issue and the view is that they will increase their forecast for rate cuts from the current 50bps level during the December meeting. We don't see that as likely however, because it's too soon to make that call and the unwinding of tighter financial conditions in the last two to three weeks will likely continue into the FOMC meeting in mid-December.
Here’s wishing you safe investing.
Ayesha Tariq, CFA
There’s always a story behind the numbers.