Asset Allocator: July 2015- Return to Oil Volatility?

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

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ASSET ALLOCATOR: JULY 2015

 

20/07/15- Return to Oil Volatility? 

 

This week I want to return to a familiar subject, oil prices and their likely direction in the coming months. Overall I’ve been fairly bearish about the price of oil suggesting that we won’t see the bottom in terms of prices until we’re at the $20 level. We’re still a long way from that point but I think we’re now entering a fascinating end game involving three fascinating acts. 

My own sense is that oil prices might weaken over the next few weeks as the implications of the Iranian deal begin to sink in, but then we may see another rally in prices (upwards) over the early autumn as investors become more positive about global growth. 

But towards the end of the year my guess is that we’ll enter the final act of this three part play, with all that Iranian oil finding its way on to the global markets in 2016, and surging output from North America helping to unsettle prices. In this final act, the cynic in me even wonders whether the likely end of year US interest rate hike might be given a positive headwind (after initial taper tantrums) in 2016 by these much lower energy prices, helping to push US equities forward again after a short bout of volatility. 

Anyway let’s start this investing with a quick current market snapshot. The chart below from www.sharepad.com shows the price of Brent crude through to 16th July 2015, with the thin black line the 200 day moving average. After a rally in the spring oil prices have started to move back lower again as investors have continued to worry about robust US output and the possibility of a deal with Iran. This uncertainty is most clearly visible in the short and leveraged tracking products space where demand for energy based options is still fairly subdued. A couple of weeks back Boost ETP for instance released global stats which suggested the assets under management for oil was running at $3 billion, followed by natural gas at $1.1 billion. These numbers are fairly subdued for S&L products and in truth ETPs tracking crude oil have experienced outflows in both long and short positions.

 

 

 The big driver for much of this caution has been the impending Iran deal, which we now know has been rather miraculously completed – although doubts remain about how long the agreement will last!

 

 Investors are clearly spooked by the possibility that Iran will start massively increasing its output of oil and gas, unsettling energy markets. Analysts from US bank Goldman Sachs rightly observe though that the devil is very much in the detail and that any massive expansion of trade is still a long way off. 

According to a note to their investors on July 14th Goldman’s analysts observed that “Once inspectors verify compliance, the sanctions relief would be wide ranging: the EU oil embargo and other nuclear-related EU economic and financial sanctions would be lifted and Iran would also be allowed to use SWIFT for international banking. The nuclear-related secondary sanctions imposed by the US, which are generally aimed at trade between non-US companies and Iran, would also be lifted once the IAEA verifies compliance. The EU sanctions lifting will have to be coordinated with the US so that European companies do not face secondary US sanctions if the EU ones are lifted too early. If there is cause to believe that Iran has not met its obligations a joint commission will have 30 days to resolve the dispute. Failing that, the UN Security Council needs to vote to continue sanctions relief. A veto by any permanent member would result in the re-imposition of sanctions. The whole dispute resolution process could take 65 days unless extended by consensus of the parties. Net, the above timeline suggests that the sanctions relief under the agreement would take effect most likely in early 2016 assuming no additional delays. One of the key uncertainties of the above timeline remains US Congressional review.” 

This excellent summary suggests sanctions relief won’t really help that much in the short term and “that Iranian oil flows will continue to remain capped until 2016. The impact of sanctions relief on Iran’s production would likely initially be a draw-down of floating storage and an increase in production of several thousand barrels per day. We tentatively assume that this will lead to a c.200-400 kb/d increase in exports in 2016. Uncertainty around this estimate is large, even beyond the timing of sanctions relief. For example the Iranian Oil Ministry has stated that the country can increase exports by 500 kb/d as soon as sanctions are lifted, and then by an additional 500 kb/d in the following six months while the IEA has estimated that production could increase "swiftly by 600 kb/d" back in April.” 

Nevertheless it’s also obvious that some Iranian energy supplies will find their way on to the global markets over the next few months, depressing prices in the short term. Another recent note from an investment bank, this time Societe Generale, observes that “$59 Brent is $5 lower than its rangebound June average of $64, and $53 WTI is $7 lower than its June average of $60. China, Greece, and Iran have clearly caused an upswing in risk aversion, which has been bearish for crude.” 

But the chart below shows energy bears shouldn’t get too carried away with forecasts of a collapse in the price of oil. This chart from SG energy analysts shows refinery crude runs i.e flows of oil into refineries for processing. It suggests that 2015 demand is running consistently higher than previous years.

 

 As SG analysts note “Strong product demand, refining margins, and crude demand should drive a recovery. It’s still summer, and gasoline is key. The most likely catalyst, in our opinion, will be gasoline. There has been continuing strength in gasoline cracks, with NYMEX RBOB vs. LLS trending higher and almost reaching $30 this week. Gasoline demand is strong, not just in the US, but also in Europe and Asia.” 

The broader backdrop for this argument is I think obvious – a strengthening global recovery. After the risk aversion of the Greek crisis and the Chinese stockmarket meltdown, investors might start to become more optimistic about the global recovery in the second half of 2016. The US economy recovery has not been derailed – in fact it seems to be so strong that the US Federal Reserve is now openly talking about increasing interest rates this year. The Eurozone economy should also bounce back in the second half of 2015 and I’d tentatively suggest that China may surprise to the upside in the remainder of 2015 as the government swings into action to contain losses from the stockmarket crash. All these factors should combine to push demand for energy higher in the second half of 2015, with gasoline prices the first indicator of resurgent demand.

 

 

 

But as we head into the closing months of 2015 the final act of this tragedy might unfold. That Iranian deal – if it has survived its various challengers – will by 2016 have started a scramble for Iranian oil. Although Iran needs vast investment to reach its pre-sanction output level of 3.8 mb/d, many energy multi nationals are now lining up to move back into the country. By 2016 we should start to see the first major impacts on global energy markets, with more Iranian crude in particular finding its way into Asian markets. The strengthening US economic recovery will also have encouraged its local unconventional producers to ramp up capacity again, flooding the global markets with more cheap oil and gas. 

 

At this point my guess is that we’d also have run into the next taper tantrum episode, assuming that the US Federal Reserve has increased interest rates (slightly) later this year. Investors will inevitably react negatively to any interest rate increase although in fact such a move should be greeted with some enthusiasm as it signifies confidence in the recovery. Volatility in a series of asset classes might increase and my guess is that investors will start worrying that the US Federal Reserve’s actions might choke off growth, with an inevitable impact on energy prices. Cue an early 2016 fall in energy prices as those market worries combine with resurgent Iranian output to push oil prices much, much lower.

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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