The Market Corner: the month in review
By Filippo Lecchini
The return of the king
Often at the end of 2016 we discussed and mentioned the bottoming oil prices. At the time OPEC (https://en.wikipedia.org/wiki/OPEC) was desperate for getting a spike in demand by curbing production, often with mixed results.
Fast forward a year or so and the picture appears quite different. A production freeze is still in place, it was negotiated at the end of 2016 by OPEC to include Russia, a nonmember whose fortunes are greatly affected by oil prices, but not everybody is happy. In mid-April the President of the United States took it to Twitter concerned that “Looks like OPEC is at it again” and the 2016 low of $26 per barrel looks like a distant memory now.
To understand what happened it’s useful to go back to 2014 when oil was trading around $100 a barrel. At the time a number of US producers with a heavy cost structure increased their participation in the market and many had loans and liabilities collateralized by their oil reserves. They joined OPEC, Russia and the other producers to eventually realize that demand was not catching up to supply. Especially in a market undergoing a long term shift where alternatives to fossil fuels are becoming more viable demand cannot be thought of as a static factor and that possibly played a role too.
The sliding prices caused producers with high cost and debit in the US to exit the market. The Russian economy similarly was hit hard. All the countries and producers were forced by the glut into looking for countermeasures.
The current production freeze is negotiated to run through the end of the year but now the question is how high is too high. The conundrum has interesting implications for different types of economies. In the US oil producers like higher prices but people who have to buy gas at the pump or business for which oil is an input not so much. That’s a decentralized economy where ideally market forces determine prices. How high becomes an irrelevant question, if this was strictly a domestic issue it would be easy to say tampering only creates distortions, other countries however have different models. Saudi Arabia for example is a producer first so if the demand is sustained, higher is better. For those versed in conspiracy theories in fact the rumor is that the Kingdom would like to push the price of crude toward $100 in anticipation of the Saudi Aramco IPO.
Different forces and tensions push prices in different directions and then there is politics. The announcement that the United States will pull out of the Iran deal brings a whole new layer of complexity into this discussion. If the deal is dead, the sanctions will be back and Iran’s production will be out of the market decreasing the global supply. From there the future is uncertain: a new deal could be negotiated or the rhetoric could escalate into conflict and eventually war. There is already military tension between Iran and Israel and Iranian forces are heavily involved in several countries in the region including Syria. At that point, it would be hard to know where crude could trade and is not only the price but also the velocity of a spike. Going from $70 to $100 has different consequences if it happens in 2 months or 12.
Regardless of what happens uncertainty and volatility have returned to the market. Crude oil is back.
Looking ahead:
A rate hike at the FED meeting in June seems like a sure thing. Volatility is back in some capacity across asset classes but is not quite clear where the markets are heading next. Some people talk of a looming recession but there are no real signs coming or reasons why it should with a healthy economy, good earnings and rates historically still low. There is also plenty of optimism around the meeting between Donald Trump and Kim Jong Un scheduled for June in Singapore, even though denuclearization is far from a done deal. Trade conflicts and possible confrontation in the Middle East on the other hand can change everything very quickly and, to add to the uncertainty, the US and Europe seem to disagree on a number of issues, which has not been the case in recent history.
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