We were too early into the oil trade, positioning long oil via equities and a hedge fund in early 2017. We sat through a lot of mark to market volatility. Oil prices fell, disregarding OPEC’s production cut announcements and a trend of inventory draws in crude, gasoline and distillate. Markets focused instead on US shale and rising rig counts pointing towards a future glut, ignoring increasing depletion rates and rising costs. As the speculative market sentiment deteriorated, the physical market was getting tighter. Since August, the market drifted from steep contango to backwardation by mid-October. It remains firmly in backwardation, indicating sustained tightness in the physical market. Political turmoil in the middle east and supply disruptions added to price pressures. These cannot be relied upon but cannot be discounted either. On the demand side, developing world demand has overtaken developed world demand as the marginal driver and continued growth in the emerging markets has fuelled demand. Our thesis has not been based on short term cyclical factors but on chronic underinvestment in exploration and infrastructure resulting in structural supply constraints in long cycle oil going forward. The market has now recovered and there is even talk of over-confidence as hedge funds and speculators position for further price rises. This may well be, and volatility may return, but the demand and supply conditions cannot be changed in a matter of weeks or months or even a couple of years. Absent serious investment in future capacity, oil will be undersupplied. Electrification of transport, heating and industry will not happen sufficiently quickly or in such scale as to change the demand supply conditions for the next 5 years at least.
And the USD continues to slide. In December 2015, the consensus forecast for the EUR a year ahead was 1.09. Spot was trading at 1.086. By June 2016, EUR was 1.11 and the forecast was 1.10. At the end of 2016, the EUR was at 1.053 and the forecast was still at 1.10. In May 2017, spot had moved to 1.12 but the forecast had been dropped to 1.04. By September, the forecast had risen to match the spot which 1.18. Currently, the consensus forecast for the EUR is 1.18, it trades at 1.22. The efforts of over 60 of the world’s most formidable banks has struggled to produce consistent forecasts for the EUR. FX makes for interesting intellectual macro debates but forecasting accurately and investing in it are notoriously difficult. We think that fundamentals support a stronger USD in the long run, especially if a trade war resumes, but the positioning of the market is still net long USD and needs to be unwound, and current sentiment is stacked in favour of EUR. We are not making significant bets either way.
The BoJ meets this week and lately, JPY and JGBs are behaving as if the BoJ will announce a tapering of QE. This is probably premature. The pre-emptive pricing in FX and rates markets complicates matters for the BoJ. Growth has been accelerating but it is very early days yet and the BoJ will not likely want to choke off the recovery this early. The strength in JPY is a particular bother for an export nation like Japan. It is likely the BoJ will signal business as usual while upgrading economic forecasts, signalling a tolerance for higher prices, hardly a stretch for a country plagued by disinflation.
The ECB also meets this week. The EUR has been quick to price the progress made in forming a coalition in Germany. This Sunday, the SDP in a party divisive decision decided to throw in their lot with Merkel for a grand coalition. After spending 3 years (2014 – 2016 inclusive) of weakness, the EUR is reacting more positive to any news. An Italian election looms where ex PM Berlusconi’s party threatens dominance. Catalonia’s recent elections were hardly a sign of stability with a large turnout and a major swing to the secessionists. But the main story driving the EUR is the continued momentum in economic growth now 18 months into its acceleration. The ECB’s reaction will be complicated by the strength of the currency. Meanwhile, it has emerged that the ECB’s bond buying has been deviating significantly from its capital key with the bond buying skewed towards the Southern members’ debt.
No commentary would be complete without some reference to the US government shutdown. This isn’t the first and won’t be the last time the Americans quarrel over how much they can borrow. Market impact has been moderate in the past and has been muted going into the current shutdown. Some have identified the shutdown as a factor in USD weakness although it hasn’t shown in other markets. Senate has been working all weekend and the President has even had to miss his own inauguration anniversary party (surely much to his frustration) to try to come to an agreement. One point of contention is how to deal with undocumented immigrants brought to the US as children. A centrist, bipartisan group of Senators has formed to broker a compromise deal in the early hours of Monday morning.