Crude oil has been struggling to maintain its gains since the start of the year, nearing the lows that it has seen in early March. The rise we have seen in oil was from the OPEC members (and others) agreeing to output cuts to shore up prices. This has faded over time as inventory levels started to creep back up, but not all of this is to blame on the Cartels.
The US onshore producers have increased production with the rise in oil prices making many of their fields profitable again. This spike in production can stop almost as easy as it started. Longer term, many oil companies are locking in contracts for oil, sacrificing price for stable cash flows. Should this trend continue it could be the start of major oil companies starting to put more of their revenues into longer term offshore projects and exploration.
This could be a good thing for ETFs like the SPDR S&P Oil & Gas Exploration & Production (XOP), which have been underperforming along with the oil market. As oil contracts get locked in prices and we see a stabilization in prices from a lack of investing in replacement wells, the yield on this ETF could start to justify higher prices in the future.
Today the Fed will most likely raise rates. The markets have priced that into near certainty. What is more important is the message that will come after the increase. The Fed's reaction to the 'reflation' trade spurred by a Trump victory is making assumptions of higher growth and inflation rates in the future. This trade has put the markets at record highs in the US and saw the price of gold driven down by a rising dollar and higher rates in the bond markets. What will determine the trajectory of gold in the coming year will be dependent on the message the Fed delivers.
If the Fed gives into the reflation trade and talks aggressively on inflation threats on the coming year the price of gold will suffer more. The yield curve will flatten as rate increases look to dampen the longer term inflationary prospects of the U.S economy. The more likely case is that the Fed will wait to see if this rhetoric will come to fruition in the coming year and keep an eye on inflation numbers through the first half o next year. If and when fiscal stimulus legislature gets passed you could expect to see more concern from the Fed. In this case the threat of inflation going higher than the nominal GDP rate could spur a drop in the dollar and a rally in gold as a hedge against the potential if negative real rates.
Russia and Saudi Arabia spiked oil up over the weekend with talks of a production freeze. The news has initially spiked the price of oil, but has since seen the price come back down. the oil production freeze talk has lost its potency in the markets since the start of the year as many of the smaller fracking companies have proven more resilient and ramped up production in light of the spring price spike. While not near last years levels the rig count shows that some producers have the ability to increase production in the face of overall lower prices, if they see a rise to the upper 40s in price.
What Saudi Arabia and Russia should really look at in order to raise prices and keep them that way, is the ability for these smaller fracking companies to borrow at attractive rates, making $50 a barrel oil a possibility. So long as frackers can access cheap funds at lower rates the most a production freeze will accomplish is raise the price to start the us shale boom back up.
The Bank of England did not look to increase stimulus or cut rates at this meeting, which many were anticipating. The reaction was a drop in the UK 10yr price, moving yields higher. Across the world we are seeing yields continue to hit record lows and the BoE’s decision to stand pat was the first of expectations of easing not being satisfied. Should the Fed talk alter today be less dovish and Data points for the US and UK are better than the expectations, you could see interest rates start to move Treasuries and even Gilts back towards safe havens.
This could have a negative implication on Gold and Silver, where the rise in these metals can be correlated with the dampening expectations of inflation and interest rates over the coming years. To an extent the rise in the precious metal prices are justified, growth across the globe is being revised lower and inflation expectations are going with it. Central banks seem to need to start increasing asset purchases in Japan, the Eurozone, and the UK (depending on data according to the minutes). As discussed in an earlier post, expectations of longer term interest rates and the price of precious metals will have a higher correlation and any mis-match in expectations could take the wind out of the precious metal rally.
Markets have taken prices of gold and silver to new highs and there is talk of the rally being over, and the rally just beginning. With precious metals it is difficult to place a finger on the factors that make move in either direction. With no major industrial uses the metals are thought of as currencies, commodities, or alternative asset.
Whatever the reason for people to get into precious metals the universal reason to get out is the lack on income from holding longer term, especially in the face of higher rates. Now in the current settings we have no real loss of income from holding gold, in fact in some countries it would be better to hold gold as the yields on other safe haven alternatives (I struggle to call them that with a guaranteed loss) are negative.
Before the Brexit there was a sense of safety in Gilts and US Treasuries because of the higher interest rates and the prospects of higher yields in the future. Post Brexit the markets seem to be pushing the Fed’s next rate increase further into the future. The UK is now expected to ease policy and lower rates as a result of the referendum. This combination of lower for longer and the possibility of cuts is creating an opportunity for gold and silver to be a safe haven for Europeans. To measure the interest in precious metals going forward I would look to the European and UK yields as a guide. Excluding the periphery countries, most of Europe is going deeper into negative rates (Japan included) and the Pound has collapsed in value and continues to stay volatile. This makes Gold and Silver the perfect place to park gold in the interim. Factors to watch would be good economic data from the US, giving investors some hope that the US will not turn around and resort to easing anytime soon.
Commodities have experienced a good run in the past rally. Oil now above $51 a barrel and gold up about 15% of looking at the GLD. Many macro factors can pay into this trend with China and other markets not having the day of reckoning that seemed so likely even through May. These factors helped commodities off their lows (along side some external shocks in the oil sector) but the dollar cannot be ruled out as a main driver of performance. Fundamentals in oil have not changed in the near term, with OPEC not coming to any agreements at the past meeting. Gold is taking the majority of its cues from the dollar movements this year, with the volatility of the Fed rate hiking decisions providing the majority of those moves.
I still believe that the market is underestimating yields and the poor jobs numbers reinforced that bias. As a result I think that the call for gold to continue its accent from this point could be met with some resistance and will need another catalyst to continue higher. More market turmoil could be a cause of this, if there seems to be a spillover into the real economy and the Fed decides to hold off on rate increases over the summer.
Looking at the current trend in oil it seems that a move back to the lows of the year are a lot less likely. Having moved up 80% from the lows a lot of the oil industry players have seen higher share prices and tightening spreads in the bond markets. While still bullish on the longer term prospects of oil, it could be a good time to take some profits from the more aggressive oil plays in a portfolio or hedge to some degree.
The OPEC meeting today is going to show some clues to what the group is thinking but there is little action that is expected. The positions of the countries seem to be entrenched with Saudi Arabia and Iran in a market share dispute and some of the smaller countries like Venezuela and Nigeria in turmoil from lower prices. What is more concerning is the fact that temporary supply disruptions in Canada, Nigeria, and slowing production in Iraq have caused the supply and demand situation to balance out, albeit temporarily. Once these changes to the supply side dissipate you could see some resistance to the upward moves in oil prices. From a stock perspective, anything dividend paying should be held onto because the elevated price will help to ensure a steady payment cycle (perhaps some covered calls would be a good choice for them). Any outright plays in the move in oil prices has most likely seen a good run and should have profits taken while looking for a better entry point in the future.
The Oil quandary in the idle east has caused a stir in prices, over the last few days. The drop in early trading Monday followed by a spectacular rebound leading to positive gains on the Week Tuesday. The underlying trends had little to do with the meeting however. The strike in Kuwait (and the ending of it today) were main causes of the price movement so far this week. Looking longer term it will be interesting to see how much of the rise in oil prices over the past month will be given back on the breakdown of the deal.
News is coming out of the EIA today that will give some insights into oil stock in the US, but more insightful news is coming out in a few days. Saudi Arabia is coming out with its vision of the future and how it plans to build a country not entirely dependent on oil revenues. The architect of this vision is Prince Mohammad Bin Salman, the same person who allegedly halted the negotiations this weekend. The success (or failure) of this plan will determine if the country will be firm on maintaining market share in the future or higher prices.
Oil has been quiet in recent days, with volatility down and the price rising steadily. A lot of this has been attested to the talks between Saudi Arabia and Russia in their pledge to freeze production increases. This could have given reluctant buyers the conviction to take speculative positions forcing up oil and oil related stocks. The stability of oil prices will have longer term effects on oil price directions as companies start to look at the reality of a lower price band and move their cap-ex towards projects that will align with the new reality of oil prices.
A good example of these shifts is the series of discussions in Canadian politics about the need for the oil industry to transport their goods to global buyers and not rely on transportation to the US and the sole selling point for oil. The oversupply in US oil has caused the majority of the pain in Canada because they couldn’t tap the global markets after the denial of the Keystone XL permit. Looking at companies that are making a shift in exploration and cap-ex to meet the new economic realities of the energy market will be good long term plays which, in hindsight, are priced very attractively.
BHP Billiton is in the news because of its shift into oil and how that has changed the fate of the company compared to its competitors. This has caused the company’s share price to follow oil more than the price of copper has given BHP a lower valuation than its peers. This creates an opportunity with earning due tomorrow to assess the financial condition of the company and make a longer term assessment of the company’s prospects.
The macro factors seem to be against the company at the moment but should the company look to snap up more fire-sale oil assets BHP could be a strong longer term player as oil recovers and eventually base metals. One risk to look at is the possibility of litigation from the Samarco dam accident. While a lot of reports will come out over the week because of the earnings, it would be good to take a longer term look at the numbers and make an assessment for the longer term.