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Oil has suffered from a major sell-off and volatility has spiked amid multiple bearish developments. We increasingly think that the drop is excessive and see scope for a tactical rebound.
AAUC Head of Commodities and Hedge Fund Strategy
Oil markets have had a turbulent few weeks with both WTI and Brent shedding more than USD 20 since the beginning of Octo- ber to drop into the low-USD 50s and low-USD 60s, respectively. This plunge was indeed accompanied by bearish fundamental shifts such as Iran sanction waivers, significant agency revisions to supply and demand estimates, weak seasonality, and broadening macro concerns. That said, we increasingly believe that the magnitude of the sell-off is overdone and see scope for a rebound into the year-end, subject to two major prerequisites: The Organization of the Petroleum Exporting Countries (OPEC) must adjust supply again and US inventories need to start drawing soon.
The sell-off has been exacerbated by an abrupt positioning unwind among investors who have amassed at record length during the H2 2017-H1 2018 uptrend. This process now appears advanced through the absolute position has not yet reached extremely low levels – unlike in other commodity segments.
Iran: The market has gone from pricing huge disruptions to Iranian oil exports (>1.25 Mb/d) to now expecting a much smaller disruption (about 0.5 Mb/d), if at all. We would stress that the market will still lose considerable volumes of Iranian crude in the coming months but in a more staggered way. It is also possible that US authorities will again adopt a more hawkish stance on sanction implementation now that the midterm elections are over.
Supply/demand estimates: Lowered consumption numbers could prove sticky given a more uncertain macro backdrop, but supply upgrades, particularly to US shale volumes, are now prone to renewed downgrades since drilling activity remains price sensitive. As upgrades were made when WTI prices traded in the mid-USD 70s, it is likely that renewed downgrades will follow next.
OPEC: Anticipating strict US sanction enforcement, OPEC ramped up output too much in October, creating excess supply in the market when the USA has decided to change course on Iran at the last minute. Indeed, Saudi Arabia and several other OPEC members should acknowledge the need for renewed supply cuts at the upcoming meeting on 6 December (by about 0.5–1.0 Mb/d) in order to prevent inventories from piling up again next year. While we think that such an action is likely and necessary for prices to find some grip, it is not a given, especially considering the current pressure exerted by the US administration on Saudi Arabia. It is possible that OPEC will simply stress that it will focus on meeting actual client demand and adjust output accordingly instead of committing to firm targets.
Seasonality: Seasonal effects should tilt in favor of firmer prices into the year-end. We are currently observing seasonal stock builds in the USA as refineries conclude their October/November maintenance programs during which crude intake drops considerably. Activity is now set to pick up in the coming weeks until early January, which should lead to renewed stock draws. This might prove an important catalyst for stabilizing sentiment and lifting prices.
Against these uncertainties, volatility has spiked to above-average levels and put skews have widened sharply, flagging still-elevated two-way risks. However, we see chances of a tactical rebound in the coming weeks as flagged by our Investment Committee’s view change to outperform. From an investor perspective, we would consider selling the current volatility spike. Risk reversals or bullish put spreads (with different tenors to cover the OPEC meeting event risk) could be expressions to explore. We would stress that this is a tactical call for risk-tolerant investors and that caution remains warranted in 2019.
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Important Information:
This part of the material: (i) aims to provide macro-market commentary; (ii) does not contain any statements or advice in relation to any specific marketable security or financial product; and (iii) does not take into account your personal circumstances and should not be treated as any form of regulated financial advice, legal, tax or other regulated service. 