Today, we want to present readers with some insight into the forces that drive the commodities markets and how cases of divergences may present traders and speculators with opportunities.
Returning to a market which have been fairly well acquainted with, readers will understand the differences between the spot physical markets, and the futures markets. A good deal of price discovery has taken place since we last penned our note on March 19 calling for an inflection point in prices, and especially so after our first long trade on oil nailed the initial bottom back in January.
For the record, we still feel higher oil prices should be expected. We favor upside at or slightly under current prices - $57.50 on WTI, and $62.30 on Brent - and see the most recent decline as an opportunity to initiate long positions. The fundamentals of the U.S. oil market have changed rathe significantly in the last 2 months; and this has lagged prices, something that we find interesting.
We will probably pen a separate piece on this. But for now, here is some good commentary about the schism that has developed in the oil markets.
Oil Futures Prices Divorced From Physical Markets For Now
"Like pushing a rock up a hill"
That’s how some trader’s view the current disconnect between the physical market for crude oil and the futures market with speculators pushing futures prices higher while the physical market remains moribund.
Before continuing, it’s important to make the distinction between the physical market for crude and the crude futures market.
- Physical (also known as cash) market prices are determined by the supply and demand for physical crude. Here traders buy oil from the producer and sell it to the refiner, for immediate delivery. Physical buyers and sellers have a direct pulse on the market and may feel immediately when it is well supplied, or not.
- Futures prices, on the other hand, are determined by the supply and demand for crude futures positions. Futures markets provide a means for trading the probability of where crude prices will be at certain points in the future; this allows physical market participants a means by which they can hedge their position and so reduce risk.
The physical crude market tends to show weakness (i.e. too much crude swashing about) when the premium for the best crude grades weakens against the benchmark Brent. One of the most favoured grades in Europe is Azeri Light due to its high quality.
Over the past couple of months physical crude traders have noted the weak premiums for Azeri Light versus Brent as other cargoes, particularly from West Africa compete to supply crude into an already oversupplied Atlantic Basin market.
This apparent disconnect between the futures and the physical market appears eerily similar to mid-2014, just prior to crude prices collapsing. So is the current weakness in the physical crude market a precursor to an imminent weakening in crude futures prices?
Don’t bet on it - at least not based solely on what the physical market is doing.
While the physical fundamentals of supply and demand prevail eventually, the physical market may not always be able to anchor futures prices for days, months or even years.
If commodity futures prices rise too much, perhaps as a result of speculative interest, as there is now, physical supplies will start to be delivered against short positions (a manufacturer looking to hedge its inventory of raw materials might have this kind of position).
In practice, there is never enough physical material readily available to deliver against all the short positions, so rising futures prices can only be offset by buying back crude futures contracts rather than making physical delivery. It takes time to divert and accumulate sufficient physical crude supplies to meet a rise in futures prices driven by speculative rather than fundamental factors.
To get an idea of the extent to which this process is occurring take a to look at the net contract short position for commercial hedgers from the US CFTC weekly Commitments of Traders report. Back in mid-2014 the net short position amongst commercial hedgers (actual producers and users of crude) rose to around 500,000, a record level. This position has since fallen to just over 300,000, but it is still high on an historical basis.
As we know from the months leading up to the oil market crash that began in the middle of 2014, oil futures prices can divorce themselves from the physical fundamentals for a long time.
The price of crude, as with any other commodity is only worth what someone is prepared to pay for it. The market’s perception of scarcity in mid-2015 is such that participants in crude futures markets are now willing to pay less than half what they were paying just one year ago.
While theory suggests crude futures markets are anchored to the physical market as contracts expire, in reality the link is a lot more tenuous. As with the myth of Sisyphus the rock will eventually start to roll back. Timing when that will take place, and the catalyst involved, is a whole different matter.
This coming Thursday, 23 June 2016, the United Kingdom will vote on a historical referendum deciding on the status of its European Union (EU) membership. For the last 2 years since 2014, the UK parliament, led by acting Prime Minister David Cameron have promised a public referendum on Britian's EU membership. Britain's relationship with Europe has always been one of contention, and many have long been awaiting this once in a generational lifetime opportunity to voice their opinions through the democracy of a vote.
The global financial markets have also been eying this key event risk for some time, and since events have heated up recently as we enter the final week before the ballots are cast, there has never been a more important 4 days for English markets (that's including the pound sterling, GBP) since the "Black Wednesday" of 1992 , the day the Bank of England was broken by the markets.
We are not usually pessimists but when we see the writing on the wall getting bold redder each week that passes, we can't help but to take serious note. Just last week, we warned readers that markets might be about to get nastily volatile during the summer. So far so bad. May hasn't started well at all. The S&P 500, as of the week ending this past Friday, posted its first 3-week losing streak since January.
Recent macro developments both in the U.S. and elsewhere have however strengthened the bearish case for risk, in our opinion. It might have reached a point where downside skews in risks make a derisking maneuver potentially more rewarding than chasing beta.
As such, we have shifted our bias to the short side of risk. The positions in our portfolio (which we keep private) have partially reflected this change in view and will continue to do so as the situation evolves.
It is a known fact that credit cycles often lead business and economic cycles. It makes sense on paper and even more sense in practice. This is a subject that we havehardly yet touched on, but will be doing so in this piece. For a majority of the investing community, the topic on credit cycles remain much of a novelty.
As of March 2016, total default volumes on HY bonds (high yield) and institutional loans in the U.S. hit a 6-year peak of approximately $16.2bn, almost half that seen in the entire of 2015. Just this past week alone, we saw at least 4 corporate defaults with 3 in the energy sector.
So far in 2016 (Jan-Mar) default volumes have reached a jaw dropping $32.4bn. To put this in context, 2015's default volume (which was already abnormally high) stood at $37.7bn. If this trend were to continue through 2Q and beyond, we are talking about a full-fledged wave of defaults.
For the first 3 and a half months that have already elapsed in 2016, no asset class has seen the consistent volatility that currencies have. Central banking has been busy, almost too busy, all while the macro fundamental landscape has hardly moved an inch. With all that drama, noise, and play in monetary policies throughout the global economy, one would expect sizable trends in FX. But that hasn't been the case.
For instance, when the ECB first lowered its deposit rate to zero back in the first half of 2015, that sparked a major bear market in the euro, and a bull market in risk assets including euro bonds. When the Fed announced it planned to gradually taper QE3 and eventually end it late in 2014, the U.S. dollar began building up into what we now recognize as one of the most fervent dollar bull markets ever.
Monetary policy divergences used to herald the alpha and omega of huge trends. But not today.
Now, thanks to a comprehensive piece by Bank of America Merrill Lynch, we can provide readers with a glimps of what might be the next big trend in FX.
Last week, Bloomberg broke a story which greatly fascinated us. It involves a mysterious "specter", one which we have no clue about, flooding the Turkish stock exchanges with massive buy orders, massive to the tune of some $450mn in a single day.
Turkish locals refer to this entity (whoever or whatever it is) as "the dude", crowning the figure with an amphibious demeanor worth of a chapter in Slenderman. We have no idea, absolutely no idea who or what "the dude" is, how it specifically operates, and what its motives are for slamming a relatively illiquid market with order sizes so large, they scare the living daylights out of even the staunchest of permabears.
All we know is that local authorities have been rattled, investors shaken off to the sidelines, and a stock market that is now a stellar outperformer in the emerging market (EM) space. Even with the gruesome terror attacks in Istanbul over the weekends, an attack which has killed at least 37 people the last we checked, the Borsa Istanbul Index has now rallied for the 9th straight day.
That's right, we need the U.S. dollar to be BOTH strong AND weak at the same time for continued upside in equities. Much has been said about the greenback ever since the end of the Fed's QE3 program in late 2014. It was then all about king dollar leading up to the Fed's first (in a decade) rate hike in December 2015. Speculators kept piling in on the the freight express train that was the long dollar trade du jour, creating what has become one of the most crowded trades in modern history.
It's likely going to be a tug of war between these forces we've highlighted in this piece. Again, we make no predictions as to direction. We do however expect this conundrum to continue until a novel catalyst emerges that alters the way market participants trade and position. What this novel catalyst is, we don't know.
This conundrum is big, as we shall explain below.
The top 0.01% of the erudite elites control more than 60% of the world's wealth, while the 80% of us have a collective net worth less than the top 1% of society. In a world decorated with such gaping inequalities, risk and opportunities present themselves. While problems may be plentiful, there are also long term opportunities to capitalize on the mother of all trends: A globally aging demographic.
Which is what Janus Capital's Bill Gross, well revered as being called the "Bond King", is driving at in his latest investment outlook. In the race between the tortoise and the hare, the former analogous to a gradually aging population, the latter to technological advancements, the tortoise eventually catches up. Time isn't on our side, and we're sitting in a ticking time bomb.
It's a known fact that a large majority of the world's baby boomers are not adequately primed for retirement, lack the financial resources to meet mounting healthcare and insurance obligations as they further age, and are more dependent on the state's hospitality than ever before. But who pays the ultimate price?
The prospect of $20 oil prices has been raised thanks to this one Black Swan. A Black Swan is also known to statisticians as tail risk, or events that are highly improbable but are of great significance. One can liken such an even to a large meteoroid making its way through the Earth's protective atmosphere and impacting land or sea; an extremely unlikely event but if actually true, mankind's existence would be threatened.
Low oil prices have been the bane of many oil producing and export nations, whose currencies and economies have taken incessant hits every cent crude continues to plunge. The ruthless combination of a huge supply overhang and waning global demand has led to a deadly concoction oil producers and exporters have no choice but to drink. What other choices would they have anyways?
Whatever we said on 5 November came true. For the first time in 9 years, the Fed hiked the Fed Funds target interest rate by 25bp to 0.25-0.5%, ending an eon of zero lower ground rates and marking the start of a new paradigm. A paradigm that is, much as most would hate to admit, unprecedented in terms of scale and bredth.
As we approached 16 December, markets had increasingly discounted a Fed liftoff, but there was still some element of uncertainty. That uncertainty now shifts to what the Fed will do in 2016. Will it continue to gradually hike rates? Will it reverse on its path of monetary tightening and start to ease? These are but a multitude of questions that everyone is asking, but no one can really answer.
Does dovish rhetoric from Europe's ECB, continued stimulus from China's PBoC, the reluctance of Japan's BoJ to step up QQE despite headwinds, New Zealand's RBNZ policy being put on hold signal a soon imminent Fed rate hike?
While correlation might not necessarily be causation, especially in the ubiquitously tangled web of central banking, we believe this development is too significant to turn a blind eye on. Ironically, market-based odds for a December Fed rate hike have never been higher.
Do central bankers know something about the Fed's near term actions which the general market doesn't? If anyone knows what the other will do, it's probably them.
We'll leave this up to you to decide. The proof is in the pudding, and this one's pretty dense. So take it for what it is, we're playing it cautious but not holding our breaths.