Oil’s deep dive is overdue for a bounce, and there is plenty in the news to trigger it this morning. Europe is juggling multiple crises from Brexit to the Italian budget. In the meantime, Presidents Trump and Xi will be meeting to discuss trade.
Bouncing Off a Diving Board
We woke up this morning to news of Russia firing on Ukraine ships. As tensions over Crimea flare up again, we expect nothing more than a small bounce in crude oil. The market is overextended on the downside, and a bounce is likely to materialize before the end of the year. However, we see any bounce as temporary, and it will likely be fueled by short-covering in crude oil futures rather than the renewed tensions in Crimea and the much-feared sanctions on Iran.
We view the threat of Iranian oil disruption as overblown. Iran produces 3.4 million barrels per day (mbpd). Of that amount, Iran consumes 1.8 mbpd internally. The combined exemptions for India, China, and South Korea will absorb 0.86 mbpd of Iranian oil exports, which leaves only 0.7 mbpd of Iranian oil off the market. To keep this in perspective, the US year-to-date production of crude oil has increased by 1.9 mbpd.
In the near-term, pressure from Trump will keep a lid on how much production Saudi Arabia will agree to cut with OPEC and Russia. Saudi Arabia came out with data showing record output in October. The Russians themselves did not appear eager to strike a new agreement for production cuts.
In the long-run, both WTI and Brent will fall below the $30, as Permian production becomes exportable. Consider the following facts:
- The Permian basin’s marginal cost of production is falling below $30 for some producers.
- The US already surpassed Russia and Saudi Arabia as the largest crude oil producer.
- The technologies and standardization that gave the US cheap shale oil will become available to other global producers
- In 2019, four pipelines from the Permian Basin to the Gulf Coast are expected to come online: Cactus II, Enterprise, EPIC, and Gray Oak. By 2020, these four pipelines will have the capacity to transport 2.1 to 2.7 mbpd to the Gulf Coast for refining and export.
- In 2020, three more pipelines will come online: The Exxon/PAA joint venture, Jupiter, and the Permian-Gulf Coast pipeline. The capacity to move oil to the Gulf Coast is expected to increase at least another 2 mbpd by end of 2020.
It is an understatement to say that the US achieved its goal of energy independence. The path it is taking with shale production, pipeline and refinery capacity will turn it into the world’s dominant crude and other oil liquid exporter. We are witnessing the end of OPEC’s pricing power.
The news media may have been too optimistic about the Brexit deal reached between the EU and UK over the weekend. We have our doubts. This deal is unlikely to pass through parliament, and the outcome has the potential to throw the Eurozone and UK markets into chaos. The deal did not achieve the sovereignty and independence that the Brexiteers had in mind, and it will not alleviate the anxiety of the Remainers. In its current form, this proposed deal is worse than EU membership for both sides.
The risks on the downside outweigh the rewards of any upside. We see no immediate positive news coming out of Europe. Eurozone’s PMI figures were dismal and confirmed the slowdown in economic growth. If you are looking to buy into Europe, wait for the aftermath following the rejection of the EU-UK Brexit deal. There will be plenty of opportunities to deploy in a distressed market.
Despite what politicians do, market regulators will do what they always have done in the past. The Bank of England is already talking the ECB and other EU regulators to implement an overnight equivalency regime to maintain the operational integrity of the financial system. Regulatory bodies in other industries like pharmaceuticals and aviation are likely to do the same until a resolution is hammered out.
Deal or No Deal
President Trump is expected to meet President Xi this week in Buenos Aires to discuss trade. The potential is high for large market moves in reaction to the outcome of the meeting. An agreement on trade will be positive for both Chinese and US equities and propel the yuan higher. The positive effects will not only be felt in the US and China, but they will also lift up most of Asia and Emerging Markets.
We continue to see Chinese equities as a buying opportunity. The CSI 300’s dividend yield is 2.54%, slightly higher than China’s 1-year sovereign yield. It is not a bad return for sitting and waiting for China’s fiscal stimulus measures to work their way through the system.
The Week Ahead
We will be on the lookout for GDP figures coming out of the US, France, Italy, Brazil, India, and Canada. Eurozone inflation figures are unlikely to bring upside surprises with oil’s plunge and slowing economic activity. The Reserve Bank of Australia is expected to stay at its 1.5% cash rate target. South Korea is expected to raise its 7-Day Repo Rate to 1.75% from 1.5%. The meeting between Presidents Trump and Xi will be the highlight of the coming week.
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