Scraping the Barrel
Risk assets, including oil, staged a miraculous recovery on Monday, shooting higher after the Federal Reserve said it would begin buying US companies' debt to help support the economic recovery.
And as the broader market continued to shrug off any concerns over a fresh round of Covid-19 infections, oil market focus turned back to the fundamentals of supply/demand drivers, which have improved more rapidly than expected since the trough in April.
I think the market is resigning itself to the fact that in the absence of an effective vaccine the virus won’t amazingly vanish. But with stringent protocols in place, governments around the world will be able to respond much quicker on a proximity basis and contain the spread rather than shutting down large swaths of the economy – similar to the incident in Beijing's largest fruit and vegetable market which led to the lockdown of nearby housing districts, not a lockdown of the city. While the run of Covid-19 headlines emphasize that a demand recovery is likely to be a slow process, it seems unlikely that we’ll see a return to the lockdown measures of 1H.
Back to the fundamentals?
On the supply side – and a key to the global rebalancing narrative which was getting obscured in a cloud of Covid-19 headlines– Iraq has agreed on measures with its oil company contractors and Kurdistan that will see exports in June cut to 2.8Mbd. Meanwhile, the Baker Hughes US rig count reported on Friday showed active oil rigs dipping below 200, down from a peak of almost 900 at end-2018. Improved OPEC compliance and a steep fall in US rig counts are unambiguously bullish concerns that were getting obscured by the Covid-19 headlines.
Still, concerns linger on the demand side. And if China's economy is the blueprint for others emerging from lockdown measures, data form yesterday shows the recovery remains uneven and muted. While the recovery continues, the data shows that it's much easier for government stimulus to fire up the industrial engines than it is getting folks to leave their apartment and spend as the recovery endures but at a slower pace than expected.
Fixed asset investment rose mainly on the back of infrastructure and property spending. However, retail sales were less upbeat with spending at restaurants and catering sales dropping 15% YoY, suggesting consumers remain cautious even as Covid-19 cases have been contained.
Buy the Dip?
Since the beginning of May, strategically positioned oil traders remain content to pocket dips and likely more so this week, encouraged by OPEC+'s substantial commitment and resolve after the weekend meeting which, on the surface, seems solid enough to form the foundation of more constructive pricing. Sure, there are many cracks in the market's structure to get filled in, and the oil market remains pretty unhealthy, but it’s by no means terminal.
Until we get a convincing downward pivot on the nationwide inventory metrics or a reversion on the three most populous US states virus case counts, traders could be prone to range trade mentality where WTI $35 is perceived to be OPEC+ line in the sand and +WTI $40 is the level where traders currently think US production starts to ramp up.
While discipline from OPEC+ will help to limit oil price downside on a bearish signal from the US, a small pull-back is probably unavoidable if US production starts to increase too soon.
So long as increases in US production is due to the return of shut-in wells rather than an increase in new investments and drilling activity, the medium-term fundamentals suggest the market is moving back towards supply/demand equilibrium, and any weakness in the oil price should prove short-lived.
A full recovery to early March levels will need continued supply discipline, demand recovery and time to work off US inventories and spare capacity. That’s a tall order indeed and could be prone to less satisfactory results over the short term, but a draw in this week's inventory data will go a long way to soothing supply concerns.
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US equities continue to welcome any high-risk event being put in the rear-view mirror – especially when rates markets look prime to consolidate lower