As WTI’s discount to Brent crude oil prices deepens, outflows worth US$5.4mn continue for the sixth week in a row. Brent prices surged to US$80 per barrel for the first time since November 2014; likely owing to the ongoing concerns of supply from Venezuela and Iran. The unsurprising overnight victory of President Nicolas Maduro at the Venezuelan election is likely to spark unrest within the nation and worsen the decline in Venezuelan oil production. Last week the International Energy Agency (IEA), showed signs of further tightening on the oil market, as oil stocks in OECD countries decreased in March to their lowest level in three years and dipped below the five-year average for the first time since 2014. The crude oil inventory reduction was aided by record high crude oil exports, as the deep discount of the WTI price with Brent is making US crude oil more attractive to the international buyers. In contrast to the inventory build reported by the API, the US department of Energy reported a 1.4 million barrel fall in US crude oil stocks. Furthermore, US oil rig count held steady at 844 last week after rising for six weeks in a row.
Gold ETPs faced weekly redemptions worth US$82.3mn, the highest level in 12 weeks. Gold prices faced significant pressure as the US dollar strengthened and 10-year US treasury yields crossed 3.112% last week. The yield differential of the 10-year US Treasuries versus the equivalent German government bonds of the same maturity widened to 250 basis point, marking its widest level in over 30 years. This points to further strengthening of the US dollar against the euro and more weakness ahead for gold prices as it fails to yield any interest, making it appear unattractive in the current rising rate environment. Meanwhile, gold’s historical role as a safe haven, may allow significant upside potential from the ongoing geopolitical risks emanating from protests in Gaza, uncertainty over the Iranian Nuclear agreement, US-China trade wars, the Korean conflict and progress from the coalition of populist Eurosceptic parties in Italy.
Gold prices declined for a time to their lowest level since the start of the year, falling below the psychologically important $1300 mark, such low levels should also encourage physical buying. Silver prices recouped some if its losses over the latter half of last week resulting in the gold/silver ratio declining to 78.5. Investors took profits as we saw weekly outflows from Silver ETPs surge to US$98.4mn their highest level since September 2017. Precious metal basket ETPs also saw US$12.3mn worth of 0utflows as sentiment toward the precious metals sector deteriorated.
Long Yen ETPs versus the Euro attracted the highest inflows in 10 weeks, last week. Following eight consecutive quarters of growth, the Japanese economy contracted in the first quarter as GDP contracted -0.6% more than consensus estimates owing to sluggish household consumption and capital spending. However strong corporate profitability, an upbeat global growth outlook and signs that wage pressures are starting to build provide evidence that the Japanese investment case still remains intact.
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Gold ETP inflows increase for the second consecutive week amounting to US$20.6mn following a mixed payroll report. The pace of inflows has slowed considerably for gold ETPs over the past month. While the jobless rate fell, wages were a weak spot in October (rising 2.4% vs est 2.7% y-o-y). However with payroll gains averaging about 162,000 over the prior three months and the economy nearing maximum employment, the third rate hike by the Fed this year seems certain, adding further downside pressure on gold prices in the near term.
Profit taking sees outflows from Oil ETPs worth US$73mn, as the rally in the oil market continues unabated. A reduction in crude and oil product stocks in the US reported by API data supported prices higher last week. In addition, according to a Reuters survey, OPEC oil production fell by 80,000bpd in October primarily owing to a decline in production of 120,000bpd by Iraq and a record high compliance of 86% as a result of the Kurdish conflict. So far the oil rally has been supported by deep OPEC supply cuts and a cyclical upturn in the economy. This seems unlikely to last and should weigh on oil prices in the near term. Speculative net long positioning in Brent have risen to a record level, two standard deviations above the five year average, suggesting a stronger potential for correction in Brent vs WTI crude oil prices.
Thematic equity ETFs, Robotics and Cybersecurity continued to see steady inflows last week, totalling US$14mn and US$4.3mn respectively. So far Q3 earnings season has been broadly positive for these two sectors with 76% and 65% earnings beat among cyber security and technology stocks globally. Interestingly a large number of cyber security stocks have beat analyst earnings estimates by a wide margin. While valuations remain high for both sub sectors, they are broadly in line with the long term average versus the technology sector.
Inflows into European equity ETPs rose by US$5.1mn reversing the prior week’s trend as German and UK benchmark indices posted record highs. Eurozone manufacturing PMIs rose to a six year high of 58.5 in October bolstering expectations of a continuous recovery in the Euro region. Despite the first rate hike by the Bank of England (BOE) in a decade, a softer inflation outlook and Brexit uncertainties indicated they were in no rush to hike rates again supporting UK equities.
Recent price strength in Nickel, drove outflows from nickel ETPs worth US$8.6mn. Renewed optimism of demand from electric vehicles amidst supply constraints, helped Nickel prices post a 9% weekly gain.
Long EUR ETPs draw in the highest inflows in 5 weeks amounting to US$8mn
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It looks like OPEC has managed to orchestrate a deal to cut production, albeit past the 11th hour. Oil prices have rallied over 8% today, following a 5% decline yesterday. While momentum is likely to keep prices rising in the short-term, we doubt that the rally can be sustained as the deal requires large non-OPEC participation.
The OPEC group went back into closed session discussions at the time when the market was expecting an announcement. The market rallied 8% when it was waiting with baited breath and then some more when the announcement was finally made.
OPEC announced a 1.2 million barrels per day (mbd) reduction in production, from the current 33.4 mbd current production (excluding Indonesia). The group has suspended Indonesia, which currently produces 0.7 mbd and will be free to produce as much as it wants now. It is notable that OPEC increased the reference production volume, which it bases its cuts on (compared to the October Monthly Oil Market Report) by 0.471 mbd (after excluding Indonesia). Saudi Arabia is expected to make an ‘adjustment’ (OPEC nomenclature for a cut) of 0.486 mbd (i.e. the lions-share). Meanwhile Iran will be allowed to increase production by 0.09 mbd (notwithstanding the error on the published table which shows post-adjustment output lower than the reference production level). At the same time the group is relying on a 0.6 mbd cut from non-OPEC members. So market balance is still highly reliant on non-OPEC! The OPEC President claimed that Russia has committed to 0.3 mbd cut and other countries will make similar announcements in due course.
Based on this announcement, we believe that the market will return to balance in the second half of 2017. Beyond the initial euphoria, to see a sustained increase in price we believe that there needs to be visible signs of curbs in production (and that this announcement is not just empty rhetoric as we have observed in the past). To this effect OPEC has set up a monitoring committee and will use only secondary sources for production levels. But we fear the deal could unravel if non-OPEC countries do not reduce production as much as OPEC hopes.
As the details sink in, we fear that the recent rally will flop. The US$1 trillion cuts in capex will be the driving force behind market balance and a lot of that comes from non-OPEC countries. Not a lot has changed as a result of this meeting in reality apart from the admission that “market share at all costs” was a failed strategy.
Nitesh Shah, Research Analyst at ETF Securities
Niteshis a Commodities Strategist at ETF Securities. Nitesh has 13 years of experience as an economist and strategist, covering a wide range of markets and asset classes. Prior to joining ETF Securities, Nitesh was an economist covering the European structured finance markets at Moody’s Investors Service and was a member of Moody’s global macroeconomics team. Before that he was an economist at the Pension Protection Fund and an equity strategist at Decision Economics. He started his career at HSBC Investment Bank. Nitesh holds a Bachelor of Science in Economics from the London School of Economics and a Master of Arts in International Economics and Finance from Brandeis University (USA).
PDVSA’s selective default risks further oil outages
Petróleos de Venezuela’s (PDVSA’s) debt swap earlier this week provides Venezuela’s state oil company temporary relief from upcoming debt payments, but this act of “selective default” is unlikely to significantly alleviate the financial concerns for the company nor the government. Risk of oil production outage from Venezuela as a result of a potentially disruptive full blown default would drive the global oil market closer to balance and push oil prices higher. PDVSA’s selective default risks further oil outages.
As we highlighted in February, the finances of the PDVSA and the Venezuelan government were precarious, with CDS spreads indicating that both are close to default. Since then, the economy has plunged further into economic chaos as electricity shortages (blamed on a lack of rain to power hydroelectricity) and hyperinflation running over 1000% have roiled the oil dependent country. That has been paired with political chaos. The opposition government is currently trying to call for a referendum to oust President Maduro (and they claim their efforts are being thwarted by the government’s “ongoing coup d’etat”).
Beyond weak oil prices, oil production in Venezuela has been continuously falling, severely crimping PDVSA’s revenues. This week PDVSA managed to swap US$2.8bn of debt maturing in 2017 for US$3.4bn maturing in 2020. However, that only represents under 40% of the US$7.1bn maturing in April and November 2017, far short of the 50% target PDVSA had set. S&P Ratings have labelled the event a “selective default”. The short-term relief of pushing maturity out, comes with the cost of higher payments later. The strategy is clearly reliant on oil prices and production volume increasing.
(click to enlarge)
While Venezuela is likely to be exempt from cutting production as part of the OPEC quota target that was recently announced, we believe that the country will struggle to raise production. Foreign oil service providers will continue to pare back on their operations in the country in this chaotic and uncertain environment.
When we first wrote about Venezuela’s financial woes in February, global oversupply of crude was assumed to be around 2.3 million barrels per day. At the time, we judged it unlikely that most of Venezuela’s 2.4 million barrels per day of production would be wiped out over-night. However, today the global over-supply is only around 0.3 million barrels. Venezuelan production has fallen 0.2 million barrels since the beginning of the year, highlighting much production can unravel in times of chaos. Therefore, we now believe that a serious production outage from Venezuela could push the global oil market toward balance and increase price.
Nitesh Shah, Research Analyst at ETF Securities
Niteshis a Commodities Strategist at ETF Securities. Nitesh has 13 years of experience as an economist and strategist, covering a wide range of markets and asset classes. Prior to joining ETF Securities, Nitesh was an economist covering the European structured finance markets at Moody’s Investors Service and was a member of Moody’s global macroeconomics team. Before that he was an economist at the Pension Protection Fund and an equity strategist at Decision Economics. He started his career at HSBC Investment Bank. Nitesh holds a Bachelor of Science in Economics from the London School of Economics and a Master of Arts in International Economics and Finance from Brandeis University (USA).
Oil Market’s Shifting Supply and Demand Fundamentals Natural Resources by Van Eck
TOM BUTCHER: Shawn, thus far in 2016, have supply and demand fundamentals in the oil market shifted as you expected them to?
SHAWN REYNOLDS: We believe that there is no doubt that the oil market’s supply and demand fundamentals are coming into place and will tighten through the end of the year. However, we think the timing is unclear in terms of how fast or slow this will happen, but we are likely to see tightening later in the year. The biggest surprise has been the depth of the changes at hand, which have created a sense that tightening might happen quicker than expected; but in our opinion, tightening is certainly going to last for some time.
When we talk about the depth of changes, we refer to the rig counts here in the U.S., which have fallen 78%. That is unprecedented in the time that we have been counting rigs drilling in the U.S., which began in the 1970s. We also look at activity levels and investment levels overseas.
Declining Rig Counts Across the Globe U.S. Count Down 78%
Source: Bloomberg, as of March 2016.
If we look more closely at integrated oil companies and consider that they cut capital investment plans by 25% in 2015, and are expected to cut another 25% in 2016, we again find that there has been no precedent. These developments have never been experienced in the history of the modern oil industry. While things are more or less playing out as we expected, there are certainly some surprises. They may be taking place slowly now, during the first part of the year, but they will likely speed up and endure for some time in terms of upside price correction.
BUTCHER: What might be some of the long-term effects of those capital investment cuts on the integrated oil companies?
Big Oil Projects Postponed or Canceled
REYNOLDS: It has been staggering to observe the reactions from the integrated companies. Obviously, many headlines focus on U.S. oil shale and the rig count reduction of 78%. If you dig into the volumes that are connected with these two major changes taking place, the E&P (exploration and production) companies and the integrated oil companies will not experience equivalent impact. The potential impact on the integrated oil companies will be significantly larger and longer term.
What do these reductions in capital investments entail? They mean big projects being canceled or postponed. If you add it all up, we’re looking at somewhere between 6-13 million barrels a day of projects being postponed or canceled. These projects were slated to take place between 2014 and 2020 and now they are off the shelf until post 2020, if at all.
We are seeing big projects being canceled by individual companies. For example, Petrobras [Brazil’s Petróleo Brasileiro S.A], or Royal Dutch Shell [Netherlands], or Chevron [U.S.], or Total [France]. Every single one of these multi-national companies is canceling major projects. For example, the French company Total has not approved any major projects in 2014 or 2015 and will likely not approve anything in 2016; and it has nothing on the docket for 2017. Royal Dutch Shell hasn’t approved anything since 2013, except for one project in the deepwater Gulf of Mexico.
Integrated Cos. Likely to Suffer Multi-Year Declines in Production
This activity is unprecedented, and we believe it sets up a situation where the oil production of integrated companies, which has grown slowly over the years but is still growing, will begin to decline. We expect a multi-year decline that may not begin until later in 2016 or perhaps early 2017. By late 2017, and certainly for several years thereafter, we are likely to see a very methodical decline in overall supply. This will heavily impact the overall oil market.
BUTCHER: For oil and gas exploration and production companies, what characteristics have enabled the successful ones to survive?
Geology, Technology, and a Healthy Balance Sheet are Critical
REYNOLDS: There are companies that are surviving and thriving. Identifying these strong companies is an important part of our process. We have always looked for a special set of characteristics that allows important and steady structural growth.
What specifically do we look for? We spend time identifying companies with the right acreage and the right geology. That’s something we do every day. We look at individual oil well results, and try to figure out what are the sweet spots for a given location. Sometimes consensus is that everybody knows exactly where the sweet spot is; but if you’re off by a few miles or a few counties, it can make a significant difference in who actually has the best rock. Therefore, we spend a great deal of time looking for the companies with the best rock. That is number one.
Technology Should be Part of the Company’s DNA
Number two is technology. The shale phenomenon in the U.S. is all about evolutionary technology and taking it step-by-step, tweaking small aspects of the technology in order to increase reserve bases, increase production rates, lower costs, and raise returns. We are always looking for companies that incorporate this process as part of its DNA or culture, and not something they’re just pulling off the shelf to try because it worked for someone else. It is the scientific culture at the heart of a company that is key in making shale production economic and taking it to the next step in terms of adding unexpected amounts of reserves.
Balance Sheet Strength Fosters Innovation
Number three is does the company have the balance sheet, the financial wherewithal to try different ideas? Obviously, if you are squeezed on your cash flow or your balance sheet is stretched, you are not willing or able to try different technologies or methods. You are not likely to risk trying something different and potentially see it fail, only to end up with a dry hole. That kind of outcome is really unacceptable, especially in this environment. But if you do have a strong balance sheet, you’re willing to try something new. We have always looked for this profile, and it is especially important in this environment. Last summer, balance sheets became even more critical, not only in terms of flexibility and the ability to try new technologies, but also in terms of simple survival. Can the company survive tough times when the price of oil is low?
The three characteristics we have always considered are the acid base or the geology, technology, and the balance sheet. This approach has paid dividends during this downturn and certainly in the early part of this year.
Reynolds has more than 30 years of experience covering the energy sector. Before his career in finance, Reynolds worked as an exploration geologist and earned degrees in geology and engineering.
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