Political premium provides temporary support for gold and oil
Oil and gold prices have risen 2.2% and 0.85%, respectively, in the past three days as a result of developments in Saudi Arabia and Donald Trump’s meeting in Asia. Unless geopolitical risks remain elevated, we expect the prices of both commodities to ease. Political premium provides temporary support for gold and oil
The Crown Prince of Saudi Arabia, Mohammed bin Salman, in his drive to modernise the Saudi economy, has taken aim at corruption in the country. With many of the economic and political elite having been caught up in the investigation, there is a risk that the fragile consensus that held the Saudi state together for many decades could unravel.
Saudi Arabia has accused Iran of committing acts of war for supplying the missile that Yemen used in an attempted attack on Saudi Arabia’s airport over the weekend. Saudi Arabia initiated a military intervention in Yemen in 2015 that has been seen as a ‘proxy war’ with Iran given the latter country’s support for rebel Houthis that had toppled Yemen’s former government. On Monday Saudi Arabia also labelled the acts of aggression by the Iran-backed Lebanese Shi’ite group Hezbollah as a declaration of war. These accusations of acts of war have increased the discord in the region, in what some people believe will be the precursor to an actual war between two leading oil producing countries.
Internal and external conflicts in Saudi Arabia
The market perceives both the internal and external conflicts in Saudi Arabia as a source of disruption in oil production. Indeed even if there is no physical disruption to production in the immediate future, the deterrent to international investors providing the capital needed to expand production, could also tighten supplies in the distant future.
Gold has also risen in the wake of increasing geopolitical tension in the Middle East. In addition, US President Trump’s comments during his trip to Asia has stoked concerns about a military confrontation with North Korea. The sabre-rattling that looked like it had calmed down over the past month is resurging. President Trump is expected to place pressure on President Xi in his visit to China today to cut ties with the rogue nuclear state.
We believe that the geopolitical premium priced into gold and oil is likely to be transient unless a war actually breaks out. Based on experiences over the past year, unless risks are crystallised, the geopolitical premium will fade away. On numerous occasions in the past year, sabre-rattling between the US and North Korea has become heated and then calmed down (but the underlying risk of a miscalculation between the two nuclear states has never diminished). The Saudi proxy war with Iran has been raging for over two years, with little reflection in the price of oil until recently. Unless investors are constantly reminded of the risks, the premia tends to evaporate within a matter of weeks.
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).
Investors rushed into gold ETPs as North Korea is threatening further military tests near the US seas. Last week saw US$122.5mn inflows into gold ETPs as tensions with North Korea intensify. Whilst the country has been demonstrating its military force since at least the 80’s, it has stepping up its provocations since the summer 2016 when Kim Jong-un claims that he can launch a missile capable of striking the US. Verbal provocations recently turned into military action with a North Korean missile overflying Japan on Tuesday morning. Allies have responded by another demonstration of force on Thursday as US bombers joined South Korea in a live-fire bombing exercise over South Korea. Russia and China, on the other hand, are pushing for diplomatic talks. Gold price rose by 2.6% on Tuesday, closing above US$1,318/oz., the highest level since September 2016, before ending the week at US$1,320/oz. Platinum and silver, on the other hand, recorded outflows of US$12.4mn and US$34.5mn respectively, likely on profit-taking as prices touched the highest levels since Q1 2017.
Inflows into short oil ETPs sent mix signals despite robust domestic demand for oil in the US. Hurricane Harvey which hit the US Gulf Coast damaged a third of US oil refineries, sending the price of heating oil and gasoline to the highest level since the summer 2015. The hurricane, downgraded to tropical depression, is the first category 3 to make landfall in the US since 2005. Oil prices, on the other hand, have barely moved from their current momentum. WTI fell 1.2% over the past week while Brent remains flat. Natural gas was up 6.2% over the week as the active contract rolled from September to October on Wednesday with a curve in contango. After six weeks of outflows, oil ETPs recorded US$5.8mn inflows last week, mostly into short oil ETPs, reflecting investors’ views that oil prices will remain range-bound. However, US domestic demand for oil remains strong as inventories declined more than expected last week despite production continuing to rise.
Copper ETPs recorded inflows on growing Chinese manufacturing activities in August. China manufacturing PMI surprised the market to the upside while service and non-manufacturing PMIs grew at their lowest pace in four months as construction activity slowed down. Interestingly, the Caixin manufacturing PMI, released last Friday, also confirmed a pickup in in industrial activities at 51.6 against 51 expected and 51.1 in July. While the Chinese National Bureau of Statistics data focus on large to mid-sized companies, the Caixin manufacturing PMI tracks smaller and private businesses and therefore provides an independent reading from official numbers. The price of industrial metals rose by 3.0% on average last week and 10.8% over the past month. We continue to expect Chinese data to beat expectations and support demand for metals.
Video Presentation
Edith Southammakosane, Research Analyst at ETF Securities provides an analysis of last week’s performance, flow and trading activity in commodity exchange traded products and a look at the week ahead.
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Equity ETFs saw the highest inflows this week with US$42mn. The recent weakness in the gold price has prompted investors to reassess gold miners which has seen inflows of US$68mn over the last two weeks. Historically gold miners have a high beta of 2x relative to the gold price but in recent months they have underperformed and investors have been taking advantage of this disparity. We see an improved outlook for gold miners, while they currently trade at 46x price/earnings, in line with the long-term average, EBITDA has tripled over the last year as the gold price has recovered, highlighting that despite aggressive capital expenditure cuts their profitability is improving. Other thematics remain popular such as robotics and cyber security which saw inflows of US$9mn and US$12mn last week respectively, having had consistent inflows on a weekly basis since the beginning of the year.
Precious metals saw a modest inflow of US$5m after the outflows following the US Federal Reserve’s interest rate hike mid-June. Despite the threat of interest rate hikes this year investors continue to favour precious metals with year to date inflows of US$609mn. We believe this is due to investors continued concern for geopolitics and the consequences of unwinding record loose monetary policy. We see a close correlation to politically turbulent events in the US and inflows into Gold ETPs. Our gold fair value for the year end remains at US$1230 per ounce, assuming that no major geopolitical events surface this year.
Price strength in palladium this year has prompted investors to take profits since the beginning of the year although we saw no activity last week and a slowing over the last month. We believe there has been tight liquidity due increased demand from Hong Kong for the metal, suggesting that China maybe stockpiling the metal.
Crude oil inflows continued this week with inflows representing 9% of assets under management over the last month. We have witnessed a trading mentality amongst investors who typically buy on price weakness, this weeks’ fall of 4% was a continuation of the “buy on weakness” trend.
Cocoa inflows last week totalled a significant US$9mn while inflows in coffee totalled US$7mn for the week. It seems that investors continue to buy those soft commodities with the poorest performance: both cocoa and coffeewere down 10% and 7.5% as of Thursday’s close respectively versus -4.2% for the broader basket of soft commodities before posting a modest rebound.
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Weekly Investment Insights Oil – Room to run lower
Highlights
Oil prices have made decisive moves lower over the past fortnight as burgeoning US production has dampened optimism around the OPEC accord.
Reports of increased output from Saudi Arabia and exempt nations Nigeria and Libya have added to concerns that the production agreement is less robust than previously assumed.
Should key crude benchmarks break lower through nearby support levels we could see the complex return to pre-November levels.
Burgeoning U.S. output
After months of range trading, the oil complex has made a decisive move lower as growing US output has dampened optimism surrounding the impact of last year’s OPEC/non-OPEC production agreement on global supply. Last week’s release of US crude oil inventory data instigated the latest move, as stocks grew at four times the expected rate to reach a new peak of 528.4m barrels. Bearish indicators have been mounting against the oil price for some time as news flow from the US has increasingly pointed towards resurgence in shale output as a result of the more favourable $50-$55/bbl price range. Research reports from Barclays and Citi (Source: Financial Times) both detail a 27%-36% surge in capital spending this year by North American oil and gas companies. These estimates are corroborated by the growth in the widely observed US oil rig count, which has climbed 95% from its trough from 2016 (see Figure 1). Our view is that oil prices could still see some downside from current levels, as they sit some 8% above the range from before the November accord and the agreement itself appears increasingly fragile.
Intentional or Seasonal?
While Riyadh has repeatedly stated its commitment to stabilising the oil market, the latest monthly OPEC report suggests that matter may not be so simple. Overall, according to secondary sources, OPEC’s compliance with its stated target currently sits at 91% and has indeed largely been driven by Saudi’s commitment to the agreement. However, the report also shows that Saudi’s own sources recorded an increase in production last month to near 10m barrels per day (mbpd), closer to estimates from the International Energy Agency (IEA) of 9.98mbpd. The bounce suggests that the reductions in oil volume seen in recent months could actually be a result of more seasonal adjustments to output rather than a conscious effort to stabilise the oil market. If this is the case we could see output normalise further in coming months, posing an additional threat to the accord.
Furthermore both exempt nations, Libya and Nigeria, have increased output by a combined 193k bpd since December, a 9% increase. The resurgence of US shale is likely to have put significant strain on the continued compliance to the OPEC agreement beyond the June expiry date. Should the deal fall apart, we could see oil prices sink further.
Broken support levels could spur selling
Having fallen approximately 8% on average over the past week both crude oil benchmarks face significant support. Brent and WTI crude oil prices have been dragged lower to the highs that persisted until the OPEC accord was announced, at $51/bbl and $49/bbl respectively (which also happen to coincide with their respective 200 daily moving average). Prices failed to consistently penetrate these levels for 15 months before November so a break below at this stage could trigger selling pressure. In this scenario prices have potential to fall to the 50% retracement of the recent 14 month run higher at $46/bbl and $43/bbl respectively for Brent and WTI. An abrupt end to OPEC’s current deal could be the catalyst to trigger such a move.
Investors wishing to express the investment views outlined above may consider using the following ETF Securities ETPs:
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Aggregate net speculative positioning across all commodities hit a record high last month, highlighting the strength of bullish sentiment toward the asset class.Consumer price inflation in the US surprised to the upside last month and we believe will continue to remain elevated as higher energy prices today will place upward pressure on the consumption basket.
Fed fund futures indicate the market does not share the Fed’s view that there will be three rate hikes this year (market is pricing in two hikes). We are likely to see real interest rates remain low if not negative in such an environment. That will be positive for gold and silver, which are negatively correlated with real interest rates.
The US dollar is likely to remain soft in the first half of the year, which is positive for the broader commodity complex. Global manufacturing PMIs are at 34-month high, providing a strong tailwind for industrial commodities. With less than a 5% further gain in the index, PMIs could reach a 6-year high.
Meanwhile supply of several industrial metals are threatened by policy changes and strikes. It is not surprising that industrial and precious metals have lead the commodity complex higher this month.
Oil continues to trade at the top of the trading range despite the strong supply response we have seen from the United States. The market has been encouraged by a 90% compliance rate toward the production cut from OPEC countries, but more than a 100% compliance rate would be needed to sufficiently absorb the overhang of inventory. We believe that risks remain skewed to the downside for oil prices in the short-term.
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