Positions: Long oil via the etf OIL; Long energy producers via the etf XLE; Long Suncor (SU); Long Petrobras (PBR)
Conclusions: Despite the recent correction alongside the global sell-off in risky assets related to Japan, a number of key drivers supporting higher oil prices remain intact. In fact, West Texas Intermediate is back above $100 per barrel and Brent is back above $114 per barrel.
This coming Wednesday, we will host a conference call that updates our outlook on energy, with a specific focus on oil. We will be looking at the energy market from three perspectives, the geo-political perspective, the supply and demand perspective, and the monetary policy perspective. The call is titled:
“HEDGEYE OIL VIEW: Launched positive at $75, Reiterated at $90, Reiterated at $97. WHAT'S NEXT?”
While the title itself is somewhat self-adulating, the point is not to pat ourselves on the back; rather it is to contemplate what is next for prices in the oil markets, and the implications therein.
Currently, we are long oil in the Virtual Portfolio, and remain bullish. In the attached chart, we’ve highlighted our current levels and quantitative view on WTI.
Below, we’ve updated two of the three key factors that we will discuss in more detail next week, both of which continue to support being long of oil.
1. Geo-politics – While the natural disasters in Japan have led to a flow of funds to, theoretically, safe assets and flow of money out of more risky assets, like oil, the geo-political underpinning of a strong oil price have only accelerated in the Middle East.
The primary issue, currently, is Libya and its 1.6MM barrels per day of production. As of yesterday, it appeared that the defeat of the Libyan rebels was imminent, but with the Arab League unanimously supporting a no-fly zone, and an expectation that the U.S. could back the same in the United Nations Security Council, the dynamic has shifted quickly. The implications of these actions are that the civil war in Libya will be prolonged, which will extend the decline in Libyan oil production (estimated to be down by two-thirds from its norm). Further, it accelerates the potential for the “nuclear” option by Libyan leader Muammar Qaddafi, in which he blows up his own oil fields to heighten the chaos.
The other key issue, currently, relates to demonstrations in Bahrain. Yesterday, Bahraini troops cleared out a central square of protesters using what is being described as military style force. The government then followed up by arresting key leaders of the opposition. The Bahraini military was backed by allies, such as Saudi Arabia who sent 2,000 troops. This support is in stark contrast to Libya, where the Arab League is subtly working to aid in defeating Qaddafi. While the Day of Rage in Saudi Arabia was largely a non-event, the role of the Saudi army in suppressing pro-Democracy demonstrators is only likely to inflame reformers within Saudi Arabia. The risk premium in oil will accelerate as protests against the Saudi royal family heighten.
2. Monetary policy – One of the key factors, if not the primary factor, driving the inflation of all commodities has been U.S. dollar weakness. Oil has a long term inverse correlation to the U.S. dollar, which for WTI is (-0.78) over the past three years. This has become more pronounced in the last six weeks. In the prior six weeks, WTI’s correlation is (-0.88) and Brent’s correlation is (-0.86) to the U.S. dollar.
We recently covered our short position in the U.S. Dollar, but continue to have bearish bias on the U.S. Dollar over the intermediate-term TREND and long-term TAIL. The three primary reasons are debt, deficit, and monetary policy. U.S. government debt is currently an estimated $14.2 trillion, which is bumping very close to the debt ceiling. Meanwhile, as we recently wrote, the U.S. federal deficit continues to accelerate with February being the largest monthly deficit on record at $223 billion. Collectively, we would argue that this fiscal situation is negative for the dollar from an investor confidence perspective, but more importantly this situation makes it very difficult for monetary policy makers to raise interest rates due to the substantial potential interest rate burden associated with $14.2 trillion in debt outstanding. Further, it seems the current Federal Reserve will continue to lead the world on dovish policy, which is negative for the U.S. dollar, based on their most recent statement two days ago:
“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”
In a scenario of heightened geo-political tension in MENA and continued weak dollar policy from the U.S. Federal Reserve, it is difficult to see much downside in the short term for the price of oil.
Daryl G. Jones