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Takeaway: The expectation for a supply/demand floor is not a catalyst for volatility-induced real-time market moves

The daily narrative these last few weeks following the sell-off in energy markets has anchored on the fundamental supply/demand dynamic in the energy space, and it’s been pretty simple:

There’s tons of supply hitting the market, and global growth appears to be slowing.

As a precursor to reading this note, the following is an over-simplified view of our risk management process (the sequence of relevant events is of importance in understanding how we contextualize the daily news flow in global macro): 

1         We quantitatively model global macro to front-run inflection points in the slope of growth and inflation which gives us the expectation for the current environment (#QUAD4: GROWTH SLOWING, INFLATION DECELERATING)

2         With this expectation, we lean on our research team for sector-specific alpha (which companies are better longs in a macro set-up where we would want to be long that sector?). In other words we look for the fundamentals to follow and confirm.

3         With an intermediate to long-term BULLISH view on a ticker (delta positive), we will use our immediate-term TRADE ranges to BUY on RED and SELL on GREEN

NOTE: A fundamental supply/demand dynamic in global energy markets follows the quant and market-based signals to confirm our view (market-based meaning PRICE, VOLUME, AND VOLATILITY signals):

  • We wouldn’t buy oil here on a fundamental catalyst when volume is 50%-100% above trailing averages over different durations on down days
  • OPTIONS COLOR: volume in WTI Jan 15’ expiry was 3:1 to 5:1 puts-call ratio on Tuesday at most strikes. 25 Delta put-call skew over the last week went from around 2 points historically to 7-8 points as the spike in volatility forces investors to pay-up for protection: #VOLATILITY ASSYMETRY        

Every mainstream financial news and media source this week supplied a myriad of quotes and one-off statistical arguments as to why prices can only go so low:

  • “OPEC will cut production”
  • “OPEC won’t cut production BUT Saudi Arabia and the other major players are deliberately making a stance not to cut production to squeeze higher cost North American shale plays” 
  • “Marginal Production costs will slow the supply flood: There’s resistance starting at $80/barrel, and this will step up as oil moves lower as more and more producers are squeezed”:
    • The Executive Director of the IEA reported this week that 98% of crude oil and condensates from the U.S. have a breakeven oil price below $80/barrel. She followed up with the estimation that 82% of these companies have a breakeven at $60 or less.

 

The supply-side of the equation is definitive. There’s tons of supply from newly developed sources flooding the market:

  • North-American oil and gas boom from newly developed, non-traditional sources
  • Stable production from OPEC countries
  • Continued E&P activity in Russia and the South China Sea

 

OIL HAS FURTHER DOWNSIDE BEFORE THE BOTTOM - OPEC Production OPEC Production

OIL HAS FURTHER DOWNSIDE BEFORE THE BOTTOM - OPEC Excess Supply OPEC Spare Capacity

OIL HAS FURTHER DOWNSIDE BEFORE THE BOTTOM - DOE U.S. Crude Production DOE U.S. Production

  • Global production increased ~+910K B/D in September (annualized) to 93.8M B/D (annualized) which is +2.8M higher y/y
  • OPEC producers have all verbally confirmed they have no plans to reduce output and several have cut prices to Asia and Europe:
    • OPEC’s largest producer, Saudi Arabia, usually leads the charge, became the first to cut prices to Asian end-markets (others followed):
      • Iraq is now following Saudi Arabia and Iran in cutting prices to Asia and Europe
      • Iraq (2nd largest OPEC producer) will sell its Basrah Light crude to Asia at the biggest discount since January 2009, the country’s State Oil Marketing Co. said this week.
  • Iran last week said it will sell oil to Asia in November at the biggest discount in almost 6 years, matching cuts by Saudi Arabia.   

While….

Global growth is slowing and demand expectations have been downwardly revised..

  • The IEA significantly cuts global crude oil demand growth for 2014-15 this week:
    • Full-year 2014 global demand growth cut by -200K B/D to 900K
    • Full-year 2015 global demand growth cut -300K B/D to 1.1M B/D (93.5M total)

Many of the statistics are self-explanatory in suggesting that production cuts are inevitable to reach equilibrium. We will be the first one to tell you that fundamentals will play-out over the long-term (and they may, but it could be at much lower prices).

With that being said, we completely disagree with the argument that an expectation for fundamental equilibrium can somehow back-stop the real-time relative changes in price, volume, and volatility. The quant signals give us indications, and we look to the fundamental set-up to confirm.

Fed-fueled easy-money policy and low periods of volatility create a few big risks:

  • Leverage
  • Volatility Spikes

Managed money is forced to chase outperformance. Longer periods of time in a low volatility environment force leveraged beta-chasing. It also creates the behavioral assumption as to what volatility is, based on how it’s been, and how it’s expected to be.


In a recent note before Janet Yellen’s September speech, we outlined the correlation risk embedded in the assumption of continued tapering and the outlook for a stronger USD…. Oil Getting Whacked

In the note we highlighted the correlation inherent in a non-consensus policy response:

1.            When Fed heads use communication tools to talk up rate hikes (like Bernanke just did) USD and rates rise

2.              When USD and rates are rising, at the same time, commodities, oil, Gold, etc. go down

3.              The machines (quants) then chase macro correlations, and macro markets get overbought/oversold”

Point three addresses the immediate, real-time risk that can smack you in the face. When those looking to minimize large currency and rate exposure anchor on macro correlations for hedge-sizing considerations one-way, large positions create the execution risk block traders love to hate:

  • Anchoring: Tighter the correlation requires a bigger hedge
  • Volume: Larger positions create large capitulation risk
  • Sentiment: The “Commitments of Traders Report” from the CFTC shows a consensus position that is short the Euro, short long-duration treasuries, and longer (Than US) on U.S. growth.
  • Volatility: If a leveraged consensus trade is wrong, the volatility risk is greater in the FX, Gold, and Oil markets as robots and scalpers chase the large trades.
  • Risk: What is the probability of price moving to a certain level? We model it higher with this correlation risk. From an immediate-term TRADE duration perspective the bands/levels for identifying overbought/oversold exhaustion signals widen." 

Yellen kicked the can in Jackson Hole, but just last week she reverted in her commentary on the minutes from the September 16-17th meeting:   

“FURTHER GAINS IN THE DOLLAR COULD HURT EXPORTS AND DAMP INFLATION.”


A.K.A we are not hawks, and we’re not reverting on the ingrained beliefs for how monetary policy should intervene in the marketplace.


We have reiterated our expectation for this policy response all year in an environment with growth slowing and expectations for growth too high as it is an input into our macro modeling.  


A +160% move in VIX from the July lows is the follow-through from Fed-induced leverage in the system.  How many of the market participants in oil markets (or any derivative of oil markets, which is a much larger pool of investors) have any interest in the physical commodity over financial speculation anyway? What percentage of average daily trading volume?

Both BRENT and WTI are currently BEARISH from both an intermediate-term TREND duration. Our quantitative signals front-ran the fundamental supply/demand story which is taking shape. As always, we will continue to look to these quantitative signals and back-fill into the story.

WTI Set-Up:


BEARISH TREND (Intermediate-Term) : $94.63

BEARISH TAIL (Long-Term): $97.95

Please feel free to ping us with comments or questions on our current position here.

Ben Ryan

Analyst