Oil : Outside of Central Bankers' influence
Updated: Apr 27, 2020
Today's ~40% oil price decline has attracted a lot of commentary, but some sifting through the sand is required to get the complete picture:
Like most physical commodity markets, there are a series of future oil contracts. Below left shows the prices for the WTI Oil contracts that are for delivery from tomorrow (CL1) to Dec21 (CL20) - this is the futures "strip". The chart on the right shows the current strip of futures prices (brown) vs the strip of a month ago (green) and of a year ago (blue). Clearly, and unsurprisingly, the whole strip is substantially lower than where it was a year ago.
However, whilst the very front contract is lower than a month ago, the rest of the curve is still slightly higher than where it was in March.
The stress of the very front months and the steepness of the forward price curve tell you about current and future "supply and demand" dynamics. Today's ~40% loss of CL1 shows the current over supply and lack of capacity to store oil. Even the 12% price decline in the 2nd contract, expiring in June, is important as the $22 price suggests continued oversupply of WTI in the short term. Certainly the strong rebound of the stock price of Vopak, an independent tank terminal operator, would attest to this, as would the prices of some oil grades going negative (Canadian select) - hat tip Omar.
However the relative steepness of the curve suggests the market is pricing some sort of a "V shaped" recovery in the future for the demand in oil.
REGIONAL PRICE DIFFERENCES
The above table and chart is for WTI. But Oil is also priced in Brent (below). The change in forward prices curves over time shows a similar lower level in prices today compared to a year ago, as well as a steepness of the curve as prices are expected to be higher in the future than they are today. However the front Brent contract is less stressed that WTI, even if it is down ~5% today.
RECENT PRICE ACTION
Unlike financial assets, the price of commodities cannot be manipulated by Central Banks. The price of spot and future Oil prices are probably a very good reflection of the state of the economy and current market thinking. Spot and forward Oil prices suggest
short term over supply which will keep very front contracts low, and then
some sort of a recovery in the price.
But that recovery needs to be put into perspective - it is not pricing a return to pre-Covid19 levels. Unlike stocks (blue), which have made a meaningful rebound, the Dec21 contract (black) remains rooted near the 8 year lows (the CL20 contract is close to the 16 year low).
Even though front end months do indicate a situation of oversupply and severe lack of capacity issues for the storage of oil, more so in WTI than Brent, there is also something to flag on recent price action.
The chart below is for the CLz0 contract (WTI Dec 2020 expiry). At the lows in March, the bearish sentiment (RSI) faded to become less bearish, highlighting a classic "divergence" pattern (where prices and momentum go in opposite directions). The subsequent rise in prices was accompanied by a rise in the RSI - but the RSI has failed to break above the neutral 50 level and is now fading to bearish again.
IMPACT ON FINANCIAL MARKETS
Should forward oil prices decline further, as the above Dec20 contract indicates, then that would flag that the market is becoming more negative on future growth. This would require further government and central bank intervention to further support financial assets.
Inflation breakevens, which are naturally very influenced by the price of oil, are in a spot of bother. As mentioned on a previous piece on CPI, oil base effects are going to depress headline inflation rates substantially in the next few months, whilst my post noting more balanced markets suggested that short inflation breakevens were a decent hedge to risk asset sell-offs.
Below left shows the price of WTI and its' year on year percentage change (%yoy), with the dark blue line plotting what will happen to the %yoy change should oil prices remain unchanged at $22 (I have used the current CL2 contract price). The chart shows how the 2020 base effect is similar to the one in 2008 that took headline rates into negative territory (right). That is very poor for instruments whose carry is linked to inflation (i.e. inflation linked bonds).
This would be a strong headwind to a recovery of inflation breakeven rates, which have fallen 30bp in the last 5 days (as an aside, the resistance for 10yr US Inflation breakevens that failed to be broken at 1.27% was the 61.8% retracement of the Jan-March sell off).
Last week's decline in breakevens produced the second of 3 candles required to complete a Bearish Engulfing formation, which would signal a further decline in breakevens to test the recent 50bp low. Certainly the move lower in Bearish sentiment suggests this to be a distinct possibility.
Commodity markets and the inflation markets are perhaps the last markets that Central Bankers can't interfere with. Commodities reflect a true supply and demand picture, with the cost of carry being the speculators cost of being involved. Likewise the inflation market is purely a mathematical expression to reflect consumer price inflation, which again, Central Banks cannot influence (unlike Real Yields which are totally under the control of Central Bank balance sheet expansion polices).
Both markets give very strong signalling effects to what investors are truly thinking. The current problems with the front ends of oil contracts, the absolute low levels of forward oil prices and the reversal in long dated inflation breakeven rates all suggest that the market is becoming less positive about the strength of the rebound post Covid19.
If the US 10 year breakeven rate closes with a loss this week, that would give a strong sell signal with a potential 50bp downside target.