Head of Commodity Strategy
Summary: Crude oil futures in London and New York continue to attract buying interest as the available supply, especially of diesel-rich crude oil from the Middle East and Russia remain tight as producers keep output well below their respective production ability. The current tightness is increasingly being expressed at the front end of the curve, where the premium for near-term barrels of WTI trades compared to the next month has almost reached 2 dollars a barrel, the highest level in more than a year. However, while the short-term outlook points to higher tight supply-driven crude prices, the recent bear steepening move in the US yield curve signals an incoming economic slowdown and with that an increase risk to growth and demand next year
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Crude oil futures in London and New York continue to attract buying interest as the available supply, especially of diesel-rich crude oil from the Middle East and Russia remain tight as producers keep output well below their respective production ability. Not least Saudi Arabia who despite OPEC’s own projection for the tightest market in more than a decade this coming quarter decided to extend its unilateral one million barrels a day production cut until yearend.
That decision along with cuts from others, including Russia, helped drive up the cost of energy, thereby supporting the risk of sticky inflation, and together with a still resilient US economy and strong labor market they recently led the US Federal Reserve to deliver a hawkish pause in their aggressive rate hike campaign, while at the same time indicating that rates may have to stay higher for longer. A signal which helped send US 10-year Treasury yields to a 16-year high while the dollar reached a year-high against a basket of major currencies.
Looking ahead, there is little doubt that until a decision to raise production is made, the global energy market will remain tight, and during this time the risk of a major correction still is relatively low, something that is being reflected in the current positions held by hedge funds and CTA’s, more on that later. However, at the same time the US yield curve is increasingly sending a signal of distress, as recession risks continue to gather momentum, not only in the US but also in Europe where German economic institutes forecast a 0.6% GDP contraction already this year.
There has been a lot of talk recently about the US yield and the so-called bear-steepening move, and what it signals. Since early July, the US 2-10 yield curve spread has steepened, halving from around -110 basis points to the current -55 basis points. The latest steepening has been driven by a faster increase in the 10-year yield while the 2-year yield held steady amid doubts about how much higher the FOMC will be able to raise rates without damaging the economy.
Bear steepening does not only raise red flags for stock market investors but also the wider economy. Rising long-dated yields has a large and rapid tightening effect on the real economy given the impact on private mortgage rates and corporate borrowing rates. In a situation where the economy is running hot, rising interest rates pose limited risks as rising yields are a normal reaction to robust growth. However, in the current situation where sticky inflation drives long-end yields higher it may pose a threat as the economic outlook looks increasingly challenged and could deteriorate faster.
Back to the oil market where the current tightness is increasingly being expressed at the front end of the curve, where the premium for near-term barrels of WTI trades compared to the next month has almost reached 2 dollars a barrel, the highest level in more than a year. Looking further out the curve we find the 12-month spread between December 2023 and December 2024 has jumped to more than 11 dollars a barrel from around 2 dollars back in July. The chart below shows the rising backwardation - higher prices now followed by lower prices later – and the mentioned bear steepening of the US yield curve.
It's often said the oil curve never lies, and it is currently telling us that prices will remain high in the short term before recession risks begin to weigh on demand into 2024. A situation, if realized, that may force OPEC to accept lower prices or forcing an extended period of production cuts.
The latest Commitment of Traders report covering the week to September 19 showed continued belief in higher crude oil prices with hedge funds adding to their long positions in WTI and Brent Crude oil futures. Since June 30 when the latest round of production cuts began to bite, the combined net long in Brent and WTI has risen by 329k contracts (329 million barrels) to 560k contracts. However, looking at how the change has occurred,we find the increase being driven by 171k contracts of fresh longs and a 158k contract reduction in the gross short, and while the WTI long has reached a February 2022 high, the Brent long has not even returned to the March 2023 high. Funds are buying Brent and especially WTI futures, but not at a pace that could be expected given the recent strength and momentum, potentially signaling a battle between current tight fundamental and macroeconomic headwinds pointing to lower prices later.
In addition, with almost half of the increase in the net long being driven by short covering, the gross short has collapsed to a 12-year low at just 46k contracts, and while a very small gross short attracts little attention while prices are rising, it will pose a challenge once the technical and/or fundamental outlook turns negative. At that point, a sizable number of longs might be forced to chase a small pool of short positions willing to buy and it may lead to expanded daily trading ranges.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
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