Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Head of Commodity Strategy
Summary: Crude oil's longest winning streak in two years has started to show signs of pausing, thereby allowing fundamentals to catch up with a rally that has taken prices higher by 22% since Saudi Arabia announced their unilateral production cut decision in early January. A decision that undoubtedly has helped the market through what otherwise would have been some challenging months, with billion of consumers still facing lockdowns and reduced mobility. Tightening market conditions driving rising roll yields, however, continue to support "paper" demand from funds buying commodities as a hedge against the risk of rising inflation.
What is our trading focus?
OILUKAPR21 – Brent Crude Oil (April)
OILUSMAR21 – WTI Crude Oil (March)
____________________________________________________________________________________________________
Crude oil’s longest winning streak in two years continues despite emerging signs of the rally beginning to show signs of overheating. The cost of a barrel of crude has now risen by an impressive 64% since early November when vaccine news helped turn the focus towards the recovery while President Biden’s stimulus plans have helped turbocharged inflation expectations, and with that demand for hedges through commodities.
In addition, the rise by nearly one-quarter since January 4, when Saudi Arabia announced its unilateral production cut for February and March, has increasingly removed barrels from the market, thereby creating the tightest conditions in more than a year. While billions of people around the world remain impacted by lockdowns and lower mobility, Asian demand, led by China, has been strong.
WTI crude oil has returned to the old consolidation area between $50 and $65, an area that supported rising US oil production to 13 million b/d before collapsing to the current 11 million. The US Energy Information Administration in their latest Short-term Energy Outlook wrote: “Although oil-directed drilling has increased in the United States in recent months, the number of active drilling rigs remains lower than year-ago levels. EIA expects production from newly drilled wells will be more than offset by declining production rates at existing wells in the first half of 2021”.
As a result they see no pick up in US oil production from the current 11 million b/d in 2021. For 2022 they see oil production only rise to 11.5 million b/d, a level that would leave plenty of room for OPEC+ to increase production and attract market share as global demand starts to recover.
The International Energy Administration in their February Oil Market Report (OMR) said the rebalancing of the oil markets remains fragile during the early parts of 2021 with lockdowns and reduced mobility weighing heavily on the near-term recovery in oil demand. But the prospect of tighter markets ahead due to increased economic activity and a pledge from OPEC+ to hasten the drawdown of surplus inventories remain the overriding market focus.
They forecast global oil demand will recover by 5.4 million barrels/day to average 96.4 million barrels/day in 2021. With OPEC+ currently withholding around 7 million barrels/day, the recent price upgrades from analysts are based on discipline in rolling back production curbs and a muted non-OPEC production response to higher prices.
Supporting the energy market in general and crude oil in particular is the rising backwardation or roll yield. The tightening supply outlook has led to a relative stronger rally at the front of the curve meaning that WTI and Brent are effectively yielding 8.6% and 7.7% respectively on an annual basis for investors who keep rolling their long positions from one month to the next.
Given current strong fundamentals as OPEC+ maintain tight supply, a roll yield of this magnitude, continues to lure speculators into the sector. Not least considering the reduced threat of a sudden jump from other producers, example being those in the US, who are focusing more on bringing down debt and deliver value to shareholders instead of embarking on low profit production growth. This development further strengthen oil as one the current favorites, together with copper, platinum and gold, as the go-to commodities from macro-orientated funds looking for reflation hedges.
The combination of tightening fundamentals, reflation hedge demand and not least an unchallenged momentum, have led hedge funds to increase their combined net-long in WTI and Brent crude oil to 699k lots and within a few thousand lots from the previous two peaks in 2019 and 2020. While potentially signaling a risk of a short-term pullback, given current RSI’s at overbought levels, it is worth keeping in mind that the net-long peaked at close to 1.1 million lots back in 2018.
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)