To paraphrase the widely-respected economists of the Wu Tang Clan, Crude Rules Everything Around Me. Oil prices are sitting at substantially higher levels and equity bourses are edging into record territory this morning, after Saudi Arabia’s energy minister hinted that the Organization of Petroleum Exporting Countries (OPEC) would consider cutting production at the informal meeting scheduled for late September. In response to questions from the country’s state news agency, Khalid al-Falih said, “We are going to have a ministerial meeting of IEF (the International Energy Forum) in Algeria next month, and there is an opportunity for OPEC and major exporting non-OPEC ministers to meet and discuss the market situation, including any possible action that may be required to stabilize the market”.
Currencies like the petro-loonie smashed through several layers of resistance over the last twenty-four hours, and the prospect of a reduction in losses across the energy sector has put stock markets on a much stronger footing ahead of the weekend.
While one might hope to see further gains, there is a risk that like Icarus, markets might fly too close to the sun in the coming days and weeks – Saudi Arabia’s work to talk up the market seems motivated more by a desire to make hedge fudgers eat their shorts, than to address any fundamental oversupply concerns.
Taking a broad view, a two-year period of price depreciation has forced a drastic adjustment on the supply side of the market, wiping out a substantial part of the marginal production in the United States – even as demand has risen across the global economy. In its most recent forecast, the International Energy Agency said “Our balances show essentially no oversupply during the second half of the year”.
That said, the glut of refined products remains enormous, with a persistent supply overhang likely to impact prices well into the autumn months. Ahead of al-Falih’s comments, hedge funds and other speculators had responded to these technical conditions in taking record short positions against a number of oil benchmarks, raising the risk that a move below the psychological floor at $40 could turn into a rout. This would have an unquestionably negative impact on the Kingdom, hurting budgets and creating further upheaval across the Middle East.
At the same time, the energy minister is well aware that there is an ocean of cheap capital sitting on the sidelines and poised to pour back into the market if a case can be made for scarcity. Triggering a spike above $50 would jeopardize the Kingdom’s geopolitical agenda – and by bringing supply back online, plant the seeds for an eventual price collapse.
If past efforts at verbal suasion from Russia, Iran and the Saudis themselves are any indication, the effect could last several weeks before collapsing when political or fundamental realities assert themselves once more.
In short – hope for further gains, but prepare for a reversal.
More broadly, foreign exchange markets are caught in the dull-drums, with the dollar, yen, euro (and most recently, the pound) acting as funding currencies for trades into higher-yielding asset classes. Investors appear convinced that economic headwinds will ensure that major central banks keep interest rates depressed, even as cheap liquidity provides a tailwind for asset prices for months and years to come. Intraday currency ranges have become incredibly compressed, and broader market indicators like the VIX Volatility Index have fallen to lows not seen since July last year.
When wide yield differentials are combined with low-volatility conditions, we have the ingredients in place for a carry trade of record proportions.
To market veterans (and risk managers) this is worrisome. By its very nature, this type of environment encourages the buildup of leverage in the financial system, and has historically led to sharp unwinds – to list a few examples, last year’s yuan devaluation, the 2013 ‘taper tantrum’ and the 2008 global financial crisis were all preceded by a heavily-correlated rise in asset prices and a drop in volatility.
Market participants may have learned from these episodes, and may avert problems by beginning to reduce leverage over the coming weeks, but we wouldn’t bet on it. As such, we would strongly suggest that corporate hedgers who might otherwise be carrying exposures into the autumn months should consider some degree of de-risking over the coming few weeks. The catalyst for an unwind is never obvious ahead of time, but the precipitating conditions often are.
Have a great weekend – and dolla, dolla bill ya’ll.
Head, Enterprise Risk
Some things to read while you’re watching two trees fight over a dog tomorrow:
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