Risk appetite appeared insatiable last week. It was a sudden turn of sentiment after the previous week’s sell-off. Several developments are responsible for brightening the mood. The possibly unfounded rebound in Chinese equities, attractive US earnings, the realization that the acrimony and the hostility in the most salient oil producing region in the world will not recede in the foreseeable future and acute product shortage that is due to geopolitics and US refinery maintenance all helped oil strengthen. Prevalent enthusiasm pushed WTI and Brent $4.56/bbl and $4.86/bbl north. The Brent structure, spreads and CFDs, exploded as a sign of strong physical market and due to a possible strike action at the Sullom Voe oil terminal. Products fared better. It is illustrated in the decisive jump in crack spread values. The CME 3-2-1 crack gained $5bbl over the past 5 days and ICE Gasoil’s premium over Brent widened to $41/bbl, a weekly increase of $9/bbl.

Notwithstanding these positive performances the oil complex remains bound by its weekly range, the limits of which are the peaks observed in 3Q 2023 and the valleys seen towards the end of last year. Uncertainty, which seems to have been embedded in investors’ thinking, and justifiably so, is the major force of keeping prices in check. Attempts to violate either the top or the bottom end have been akin to Don Quixote’s tilting at windmills. The current fundamental backdrop implies a tightish oil balance going forward limiting any downside potential, but a protracted rally is also deemed dubious. Nonetheless, it is a useful exercise to draw up a list of eventualities, however implausible they appear, that could force a change in attitude and push prices outside the established boundaries.

It goes almost without emphasizing that the Israel-Hamas stand-off, the consequential Houthi attacks on commercial ships and the increasingly deepening involvement of the US and Iran in the conflict set the scene for a tentative upside break-out. It would be an extreme scenario and the production and supply of crude oil from the region ought to be materially and severely affected to trigger a considerable rally. This might come in the form of a direct US attack on Iran and from the resultant closure of the Strait of Hormuz. Around one-sixth of global oil production and one-third of the world’s liquified natural gas output sails through this 39 km artery, therefore the repercussions of such a development would be catastrophic. The implausible case of a long-lasting ceasefire between the warring parties could swing the pendulum the other way. Alas, Benjamin Netanyahu made it abundantly clear last week that contemplating this outcome is the equivalent of utopian daydreaming as he ruthlessly continued its mission against Hamas last weekend with no regard to civilian casualties.

The question of the potential lowering of the cost of borrowing is also a thorny issue. Investors react sensitively to every single word monetary potentates utter. The current consensus is one of hesitancy, albeit it has been widely accepted that interest rates will not go higher unless the health of the global or regional economies suddenly deteriorates. The CME FedWatch Tool now prices in a 51% probability of the first rate cut from the Fed in May. It is worthwhile noting that the can of rate cuts has been kicked down the road for the better part of the past year, yet market players seem much more sanguine about its chances than policy makers. The view here is that the Federal Reserve’s first move will trigger a chain reaction but given how horribly wrong the Fed got inflation prospects in 2021 and 2022 (does the word ‘transitory’ ring the bell?) it will be very careful and conservative to initiate action and reducing rates might not happen until after the first half of 2024 is behind us.

An unequivocally bullish development has been the revived strength of products, especially distillates. The topic was extensively covered in last Tuesday’s note. The collective impact of Ukrainian drone attacks on Russian oil installation (two more assaults took place on Friday), sputtering products exports from India to Europe and the ongoing turnaround of refiners in the US is undeniably being felt in sturdy product prices and crack spread values but once the US maintenance is over and Russian refiners come back online the role distillates currently play in the formation of oil prices will be diminished.

On the bearish side we see three potentially adverse developments that could palpably dent optimism. The first one is the dim chance of a supply war. The recent Saudi decision to halt the expansion of production capacity from 12 mbpd to 13 mbpd took most by surprise but has more to do with resilient non-OPEC+ supply than with faltering demand perceptions. Yet, it is curious to note that the Saudi spare capacity is still at 3 mbpd and in case of lax compliance within the OPEC+ group opening the spigots, just like in the first half of 2020, would not be taken kindly by the market. Secondly, China’s economy is now showing signs of chronic illness, the major symptom of which is deflation. The Shanghai Composite Index has rallied 5% from the last week’s low due to bans on short selling and state-mandated stock buying, but these remedies are more like symptomatic treatments rather than effective methods of addressing the root cause of the problem. Lastly, the euphoria surrounding the performance of the US stock market cannot mask the trouble some US banks find themselves. The latest in line is the New York Community Bank, whose share sharply dropped when Moody’s downgraded its credit rating to junk after reporting a surprise 4Q 2023 loss. There are no signs of bank runs or crisis, but a watchful eye must be kept on the performances of US financial institutions.

Admittedly, most of the above-mentioned individual bullish or bearish factors are not significant enough to trigger an earth-shattering change in oil prices on their own. Yet, an unforeseen alignment of bullish or bearish stars might just precipitate unexpected moves in prices leading to a break-out from the current $25/bbl medium-term range. It is far from being the base case scenario but if one concludes that there are, say, 2% chance of this happening then it is only prudent risk management to prepare for such an implausible scenario by using the proportionate amount of funds allocated to oil to bet on an upside or downside break-out in the form of, for example, acquiring out-of-the-money call and put options.
 

Overnight Pricing

tamas.varga@pvm.co.uk

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