Barclays Does Best “Frank The Tank” Impression: Don’t “Freak Out” On Commodities

You’d be forgiven for pushing the “panic” button right now.

That, in my opinion, is not a needlessly hyperbolic assessment.

This week’s veritable collapse across the commodities complex is worrying on any number of levels, but I guess what I would suggest is that it seems to completely undercut the global reflation meme.

Investors had already faded virtually every Trump trade on the board (so, they faded the US reflation story), a move that telegraphed extreme angst with regard to the administration’s growth-friendly policy platform. Now you’ve got China pulling the rug out from beneath the global reflation story both passively (in the form of poor PMIs) and actively (in terms of stealth tightening via the OMO back channel and curbs on the labyrinthine shadow banking system).

Throw in the fact that earlier this week, Prince bin Salman confirmed what we’ve been saying for months (namely that Riyadh doesn’t really need higher oil prices in the near- to medium-term thanks in no small part to a low public debt starting point from which to embark on a borrowing binge), and you’ve got a nightmare setup for oil which was already teetering on the precipice of a deflationary dip thanks to ramped up US production. This week’s EIA data didn’t help.

If you’re interested in the latest on the commodities carnage, please see this morning’s assessment here.

For their part, Barclays doesn’t necessarily agree that it’s time to freak the fuck out.

Read their latest on the commodities rout below for the counterpoint, although I would note upfront that this title doesn’t convey much in the way of bullish conviction:

Market

Via Barclays (dated Thursday)

Oil and industrial metals experienced the sharpest sell-off in months this week.  The midnight release of the China Caixin PMI indicator is one factor that caused concern for market participants across the commodity complex.  But assigning blame to one factor risks missing dynamics unique to each commodity that could eventually prove transitory due to other impending developments.

Oil’s decline fundamentally driven but temporary, in our view

In oil, the market has been hyper focused over the past two months on two dynamics: OPEC compliance and the US oil balance. The broader backdrop was weak, which is why we warned prices could fall lower in an April 12 note.  Today, global refinery maintenance is still underway, doubts about an OPEC renewal have emerged, and Libyan supply stands poised to rebound by 200 kb/d by the end of the month.  To add insult to injury, EIA’s weekly inventories have not sufficiently drawn as US refineries have exited their turnaround period, and EIA monthly data reaffirmed the breakneck pace of US production growth.   Amid stretched positioning, the market began to lose patience and, in our view, fears of a recession were not the primary culprit.

The downward correction this week also comes at a time during producer earnings season. A review of oil price dynamics over the past several quarters has been associated with a rebasing of the market’s expectations about the breakeven price of shale. In eight of the last twelve earnings seasons, oil prices ended lower than where they began, and on average, declined 2.5% over the earnings period (Figure 1). Q1 2017 earnings showed that producers have not skipped a beat, with most producing more oil than analyst expectations. Headlines around these results have cause the market to readjust higher its expectations for US crude oil production, and this is likely contributing to lower prices.

There are two primary reasons we believe the downturn is temporary.  First, the inventory picture should be much more constructive in Q2 than in Q1.  In Q1, our global stock indicator showed a substantial build, likely driven by OPEC countries producing more oil in the waning months of the year before the cuts took effect and by an almost 1 mb/d implied build in stocks in China.   The stock series shown below (Figure 2) covers 75% of global demand, and the build shown in Q1 is not consistent with our global S&D balances, which show a 1 mb/d “draw” during the quarter.  In reality, the visible draw is therefore unlikely to emerge until this quarter, for which the market has no actual data yet.

Second, we see the current sub-$50 price environment as one that will encourage a producer and demand response. On the producer side we expect these price levels to increase the probability of an OPEC deal, at least in some form.  US producers will also behave differently at $45-50 WTI than at $50-55, possibly lowering their completion activity. Drilling would also decline in Venezuela, Nigeria, Mexico and other key global producers.  Finally, as we showed in the most recent recap of the US Petroleum Supply Monthly, gasoline demand remains quite elastic to retail price changes.  Staying at current levels through the summer significantly curbs the dramatic y/y increase in retail prices that was present from January-March of this year.

Copper falling as a result of inventory surge, not demand collapse

Given its history as the “macro metal,” it is understandable why the recent sell-off in the red metal has investors spooked. However, its record as an indicator of global industrial activity is mixed and the commodity often trades according to its own particular fundamentals, registering price gains and declines that have little to do with the real economy. With the current sell-off, we do not think copper is acting as a macro warning of an imminent global recession.

Instead, we think three factors are playing a role in the decline in copper.

  • First, LME warehouses registered a 31kt rise in inventories in a single day (03 May). This occurred after a significant spike in prices in late April, and is one of several such single-day inventory spikes. On March 09 inventories rose by 39kt in a single day as large volumes flowed into LME’s Asian warehouses. On 19 December 2016, inventories rose by 38kt in a single day as well, again into LME warehouses.
  • These frequent spikes in LME inventories coincide with sustained price rallies from copper, and we think they are the result of traders moving metal to take advantage of price fluctuations. While a single-day surge in inventories may make for good headlines (and a short-term collapse in price), the focus should be on longer trends in order to discern the health of the copper market. As illustrated by Figure 3, LME inventories are below past levels (2015, 2013) and are broadly in line with previous storage volumes.
  • That said, Chinese economic data, while not yet bearish, is in danger of topping. The collapse in steel prices that preceded the copper and iron ore sell-offs was an early sign that the metals sectors of the Chinese economy were showing signs of a slowdown. Macro data remain in expansionary territory, but as the stimulus efforts begun in Q1 16 begin to wear off in China, we expect a further weakening of demand conditions.
  • Finally, even including the recent sell off, copper is well above 2016 price levels, a year of moderate global economic growth. Our forecast for Q2 17 (255 c/lb) and for the full year (250 c/lb) assumes a modest retreat in benchmark prices, but stabilization around the 250 c/lb level. The supply situation in the concentrate market has tightened which should act as a floor to further price sell-offs.

BarclaysC

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All of that to say what “Frank The Tank” conveyed much more effectively in far fewer words…

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