On Thursday, we brought you our take on OPEC’s latest monthly report, highlighted BofAML’s latest in which the bank adjusted their price targets lower to reflect what they call “the crude reality,” and noted some commentary from Citi which looked at historical precedent for output cuts. You can read that post here:
Earlier this week we also looked at FX vol on the way to asking how markets are pricing the upcoming OPEC meeting at which the cartel is widely expected to extend the output cuts that helped drive up prices late last year.
Well on Friday morning, Goldman is out taking a look at what’s priced in (or not) across asset classes ahead of May 25’s “all-important” pow wow.
What they found probably won’t surprise you, especially not the bit about energy credit having outperformed. After all, we’ve been saying for months that credit markets are acting as though crude is still trading in the $90s.
We also know that specs recently liquidated a large number of longs, as “smart” money made to look quite “stupid” gets gun-shy. Predictably bad timing ahead of this week’s bullish EIA data. We’ll get the latest positioning this evening.
Anyway, here are some pretty good excerpts from the Goldman piece…
Since the last OPEC meeting, Energy credit has steadily outperformed Energy equity and oil. This outperformance has coincided with general credit market outperformance over equity. This divergence leads us to believe that there is more asymmetric downside in energy credit if the oil selloff continues.
We find investors cite three key reasons for the outperformance of energy credits:
(1) Energy credits are a large portion of the HY index and passive index investments may proportionately benefit energy credits. The rising correlation within the credit market supports this theory, and
(2) The breakeven oil price for many of the HY E&P companies is in the range of $50- $55; unless oil falls substantially below this level, credit valuation may not be as sensitive to oil price moves as equity valuation.
(3) Metrics used to value credit may disproportionately benefit from higher production (driving incremental cash-flow and short-term EBITDA) even if higher production is not optimal from a long-term equity investor’s perspective. This could temporarily support credit relative to equity.
Ultimately, we believe strength in energy credit shows a decrease in concerns regarding downside tail risks in recent weeks. Of the energy credits we show in this report Chesapeake and Transocean 5Y CDS show a strong history of volatility on OPEC, but spreads are near their 3-year tights.
Kink in the volatility curve shows investors have started positioning for volatility around OPEC, even as the absolute vol level is still low. Thinking more specifically about event risk, we monitor the term structure of volatility for oil and energy equities. We find a larger kink in the oil options curve for the upcoming event, but a growing kink in the XLE curve.
We estimate that the XLE straddle price that captures the event is 32% undervalued when compared to this time ahead of the past 7 OPEC meetings. We see the potential for implied volatility of the May 26th term to rise while other terms may not rise as much ahead of the event. USO options appear less undervalued priced relative to past straddle prices ahead of OPEC meetings.
What’s priced into Equities?
E&P valuations currently imply a long-term oil price of $57, down from $62 at the start of the year and above the 5 year oil futures at $50. E&P stocks tend to have high correlation with the price of oil because the long-term oil price drives the value of their discoveries. Our equity and credit analysts collaborate to estimate the long-term price of oil that is consistent with credit and equity valuations each quarter (in the context of their expected costs to extract). We find this measure is less volatile than oil futures themselves, potentially reflecting less volatility in the very long end of the curve beyond where oil forward markets trade.
The flattening of the oil curve suggests oil may be reaching a new equilibrium. The steepness of the oil curve has decreased significantly since the last OPEC meeting. In fact, the absolute difference between the first five years of the oil forward curve is in its 7th percentile relative to the past 20 years. Ahead of the Nov 2016 OPEC meeting the steepness was in its 50th percentile relative to the past 20 years. As discussed on May 9, our commodity strategists expect increased volatility in the front month to be driven by uncertainties with regard to inventories and shale production ramps with the constant potential for supply disruptions. Ultimately spot commodity prices are driven by current supply and demand while forward prices can imbed other considerations. We expect volatility in oil to be higher than is implied by short term options given the importance of the upcoming OPEC meeting
Finally, here’s some further color on crude from former FX trader Mark Cudmore.
What a difference a week makes. Oil prices are more than 9% above last Friday’s capitulation low. The bounce has legs in the short-term but it doesn’t alter the long-term bearish story.
- Recent newsflow justifies this rally. U.S. oil inventories just showed their largest drop of 2017, and a fifth consecutive weekly decline. OPEC is expected to extend production cuts when it meets May 25. Goldman reiterated its bullish call for an imminent supply deficit
- February’s record speculative long position has been roughly halved. The market technicals appear healthy and fresh for a sustained bounce
- That’s the short-term outlook. But at some point the much bigger picture will dominate again and that entails a far more negative skew on the situation
- As Bloomberg oil strategist Julian Lee wrote, the OPEC production cuts would need to be significantly deepened to remove the OECD stockpile by year-end — especially in the face of increased output from Libya and Nigeria
- OPEC itself just raised its forecast for 2017 production from non-members by 64%. U.S. Baker Hughes rig count has climbed for the past 16 weeks
- U.S. stockpiles may now be showing a steady decline — but only from an extreme record. They are still above any level seen before this year
- The important backdrop is that extraction from shale continues to become cheaper and more efficient all the time, lowering the price point above which production will rapidly increase to flood the market with supply
- And simultaneously, there’s the slow and steady growth of renewable/alternative sources of energy as well as technological improvements in energy storage and transfer. That’s without mentioning the C-words: carbon and climate change. Even without Trump’s support, efforts to reduce emissions and the use of oil-derived products are garnering more and more support
- All this boils down to a long-term, structurally bearish story. Rallies can last for weeks, or even months. But don’t get too attached. They won’t carry you through to old age