Citi is out with a new take on crude, which is pretty interesting in the context of Goldman’s “green shoots,” note and against what certainly appears to be a brightening fundamental picture.
As we detailed earlier today, oil hit an 8-week high on Wednesday, buoyed by EIA data which largely confirmed Tuesday’s bullish API numbers, jitters about Venezuela, and promises of a cap on Saudi exports. Then, after the bell, we learned that Whiting is cutting its 2017 budget by 14% to $950 million. That came one day after Anadarko announced plans to cut spending.
“It’s been a bullish week certainly, data-wise,” John Kilduff, a partner at Again Capital, a N.Y.-based hedge fund, said earlier on Thursday. “There is an impression that we’re coming into balance finally and it’s driven by this pretty steep decline in U.S. crude oil inventories.”
As far as price action, crude has had a highly amusing day, plunging on heavy volume early in the session only to reverse course and head higher a little over an hour later.
Getting back to the Citi note mentioned here at the outset, the bank notes that despite all kinds of headline risk, “there’s no geopolitical risk premium in the oil price.”
First, Citi notes that the return of Libyan and Nigerian supply is tenuous and in any event, the Venezuela wild card along with sanctions against Iran and Russia have to be factored in:
The biggest supply surprise to the 2017 crude oil market to date has been the return of Libya and Nigerian output, long in persistent disruption. None of the signatories to the OPEC/Non-OPEC agreement to cuts thought this return was on the cards. Their return along with growth in US shale and other light sweet crudes have impacted not just supply but quality imbalances as well. Now with a bare minimal level of disrupted supply, risk has shifted in the other direction. To be sure, the return of disrupted Libyan and Nigerian supply has offset a significant chunk of the OPEC/non-OPEC oil production cuts, but this could reverse, along with disruption risk in Venezuela.
Global oil supply disruptions remain at very low levels relative to the last 5 years, yet there is no shortage of potential catalysts that could trigger an increase in offline oil. US/UN interactions with Venezuela, Iran and Russia could escalate quickly if unintended consequences of sanctions policies spur more antagonistic behavior by these countries.
On Venezuela, Citi warns that we’ve reached “the point of no return” beyond which the potential for a deeper disruption rises materially:
Venezuela’s social, economic and political crisis has accelerated and deepened over the course of 2016 and appears to have reached a point of no return, with dramatic impacts on the country’s oil sector. Despite the country’s boast of holding the largest oil reserves in the world at over 302-bln bbls (vs. Saudi Arabia’s 268.2-bln bbls), its production has slipped dramatically over the course of the past two years along with its exports. Suffering from the double whammy of low prices, declining production and growing dependence on oil imports, it appears to be at the point of further acceleration in the decline in output. The country’s sliding rig count provides a clear indication that output will continue to slump, but the question is how far can production slide all else equal? And even more critical, combined with growing domestic disorder, discontented workers and fragmenting politics, it appears that the likelihood of a collapse in production has grown to the 50% range or higher, even without the imposition of further sanctions.
Venezuelan disruption risk seems the most palpable and likely over the course of 2017. Over the short-to medium term, Venezuelan production exports should continue to decline, where the current rate of decrease would put production at 1.65-m b/d by year end and 1.3-m b/d by end 2018; but a sharper drop could occur at any time, whether by 500-k b/d, 1-m b/d, or a full 1.9-m b/d.
Next, Citi describes what it calls the dawn of the “Trump Doctrine”, part and parcel of which is preserving the integrity of “red lines.”
For lack of a better way to summarize, Citi basically says that in order to preserve his image as an international badass, it’s probable that Trump turns up the heat on Venezuela.
“And then there are still more sanctions to consider,” Citi writes, before expounding as follows:
The severing of diplomatic ties between Qatar and Saudi Arabia, U.A.E, Bahrain and Egypt in June was clearly a step-up in “disruptions risk” given the 5 countries produced ~18% of the world’s crude supply during the month.
Moderation efforts by Turkey, Germany, the UK and most notably the US and their Secretary of State Rex Tillerson appear to be having an underappreciated calming effect however. Already the list of demands on Qatar from the Saudi-led bloc have been reduced to 6 principles, down from 13 principles initially. Qatar for its part has continued to appear “reasonable” in its negotiating positions, pushing for open dialogue as long as Qatar’s sovereignty is respected whilst their Emir gave a speech over the weekend regarding Qatar’s commitment to combat terrorism and terror financing. For now, it appears the two sides are some way apart in terms of negotiations and economically and politically the situation may well stall for some time. Yet the likelihood of near-term supply disruptions or further escalation is likely to be reduced as long as the US and other allies continue to pressure both sides into a diplomatic solution.
Additional US sanctions against Russia have been wrapped into the same bill that increases sanctions against Iran and North Korea and was passed earlier this week by the US House of Representatives. Although Congress has struggled to pass legislation this year, anti-Russia and anti-Iran sentiment in Congress is one of the few genuinely bi-partisan issues on Capitol Hill. An earlier version of the bill passed the Senate on June 15 with a vote of 98-2 but Bob Corker, Chairman of the Senate Foreign Relations Committee, appeared to dampen prospects on Monday by stating that they “still have a lot of work to do” on Russia sanctions and that optimism on the deal over the weekend “seemed somewhat premature.”
The bottom line is that this seems like a shit load of geopolitical risk that’s deserving of some kind of premium in oil prices.
With regard to that, Citi has the following to say:
Despite enhanced volatility since 2Q’17, the vol risk premium has diminished in crude oil options market. After the surprising tranquility earlier this year, crude oil price volatility has increased significantly, with WTI flat price going on a rollercoaster ride and the 3-month realized vol climbing from ~22 vol pts in April to ~32 pts in mid-July. Meanwhile, however, the 3rd contract implied vol has been trading within a narrow range around 30 vol pts, with little risk premium priced in (Figure 2). And its relationship with flat price, while still negative, has weakened markedly (Figure 3). To be sure, the volatility of the implied vol itself has declined to the lowest level since 2Q’14.
While this partly reflects the current low vol environment across the commodity complex, except for some agricultural commodities due to their strong seasonality, and indeed across asset classes, it might also be driven by a lack of near-term event risks in oil markets since the May OPEC meeting.
Investors should not interpret this as a sign of quiet trading in the summer and muted price moves ahead. Instead, we view this as a good opportunity to add to their long exposure with cheap optionality, especially with global oil inventories continuing to tighten and geopolitics heating up again. The implied vol can re-price sharply higher if supply disruptions rise meaningfully or if the bearish market sentiment reverses quickly.
So I suppose the takeaway here if you’re a bull is that the potential exists for still more upside based on a repricing consistent with the palpable geopolitical risk.
Of course none of this necessarily has to materialize, but given the fact that so many of the players (Maduro, Trump, the Saudis, etc.) can very fairly be described as irrational actors, someone seems bound to step on a land mine at some point.