If one were to read about President Trump's latest explosive Twitter threat with Iran, followed by a speech by Secretary of State Pompeo in which he accused Iran's leadership of corruption and human rights violations, one would be calling their broker asking them to buy upside calls on oil immediately. These tweets started two weeks before the administration will begin imposing sanctions on Iran that had been lifted under the 2015 nuclear deal. One wonders what changed that caused this latest outburst, especially as Trump wants to get the price of oil down? Perhaps the more pertinent question to ask is: why is the oil price not phased by this latest caps lock challenged address to President Rouhani?
The answer lies in the shape of the Brent oil curve. Given the importance of oil and its impact on global markets, it is amazing how few people actually understand or look at the oil price structure when discussing it in the media. Commodities are not equity instruments. They do not have one valuation based on discounted future cash flows. Commodities are dictated by a futures curve, a price at every month from now till five years from now and beyond. Based on the demand supply constraints, the price of the future is higher than the spot (in Commodity jargon known as "contango"), or price of the futures is lower than the spot (known as "backwardation"). Contango usually implies that there is excess inventory in the front and so the price of the spot falls as the market is flooded with it, implying a fundamentally weak market.
This is what is happening in Brent right now. Brent is the global benchmark for oil, not WTI, given the latter is landlocked in Cushing, Oklahoma, and its price is determined by the inventory balance only in that region. It's not indicative of the global supply of oil per se. If you look at the price of the seventh month Brent contract and first month Brent price, that difference has gone down to -1, which traded as high as $3 plus in April. This implies the market is seeing more oil in the near term. But does the average generalist trader or retail investor actually know this? Or are they too busy trying to trade headlines from Trump and OPEC? Physical markets always tell the truth.
It is summer so we are in the peak gasoline demand season. Demand is holding in but supply is also picking up as we see US production reaching 11 million bpd. We know OPEC and non-OPEC nations are raising output going into July/August. With stable demand (potentially lower demand yet to print post the collapse in emerging markets last month), supply increasing, where do you think the price of oil can go? Lower, of course. However we still need to get through the next 1-2 months of gasoline and the hurricane season. Worst case, the oil price is capped. But the risk reward is lower from here.
But one does not need to give up on commodities entirely just yet. There is better alpha elsewhere. One just needs to look at the fundamentals where inventories are actually tight, but not tainted with fear and worries, like copper. With the yuan reaching close to 6.80 yesterday, the last level of pain for PBOC, it was only a matter of time if they would defend their holy grail of a 6.5% rate of "official" printed GDP growth. Things had gotten worse the last few months with all the trade wars. Shanghai composite and Emerging markets have been crushed this past month and panic set in, as to how low they would let the yuan drop. Deja vu 2016?
Today China unveiled its latest package of fiscal policies to boost domestic demand amid growing concerns of a slowdown. Seems a lot to me that they are putting their foot back on the pedal. The package contained measures giving an additional tax cut of 65 billion yuan ($9.6 billion in US dollars) to companies with R&D expenditure expediting special bond sales to assist local government infrastructure financing. Did someone say infrastructure?
To me it is a green light for China's exposed casualties of trade wars to come back into focus, namely copper. It is down 20% since this trade war saga started. It has been beaten up as traders quoted yield curve inversions suggesting recession risk around the corner. As Trump went all in threatening to impose sanctions on all $500 billion worth of imported goods, the market was worried what would happen if China retaliated with fiercer measures. Is China as irrational as Trump, hmm. It is all about strategy for them. Why would they when they have invested billions in initiatives like One Belt One Road, if not to keep growth stable and growing slowly?
Quality large cap stocks like Antofagasta, Kaz Minerals and Rio Tinto (RIO) , are down anywhere between 10%-20% since the summer started. Nothing has changed fundamentally. These companies have solid balance sheets and display the only growth in copper projects around the world, and dividend yields of 4%. But everyone is short and thinks China is about to collapse. Sod's law. Pain trade is higher. Seems like a great entry point to me.