Given the level of Fed money printing seen since last year, there is no doubt that we will and are seeing inflation. It just depends which inflation measure you are looking at. If you are the Federal Reserve, then clearly your metric is so vastly understated that one could delude themselves into believing that this monetary experiment has no consequences, so let's just print more! It works, until it does not. As we see inflation popping its ugly head, the question becomes one of asset allocation. That is where commodities comes in. Money keeps pouring into commodities and this past week more than $500 million came into funds reported through Thursday, bringing it above $2 billion for this year. But this is only what is listed, there is a variety of non-reported ways to allocate money to commodities. What does this all mean?
Most of the commodity indices have a majority weighting in oil, by default, given the size of this market. Most of the oil market is traded physically given that total annual oil consumption is around 100 mbpd for sake of rounding, prior to Covid. The physical market dictates oil pricing and structure. The macro liquidity related flows tend to affect the front of the structure, but the back end is where the producers are active. Back in November, we saw the oil curve go from a full contango - where spot prices are below future prices - of around -$2.5/bbl. on a one year forward basis, all the way to +$3.5/bbl. backwardation, where spot prices are above future prices. That is synonymous of a market that is extremely tight. Thanks to vaccine related recovery hopes and OPEC+ keeping oil off the market for longer, this exacerbated the trend. From a flow point of view, as the inflation theme was getting more mainstream, this played well into commodity index funds as the roll yield was positive when curve was in contango. Now the roll yield is negative. What that means is that even if oil keeps going up, investing in oil commodity ETF products can see performance fall. This is bewildering to most but is one of the perils of investing in commodity markets.
Another point is that the oil market is a seasonal one. It is dictated by winter heating oil demand or the summer gasoline driving season. Right now, we are in the peak of the winter heating demand, as seen by the cold spikes in the U.S. OPEC+, namely Saudi Arabia, took an additional 1mbpd of oil out of the market in February and March, a crucial time when demand tends to be the strongest. They were not sure what Covid lockdowns would do to demand and did not want to see a repeat of 2020. What they failed to realize was that market was normalizing, so cutting production more now only to release later, would mean a temporary spike in prices, and not a sustainable rally. They are hoping it rises fast enough so that they can sell at higher prices. This strategy might backfire on them. Non-OPEC producers are selling the back end of the curve locking in prices so that they can produce more. Meanwhile, how long can Saudi Arabia keep eroding its market share or get OPEC+ members to sit back and hold off on monetizing at these juicy levels.
Those calling for a super cycle, the rally of 2000-2004 rally was entirely demand led. This one is supply induced, thanks to OPEC+ removing 8.7 mbpd of oil out of the market. Refining margins were falling recently despite the price going up - not symbolic of a demand induced rally. Watching U.S. bond yields tick higher and trading oil tick for tick is a fool's errand without understanding what is driving it. The macro tailwind only works for the oil market until physical market dynamics take over. When they do, unwinds can be sharp and painful. That is the beauty of "shoulder" periods in Oil. Do not underestimate them.
