The last decade has been one of the worst for the energy sector, which closed up just 5% vs. the S&P 500 up 180%. That is some serious underperformance. Today, energy holds just shy of 4% of the weight in the S&P 500 compared to 13% back in the 1990s. The last decade was essentially the lost decade for oil and oil stocks, and to an extent a pretty horrendous time for commodities in general not counting the intermittent boom and busts seen in between.
As is typical, everyone had given up on energy from the fourth quarter of 2019, given high crude stocks, slowing demand, and EIA and IEA all cementing exponential growth rates for U.S. shale for 2020 onwards. One wonders if they even understand how decline rates work or the amount of capital that is now closed to most shale drillers, making it harder for them to even sustain existing wells let alone drill new wells.
So as 2019 ended, all sell-side analysts and physical commodity players just pencilled in bearish doom and gloom for energy and oil prices as they focus on what is now, not what can come looking at all the policies in place over the last few months.
Let's put aside geopolitics on Iran/Iraq/U.S. for a second and look just at pure oil market fundamentals. Following U.S. Fed Powell's drastic U-turn in September, they pumped endless amounts of money to shore up repo markets and start buying U.S. Treasury bills via not-QE QE. Call it whatever you want, liquidity ambush helped shore up asset classes around the globe as dollar fell. More importantly, it was the communique that the Fed has a much higher tolerance level for inflation, and does not even care if it trades above 2% sustainably for a while.
In summary, the Fed is not raising rates any time soon. This is what changed the game in Q4 and most physical and fundamental guys -- fixated on looking purely at inventories, that tell you how much slack is in the system today -- are convinced that oil prices are too high with respect to their inventory relationship. But what if inventories start to fall? Then what? That is what is starting to happen as more than 50 central banks have cut interest rates around the world to stoke economic growth, including China and the U.S. The entire world has synchronized to boost economic growth through loose monetary policy. Growth is bound to pick up.
As that demand picks up, oil inventories will start to withdraw, and markets get tight; the reflation trade. Along with copper and other commodity prices, oil prices started bouncing in Q4 from $58/bbl Brent reaching $66/bbl Brent prior to any attacks or U.S. heated rhetoric against Iran. Also, typically Q4/Q1 is a time when oil demand tends to pick up seasonally as we enter peak winter heating demand season. Now add OPEC+ alliance having taken a further 500,000 bpd of oil out of the market, making it a total of 2 mln bpd sitting out, the market is entering a "tight" period. U.S. shale grew at an alarming rate of 1-1.5mln bpd over the past few years, but that cannot and will not be sustained going forward.
High yield debt markets are closed off to shale names, as they have been losing money these past few years and fell back on their promises of capital discipline. It is game over for them now, as shareholders are no longer willing to reward them for negative free cash flow yields. They are now entering an era of capital discipline, they have no choice. Only the capital disciplined and prudent managements will survive as they sustain current production and maximize revenue, aiming to slowly return cash back to shareholders.
The Baker Hughes rig count has been falling for past six months. There is usually a time lag associated with that, so one needs to see when U.S. production starts to plateau, which it is slowly doing.
Now let's put this weekend's attacks and geopolitics into context. It is election year and President Trump cannot risk waging an all-out war with Iran, or anyone for that matter, especially risking higher gasoline prices at the pump hurting the U.S. consumers, losing votes. Heated rhetoric and turning voter attention away from impeachment proceedings could be on the agenda -- after all, the Trade War with China is so last season -- now perhaps it's time to flex his muscles on Iran, but that will be all.
There is no doubt that if an all-out conflict were to break out, we are talking potentially 4 mln bpd of oil at risk, even allowing for OPEC+ cuts, that will squeeze the markets and cause the next recession surely. We all wonder what will be the reason to stop this "everything bubble" market and endless Fed printing. It could be a massive oil price inflation squeeze, but we are nowhere close to that level of pain.
Most physical guys did not see this rally coming over the last few weeks, and even today will call to short oil, without realizing the reflation trade and global monetary policy backdrop is accommodative. There is very little war premium in the price, the market is tightening without it. The economic data over the next few weeks will be important to see if GDP growth and ISM Manufacturing is picking up, not only showing signs of stabilization.
Until the music stops at the Fed liquidity merry go round, think the stars have aligned perfectly for oil markets, at least for the next few months. Energy stocks are incredibly cheap, always have been, but now the momentum is in its favour too, but the icing on the cake is that everyone is still underweight.