With the volatility index (VIX) trading below 12 at the end of April as the S&P 500 touched new all-time highs, investors refused to believe there was a need to price in any risk premium into the market as they firmly believed "the market will never go down". This made the short volatility trade a "no-brainer" as traders kept cashing in the premium decay. May has seen volatility shoot up towards highs of 20 as shorts ran scrambling for the exit doors and Trump rhetoric towards China heated up when he did not get the deal he wanted. Boohoo. Does China really care?
China will do a deal that works for both them and America, as one does when negotiating a trade deal, not sign up to a deal that yields them to Trump's wishes. The 2020 election year is creeping up quickly and Trump is backed into a bit of a corner. He has to save face, given he promised his people a "very very good deal." China knows this, and can afford to wait. The next catalyst is the G-20 meeting in June where both presidents will meet up. It will be interesting to see the tone -- or the tweets, rather -- as the market grinds lower.
Not that China was not exciting enough for Trump to antagonize, for the last few weeks, Iran has also been a target of Trump's rage. The oil market by and large ignored the angry tweets targeted at Iran, given the ample supply that remains in spare capacity across OPEC and the U.S. Trump has tried to halt Iran's oil exports by ending sanction waivers on Iranian oil purchases. However, China, India, and Europe have refused to comply as they import most of Iran's oil, and do not see any reason to please Trump. OPEC very happily jumped in to say that they would match any lost barrels if Iran's exports fell; go figure.
There has been quite a bit of jawboning between Iran and the U.S., as Iran even threatened to block of the Strait of Hormuz (the waterway where 20% of global oil is shipped daily). The U.S. has now sent an aircraft carrier and a bomber taskforce to the region -- its intentions are yet unknown.
But is the oil market really tight?
The U.S. has come a long way from being a net oil importer (2006) to now being a net oil exporter. It produces around 12 million barrels per day (mbpd) and has good prospects for raising its production profile in the next few years. Iran used to be the second-largest exporter of oil after Saudi Arabia, exporting around 3 mbpd. Today they are around 1.7 mbpd.
With sanctions, there is a risk that global markets could lose about 1 mbpd of Iranian oil. Venezuela used to export about 2 mbpd until 2017. Today, it exports only about 800,000 bpd. Once again, U.S. sanctions and lack of proper infrastructure have been to blame. To put it simply, the oil market could be at risk of losing a further 1.8 mbpd of oil, worst case, from Iran and Venezuela. OPEC+ have taken about 1.2-1.5 mbpd out of the market and U.S. production grows at a record pace. The oil market is not that tight, really.
As tensions rose between U.S. and China last week, this Monday the U.S. accused Iran of attacking Saudi Arabian oil tankers off of the coast of United Arab Emirates. There is no evidence to suggest that Iran was behind the attacks. To make matters worse, it was reported that Yemen Houthi rebels carried out multiple drone attacks on the Saudi pipeline on Tuesday. The Trump administration was quick to warn Iran on any aggressive attacks carried out by them or their proxies.
Despite Secretary Pompeo's statement "we fundamentally do not seek a war with Iran", the market may not be entirely convinced. Despite the selloff in Base Metal and Soft Commodities this week, as the U.S. doubled tariffs on China, the oil price held firmly to its $70/bbl. level. It faces headwinds from the tariffs in place but has tailwinds from potential oil supply shortages in the future.
Oil stocks have fallen about 10% over the past month, rightfully so, as demand concerns linger into the summer months.
Technically, the market is tight given the OPEC cuts. But as they raise production into summer months, some of that tightness should be relieved (barring a war in Iran). It seems Trump is desperate to garner American public approval by taking a strong stance on China and/or Iran to "show" his people what a tough President he is.
A war is in no one's interest, especially the U.S. As global growth is slowing down, the last thing American consumers need is a spike in oil prices. If that happens, take it for granted, stagflation will ensue and U.S. equity markets will be hammered. Asset classes are already flirting with the idea of stagflation over the past few days with serious risks if U.S. and China do not back down on their threats.
Despite Trump's desperate calls to the Fed to cut rates, if core inflation shoots much higher, the Fed might need to raise, not cut! Maybe someone needs to explain this ECON101 theory to dear President Trump before he incites and rattles every dissenting country not abiding by U.S. wishes.