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  1. Home
  2. / Markets
  3. / Commodities
  4. / Oil

Oil Remains Stuck Between a Rock and a Hard Place

Oil prices are improving, but that only tends to encourage the release of more production, which then puts a damper on prices again.
By MALEEHA BENGALI
Jan 05, 2021 | 09:30 AM EST

Inflation will be one of the biggest themes of 2021. This is a contentious topic as some observers have given up on the idea of inflation ever appearing purely because we haven't seen it in the last 10 years following the Federal Reserve's previous quantitative easing (QE) programs. Is this time really different?

It surely is, because we have never before seen an enormous monetary policy response coupled with a huge fiscal policy response.

This time, money is literally flowing in the hands of the people as stimulus checks are handed out to them. Those who are still in doubt just need to see the U.S. 10-year breakeven inflation rate, which nudged above 2% on Monday. In layman's terms, inflation can be felt and seen in the price of small consumer items such as coffee, sugar, lumber, construction and housing material costs. Inflation is here and the Fed is going to make sure that this time it sticks as it cannot pull the rug out too soon. The memories of Christmas 2018 are etched in its minds forever.

On top of this theme of inflation comes the topic of portfolio allocation going forward. Most are still bent on keeping the 60/40 rule as they know no other way. Bonds tend to fall precipitously during inflation and equities more so when inflation rates rise and are not followed by associated growth. But this time the Fed will make sure to keep rates lower for longer to avoid that scenario. Also, it is buying up all the bonds the Treasury issues, so at best the bond market is flat, with risks to the downside as inflation will creep up on the Fed at some point.

Allocations need to move toward commodities and hard assets. From a macro perspective, commodity presentations are slowly coming back on people's desks after a decade of no love. Allocations are low and this is something portfolio managers and institutions need to address but are all too jarred by the volatility and ensuing boom-and-bust nature of this asset class.

From a macro perspective, allocations toward commodities will increase and all can and will benefit, the rising tide lifting all boats scenario. But one big crucial differentiating factor for commodities is that it is inevitably boils down to demand vs. supply balances -- i.e., inventory. This is where the micro picture is extremely important as the sweet spot is to select commodities that have not only the macro wind behind them but also the micro tailwinds to support their sails.

Given years of underinvestment in the mining industry, copper and iron ore are in very low supply, especially when a big player such as China starts boosting its infrastructure spending overnight to rev up its economy. These base metals cannot be mined and excavated in a few months; it takes years and prices must rise long enough for companies to be incentivized to put dollars to work and explore.

Oil is a different beast altogether. It is one of the few commodities that have been in perennial oversupply for years. It all started with the shale boom that changed the industry forever. Now the only reason oil is holding up is because of OPEC and friends getting together and limiting supplies to avoid prices collapsing. Meanwhile, to see more oil, we literally just need to snap a finger or turn on a tap. So, the window of supposed tightness is a lot smaller.

U.S. shale oil did get hit extremely hard during the pandemic lockdowns that knocked off about 30 million barrel per day of global oil demand in a matter of days, leading to a massive buildup of inventories. This caused OPEC+ to remove 10 million barrels per day of oil out of the market in April to support prices. Now as prices rise, they are slowly itching to release that oil in small increments.

About 500,000 barrel per day were released in January and now another meeting is being held to decide whether another 500,000 barrel per day can be released for February. Russia is proposing this idea as it makes sense given Brent oil prices are above $53 per barrel and money is flowing into commodities, so why shouldn't they monetize their production when everyone else is benefitting from higher prices? Saudi Arabia is against this idea as it is afraid of prices falling. Some argue that U.S. shale industry will never be able to reach its heyday of 13 million barrel per day given constrained credit, but it still is pumping about 11 million barrel per day currently. We know the short-term memory of this market and how credit works when the price of oil rises.

At the end of the day, OPEC+ is playing a careful game of timing the supply release, but it does exist. We are seeing extended lockdowns through March in the U.K. and Europe, and the world will be far from normal until at least the second half of 2021 in terms of travel demand and normal consumer activity. This constant shift between macro tailwinds and micro headwinds will cause oil to struggle in the first half of this year until we see a solid demand response. It may hold up well, but it is far from being in a tight environment that can see prices shooting higher, at least not for the time being.

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TAGS: Commodities | Markets | Oil | Real Money

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