A Double Dose Of Chaos For Oil Markets

If you happened to be on vacation for the last week then we have good news- you didn't miss much. Just the collapse of trade talks between the world's two largest economies and a massive ramp in hostilities between two of the largest militaries in the Middle East. We entered May in a cozy bull run for risk assets. Two weeks later markets are collapsing and the White House is looking at proposals to send 120,000 troops to the Middle East to contain Iran. So it goes.

These two events may very well end up having just a modest impact on oil prices. They could also both end up shaping prices more than any other factor in 2019. Therefore, a quick recap is necessary.

On the trade front, the US and China appeared to be sailing towards a mutually acceptable deal in April which helped stock markets soar to or near all-time highs. Risk assets were pricing in a deal with near certainty which is why the recent devolution of relations has hit markets so hard. This all began last week with a Chinese effort to harden their stance on certain deal terms. The renegotiation was met with dismay from the US side resulting in fresh tariffs on more than $100b of goods and a threat of an additional 25% tariff on $300b more. China responded in turn with fresh tariffs of their own, and suddenly the near-certain deal feels highly uncertain. Both sides are beginning to acknowledge the spat will hurt the global economy and increase inflation at home. To salve the wounds, Beijing is leaning on the PBOC to ease the credit environment and Trump has rekindled his passion of badgering the US Fed to lower rates and even restart QE. We still think the odds favor the two sides reaching a deal in 2019,
but there is no doubt those odds have shrunk in the last seven days.

Meanwhile, in the Middle East Saudi/Iran relations seem to be at a boiling point. Our summary of this story begins with the Trump administration's decision to exit the JCPOA- aka the Iran Nuclear Deal- and enact extremely harsh sanctions on Iran beginning May 1 in an aim to drive Iranian exports to zero. This policy obviously represented a massive win for the Saudis as they could benefit through increased oil market share while their ideological and geopolitical opponent was economically damaged. The two sides have also been entangled in various Middle East proxy wars in the last two years, and the antagonization finally spilled into the oil markets this week beginning with the damage of several UAE (a Saudi ally) oil tankers over the weekend followed by drone attacks on two Saudi crude pumping stations on Tuesday. Both attacks were ultimately traced back to Iran-linked forces in a clear signal they will not be quiet as they are cut off from the global oil market. The US appears to be gravely serious in assessing the attacks with the White House apparently mulling a proposal from longtime Iran-hawk John Bolton to send 120,000 troops to the Middle East in a show of force.

What to make of these two sagas? We think markets are correct to de-risk as the odds of a 2019 US/China deal decrease and Iran/Saudi hostilities fester. These are very real threats to prosperity and the Middle East situation clearly transmits an upside risk into the oil market. However, options markets both suggest that newly heightened risk will not overwhelm investors in the near term. The recent run in WTI volatility from 30% to 35% puts the index about 25% above its 2yr average. Meanwhile the VIX - measuring S&P 500 volatility- is up about 50% in the last month but only 20% above its 2yr average. This sends a clear message that insurance markets see heightened risk, but it may not be time to panic just yet. The insurance markets are wise. Let's listen to them for now.

Quick Hits

- Crude oil spiked higher in early trading this week on what could be a new chapter in tensions between Iran and Saudi Arabia. The two nations have a long history of not getting along but this new era of oil market sabotage would take things to an unusual level. Brent prices ultimately touched a high of $72.58 on Monday but cooled down with other risk assets as US/China trade talks took center stage.

- In Venezuela, Maduro strengthened his grip on power this week and is set to prosecute several allies of Juan Guaido following a failed effort to thwart President Maduro in April.

- We're keeping a close eye on the crude oil risk right now as measured through the implied volatility of options prices. This week crude oil vols increased from 30% to 35% in a clear signal that traders have a demand for risk protection. For some historical perspective, the 2yr average of the CBOE Oil Volatility Index is 28% so the current level is certainly elevated but not in an extreme fashion.

- We've also taken a keen interest in observing the investor 'flight to quality' currently taking place as stock markets plummet. First, a quick recap on those stock markets. The S&P 500 has dropped by about 5% so far in May while the Euro Stoxx is down by about 6%. The Shanghai Composite is down by about 13% in the last three weeks.

- So what are investors buying? Mostly bonds with a side of gold and Bitcoin. The yield on the US 10yr bond has dropped from 2.55% in early May to 2.40% this week while gold has run from $1,270 to $1,300. Meanwhile, Bitcoin has one of the most compelling charts in financial markets having run from 5,000 to more than 8,000 in less than thirty days. We think it's premature to view Bitcoin as a 'safe haven' asset, but the flood of money into digital currencies in the last month is deserving of attention.

- Hedge funds took a break from buying oil for a second straight week last week. Money managers sold 10% of their net length in NYMEX WTI and were essentially flat in ICE Brent holdings. Funds appear to be directionally underwhelmed with oil right now with ICE Brent net length sitting exactly on its 2yr average while NYMEX WTI net length held by funds is about 5% below its 2yr average. In other words, funds aren't exactly sticking their necks out in the oil market.

DOE Wrap Up

- US crude production fell 100k bpd w/w to 12.2m bpd and is averaging 12.04m bpd so far in 2019- up more than 1m bpd from its 2018 average of 10.8m bpd.

- Crude inventories decreased by 4m bbls w/w to 467m bbls and are higher y/y by 7% over the last four-week period.

- Cushing crude stocks increased by about 800k bbls w/w to 46m.

- The US currently has 28.5 days of crude supply on hand which is higher y/y by 2.5 days.

- US crude imports fell 700k bpd w/w to 6.7m bpd. US crude exports fell 300k bpp to 2.3m bpd.

- US refiner demand dipped yet again last week falling 40k bpd to 16.40m bpd. US refiner inputs have averaged 16.4m bpd over the last four weeks which is lower y/y by 250k bpd. US refiner demand has averaged 16.30m bpd so far in 2019 which is also lower by 250k bpd versus the same period in 2018.

- US gasoline stocks fell 600k bbls w/w to 226m and are lower y/y by 4% over the last four week period.

- The US currently has 24.0 days of gasoline supply available which is lower y/y by 4%.

- US gasoline demand domestic demand + exports equaled 10.4m bpd last week representing a 400k bpd increase w/w. Implied US gasoline demand is lower y/y/ by 100k bpd YTD in 2019.

- US distillate inventories fell by 180k bbls last week and are higher y/y/ by 5% over the last month.