Are Inverted Yield Curves A Harbinger Of Lower Oil Prices?

The first quarter of 2019 was lovely for oil bulls as Brent increased 27% while WTI climbed 33%. With Brent now trading near the $69 mark and WTI above $60, there are a fair number of prominent analysts who see OPEC+ tightening and unplanned outages in Iran and Venezuela push oil higher by at least another $10 or perhaps even $20 per barrel. We concur that fundamentals are improving and see potential for supply/demand balances to tighten further as US waiver deadlines on Iranian crude are revisited in May while Venezuela and its oil sector descends further into chaos.

Unfortunately, there is also a black macroeconomic cloud over commodity markets in the form of deeply depressed global bond yields which have recently flipped inverted across some parts of the maturity curve. Fixed income markets are screaming that the global growth picture is unimpressive and to us this lack of confidence continues to suggest that the easy money for crude oil bulls has already been made. While there is reasonable hope for upward momentum this spring- do not expect to see similar returns on oil in Q2 to what we saw in Q1.

So where are these global interest rates trading and why should oil markets care? Government bonds have rallied substantially since the fall as expected global growth rates have decelerated and central banks have taken dovish measures to prop-up economic performance. In the US, the 10yr yield has dropped from 3.2% to 2.4% in the last six months and the yield on the 3-month T-Bill briefly traded above the yield on the 10yr- an inversion which many believe forecasts recession. In Japan 10yr JGB has dropped from 0.15% to -0.86%. In Germany the 10yr Bund yield has decreased from 0.6% to -0.07% and in Italy it's moved from 3.6% to 2.5%. On one hand, lower rates should boost consumption and weaken currencies. On the other, more sinister hand, low global rates can have a negative impact on market sentiment adding to the nonstop flow of 'demand concern' headlines which are already cutting into oil prices. Bond traders and central bankers are clearly concerned with the current global economic picture and our view is t
hat this will spill into commodity markets and dampen rallies for oil in 2Q.

To confirm, we aren't arguing that the global economy will dip into recession in 2Q 2019 and historical data doesn't insure that weak economic performance leads to low oil prices (see chart of oil prices in 2009 and 2010.) However, we are firm believers in the idea that the constant thumping of headlines bemoaning the sicknesses of the global economy will weaken sentiment and limit the ability of oil to rally to the $90 mark which some analysts are now predicting.

Where could our analysis go wrong? April could prove to be an important month for the global economy in 2019 with reasonably high odds of including a US/China trade deal. While our concern has been and still is the event will illustrate the 'buy the rumor, sell the news' theory, there are obviously non-zero odds that it will boost economic confidence. Our first economic data point of the month was the release of China's manufacturing PMI for March on Monday which soundly beat forecasts by moving back in to expansion territory. We'll need much more of this type of news to move significantly higher in Q2.

Quick Hits

(Click to enlarge)

- China's manufacturing PMI screamed higher in March printing 50.5- well above expectations. The index has averaged 50.6 over the last twelve months but just 49.8- slightly in contraction territory- over the previous six months. The print was widely interpreted as a green light to buy risk assets leading to YTD highs for global stocks and crude oil.

- China's data was such a story early this week it seems to have overshadowed early estimates of OPEC's March production was also very much noteworthy. Bloomberg estimated the cartel's output at 30.385m bpd representing a 4yr low and a m/m decline of about 300k bpd. Saudi Arabia was to thank for most of the cut with a m/m decline of about 280k bpd to 9.82m bpd. Iran's production was estimated to be down 30k bpd to 2.71m bpd. Iraqi output fell 780k bpd to 4.55m bpd and Venezuelan output fell 180k bpd to 890k bpd. Libya registered by far the largest gain with a 200k bpd m/m increase to 1.1m bpd due to the restart of its Sharara field.

- WTI settled above its 200-day moving average this week for the first time since October. In our judgment crude oil flat price still looks technically strong. It would be very hard to look at charts and argue the market looks bearish.

- In equity markets the S&P 500 traded over 2,865 this week marking a 15% gain for the year. The Shanghai Composite traded near 3,175 representing a 29% YTD gain.

- Crude oil spread markets also moved higher this week with Brent's prompt 6-month spread reaching +1.85 representing a 5-month high. WTI spreads have also flipped comfortably into backwardation with the WTI June/December spread trading +75 cents.

- Iran's oil minister stated he expects OPEC+ to extend their current deal beyond June following a meeting with Russia's energy minister. Russia's crude production in March is currently estimated near 11.3m bpd which is slightly above its target production level in the current agreement.

- Chinese President Xi offered a cooperative tone regarding the US in comments from Beijing this week noting that the two countries should develop relations based on consultation and stability.

- US gasoline spreads continue to forecast reasonably strong fundamentals this summer as the June contract traded at a 24-cent per gallon premium to the December contract.

DOE Wrap Up

(Click to enlarge)

- US crude inventories increased 2.8m bbls last week with help from a decrease in demand and a decline in exports.

- Overall crude stocks are higher y/y by 4% over the last four weeks and 1% below their seasonal 5yr average.

- The US has 27.6 days of crude oil supply on hand and is higher y/y by about 7% over the last four weeks. Days of supply is ½ day below its seasonal 5yr average for late March/early April.

- US crude production continued to plod along at its all-time high print of 12.1m bpd.

- Cushing stocks increased by more than 500k bbls to 46.9m bbls.

- US crude imports fell to 6.5m bpd and are averaging 7m bpd so far in 2019 after averaging 7.8m bpd in 2018. Exports fell from 3.4m bpd to 2.9m bpd and are averaging 2.7m bpd after averaging 1.96m bpd in 2018.

- US refiner demand continues to disappoint printing 15.8m bpd last week for a 400k bpd w/w decline. Overall inputs are averaging 16.36m bpd which is lower by 80k bpd versus 2018. US refining margins also fell this week with the WTI 321 crack moving from $22/bbl to $20/bbl.

- On a more bullish note, US gasoline inventories continue to fall and decreased by 2.9m bbls last week to 239m bbls. Total US gasoline stocks are flat y/y.

- Inventories declined despite stubbornly lower US gasoline demand + exports which printed 9.82m bpd last week. Demand has averaged 9.98m bpd over the last four weeks which is lower by about 200k bpd y/y. Overall demand is averaging 9.78m bpd so far in YTD in 2019 which is lower y/y by 65k bpd.

- US distillate inventories fell 2m bbls w/w to 130m bbls and are higher y/y by 1% over the last four weeks