Month: April 2021

The energy sector is shining again and starts capturing the attention of the investors and broader media, as the prices for both WTI and Brent crude oil contracts have recently recovered faster-than-expected to the pre-pandemic levels of $60-$70 per barrel.

Rising demand for gasoline and diesel from the USA, China, Japan, South Korea, and India (after the resumption in their economic activity) coupled with the falling US dollar and the massive OPEC+ production cuts during the second half of 2020, have helped the energy market to rebalance, allowing the WTI and Brent oil contracts to double their prices in the recent months.

Crude oil rally hit our 2021 price targets:

We are delighted to announce that our price projection of $70/b in 2021, anticipated back in December 2020 (when the oil prices hovered around $45/b), it hit the mark during the very first weeks of the year. Here is the link for the Yearly Outlook 2021 https://exclusivecapital.com/research/quarterly-outlook/q1-outlook-2021-growth-led-commodities/ .

Bullish Outlook for Q2, 2021:

As we are entering the second quarter of the year, we remain bullish on crude oil prices amid signs of faster-than-expected demand recovery for petroleum products in key consumer regions such as North America and Asia fuelled by the massive infrastructure packages and economic stimulus.

3-month targets:

1. Base scenario: WTI and Brent crude oil prices could top $70/b and $75/b respectively, up 15% from current levels.
2. Bullish scenario: WTI and Brent crude oil prices could revisit October’s 2018 highs of $77/b and $87/b respectively, up 25% from current levels.

The growth-sensitive crude oil prices will continue receiving support on the prospects for stronger global economic growth based on the rapid rate of COVID-19 vaccinations and the resumption of global trade, traveling, manufacturing, and tourism. Thus, this will increase the demand for gasoline, diesel, jet fuels, maritime fuels, petrochemicals, and other petroleum-refined products.

Our bullish scenario for oil prices to revisit October’s 2018 highs, is based on the expectation of additional fuel demand coming from Europe and the UK, after the removal of the social restriction measures, and on possible supply disruptions in case of escalating geopolitical tensions in Saudi Arabia, Iran, Iraq, Libya, Middle East, Nigeria, Venezuela, Straits of Hormuz, Straits of Yemen, and Suez Canal.

Demand and supply dynamics affect oil prices:

The crude oil price formation mechanism is ultimately affected by the dynamic changes in the demand and supply equation. The fundamental dynamics in the energy market will play a significant role for crude oil prices in Q2. Below are the main bullish and bearish price catalysts that could affect the demand and supply equation:

Bullish price catalysts:

The global growth outlook is positive for oil prices:

The International Monetary Fund (IMF) raised its global economic growth forecast to 6% from 5.5% in 2021, reflecting the better-than-expected outlook for the US and China’s economies, which are the largest economies and fuel consumers in the world.

Market sentiment is optimistic for the US economy, the world’s largest oil consumer, with nearly 20 million barrels per day, 20% of the world’s total. The IMF expects the US economy (GDP) to expand by 6.4% in 2021, its highest growth rate since 1984, and 3.5% in 2022, driven by the massive monetary policies from the Federal Reserve, the US President, Joe Biden’s $1.9 trillion pandemic-relief fiscal stimulus and the greater-than-expected employment figures.

Moreover, China, the world’s second-largest fuel consumer, with nearly 14 million b/d, is expected to grow (GDP) above 8% in the H1, 2021, as consumer spending and manufacturing activity have recovered to pre-pandemic levels. Since China has exited early from the Covid-19 crisis, it helped the restart of economic activity and the demand recovery for crude oil, petrochemical, and other industrial commodities.

Weaker US dollar boosts oil demand:

The falling US dollar is a bullish catalyst for the US dollar-denominated crude oil contracts. The greenback retreated more than 10% from 2020’s highs, making energy products cheaper for buyers with foreign currencies, especially from China and India.

Bearish price catalysts:

Higher oil prices lead to higher production:

With oil prices rising above $70/b levels, we expect US shale oil producers to boost production rates. The total US production is more than 11 million bpd in 2021, almost 2 million bpd lower from its peak in November 2019.

We also expect some OPEC members such as Iraq, Nigeria, Libya, Angola to abandon (not comply with) the production quotas under the OPEC+ deal and start pumping more barrels to relieve under-pressure economics.

History says that elevating oil prices could create pressure on the demand side of the equation, as some top net oil importers such as China, Japan, India, and South Korea would be unhappy with the high prices and would start pressuring the OPEC group to increase supply.

OPEC+ and Saudi Arabia ease crude oil output cuts from May:

We believe that any further upside beyond $70/b would be limited, given the decision of the OPEC+ alliance to gradually ease the crude oil output cuts from May.

The surprising decision by the OPEC+ alliance to loosen their production quotas has already added downward pressure on crude oil prices. Under the agreement, OPEC+ will bring back 350,000 b/d of supply in May, another 350,000 b/d in June, and a further 400,000 b/d or so in July. As a result, the total supply cuts would drop near 6.5 million b/d in May, down from nearly 7 million b/d in April.

In addition to the above, Saudi Arabia, the de-facto leader of the OPEC group, will also ease its 1 million b/d voluntary cuts by 250,000 b/d in May, 350,000 in June, and 400,000 b/d in July, respectively.

Iran-US nuclear talks:

Energy investors will turn their attention to the renewed indirect talks between Iran and the USA, regarding the 2015 nuclear deal that the USA abandoned in 2018, under Trump’s presidency, which disrupted the supply of half of the Iranian oil exports.

We believe that any deal is far out of reach now, despite the efforts from the world powers to save the nuclear agreement. For the US to lift the sanctions on Iran’s energy sector, (and increase the oil supply) Iran must abandon its nuclear (uranium enrichment) program, making it harder for Persians to develop a nuclear weapon soon.

However, in case of a possible nuclear deal, any potential recovery of the Iranian oil exports could be a bearish catalyst for oil prices in the short term (but not a “shock” event), as it could add an extra 1 million of cheap barrels of crude oil per day in the already oversupplied global energy market.

Bottom Line:

The energy market is entering the second quarter with increased optimism over a stronger global economic outlook despite the relatively high oil price levels and the many bearish price catalysts.

Even though the OPEC+ decision seems bearish for oil prices, it is signalling a potential robust growth in fuel demand in the H2, 2021, over projections for stronger seasonal demand during the coming summertime (kick-off of summer driving season).

We expect that any price corrections over concerns for a new wave of infections or new virus outbreaks could be a buying opportunity since the recovery in the energy sector is underway.

We believe that the worst may be behind us in terms of peak damage point, and the expected price volatility could offer trading opportunities for investors and traders in the months ahead.

The main characteristic of the state of the markets for several months now, has been a rotation from high-beta momentum stocks to other parts of the market. Many have called this a rotation from growth to value.  

The other thing to point out is that markets have not caved-in as a result of certain parts of the technology sector correcting. For example, Tesla went from about $900 to about $550, a 40% correction, but markets didn’t even blink. Many other high-flying names such as Zoom Video Communications have corrected by 50%, and the EV space has been decimated, while others like Apple have gone nowhere since the begging of the year. Yet, the S&P Index is at record high. In my mind this means this bull market is still intact. However, investors will have to change their approach to the market and find new winners.  

Another characteristic of the past several months has been the rise in yields, and a slight appreciation of the dollar vs the Euro. In my mind both should not be happening. Insofar as yields, central banks are still purchasing assets with their balance sheets recording new records on a weekly basis. And when yields go up, it means investors are selling fixed income assets. My question is where do they go and what are they buying? I don’t have an answer.  

The second peculiar phenomenon is the correction of the Euro vs the dollar. While many point to yield differentials as the reason for the slight appreciation of the dollar, I am very sceptical. The main reason is that Europe still has a current account surplus vs the US. Insofar as yield differentials, the US has had higher nominal yields for about a decade now. So, I will take the yield differential explanation with a grain of salt. Also, European manufacturing is bouncing back thanks to Germany.  

As the chart below shows, the current consensus is that the US economy will come roaring back in 2021. Is this a reason to be dollar positive? Not always.   

In fact, it might actually be a negative for the dollar vs the euro. How so? Well, if the average US consumer will have more money to spend on stuff, and Europe (mostly Germany) will be able to manufacture this stuff, then the trade deficit the US has with Europe might widen, which is a negative for the dollar.  

Furthermore, as vaccine rollouts continue, we believe more cyclical currencies will benefit, as well as commodity linked currencies. Also, as volatility declines, we should see lower demand for safe haven currencies like the dollar.  

Finally, PPP and interest rate models continue to show that a fair value for the dollar vs the euro is at about 1.30. So while we have seen a slight appreciation of the dollar vs the Euro recently, an average we continue to think that the Euro will outperform the dollar 2021.  

How expensive is the market? 

According to data from the Wall Street Journal (compiled by Birinyi Associates as of April 1, 2021), the current trialing PE ratio of the S&P 500 in the US is about 45. Yes, this is a very big number, if not scary. However, the more important number is the forward multiple.  

If analysts are correct, the forward multiple of the S&P 500 index is about 23. Yes 23 is also a high number from a historic perspective. However, as we have said almost from the start of the pandemic, we expect a multiple expansion for the index because of the liquidity created by Central Banks. As such, while I am uncomfortable with today’s valuations, if things go according to plan and economies grow, this time next year the multiple should be more down to Earth.  

Obviously if anything distracts or derails the recovery then all bets are off. Also, we can have a correction for no reason at all, because that’s what markets do from time to time. And given the current rich multiple, a correction would not surprise me. While we currently do not foresee a major correction, we are vigilant of a market correction even if nothing derails the economic recovery.   

Economic recovery is on track with fiscal and monetary support  

Europe is forecasted to grow 4-5% in 2021 depending on who is making the call. The recovery in Europe will probably stall a little because of vaccination delays. However, about 300 million vaccines will be administered during the 2^nd quarter and beyond, therefore economic activity in Europe should catch up.  

As for the US, many say that it will be the global growth driver during 2021. And they are probably right. The latest ISM services index reading rose to 63.7, the highest reading on record since the data series started in 1997. At the same time (chart above) Germany’s manufacturing sector is firring on all engines, which also mean economies will do much better in 2021.  

Finally, fiscal and monetary policy remain supportive both in Europe and the US, and will continue for some time. The US administration’s proposal for a $2.25 trillion infrastructure spending bill is indicative of the support from governments to cope with the pandemic. In fact, fiscal support will act as a tailwind for economies for several years to come.  

Inflation expectations  

Oil prices have rose 150% during the previous year, as have many other commodities (such as metals 60%) which are fuelling inflation expectations. Indeed, with fewer new COVID cases on the horizon and with movement restrictions being lifted, we will see pent up demand across the board in most economies. Household demand for purchases like furnishings, automobiles, and many other durable goods are likely to see an up-tick in pricing. As such inflation will should tick-up in the US and many other countries. 

However, it’s difficult to see inflation expectations playing out longer term. On the one hand inflation is measured against depressed price points of last year, and on the other, longer term pricing for goods, services, and wadges are still subject to international competitive pricing and global deflationary pressures. So, while we might see an up-tick in inflation short term, we see this as a transitional period as economies open up again and return to normality.   

Insofar as how the market might react to inflation expectations, we think that a correction as a result of inflation fears will be a buying opportunity.  

Will there be fallout from Archegos Capital? 

Irrespective if the unwinding of Archegos did not cause any damage to the market, there are questions as to how prime brokers might  change lending practices from now on.  

If risk management policies within these firms permitted funds like Archegos to have such high leverage, might this be standard practice in all prime brokers? Is so, have many of the stocks that have no valuation logic gone up so much because of this overextending of credit?  

I don’t have an answer to these questions; however, it is sure that risk policies will be changed in the industry and investors have to adjust to the possibilities that many of the valuations that make no sense were a result of such practices. 

The bottom line here is be wary of extreme valued stocks, because in many cases some of these extreme valuations might not be seen again any time soon.  

Bottom line 

As we have said in previous letters, while markets remain at all-time highs, we don’t see any catalyst for a major market correction in the US or Europe. While we are always vigilant of a market correction, until such a catalyst emerges, we will assume a correction to be a buying opportunity. 

Having said this, it would also not surprise us if the major indices declined this year. Stocks like Apple and Amazon are rich enough on their own, no catalyst is needed for them to correct. At the same time however, they are in just about every ETF under the Sun.  So a major selloff in equities will be needed for these stocks to decline and take the market down. As I write these words, I see no reason or catalyst for such a selloff.