A fluid and crude awakening

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Oil price surges are a nasty economic shock and rightfully have form down the decades as recession triggers. The assault on two major Saudi Arabian oil facilities in a drone attack over the weekend has caused the loss of more than 5m barrels a day, equal to 5 per cent of global supply.

Just as Citi’s Economic Surprise indicator has finally crawled back into positive territory, things are looking murkier again. Chinese data for industrial output and retail sales for August arrived below forecasts on Monday, while the surge in oil prices, if sustained, raises the prospect that businesses and consumers face a “tax” via higher energy costs.

That said, context is important. Even after Monday’s jump in the cost of crude oil, the price of Brent remains one-fifth below last October’s peak of $86.74 a barrel. Moreover, the broader market reaction, at least for Monday, has been limited (see Quick Hits), with a relatively muted rise for inflation expectations. 

But the fluidity of the situation does leave broader markets watching crude oil closely in the coming days to see if Monday’s leap is a taste of things to come or one that fades.

The trading week began in Asia with a 19.5 per cent rise in Brent crude to $71.85 a barrel (the kind of jump not seen since the Gulf war), before easing to about $68 a barrel. West Texas Intermediate, the US benchmark, rose as much as 15.5 per cent to $63.34 a barrel, and was just shy of that level in New York afternoon activity. 

There is naturally a great deal of uncertainty as to how long the outage lasts. Drawing on inventories will probably stem the supply blow but any further disruptions in the global oil market will compound matters. The risk of escalating military action is another wild card for the oil and broader financial markets. 

The commodity team at TD Securities estimate “a $3-4/bbl geopolitical risk premium is expected to remain embedded in prices” and one that sets a near-term floor of $58.50 a barrel for US WTI. The team writes: 

“As global producers tap into spare capacity to lessen the impact of the disruption, thereby shrinking spare capacity to critical levels, the market would struggle to deal with any additional outage.”

Andy Hall, the retired oil trader, spoke with the FT’s David Sheppard earlier on Monday. Here are some key pointers: 

“This attack underscores the vulnerability of oil production facilities in the Middle East in particular and the world in general.”

“An SPR [Strategic Petroleum Reserve] release in the US isn’t going to help offset it much as US crude export capacity is maxed out and opportunities for import substitution are very limited.”

“Opec ‘spare capacity’ consists primarily of Iranian production constrained by US sanctions.” 

“It would seem the oil market needs to not only price in the current supply loss but also a higher risk premium for the future.”

Over at UniCredit, the bank highlights in this chart how the outage ranks as the biggest disruption to oil supplies:

The bank’s Edoardo Campanella notes:

“The probability of further price spikes remains high. At present, it is unclear whether Saturday’s attack was a one-off event or it will lead to a diplomatic or even military crisis between the two competing powers of the region: Saudi Arabia and Iran.”

But he also points out:

“It is important not to lose sight of the market fundamentals that actually point to a problem of supply excess, and not shortage.”

Should the situation in the Middle East stabilise, he believes:

“Investors will soon have to grapple again with unfavourable market fundamentals and with the inability of Opec+ to deliver longer and deeper cuts for the lack of internal cohesion.”

And for all of Monday’s fireworks, the price action needs to heat up a great deal before concerns over the global economy fully register, particularly for the US. 

DataTrek’s Nicholas Colas shows in this chart of WTI crude how previous “spikes of +90% are closely correlated with current/impending recession”, with such episodes occurring in September 1990, February 2000 and June 2008.

Nick adds:

“Even if we haircut the tipping point for oil causing a recession by half, to a 45% increase, oil would have to rally to $80/barrel before we hit this warning track.”

Quick Hits — What’s on the markets radar

Across financial markets, the oil surge registered with energy companies leading share markets, while airlines and the transport sector in general felt the burn. Oil currencies such as the Norwegian krone, Canadian dollar and Russian rouble recorded modest gains, as have the usual havens of gold and top-tier sovereign bonds. 

Higher oil prices tend to drive inflation expectations and yet on Monday there has only been a modest climb in so-called break-evens, the bond market’s spread between nominal and real yields. In the case of US 10-year break-even rates, after a leap towards 1.71 per cent, this measure has eased to about 1.67 per cent, a level well below the 2.20 per cent area of 12 months ago. Even shorter-dated measures of inflation expectations have pulled back from Monday’s earlier highs.

US secured funding costs surged on Monday and this is normally the case at the end of the year, or around the end of financial quarters, when there is a scramble for high-quality assets. This time the culprit for pushing the overnight repurchase rate beyond 3 per cent is what BMO Capital calls a “combination of corporate tax payments, coupon settlements, and associated reserve drains”.

BMO add:

“The volatility spike, which was reminiscent of quarter- or year-end conditions, establishes that funding markets are not functioning particularly well. Whether this is a one-off day explained by a convergence of distinctive factors, or evidence that more troubling developments are afoot, will be a crucial question for short-rates in coming days.” 

That’s another quandary for Federal Reserve officials as they meet this week.

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