HFI Research article... No foreplay, let's get straight to it. I like what I am seeing from the market this week. We had 1) additional China lockdown news, 2) a bearish EIA oil storage report, 3) bad Chinese economic data, and 4) a breakdown in oil, and despite all that, we are essentially back to where we started this week for oil.
In addition, other things I'm seeing are:
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A possible peak in US Dollar.
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Copper prices bottoming (the most important one).
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TSI reversing for energy stocks.
Keep in mind that while the timing of our sell decisions 10 days ago coincided with a $10/bbl drop in oil, energy equities have not fallen nearly as much. Many of the names are showing resilience around their respective support levels, which signals underlying fundamental strength.
For obvious reasons, we do not need to argue the merits of why energy stocks should trade higher regardless of the recent volatility in oil prices. Given that oil prices remain in the mid-$80s, energy companies are still printing free cash flow, and the majority of that free cash flow is going towards share buybacks and dividends.
The problem with the market today is a perception problem. The perception that 1) China is weaker than normal, 2) global oil demand could be lower than normal in the incoming recession, 3) elevated prices have dampened demand (proven not to as material as the market believes), and 4) the Fed will be successful in fending off inflation.
All of these things will take time to resolve themselves, and the easiest way to do it is through market price action. If the signals we are watching this week continue to manifest themselves into a trend, we like where we are headed. Because while this does not eliminate the downside risk into year-end, it does create a more asymmetric set-up on being long oil and energy.
In the WCTW report we wrote this week titled, "OPEC+ production cut - a symbolic gesture but a powerful one," we said:
For those of you that are new to our writing, why is it that we compare this year to 2018 so much? There are a few important similarities to understand:
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Global growth was very strong in 2017. The same could be said of 2021 as the world was recovering from 2020.
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Like 2018, there were visible signs of macro pressures heading our way. USD was raging in 2018 as it is today. China/US trade war resulted in increasing uncertainty about global growth. This year, the zero COVID policy in China along with worsening economic growth in China is leading to similar concerns about global growth.
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Copper prices were falling in 2018, and similarly, they are weak today.
And for energy investors, 2018 saw energy materially outperform tech from March to October only to falter into year-end. And like 2018, the broad market was very weak, which lead to underperformance for fund managers across the board.
So what's our point?
Well, if you have been paying attention, you will know that there are two very big differences.
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Saudis are not interested in preemptively reacting. Instead, it is taking a cautious approach to the oil market even going as far as signaling a production cut. This is the exact opposite response it took in 2018, which should give oil markets the tailwind it needs down the road.
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US oil production growth averaged ~250k b/d per month. We are lucky to average +70k b/d this year. Again, a huge delta and difference to 2018.
Aside from the demand worry similarities, the oil market is in a much better place, which should give the oil bulls and energy investors peace of mind that the bottom won't fall out underneath us.
Now if you circle back to the point of this article, if the market price action say in copper, for example, starts to move back higher, it would suggest to me that the worries over global oil demand may be waning. This, in turn, would materially reduce the risk that global growth surprises to the downside, which would make the bull case more asymmetric.
And if you look at the oil market from the 30,000 feet view, it is just worries over demand that are keeping a lid on price. One of our core theories for why oil prices sold off in June was that oil demand was weak in the US, and as a result, prices were going lower to find where it would start to stimulate demand again. But following the EIA PSM report, it was evident that US monthly oil demand was strong as ever despite the spike in price. So the oil sell-off has much ado with worries over a potential drop in demand, then an actual drop, which makes a huge difference.