Market Thinking

making sense of the narrative

Investors choose to ‘Self Isolate’

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The markets are largely behaving like q4 2018, but economically the virus is causing a working capital crisis more like 2008. The latest market ‘crash’ has come in Oil, with Brent crude dropping 10% on Friday and the West Texas Crude price heading for below $40 for the first time since 2016. In effect, Oil has joined equities in replicating the leveraged unwind sell-off of q4 2018. This in turn has led to equities being limit down today on Wall Street as we see a classic market contagion of deleveraging, margin calls and ‘risk management’ driving risky behaviour.

While the size of the move on Oil may be a shock, the direction should not be. We would note that since the Covid-19 story broke back in mid-January, going short energy has been one of the big ‘trades’ being put on by active investors/traders, not least as the panic over Iran at the time (remember that?) had pushed Brent Crude towards $70 and traders were aiming to take out the April 2019 high and thereafter the 2018 highs. However, that didn’t happen, which, together with the easing of Iran tensions, was a good enough reason to take profits in early January. Meanwhile the emergence of Corona Virus as an uncertainty became a reason to now switch and go short and saw West Texas Oil take out all its long term support levels around the $58 level. The subsequent failure to sustain the brief rally in February from around the $50 level was a set-up for a sustained downtrend. The next target is just under the $40 level, with the ultimate low of August 2016 of around $26 being touted by the short sellers.

The move in crude on Friday was linked to the failure of OPEC talks, specifically with Russia, but this in turn reflects pressures similar to those that led to the 2016 sell-off; once below a certain level, lower oil prices produce a seemingly perverse response in that the lower prices fall the more production increases as heavily indebted producers rush to cover fixed costs and thus drive a beggar thy neighbour policy. Meanwhile, two of the three largest oil producers in the world, Saudi Arabia and the US Fracking industry, have a dangerous combination of weak balance sheets and a need for cash flow. The third, Russia, not only has a budget surplus, but also memories of how the Saudis acted to push prices down in 2014 as part of a US promoted ‘sanctions’ effort. Moreover, with the current Middle East politics putting KSA very much in opposition to Russia in Syria, it is difficult to see why Russia would be inclined to help out. The Saudi Budget deficit, estimated at around $50bn, or 6.4% of GDP is based on an assumed Brent Crude price of around $63 a barrel and production of around 9.3m bpd. Until the Oil markets broke down in mid January, this was close to the long term support level. At time of writing, Brent Crude futures are trading at under $35. If that were to continue, then the back of the proverbial envelope says that is a further $94bn shortfall, pushing the deficit to over 20% of GDP. Throw in the fact that the Saudis have suspended the major pilgrimages due to Covid-19 which is another major source of revenue and there is the potential for real trouble.

 The moves at the weekend are thus a wake up call for some and a reminder that the economic entities most at risk from putting the world on ‘Pause’ are those with the weakest balance sheets and the worst operational gearing. And that includes countries like Saudi Arabia, where we also had some political moves by the Crown Prince that would have further increased uncertainty. It is also interesting to look at the Saudi Aramco share price yesterday (Sunday) for of course Riyadh trades on Sunday. At the close a large order went through such that the price dropped 10%, crystallising mark to market losses for IPO investors.

In the chart, we show US west Texas intermediate crude alongside Aramco, but also alongside an ETF of ‘Fracking stocks’ aimed at tracking the unconventional oil and gas sector, which we have annotated to show the extent to which not only are they highly sensitive to the oil price but also how they have ratcheted downwards steadily over 5 years, losing over 70% of their value. For this reason we have used the US West Texas intermediate crude price, which is more relevant for US shale producers (Saudi are more sensitive to Brent prices, which move similarly but are usually at a modest premium).We said at the beginning of the year that one of the bigger risks to markets was Elizabeth Warren’s statements that she would ban fracking on day one, given how much leverage remains in the unconventional Oil and gas sector. Instead it looks like Covid-19 is doing her job for her.

Perhaps this is why, unlike other markets, the one area not seemingly following the Q4 2018 playbook is the US$, which rallied back then, but is now dropping sharply against most major crosses.

The message remains the same – the tendency of long term investors to buy the dips has switched to now selling the rallies and leverage is being unwound across the board. There is already a lot of value around, but it makes sense to wait for things to settle. Meanwhile, the losers are going to be those with poor balance sheets, high fixed costs and a need for cashflow.

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