People by nature are universally optimistic, studies show. This optimism is probably rooted in the instinct of survival. Human race outlives wars, famine, or economic recessions. Health epidemic must be added to this list. Self-preservation is present in all walks of life, including the investment fraternity. This unquantifiable confidence is one of the reasons behind bull markets that last much longer than price crashes. The 2008-2009 stock market fall, for example, was followed by a 10-year move up in equities. Investors’ confidence grows when asset prices are low. The temptation to invest is usually greater as asset prices fall, simply because the same amount of asset costs less and promises a higher percentage return should the investment prove justified. In falling markets positive or encouraging news or data will weigh more than in a bull market. The lower the prices the bigger the chance of trend reversal.
This phenomenon has been observed both in the equity and oil markets, in the former since the end of March and in the latter in the past two weeks. The S&P 500 index has regained 34% of the lost ground since it bottomed out six weeks ago. Brent has almost doubled in value after the infamous Monday at the end of last month.
Both asset classes have been supported by a number of factors. Stocks are getting a significant boost from the slowdown in the growth of coronavirus cases worldwide. This peaking action has led to the easing of lockdowns, first in China, followed by several European countries and US states. Most importantly, the biggest financial stimulus that has been launched worldwide serves as an insurance that the global economy would be able to weather the economic downturn caused by the pandemic. These measures come in different shapes and forms: cash hand-outs, interest rate cuts, cheap loans, or bond-buying. It is globally over $6 trillion, the equivalent of every human being, from pensioners to new-born babies receiving around $800 each.
The recent turmoil in the oil market was triggered by supply and demand-side developments. The very same factors have seemingly reversed and are now supporting oil prices. On the demand side the aforementioned lifting of restrictions is having a positive impact on oil demand. A recent example of this is the rise in Chinese crude oil imports. As economic activity is rebounding the second biggest economy in the world needed 9.84 mbpd of foreign crude in April, up from 9.68 mbpd the month before. Moreover, as economies started to get unlocked product demand, especially for gasoline is on the rise. Gasoline cracks have been strengthening, in the US refineries have increased their utilization rates by almost 3% in the last two weeks and they supplied 6.66 mbpd of finished motor gasoline last week, up from 5.06 mbpd four weeks ago. On the supply side the historic OPEC+ output agreement came into effect at the beginning of the month, Persian Gulf countries led by Saudi Arabia raised their official selling prices to Asia, Europe and the US, output in the latter is down by 1.2 mpbd from the year’s high, weekly EIA data suggests and rig counts fell below 300, according to Baker Hughes, down from 683 two months ago.
The recovery is well under way, but it will not be plain sailing, headwinds will emerge at the different stages in the future. The current economic optimism will be dented by high unemployment (in the US more than 33 million people have filed for unemployment benefit since the end of March and non-farm payroll jumped over 20 million in April) and by dismal growth rates for the balance of this year. The economic recovery might also suffer a significant setback in case the monetary stimulus programme backfires. Central banks are effectively injecting money into the economy to support expansion. Liquidity is the most important characteristic of a market that functions smoothly. When it dries up it is the duty of central banks to create liquidity. It is a sensible step to take when the economy is under severe strain, however the Fed included junk bonds in its latest asset buying schemes and the ECB is discussing the same measure. Under the current circumstances distinguishing between who deserves central bank support and who does not is an impossible task. However, there is a real danger that the bond-buying programme will end up being a bail-out for several of the less financially stable companies. Even those companies that should not be saved will be saved. Quantitative easing supports the economy in times of need, but the quality of the growth is equally important. The impact of current stimulus measures can be short-lived.
As frequently discussed on these pages, the gradual improvement in oil demand and the tangible fall in global output is expected to deplete global oil inventories from the current high levels in the second half of the year – after all demand is expected to exceed supply. The known unknowns are from what level and by how much. After the close to 20 mbpd global stock builds in April inventories will still rise in May and June, albeit at a moderate pace. Physical crude markets are still weak; dated Brent is around $4/bbl below forward and the CFD curve is about $2/bbl in contango four weeks out. And there is the question of compliance. It is not far-fetched to speculate that oil producers, OPEC+ or otherwise, will jump at every opportunity to maximize their revenues by ramping up production.
Apart from relatively high oil prices they will further be tempted to do so in case the dollar continues to strengthen. The current health crisis hit hard not only oil but other raw material exporters. These exporters have lost their main source of revenue by the unprecedented impact on economic growth and due to falling commodity demand, yet they have to finance their dollar debt in months and years to come – they are dollar short. If or when they are forced to cover the world’s reserve currency will strengthen further (parity to the euro, maybe?). This, in turn, will provide extra incentive to oil producing nations to maximize their output. Optimism will eventually prevail but the road to recovery will be rocky, indeed.