The rise in global infection rates might be causing angst amongst investors in the oil market but currently supply considerations are the major driving force. Stock markets are buoyant. The Shanghai Composite Index gained a timely boost from the People’s Bank of China intervention to weaken the yuan. Hopes for a deal on US fiscal stimulus provided the US equity markets with support as the main stock indices rallied between 1% and 2.5%. The difference between Republican and Democrat offers is narrowing, and the market probably smells a deal. Once it is struck oil will likely receive help but until then there are significant supply issues that need to be addressed.
As mentioned in yesterday’s note around 2.3 mbpd of involuntary supply cuts could flow back into the market in a relatively short period of time. These are made up by the agreement between Norwegian oil companies and the trade union to avert the oil workers’ strike (330,000 bpd), the lifting of the force majeure of Libya’s Sharara oil field (total output could reach 350,000 bpd in coming days whilst full capacity of 300,000 of Sharara can be achieved in a little over a week’s time). In the US hurricane Delta has been downgraded and oil production and refinery operations are being restarted. Although 70% of the oil production in the US Gulf Coast is still shut in, according to the Bureau of Safety and Environmental Enforcement, gradual restoration is expected in coming days. These developments, especially the revival of Libyan oil production and exports, pose a significant challenge to the OPEC+ producer group. Although Saudi Arabia implied last week that the planned easing of output constraints from January 2021 could be put on hold, this is the time when words should speak louder than actions. Firmly re-assuring the market that the rise in Libyan production will be efficiently dealt with would help a great deal to re-instate confidence in the re-balancing process.
Bond yields start showing signs of life
Government bonds and commodity/oil prices have a turbulent relationship. Sometimes they are inseparable but at other times there are massive fallouts, and they refuse to acknowledge the existence of one another. When the coronavirus started to spread both treasury yields, and oil went into free fall. Brent weakened from well over $60/bbl in the middle of January to just below $20/bbl by the second half of April. In these three months the 3-year US Treasury yield went from 1.6% to 0.24%. One would not have taken a step lower without the other. The logic behind this sort of behaviour is unquestionable. As oil became less attractive as an investment tool money flew into the less risky Treasuries bringing the bond price up and the yield down.
From the end of April, however, this harmonious relationship started to sour. Bond yields remained depressed but oil, along with other commodities and equities, including gold, started its march towards recovery. As the “rally of everything” got under way bond yield remained depressed due to central bank interventions that came in the form of assorted bond buying programmes. The correlation between the 3-year US Treasury yield and front-month Brent has fallen from +94% in the early part of 2020 to -65% in April-September. On one hand, investors grew in confidence that the economic recovery would continue unabated. On the other hand, central banks were of the view that without protracted monetary stimulus this recovery would be in jeopardy – interest rates and bond yields have remained low.
Then in the last two weeks the unexpected happened – yields started to rise as bond prices fell. The 3-year Treasury yield jumped from 0.146% on September 29 to 0.203% on October 7. The 10-year Treasury yield rose from 0.504% on August 6 to 0.797% on October 7 reaching its highest level since June. Although they eased back a little bit since last week, by recent standards yields are still deemed healthy. Let us assume for a moment that bond prices will continue to weaken, and yields will keep going higher. Why would such development take place under the current social and economic circumstances and what impact would it have on our beloved commodity?
One plausible explanation is that sentiment is changing, and investors are getting optimistic on economic recovery – with or without stimulus measures. It is possibly true for both the short and the medium-term. For the immediate future, the consensus is that the US economy is perceived to have performed better than originally anticipated. The US manufacturing sector kept expanding in September, albeit at a lower rate than in August and services PMI rose to 57.9. Unemployment rate is down from 14.7% in April to 7.9% in September, although the job market recovery is rather uneven. These encouraging economic developments have kept US gasoline demand steady just under 9 mbpd, up from 5 mbpd in April. Secondly, regardless of the outcome of the US elections further support will arrive whoever occupies the White House in January. In case the incumbent president is re-elected he will push for more spending helping boost the economy. More crucially, if Democrats win and have majority both in the Senate and the House of Representatives, they are likely to table a massive economic package that will also speed up the recovery.
Looking ahead to next year and beyond a solid performance will sooner or later couple with the emergence of a coronavirus vaccine, the thinking goes. It will dent demand for safe havens and make risky assets, such as equities and commodities, popular again. Bond prices will fall, yields will start climbing further. The increase in interest rates might happen earlier than currently anticipated. Under this scenario the dollar should weaken, and bond yields and oil could re-establish the positive correlation again. Of course, we can be accused of reading way too much into the recent mini rally of bond yields and of jumping to pre-mature conclusions. Admittedly, under the current uncertain circumstances and fragile conditions nothing is set in stone, nevertheless, changes in bond yields will serve as a good barometer of investors’ mindset and confidence about economic prospects and the impact on oil demand.