Saturday, March 18, 2017

American Health Care Act: Shifting the Structure of Health Care

Last week, the Congressional Budget Office (CBO) released their cost estimates for the American Health Care Act. The piece of legislature is looking to be passed in the House of Representatives but is struggling to obtain the support to pass it. Speaker Paul Ryan recently said that his bill would need to change to secure the votes it needs to pass. The CBO report has done its part to affect the bill’s popularity and proven it deserves some review.

The federal budget deficit continues to be one of the divisive issues in the two-party system with Republicans and Democrats blaming the opposition for its death of financial accountability. When the CBO mentions that the bill will reduce federal deficits by $337 billion, ears perk up. In a ten-year period, estimates predict that $1.2 trillion of spending would be erased with most that reduction coming from $880 billion in federal outlays for Medicaid. Much of the opposition to the bill comes at this point where the program that supports those who have the most trouble obtaining health care threatens to be gutted.

The legislature seeks to give the states more power over their own spending forcing the populations of each individual state to be subject to the local political environment. The bill does this by switching to a lump-sum allocation plan. Liberal opposition to this change claims that this will hurt Medicaid members in conservative states which predict that governments in these states will be stingy with these funds. The CBO sees a 17 percent drop in Medicaid enrollment compared to the 2026 estimate for the current law. The lower enrollment will be responsible for the majority of the spending declines with cuts to the federal matching rates being the second largest factor affecting spending.

The new legislature will also cut out the individual mandate penalty as it was one of the contentious points of the bill. The CBO notes that the revenue lost from removing the individual mandate will exceed the savings from lower enrollment. The removal of the individual mandate would result in an interesting exchange of government revenues for higher disposable income. The idea is that consumers are more efficient with their money because the government is disassociated from their preferences, but the logic is not flawless. In reality, the average consumer underestimates his need for insurance and is often overconfidence with how healthy he is or how likely things are to happen to him. Nevertheless, the reductions in Medicaid spending show that the Republican party still believes that the private sector is better off making financial decisions.

Second to the Medicaid cuts, reductions of $673 billion in healthcare subsidies including tax credit for premium assistant and cost-sharing will be implemented. Not only are the cost structures being revised, but the timing of the payment is being pushed back to tax season. The CBO finds that, for households with income exceeding the 150 percent of the federal poverty line, younger people would pay less towards their premiums than older people. For that reason, the CBO sees younger than older individuals enrolling into the new program.  The new legislature looks to capitalize on the wealth of the older generation to allow the new health care law to be cheaper than the last.

The chart above shows CBO estimates under the current and new laws for a 21-year old, 40-year old, and a 64-year old. Based on net premium paid for individuals at 175 percent of the poverty line, the current law has the same rate across ages, but the new law would have the 64-year old premium over 5 times higher than the younger individuals. The age trend, again, holds for individuals with higher annual income (450 percent of the poverty line). Overall, estimates for premiums have increased significantly for older individuals to finance lower premiums for the younger population.

The strategy of leveraging the premiums of the older population to finance lower premiums for the younger population is most likely supported by the fact that individuals over 55 have, on average, higher net wealth than the younger. Moving money out of Medicaid and into support for the non-group insurance market is another indirect way of pushing the burden of the cost of healthcare on the older generation who have the highest enrollment in the program.

Besides these major changes, the plan includes a few other notables. Planned Parenthood funding would be more or less cut completely. The actuarial values of the plans would be allowed to be reduced permitting insurers to cover less of the costs that are required under the current law. The establishment of the Patient and State Stability Fund would help disruptions in the stability of the market.

Voting on the plan will continue through the first half of the year, but currently, there is enough opposition to keep it from being passed. A macroeconomic analysis was not provided by the CBO as more analysis was needed, but it seems clear that the higher premiums would cause a drag on consumption especially in the oldest demographics.

Sunday, November 13, 2016

Chart of the Day: OPEC Price, Output, and Revenue

While doing some research for my book earlier this month, I came across an interesting graphic created by Dermot Gately in his paper "Lessons from the 1986 Oil Price Collapse." The chart provided a useful perspective on the equilibrium price of a barrel of oil during a period where OPEC sought to control the price by cutting production after it fell to lows in the 1970's. Revenue levels for the oil cartel declined to almost $50 billion endangering the health of many economies that relied on its natural resources for survival.  As more members began to feel the pain of tighter trade balances, more support for a supply cut forced the hand of the swing producer, Saudi Arabia. The price control worked until 1986 when prices crashed again.

From Gately's "Lessons from the 1986 Oil Price Collapse"

Gately's chart plots output, price, and revenue on a graphical space that can be pictured as a curve in three-dimensional space, but, for informational purposes, it relies on level curves to make its point. The display is also set up to reflect the structure of a standard supply and demand graph with price on the y-axis and output on the x-axis, and this allows us to theorize about an equilibrium if the data provides some structure to the behavior of the market. Because OPEC acts as a cartel with quasi-monopolistic powers, plotting its output alone is sufficient. 

At first glance, I noticed that the behavior of the OPEC output movement appeared cyclical from 1970 to 1986. With the exception of a kink in the late 1970's, the trend in the market appears to mirror a positive feedback loop in which price and OPEC output respond to each other's movement with revenue level accelerating the shifts. As prices grew from 1973 to 1974, OPEC kept output levels high to take advantage of higher revenue. In 1980, prices peaked after the global supply of oil had grown from the growth of production in North America and OPEC. In response, the cartel attempted to cut production to cushion the fall to a low in 1986. Prices would bottom out later that decade and, encouraged by low revenue levels, OPEC would add to output in anticipation of a higher equilibrium price. Saudi Arabia's data reflects the same kind of trend but with more inelastic output changes. From 1970-1973 and 1980-1985, the Middle Eastern nation had the most flexibility in its output policy. The years following the shifts in production were defined by dramatic moves in price suggesting that OPEC's swing producer had an enormous amount of control over the pricing mechanism. Although, is was still susceptible to the cyclical trend because its government relied on oil revenues to keep the country operating.

But 1986 is history, and if one reads more and more about the behavior of 20th century OPEC, it becomes quite predictable amidst the countless number of regional conflicts and price control tactics. Using the behavior in this period as a predictor of what should or could happen in the most recent oil glut of 2014-2015 has proven to be useless. This is most likely caused by the growth of non-OPEC supply, particularly the North American shale producers. Nevertheless, OPEC actions still have some effects on the markets, but, overall, the effects are muted. To investigate the fundamental picture, I recreated the chart above to track the movement of price and output in relation to revenue from 2000-2015 using Gately's style.

Based on price data from OPEC's Statistical Review adjusted for inflation and exchange rates and daily output figures from the Monthly Oil Market Reports, I was able to map the two series over some revenue isoquants calculated by multiplying price and output together. The behavior that is observed between 2000-2016 is very different from that of 1970-1986 with a circular figure turning into a curve that appears to trend linearly over time (as shown by the purple trendline). We have a gradual increase in OPEC output accompanied by a quasi-proportional increase in the price of oil up until 2008. The financial crisis occurs producing a slight deviation from the trend which reaches its peak, in both price and output, in 2012. Based on a linear regression analysis, we can develop a theoretical supply function that appears to define OPEC price policy from 2000-2012. So have we observed a deviation from the monopolistic behavior we saw in the previous graph? Not exactly.

The oil cartel is taking advantage of the inelastic qualities of petroleum demand to secure the best price for each barrel they produce. Because OPEC member nations need to reach these higher revenue levels to support the growing costs of government and higher rates of inflation in the 2000's, they seek to optimize policy to be as far right on the supply function as possible. In order to do this, OPEC made use of the regional conflict in Iraq and demand growth in emerging economies to achieve its goal, but there would be residual consequences. Remember how higher revenue levels would accelerate the trend in the opposite direction as producers seek to maximize output to reach even higher revenue levels? Well, the trend of price leading up to 2012 sparked a new set of producers to optimize and, in the end, flourish. North American shale producers reaching untapped reserves and pumping them quickly challenged OPEC for its market share causing the green line to drop to where the awkward looking 2015 data point falls. Here, the market has changed as OPEC's monopolistic powers are threatened by this surging source of output. This new competition can be modeled by a shifting of the purple supply curve so that to intersects the 2015 data point. The oil cartel now has less control over its revenue streams.

The new pricing mechanism in the current market will not allow a trend like that of the early 2000's to develop. For that reason, OPEC has been wary in trying to influence the market with an output freeze (or an outright cut). While that cut in the 1970's would have supported price, one in 2016 would be met by an increase in North American shale output. Saudi Arabia hinted at this shift in power when it announced a sale of 5 percent of Aramco stake in the U.S. markets with the goal of financing an investment fund that would reduce the country's reliance on fossil fuel income in the long run. Suddenly, OPEC looks useless despite calls for action by investors have suggested otherwise. At the moment, only a Saudi Arabian-Russian agreement looks to have any major effect on the price of oil, but based on economic circumstances in both countries, neither can risk a drop in output being negated by an increase in North American production. In the end, I see OPEC countries being forced to come to terms with a new oil market. After all, renewable energy is getting cheap, and there is clearly a global preference for those energy sources.  

Friday, November 4, 2016

Normalization Versus Rate Hike Policy

The steadfast Federal Reserve is at it again. After a meeting on November 2nd, the committee of ten concluded with the federal funds rate and the discount rate held steady at the status quo. In the release, they say that “the case for an increase in the federal funds rate has continued to strengthen,” but of course, confidence wasn’t strong enough for the economy to off of low-interest rate life support. Three hesitant words stuck out to in particular: the labor market is expected to “strengthen somewhat further,” economic activity well grow “at a moderate pace,” and market risks “appear roughly balanced.” To me, these filler words indicate that the Federal Reserve recognizes the signs of a cyclical peak and seeks to diffuse tension in an economy that is moving flatly. The S&P 500, Dow Jones Industrial Average, and Nasdaq indices are trending at all-time highs, valuations continue to rise, and economic numbers paint an ambivalent picture of the economy. It’s not hard to conclude that we’re reaching a cyclical top after considering the fact that a seven-year bull market has pushed us to this top.

During a bull market, central banks typically raise interest rates to keep in check a rising level of inflation, but the Great Recession lead to a recovery that suggested typical monetary policy should be abandoned. Instead, policies like global quantitative easing and cheap debt were held in place to support a recovery. A divergent strategy has forced the Federal Reserve, along with the rest of the world’s central banks, into uncharted waters where it elected to keep the status quo. Companies liked that, but weird things started happening with inflation. An oil price shock caused half the world to develop symptoms of deflation, and rate hikes in this scenario would only hurt world markets.
Needless to say, the Federal Reserve finds itself in a very “un-normal” position where it must protect investors from a bubble while also shielding the economy from deflationary pains. In order to do this, the FOMC committee has elected to move in the direction of a “normalization” policy. When I first heard this term from one of the Fed member’s speeches, I just assumed “normalization” meant “rate hike,” but there is a distinction between the two that the Fed has intentionally signaled. While both involve increasing interest rates, a rate hike policy has a bearish connotation that suggests an abrupt shift in rates while normalization implies a more neutral move towards a clear target indicated by the central bank.

The key driver of the use of “normalization” language is the lapse in the recovery of inflation after the Great Recession. The chart above shows how a series of three periods of quantitative easing lead to a decline in the inflation rate from 3.77% annually in 2011 to -0.20% in early 2015. The FOMC first signaled that inflation was not where it wanted to be in the release following the December 2012 meeting by saying, “Inflation has been running somewhat below the Committee’s long-run objective.” Ever since then, the issue of inflation has risen to the top of the Fed’s list of priorities and has consistently been the reason why rates were held low. “Normalization” is the “solution” to this problem of nagging deflationary pressures, and I say “solution” carefully because this policy only works if markets respond the right way.

As evidenced by USD and Treasury yield movements at the conclusion of an FOMC meeting, investors like to jump the gun when it comes to reacting to a monetary policy updates. Normalization seeks to avoid the volatility associated with these movements, so the Fed acts in an extremely slow manner. In fact, they will set medium-term plans for the next three year and purposely act slower than what they projected. For example, projections from the December 2015 meeting suggested that four rate hikes would be a plausible way to move forward in 2016. Seven out of eight meetings later, the Fed has yet to raise even rates even once. In doing this, the Federal Reserve is manipulating expectations so that investors trade like four rate hikes are in play. When the meetings actually do come around, expectations are gradually dropped and the markets perceive the lack of rate hikes as accommodative policy. When rates are increased in December 2016, the markets’ reaction shouldn’t be decisively bearish. “Rate hike” policy suggests that markets should expect a rise in interest rates, and the Federal Reserve will follow through on these intentions. This distinction is necessary if a 2 percent inflation target is to hold any legitimacy. Only through normalization policy could the Federal Reserve massage inflation rates to their liking; a clear rate hike agenda is deflationary and would yield different results.

An agenda that is contractionary on purpose would be very dangerous in the current global monetary condition where central banks across developed and emerging economies have failed to move in a coordinated manner. The BIS released the charts above showing how central banks have been forced to respond to local inflationary effects. In Europe and Japan, negative yields have been introduced to combat stagnate growth and deflation while developing countries like Brazil, Colombia, South Africa, and India have set rates higher to tame inflation rates above the respective bank’s inflation target. This environment differs drastically with the coordination that was required to repair the damage of the financial crisis. If the Federal Reserve chooses a “rate hike” policy which could upset measures being taken in countries troubled by deflation, it could send negative shockwaves in the foreign exchange and capital markets. Adopting “normalization” would put the Federal Reserve more in line with foreign central banks who are attempting their own forms of careful normalization, and consequently, would calm volatility in equity and bond markets that is being caused by shifting investor expectations.


The Federal Reserve has shown its preference for normalization policy by choosing the appropriate signaling and maintaining global monetary coordination. Going forward, the Fed will deviate farther from rate hike policy by ensuring that the differences in timing are evident. In May 2015, BBVA published some interesting research on timing differences in normalization and tightening (rate hike) policies. A comparison of “past tightening cycles” shows that the length of low rates and the expected length of tightening period is projected to surpass the five other cycles that have occurred in the past 35 years. According to basis point per month calculations, this cycle of “tightening” will occur 31 percent slower than the slowest cycle in 1999. These numbers were published in 2015, and since then, the actual rate of increase has been about 1.3 basis points per month. Even if the Federal Reserve had held to its policy projections in December 2015 (25 basis point increase in Dec 2015 and four 25 basis point increases in 2016), the basis point per month increase would be 6, significantly lower than what investors expected at the time of this paper’s publication.

With such a clear difference in the uptrends of these tightening cycles, it seems clear that the Federal Reserve is trying to implement a different policy framework. BBVA even identified this shift toward tightening suggesting that “’normalization’ is defined as an increase in the Fed funds rate at a point when monetary policy could be assessed as loose.” Even if Janet Yellen and her FOMC cohorts have successfully aligned expectations, coordination, and timing with a policy considered “normalizing,” can we be sure that it will work?

There’s really no way to tell. Markets only have one rate hike under their belt, and that instance led to a sell-off at the beginning of 2016 that threatened to turn into a full-on bear market. Expectations say another 25 basis point rate hike is in the cards for December, so will a similar reaction greet 2017? Once again, it’s a toss-up. One year ago oil prices were significantly more volatile, but the UK had not left the European Union. Growth rates in the United States appear to have stabilized with the most recent GDP figure of 2.9 percent surprising positively, but the Eurozone and Japan had sunk deeper into negative interest rates. The economy is no replica of what it was a year ago, but only a few structural shifts make it distinct.

As far as predictions go, I see a rate hike in December confirming the Federal Reserve’s commitment to “normalization” rather than “rate hike” policy. In that meeting, it will project another three or four 25 basis point rate hikes in 2017, but, like in 2016, that will be an overshoot of its actual path. If markets respond bearishly to the December hike (like this year), the Fed might squeeze in two 25 basis point but one is more likely. If the economy shows improvement and earnings season at the end of 2016 isn’t a total bust, we might see two to three rate hikes. However, the amount of rate hikes in 2017 will always be at least one less than what is projected. This is essential in case the FOMC committee needs to pull out a “bullish surprise” of holding out one meeting so as to avoid any contractionary moves.

Monday, October 10, 2016

Italy Industrial Production and Chaos Theory

Yes, I'm eating spaghetti today for lunch in honor of Italy's second straight month in a row of beating industrial production expectations. A positive trend in this industry will bode well for President Renzi's hope for the passing of his constitutional referendum to pass next week. In August, output rose 1.7 percent, a positive surprise over the -0.1 percent expected. In July, expectations were also beaten with a 0.7 percent jump. Such meager statistics are not trivial, for those who doubt my need for celebration, as any positive growth trend is critical in a world that has been deemed "low growth." This will be especially true for the ailing Italians who have been in perplexing economic and political positions for some time now. Renzi's cut in corporate taxes will hope to rectify business sentiment that has drifted with low growth. GDP of the ninth largest economy in the world has stagnated over the past four years with growth finally positive midway through 2014. But, in June of this year, GDP movement fell flat. So you'd understand why a spaghetti dinner is appropriate, and it might not be the only rejoicing meal either.

The STOXX 600, composed of major European stocks, posted healthy gains of about 0.7 percent today. The Italian stock exchange, with the largest overall increase out od European exchanges, led with gains of 1.38 percent gains. The short-term euphoria helped by good feelings in Italy was mostly caused by new highs in the crude oil market. WTI and Brent prices are both up about 3 percent on the news that Putin might actually cut production. Spaghetti? That news warrants an entire pan of lasagna. ENI's investors are certainly taking a slice as they watch their shares in the largest Italian oil and gas company grow by 2.33 percent. The stock is reversing a month-long downtrend in favor of a five-day gain of over 5 percent. This growth, not particularly driven by technicals, could continue in response to more catalysts, especially if a higher oil price remains in play.

But we didn't come all this way to talk about Italian energy stocks. After all, Total , BP, and Royal Dutch Shell account for most of the sector's movement in European stock indexes. The same could be said about Italy and its economic woes. The world, and really Europe for that matter, should be large enough to make up for weakness in a small branch of its hierarchy. At some level, this kind of compartmentalization helps us diversify and avoid risks that made the 2008 crisis so deadly, systemic risks. Already seen by the Greek example, debt-burdened countries see softer growth and political destabilization both of which lead to recession and financial collapse. These risks and uncertainties are relatively compartmentalized and only send small shockwaves to its closest trade partners. Italy is the next economy under the microscope and many see its weaknesses secular to the domestic system. Instead, analysts prefer to pick apart events like Brexit which appear to pose a larger systemic threat, but the impact may be overstated as the status quo is likely to remain.

Italy's debt to GDP ratio has risen by over 30 percent since the financial crisis struck in 2008 and the beginning of the low-interest rate environment. The proliferation of cheap corporate and sovereign debt bogged down major developed economies like Japan, Ireland, Portugal, and Italy which saw this credit growth as the only way to stimulate growth coming out of the Great Recession. Whether or not that is the case, risks within the economies aren't as compartmentalized like they should be. Instead, this risk has been transferred to the European banking sector. This year, headlines lamenting the performance of financial firms within the eurozone have caused investors to be wary in the bond and equity markets. The STOXX Europe Banks index is down over 25 percent year-to-date. But why have I jumped from an Italian debt crisis to weak European banks?

In chaos theory, the butterfly effect is summarized by the quote: "It has been said that something as small as the flutter of a butterfly's wing can ultimately cause a typhoon halfway across the world." The incredulity of such a claim is only overshadowed by the monstrosity of a chaotic system. In these systems, the initial condition means everything as a tiny tweak in that condition could translate to an amplified effect later on down the road. Financial systems are no different with millions of minds and trillions of dollars connected by a web, not unlike the spaghetti I eat. Economists and financial analysts can worry about macroeconomic events like Brexit and a shifting price of oil and make decent observations about the economy, but in chaotic systems, this analysis is often not good enough. And that's often the problem with financial interconnectedness, there are too many factors to begin with.

Recently, the weaknesses of Deutsche Bank and other European banks have been in the spotlight. Their profitability has run low and negative bond yields ultimately threaten the profit margins of the financial institutions that rely on them for safe assets. As a result, these institutions have fled to higher yield securities like corporate bonds and risky sovereign bonds. The web has been strung. Now these banks have left themselves exposed to riskier underlying assets in an environment where equity valuations are high and government debt is growing (especially in those countries with higher sovereign bond yields). The bank stocks may have supported their bottom line, but implicitly, their assets make it riskier. Although, this isn't exactly clear to the plain vanilla investor. In June, the IMF released a report on a stress test of the German financial sector. The analysis revealed that Deutsche Bank has heavy exposure in the sovereign bond market, and later on, the same paper suggested that the bank is one of the most "systemically important" institutions with regards to interconnectedness.

Through that channel, a weak Italy could explode into something bigger, helped by the size and complexity of Deutsche Bank's dealings. I do not suggest that a slow Italy will break the system, but by the tenets of chaos theory, lower sovereign bond valuations will create a weaker DB portfolio. Questions regarding the bank's financial health are systemically dangerous (as indicated by the IMF). So yes, celebrating a minor recovery in Italy is warranted. Similar celebrations would be appropriate for improvements in Portugal, Ireland, and Greece, all countries which, domestically, show compartmentalized weakness, but are often not considered to be a systemic threat. But, it is important to acknowledge chaos theory and recognize that even the smallest change can be relevant. If you're still unconvinced, rewind to 2008 and observe what a small increase in mortgage defaults

Tuesday, August 30, 2016

Preparing for September

Last week ended with another heavy statement from the Federal Reserve Chairwoman, Janet Yellen, addressing her fellow central bankers at an annual conference at Jackson Hole. Her words, "In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months," were enough to inject a small dose of volatility into trading on Friday. Equities which had grown earlier in the day weakened in later trading, and the dollar jumped against foreign currencies.

from WSJ
Trading opened the week with Yellen's remarks in mind and a fresh batch of economic data in the morning. Income and inflation metrics met consensus estimates with earlier estimates revised slightly upward. Personal income and consumer spending inched upward in the last reported month showing signs that the economy has begun to stabilize, but a small increase will fuel pessimism surrounding third quarter results in a couple months. Consumer goods and services should be wary of a flat consumer consumption growth, and utilities will have the edge. Sluggish prices also fuel the slow growth trend that the Fed will reconsider in September. A "lower for longer" oil scenario translates to a limp PCE index which could discourage any hawkish action by the Federal Reserve during the next meeting. An inflation target of 2 percent looks very lofty when looking at yesterday's numbers. According to projections in June, PCE inflation should be at about 1.4 by the end of 2016, but the current reading of 0.8 suggests a pessimistic outlook. On the other hand, Core PCE is on target to meet the Fed's projections of 1.6. Most sections of the economy appear to be moving fine which supports Yellen's comments on Friday. Perhaps the most troubling numbers are personal income and consumer spending which appear stagnate. If more optimistic data supported a growing consumer, then a low rate of inflation wouldn't be as dangerous.

Inflation could be supported September when OPEC meets for the second time to consider an output freeze. In the last meeting, a sanctionless Iran ruined any hopes for a deal when it asserted that it needed to resume production to pre-sanction levels. After a couple months and a 600,000 increase in Iranian output, OPEC members will try again. Investors initially traded the news bullishly, but losses on Monday and Tuesday this week suggest that most don't think that a deal will go through. The pessimists have a good reason to doubt the chances as well; the current state of the oil market is bullish for countries and companies looking to produce more. OPEC's own monthly reports have set the scene perfectly with updated data.

  • Spot prices are significantly higher 

Every major crude oil spot price is trading higher over the past couple of months. Brent crude and the OPEC basket price have gains over $1,00 higher than WTI crude oil suggesting the international oil market may even be more balanced than the U.S. market despite the output freeze failure. The members' own price metric has grown the most according to a percentage calculation implying their situation may be improving faster. If an output freeze couldn't be negotiated at April 17th prices, then a deal in September will be unlikely especially considering an end-of-the-year target around and above $50 a barrel for Brent and WTI.

  • Oil consumption estimates and projections are bullish 

Monthly reports gauged global oil consumption as higher in August than in April. For the month of April, world growth in consumption was expected to be 1.2 million b/d for the 2016 year, but four months later, the same number came in 30,000 barrels higher at 1.22 million b/d. The increase is not enormous, but it asserts a positive outlook on the demand side which will bolster more production from OPEC members. The report upgraded demand estimates for North America, Europe, Africa, and India. The important players are India and Africa as they will be major sources of demand growth in the near future. On the other hand, Chinese demand was revised slightly lower along with Latin America which had the largest decline. A source of concern may be China's flat demand trend. The Asian giant is a neighbor to many OPEC members, and thus, has become their biggest consumer. A strong China is necessary for the cartel's survival. Oil product markets also looked to be heating up in some areas of the globe. In the United States, the product markets showed more demand which could bolster OPEC exports. Asian markets, though, appeared to weaken. This bearish concern may outweigh U.S. product demand strength in the long run.

Since the oil market is turning in their favor, participants at September's summit will be less likely to conclude with a deal negotiated. Yes, revenue streams are still pinched, but the small amount of breathing room that the market has allowed will send producers into a wild-goose chase for more market share. The competition could threaten the survival of the oil cartel, in the long run, a death that would shake the global economy to its core. With two important meetings in September (Fed and OPEC), the month has the potential to instantly shift the current market trend in either direction.

Thursday, August 25, 2016

Does Iranian Oil Still Matter?

With a crude oil rallying looking to end out a hot summer, investors will be focused on OPEC supply reactions that will develop over the next couple of months. At the end of last week, WTI contracts are trading up 9.16 percent over the past month posting a year-to-date gain of 11.04 percent, and Brent contracts are up 9.55 percent and 14.58 percent respectively. Worries that a glut still remains have subsided, and instead, investors have piled behind a rally off of all-time lows that were seen at the beginning of the year. Now, eyes are on producers to see how they will react to the higher prices.

The rally came after seven strong bullish trading sessions that were supported by reports of an OPEC output freeze in consideration and a surprise 2.5 million barrel draw on inventory last week. Prices jumped from lows near the $40's into territory well above both the 50-day and 200-day moving averages. Volume was not as strong, but the clear direction of the trend did not lack conviction. We're now at a bit of a resistance where bullish traders have backed off, and the bears have taken control. With relatively bland data coming from North American producers, investors should keep their eyes on production totals from their counterparts in the Middle East. Bolstered by a slightly mitigated glut, OPEC members from that region have continued to pump at higher levels hoping that an increase in fossil fuel consumption will make up the supply difference. Although, reports of a September output freeze in the cards has done enough to convolute the fundamental picture and any rational sentiment. The spotlight will, once again, be pointed towards OPEC's swing producers, Iran and Saudi Arabia, two nations which couldn't put aside their geopolitical difference to arrive at an agreement. In just under a month, the biggest oil producers in the world will come to the table once again, and the hopes for a freeze reside in the unstable relationship between Iran and Saudi Arabia.

The question that most people have going into the September meeting is whether Iran has enough pull to influence the proceedings. There's no doubt that Saudi Arabia remains in the saddle, but the Iranians have the most availability capacity as they continue to rebound from the sanctions that were just lifted at the beginning of the year. Since then, monthly production figures have grown almost 300,000 b/d which makes Iran's output the fastest growing in OPEC. This fact made an output freeze in April all but impossible despite Saudi Arabia's desires to come to an agreement. With Iranian production returning to pre-sanction levels, the nation's available capacity has shrunk. Thus, volatility in output figures should fall in tandem, making an output freeze deal more likely if other OPEC members can cooperate. Countries like Nigeria and Venezuela might show more resistance as their governments, like Iran's, are strapped for revenue and slightly higher oil prices would relieve some financial pressure if the output, at the very least, remained stable. But that shouldn't dim the outlook much, in the end, Saudi Arabia has most of the power. However, Iran will once again be in the spotlight as its fundamental position is brought into the foreground. Investors need to pay attention to updates on its oil output there in preparation for the upcoming OPEC meeting.

Unfortunately, statements from the Iranian government have suggested a dim outlook for the September meeting. The Wall Street Journal reported that Iran said "it doesn’t expect that its production will have risen to the levels the country" and "it needs to justify cooperation with its rivals." Officials say that production would have to breach the 4 million barrel a day level for they would consider cooperation. In reality, this output goal does not appear to be achievable in the near-term, and definitely not by September. Naturally, an output freeze should be counted out, but Saudi Arabia's sway should never be counted out. If a freeze is a necessity, the combined power of OPEC members without Iran would have enough production to influence the global markets. But in allowing Iran to successfully resist, the cartel is endangering its own existence through moral hazard. Nations in monetary distress would feel hard done by and be quick to nominate themselves for an exception. Estimates from suggest that Iran would need $70 billion in foreign capital to increase its production to its 2021 target of 4.8 million b/d. In the end, Iran's target bring low, steady growth in the long run, a plan that wouldn't be significantly interrupted with a short-term output freeze.

News of oil swaps between Iranian and Russian energy companies might also be disturbing to OPEC going into September. As the largest oil and gas producer in the world, Russia has the potential to undermine any production moves made by the oil cartel. According to Mehr News, the swaps could include a capacity of up to 150,000 barrels a day with the opportunity to increase natural gas trade by a third as well. The Iranian government implemented these plans in order to rehabilitate energy exports which had fallen during a period of trade sanctions. In the first five months of 2016, Iran's exports have grown by 1.4 million barrels a day with hopes of growing above 3.0 million barrels a day in the coming months. Growing exports don't necessarily mean more production, but it certainly means more oil, whether stored or pumped, will reach the markets. A joint deal with Russia will put pressure on other OPEC members to secure their own buyers. Market share has definitely become a real issue as China's growth begins to level off and U.S. oil is allowed to be exported. These concerns will be in the mind of minor and major OPEC members alike and might have enough sway to diminish hope of a freeze.

Iran's recent policy changes and production trends don't bode well for an output freeze in September which will be bearish for oil through the end of the year. North American production has started to stabilize to a less volatile equilibrium point which might do little to move energy futures in the latter half of the year. In fact, OPEC's meeting in September might be the last event for a major crude oil trend shift before the election in November. Speculation before the meeting next month will most likely boost oil, but investors shouldn't be fooled by this peak. If fundamentals are stable, oil will remain in the $40's through December barring any "black swan" event.

Tuesday, August 2, 2016

Oil is Going Down Again

After a rough first quarter for oil in 2016, spot price trading has shown reduced volatility compared to the past year and a half. Supply movements have been relatively unsurprising in North America and other oil exporting nations. After the failure of the output freeze, OPEC's role changed from market leader to a market reactor waiting on true supply data to affect commodity traders. For the WTI spot price, a range of $40 to $50 developed with hopes of an upward breakthrough during the bullish summer months. June and July have passed and a different trend has set in. In its July meeting, the Federal Reserve was faced, once again, with tanking crude oil spot prices weighing on inflation. Now, August has come and oil is looking to break through a floor of $40. The EIA has revised their WTI projections from $48 a barrel by the end of 2016 to $44 a barrel. So why has this summer been so tame?

Based on data from the past five years, crude oil prices tend to peak in the first two months of the summer with refineries operating at full capacity. In 2015 and 2016, we're seeing deviations from this trend. Last year, volatile pricing was caused by a trend of climbing domestic production which overcame refinery inputs. This year, domestic production is stabilizing if not falling, so increased refinery utilization should help demand and reduce supply, but the WTI spot price hasn't responded accordingly. The average difference between the price of the first and eighth week during the summer over the past five years was +$0.53, in 2016 it was -$4.56. This deviation has troubled analysts who expected more bullish sentiment to be coupled with shrinking output.

Falling input prices have translated to even lower regular and diesel gasoline prices during the
summer months. The 2016 trend deviates from the usual pattern of high gas prices due to more demand from the summer driving season. In fact, the 1st to 8th-week difference in 2016 is larger than the past five years. Why is that? There are two sides of the coin to consider, the supply and demand side of the pump. On the demand side, 2016 transportation consumption remains strong and is already outperforming the previous two years according to the EIA's Monthly Energy Review. Compared to the first four months of 2015, petroleum consumption this year is up over 200 billion Btu. Therefore, supply-side factors can be assumed to have made the biggest impact.

Record high crude oil stocks have been the most bearish factor weighing on the price of oil. Initially, firms hoped that inventories would start to recede with less domestic output in the beginning of the year, but that wasn't the case. As soon as analysts started to see a reversal in upward crude oil stockpile trends, domestic production stopped falling. Going into the summer months, oil companies were faced with a rebound in spot prices, but inventories that have never been seen before. Typically, investors can expect a strong draw on stockpiles over the summer months with refinery inputs at their highest, but this year may be different (as it was last year). In fact, supply estimates for the last week of July reported an increase in crude oil stockpiles, weighing on the bulls.

The truth is, downstream trends could be having a larger effect on supply issues than producers. In 2015, we saw crude inputs rise well above 2014 levels as crude stocks grew with the oil glut, but that phenomenon did not carry over to this year. Crude oil estimates for this year have been in line with last year's even though stockpile estimates were much higher. What does this mean? For the first time in years, the U.S. upstream sector is outrunning its downstream sector which, previously, required imports to satisfy the refinery input demand. This summer, fully utilized refining operations are over-supplied and this is causing prices to fall on the producers' side. A bearish summer will force price expectations for the winter even lower as the maintenance season reduces weekly crude oil inputs.

The flood on the input side of the refinery is causing drivers to be flooded with cheap gas. Weekly motor gas production estimates have reached five-year highs. U.S. firms have maxed out downstream operations because it has become significantly cheaper to operate with growing from the transportation sector. As a result, gas prices dropped the faster this summer than the all of the past five summers. After growing to about $2.30 per gallon, prices at the pump plummeted back towards $2.00 a gallon with the EIA only projecting a rebound to $2.16 by the end of the year. The Short Term Energy Outlook forecasted summer prices to average $2.25 a gallon. The maintenance season should help stabilize prices around $2.15, but high finished motor gasoline production will persist to the end of the year.

After a seasonality analysis of the first two months of the 2016 summer, here's what we can expect:

  • By the end of the summer, a smaller draw on inventories or possibly a surplus if production increases.
  • Crude oil inputs to remain in line with last year's summer peaks
  • Motor gasoline production to peak higher than last year or follow in line with transportation consumption to show modest growth
For energy traders following WTI and regular gas prices, these three points will prove to be bearish factors in August and the fall. Rotary rig counts for June show that U.S. producers are beginning to increase their drilling activities after adding 10 active rigs in that month. If you think that the supply picture is continuing to improve, that is not the case. In fact, firms who have cut unconventional costs will find it profitable to produce at prices as low as $40 a barrel. When the industry finds this is possible, the glut will reemerge and weigh on prices more permenantly.