Friday, December 4, 2015

Rate Hikes And Iranian Oil

The end of the week has come and only two things seem more apparent than before: rate hikes appear to be almost guaranteed and oil prices continue to be extremely volatile. Trading for Friday shows positive movement as the S&P 500 and Dow Jones Industrial Average jump 1.83% and 2.00% at about midday. The Russell 2000, a measure of small-cap stocks, lags behind at 1.05% with stress over rate hikes more significant for them. Small cap performance has continued this trend of lagging since September 28th where, over the six past months, the S&P Small Cap 600 has fallen -2.53% versus the S&P 500's drop of -0.46%. A stronger dollar over the past couple of months has also been injurious to competitive advantage for smaller firms looking to do business internationally. After a peak on August 24th at about 1.16 USD per Euro, the support for stimulus programs from the European Central Bank has inspired a precipitous fall of -7.49% to 1.09 USD per Euro Friday. Nevertheless, the domestic economy continues to make its case for strength to the Fed as solid gains from all sectors but two (energy and industrials) reveal investor satisfaction from the jobs report. After a revision of 20,000 more jobs in October, the November report beat a consensus of 200,000 by 10,000 jobs. Payroll girth also increased by an expected 0.2% to stay on track for a 2.3% year-by-year increase. The unemployment rate remains unchanged at 5%, a comfortable level for an ideal stable economy; although, those adhering to strict business cycle logistics would predict more downside risks in favor of the traditional recurrent pattern. Despite wariness over growth of wages, investors have increased the possibility of rate hikes since a month ago. Probabilities of a quarter point increase in the Federal Funds rate have increased from 71.9% to 79.1% for the December meeting, and from 66.5% to 70.7% for the January meeting. Both recognize the chance of further downside risks that could be a result of sensitive investors still rubbed raw from the financial crisis, but these risks and investors should not be considered valid in the face of an overheating economy. Easy monetary policy (much like stimulus in Europe) has been stunted by its overuse and, if not corrected, could lead to soft spots in corporate and consumer expenditures structures. Cheap money has already resulted in a decrease of capital expenditures and an increase in consumption which had eliminated reasons for saving. In my opinion, the markets will react with more negativity to the rate hikes than if they had occurred sooner because of the "softness" in expenditures and the absence of adequate savings. Gradual interest rate increases will cause an influx of savings and a transfer of capital from equities to bonds which may limit growth projections for firms next year. The energy sector, on the other hand, may fare a bit better after supply glut problems have forced more rigorous corporate adjustments that will allow for more growth in 2016 (if prices cooperate with this narrative). The corporate adjustments include operating under less revenue and smaller margins, both of which may become a problem for companies in other sectors as a normalization of monetary policy occurs.

As the past week has been important for Federal Reserve watchers, oil and gas analysts were exposed to OPEC opinion at a meeting this week. Sentiment over potential decisions by Saudi Arabia and the rest of the member states was more mixed than ever as prices touched prices below the $40 lower bound. Member states continue to request price controls as their revenue streams are limited by their dependence on petroleum, and Iran reignites their oil infrastructure in order to enter the market. Production from the now sanctionless country could reach as high as 3.2 million barrels a day according to a Bloomberg article. On the OPEC website, production capability for the country is listed at 3.17 million barrels a day which is 10% of what OPEC members are already producing. Are these additions too much for the cartel? Actually, no. Instead of adjust production to its cap before last week's meeting (30 million bbls/day), Saudi Arabia established the current extraction rate of 31.7 million bbls/day as the new official quota even though it had already acted as an unofficial quota. As a result, supplies could jump more at the theoretical increase of the ceiling. If they could get away with producing a little bit more at 30 million bbl/day, who is going to stop them at producing a little bit over the new official quota of 31.7 million bbl/day. Member states that have previously wanted to curtail production will shift from a state of price protection to a competitive market share strategy which involves maxing out that production in order to compete for profits. Contrary to popular belief, I think the Saudis want their compatriots to think this way, discord within the cartel that melts into the larger plan of the Desert Kingdom. The International Energy Agency reported that oil demand and supply are currently offset by about 200,000 barrels a day in their Oil Market Report. They also cited the possibility of non-OPEC contributions dropping by 600,000 barrels. Moving into 2016, the oil and gas markets will no doubt see an increase in supply from Iran, but conclusions about the impact are overall very erratic. Reports coming from the country are already convoluted with conflict and deception in the region a very common thing, both economically and politically. This only adds to the struggle of other OPEC members, and investors trading the worldwide benchmarks. The ramifications of Iranian oil are difficult to quantify, but analysts continue to claim their addition as an obvious bearish factor. Indecision and opaque information have caused oil trading to become exceptionally volatile as a wide range of opinions populate investors and companies trading in the WTI and Brent markets. Buzzsaw movement is the result of these perspectives sparring each other over each piece of news. The real question traders should ask is how global supply and demand will be affected. After looking at data from the IEA, I have crafted some simple projections to consider for 2016.

Historical data and demand projections by IEA Oil Market Report
The chart above describes two possibilities that could characterize the flow of Iranian oil to the markets. The orange line describes IEA demand levels through the end of the next year. After a small dip in the beginning of 2016, demand is projected to beat 2015 levels. These calculations must take into account the global deflationary slowdown as well as tightening in the U.S. The green and yellow lines represent two scenarios, but both include a net 100,000 bbl/d increase over the next five quarters with non-OPEC sources projected to drop by 600,000 bbl/d by the IEA and OPEC members (except Iran) to grow by 700,000 bbl/d (number from Q215 to Q315 increase). In one scenario, Iranian oil reemerges on the market with 100% of their capability of 3.17 mbbl/d. This amount (minus the 1.3 mbbl/d already being produced by them) is divided evenly over the next five quarters to reach about 2 million bbl/d of oversupply shown by the yellow line. Clearly, the situation described above represents the nightmare that Iran could bring for the recovery of oil prices. Price projections would probably remain in the low $40's ceteris paribus. The second scenario highlighted by the green line has Iranian production reach about 60% of its potential capacity, or 1.9 mbbl/d, which would be an increase of about 600,000 bbl/d over the next five quarters. By the end of 2016, supplies would have only outgrown demand by 1 million, which is half of what was extrapolated in scenario one. Simplified results like these don't predict price and supply very well as much could happen on other production fronts and the IEA could be wrong on demand estimation, but this model, in particular, communicates how important Iranian oil can be in the macrocosm of global petroleum markets. As incomprehensible that Iranian policy can be, I would expect global volatility in oil prices to continue with high beta levels and a tendency to trade around the "implied support" discussed earlier. Remember, OPEC cannot control the new laissez-faire mechanism working in their market, but the large reserves and extraction capacity that defines them causes significant swings when finding accurate prices.

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