Oil Rally Is Welcome, but These Trends Will Determine Whether it Lasts
As the price of crude oil rallies from recent lows, a few geopolitical and economic factors are at play.
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Oil has been one of the most boring range-bound assets — one that most had given up on seeing a demand recovery for in 2024, pushing this idea out every quarter while waiting hopelessly for Chinese demand to return.
But now oil has rallied from its lows of $67 per barrel (BBL) all the way to $80 per BBL this past week.
Since the beginning of December, all of the classic "Trump trades" that were bought furiously after the election have now been unwound, with the market filling the entire gap, leaving it now where it was before the election. But what started this rally and is oil demand really picking up now?
Something snapped in the markets in December that saw bonds starting to fall as yields on the 10-year moved from 4.15% to highs of 4.80%. Yields started rallying the day that the Fed cut interest rates by 50 BPS in September and again in November and December. As the Fed cut rates by 100 BPS, yields have rallied by that amount in the longer term. This is completely opposite to how bonds would typically react when the Fed cuts rates.
It senses that inflation will be a problem or that the Fed will egg on the markets by creating animal spirits. There was no need to cut rates, yet it panicked post the summer seasonal weakness, not to mention the high interest expense bill that needs to be paid. But there is a connection to oil as well: As yields rose, this suggested a backdrop of improving growth outlook which allowed oil to move higher to play this re-flation macro theme. As funds de-levered from being long growth versus short balue, this allowed oil and its equities to move higher without any change in fundamentals, per se.
That Joe Biden announcing tougher sanctions on Russian oil made matters worse as there was a scramble to cover oil shorts before the Russian supply would find it hard to come to the market. But history has taught us that these sanctions do nothing other than re-route the flows. The market always finds a way. Needless to mention, there is really no shortage of oil, as whatever is lost by Russia can be made up for by OPEC+ and Saudi Arabia, which is sitting on an excess of three million barrels per day (MBPD) to four MBPD oil, just waiting to come back. This short covering has managed to catch a few underweight funds out.
The key to the oil market demand is dependent upon the return of Chinese demand. Last year, OPEC and IEA all got their estimates totally off as they kept waiting for the return of 1.2 MBPD of demand, when China in fact closed the year with demand down 200,000 BPD! There has been a secular change in Chinese use of oil, as its shifts to LNG trucks and moves to EVs.
Global manufacturing is weak and so it remains to be seen whether there is a real economic recovery here. Time shall tell, but sometimes portfolio unwinds can give the illusion of strength in an asset, when it is nothing other than books shuffling around locking in their gains.
At the time of publication, Bengali had no positions in any securities mentioned.
