Oil plunged on renewed concern of rebalancing; Dow recovered

Oil (WTI-Oct Exp) tumbled over -8% in the last two trading sessions and made a low around 82.16 Thursday after scaling a recent high of 95.03 on 28th Sep’23; i.e. stumbled almost -13.5% in the last few trading sessions from a 13-month high. Oil tumbled over as EIA forecasted subdued demand and as Russia may restart the export of diesel/gasoline. Also, the U.S. is now producing almost 13 mbpd, at a lifetime high, while gasoline and crude stocks are also increasing. In brief, after the OPEC production cut orchestrated by Saudi Arabia and Russia, the market is again concerned about rebalancing as Saudi voluntary cuts are being neutralized by higher productions from the U.S. and also Iran and Iraq (both controlled by the U.S.). Oil peaked just ahead of the Chinese Golden Week holiday (Festival demand).

The market is now again concerned that lower demand may offset tighter supplies going forward amid demand destruction on higher cost of living, cut in discretionary travel spending, higher borrowing costs, and synchronized stagflation on both sides of Atlantic and even Pacific (US-Europe-China/Japan). Even India is now warning of systematic demand destruction if global oil prices linger around $90 for long.

Also, the synchronized monetary policy of higher interest rates for longer periods by various G20 central banks led by the Fed and ECB may affect interest-sensitive goods and services including automobile sales, negative for long-term demand of oil. And growing adaptation of EV and permanent WFH/hybrid work-home policy is affecting the oil demand. Recent EIA data showed that gasoline stocks in the US rose the most since the first week of 2022, and the four-week average for gasoline demand reached its lowest point for this time of the year since 1998.

On the supply side, as unanimously expected, OPEC+ made no changes to the group's oil output policy, following Saudi Arabia and Russia's decision to extend voluntary supply cuts until the end of the year (which may be eventually extended to Dec 24!). Saudi Arabia said: “This voluntary cut decision will be reviewed next month to consider deepening the cut or increasing production”.

On Wednesday, the Russian government stated that there was no set deadline for lifting the fuel export ban introduced in September, and these restrictions would remain in place as long as necessary. Also, Kuwait confirmed that it’s committed to the OPEC+ production guidance, and is not going to produce above quota. But at the same time, Argentina’s oil production surges as political instability soars.

On Wednesday (4th Oct23), the Russian Energy Minister Novak said:

·         The Russian fuel export ban has had a positive effect

·         Saudi Arabia's oil cuts have significantly contributed to the balance of the global oil market

·         OPEC+ may tweak its decisions if needed

·         We see a record-high global oil demand

·         The joint actions of Russia and Saudi Arabia led to a balance of the global oil market

But Russia may be close to partially lifting the export ban on diesel, allowing pipeline diesel exports within days, as full storage facilities threaten to force refiners to cut throughput.  As a reminder, in late September, Russia surprised the markets by announcing a temporary ban on exports of gasoline and diesel to stabilize domestic fuel prices amid soaring crude prices and a weak Russian ruble. Diesel and gasoline exports are now temporarily banned to all countries except for four former Soviet states—Belarus, Armenia, Kazakhstan, and Kyrgyzstan. This led to oil zoomed to almost $95 levels.

Last week, Russia tweaked its export limitations on fuels, lifting the temporary ban on exports of low-quality high-sulfur diesel and marine fuel and allowing the export of fuel supplies that already had loading papers and were accepted for export to proceed. This led to a much-awaited correction in oil prices.

Now Putin admin may allow pipeline diesel exports, although they could be subject to export quotas, due to fast-filling storage at oil pipeline monopoly Transneft. The ban on gasoline exports is expected to remain in place, for now. Transneft’s diesel storage capacity is almost full while redirecting supply to the domestic market is technically nearly impossible. As a result, some large Russian refinery companies have expressed concerns that they could be forced to reduce refinery operations and cut not only diesel but gasoline production, too. Now the Russian government is considering introducing quotas for pipeline diesel exports to prevent a spike in prices, which have dropped by 25% since September 21, when the ban was introduced.

On Thursday, Fed’s Daly said:

·         If cooling in inflation stalls or financial conditions loosen, we will need to raise rates further

·         It's possible that the slowing so far will translate into a steady march toward our goals

·         Even with a recent slowing in the labor market, job growth remains well above what's needed to keep pace with growth

·         Tighter financial conditions reduce the need for Fed hikes

·         To ensure we fully achieve our goals, we need to finish the work

·         Steady rates make policy more restrictive as inflation falls

·         Progress isn't a victory, we must remain resolute

·         We can hold rates steady if labor, prices keep cooling

·         We don't have to rush to any decisions

·         We aim to restore price stability as gently as we can

·         The moment calls for optionality in policy

·         Market odds for hikes in November and December don't look out of line

·         We shouldn't assume we're now in a higher-rate environment

·         So far, bond market tightening has not been disorderly

·         The recent bond market tightening is equal to about one rate hike

·         With the rise in bond yields, the need to do additional tightening by the Fed is not there

·         Part of the bond yield rise has to do with the Fed's new SEP projections

On Thursday, Fed’s Barkin said:

·         Yields have come up amid fiscal issuance and strong data

·         I don't see the logic of throwing out the target before hitting it

·         Risk management calls for not declaring victory too soon

·         Rates feel high now, but they're not over long term

·         Yields have come up amid fiscal issuance, and strong data

·         We're going to start seeing more dispersion in the FOMC dot plot

·         I'm seeing a slowdown in hiring, but not a cliff

·         Short-run inflation expectations have come down, and that releases wage pressure

·         We are not in a wage-price spiral

Market wrap:

On Thursday, Wall Street Futures and gold slipped, while the USD got some boost after Challenger Job cuts and the latest jobless claims came softer than expected. But all reversed after oil resumed a downward journey again after a brief intra-short covering and Fed’s Daly sounded less hawkish than expected; the US10Y bond yield also eased slightly to around +4.70% from +4.80% hit earlier this week (at a 16-year high).

On Thursday, Wall Street closed almost flat, but recovered from earlier deep losses as bond yield eased on hopes of a softer NFP/BLS job report Friday, which may keep the Fed on a less hawkish monetary policy path going forward. Wall Street was boosted by real estate, healthcare, financials and techs, while dragged by consumer staples, materials, industrials, energy, consumer discretionary, utilities and communication services.

Conclusion:

The Fed is now preparing the market for higher for longer policy and another hike in November- then a possible end of the tightening cycle by Dec’23. Overall, the U.S. labor market and core inflation trajectory are still hot enough for another Fed hike. Fed never surprised the market with its rate action and by mid-October (after core inflation and labor/wage data for September), it will be clear whether the Fed will go for another +25 bps hike in Nov’23 before going for a final pause in Dec’23. Fed may not be in a hurry to cut rates before Sep’24.

As per Taylor’s rule, for the US:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.50.00-2.00) =0+2+3.50=5.50%

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation (CPI+PCE) =5.50% (for 2022); H1CY23 average core inflation around +5.40% (~5.50%)

As there is no significant easing of core inflation, especially core service inflation, the Fed may go for another +25 bps hike in Nov’23 and possibly the end of a tightening cycle. But, if core CPI inflation indeed eased further to below +4.0% by Oct’23, then the Fed may refrain from any further rate hike in 2023 and may also indicate some rate cuts in Q2CY24 in the Dec’23 SEP (ahead of the US Presidential Election in Nov’24) to keep real repo rate around +1.00% levels (restrictive zone).

Looking ahead, oil prices may stay elevated in the coming months between $75-95 instead of the earlier $65-75 despite US efforts to bring more supply from, Mexico, Brazil, Iran, Iraq, and Venezuela. OPEC/Saudi Arabia will not ‘cooperate’ with the U.S. for ‘breach of trust’ in refilling SPR (as agreed ‘verbally’). Elevated oil prices around $90 will continue to boost energy/transportation/logistics costs and core inflation. Saudi Arabia/most OPEC producers and even Russia are now seeking $85 oil prices on a sustainable basis to fund budget deficits, EV transition, and also the cost of the Ukraine war.

China may also deploy more targeted stimulus to bring out the economy from the deflationary spiral in the coming days, which may also support elevated oil prices. But at the same time, China is now also producing higher oil by almost 5 mbpd against its demand of around 15 mbpd. China is also taking various steps to increase domestic production of oil rather than being too dependent on Russia, Iran, Saudi Arabia, and even the U.S.

The U.S., as a producer, is also benefitting from elevated oil prices. The U.S. is also a beneficiary of the Russia-Ukraine war and other geo-political tensions involving North Korea, China, and Iran. The U.S. defense/military industry is now booming. Also, the lingering Cold War mentality with China is resulting in supply chain disruptions and elevated inflations. The global economy continues to face the daunting challenges of macro-headwinds- elevated inflation, high levels of debt, tight and volatile financial conditions, continuing geopolitical tensions, fragmentations, and extreme weather conditions.

Going by the present trend/run rate, the U.S. core CPI may fall to +3.8% by Dec’23 and +3.4% by Feb’24, which may keep the Fed to hold on rates at +5.7% till at least Aug’24 before going for any rate cuts -25 bps or even -50 bps each in Sep’24 and Dec’24 (one rate cut every QTR end from H2CY24). Fed would like to boost Wall Street as well as Main Street before Nov’24 U.S. Presidential election. Fed has to ensure a soft landing; i.e. price stability along with financial/Wall Street stability and Main Street stability.

Looking ahead, the Fed may try to balance the financial/Wall Street stability and price stability by expressing intentions to cut from June’24 (H2CY24) to ensure a soft landing while bringing down inflation. Also, the Fed has to ensure lower borrowing costs for the U.S. Government (Treasury) endless deficit spending and mammoth public debt of almost $32T. The U.S. is now paying around 9.5% of its revenue as interest on public debt against China/EU’s 5.5%. This is a red flag, and thus Fed has to operate in a balancing way while going for calibrated hiking to bring inflation down to target, avoiding an all-out recession; i.e. to ensure both price stability and soft-landing.

Overall, it seems that the White House would be quite happy if the Fed could bring back core inflation towards 2% on a durable basis, while keeping the unemployment rate below 4% ahead of Nov’24, the U.S. Presidential election. The Fed is itself eager to cut its losses by cutting rates. The U.S. 2Y bond yield is now hovering around +5.15% and may soon scale 5.25-5.50% in hopes of another +25 bps Fed rate hike for a terminal repo rate of +5.75% by Nov’23.

Bottom line:

Technical trading levels: DJ-30, NQ-100 Future, Gold and Oil

Whatever may be the narrative, technically Dow Future (33293) now has to sustain above 33450-550 levels for any recovery to 33850/34000-34150/34250 and 34300/34555-34600/34825-35070/200-415/850 levels; otherwise, sustaining below 33200-33000 may again fall to 31700-31500 levels in the coming days.

Similarly, NQ-100 Future (14859) now has to sustain over 15050 levels for any recovery to 15150/15275-15325/15500 and 15750/900-16000/655 in the coming days; otherwise, sustaining below 15000-14700, may further fall to 14500-14300/175-100/13890 and 13650-13125 levels.

Gold (XAU/USD: 1823) now has to sustain above 1843 for any recovery to 1867/1875-1885/1900 and 1910/1920-1926/1937 and 1952/1970 levels; otherwise, sustaining below 1837-1832, may further fall to 1825/1813*-1798/1770 level in the coming days.

Technically, whatever may be the narrative, oil (82.55) now has to sustain over the 83.75-84.75 area for a further recovery towards 85.50/86.75-88.00/90.00 and further to 90.50/91.50 and 94.00/96.00-102.00/115.00-120; otherwise sustaining below 82.50, it may correct again towards 81.40-81.00/80.00-78.75/77.50 and 75.00-70.00/67.00 area in the coming days.