26th January 2016
The reality of oil supply overwhelms political rhetoric from Draghi and Saudi, says Rowan Dartington Signature’s Guy Stephens…
When investing, it is essential to look forward at least six months and to remember that most of what you read and hear today has already been priced into the markets. It is rare that an investor thinks of something that hasn’t already been considered by the army of market pundits and analysts.
What is key is to identify the issues which will influence price discovery over the short, medium and long term. Then you can decide which of these you believe and which you discredit, and subsequently invest your assets in accordance with this.
As an investor you have a significant likelihood of misreading markets. Therefore, you should always prioritise the potential risks over the potential rewards. Too much of the former and you will miss the upside whilst too much of the latter leads to overheated markets.
There is currently a media obsession with the health of the Chinese economy. Some view this as an opportunity to undermine the validity of the data released by the authorities and contrast it with the open and transparent nature of the data released within democratic economies.
Others view it as a chance to ridicule the closed and opaque structure of a communist system.
The reality is, regardless of the actual Chinese GDP data, demand for commodities used in the Chinese construction boom has slowed and this has led to commodity prices collapsing. This coincides with significant increases in supply planned several years ago by emerging economies to cater for a demand scenario never previously experienced and much of this production has only recently come on stream.
Markets usually worry about an economic slowdown when there are some early warning signs displayed in PMI data, retail sales, corporate statements, currency movements and the media.
With China, much of this information is either mistrusted or not available and this leads to late discovery, paranoia and panic. What we are seeing in the commodity markets is the effect of imbalanced demand/supply equilibrium where both are misaligned whilst the cause, a slowdown in Chinese construction, started happening some time ago.
This will correct in time as supply is reduced and we would anticipate some price stability which would signal that we are approaching the equilibrium point.
In Western markets, what is happening today as a result of the economic slowdown would have been priced in many months ago and investors would be looking forward to the next stage of the economic cycle. Instead we continue to worry about the same issue that we have known about for the last two years and potentially the real risks that may lie ahead. Markets bounced at the end of last week following speeches by two key figures of authority.
Mario Draghi waved his QE wand once more without casting a spell and for some reason the markets interpreted the potential to print yet more money in Europe as a good reason to temporarily stop worrying about oil prices, commodities, emerging market debt and China – understandable in some ways but irrational.
In addition, a Saudi oil minister also said at the World Economic Forum in Davos that the movement in the oil price to below $30 was irrational and that he expects the price to recover. However, this spokesman is also the Chairman of Aramco, which is considering a flotation, and it is entirely in the interests of Saudi Arabia to talk up the oil price, as this will reduce the international pressure on them to cut production. Nevertheless, the oil price rebounded, traders closed short positions and this drove markets higher.
And this is all before Iran has pumped a single drop!
So, whilst the bounce in markets provided welcome relief, nothing has fundamentally changed. There is a strong chance that the situation will continue to intensify and that we could revisit the recent lows as the reality of excess oil supply overwhelms political rhetoric from Draghi and Saudi Arabia.
It is also highly likely that we may hear further supportive comments from the authorities who have noted how their comments supported markets. However, this is subject to the laws of diminishing returns, similar to the forward guidance provided by Central Banks. The more it is used the less effective it becomes. Eventually it becomes the subject of ridicule and leads to reputational damage as investors realise that it is an excuse for not taking any radical action.
This is why we remain vigilant. It will take more than words to solve the current problems in the oil market and the next OPEC meeting in June feels a long way off.