The anatomy of a summer oil glut

It is ironic that Brent crude has risen to as high as $120 even though the supply-demand fundamentals in the wet barrel (physical crude) trading markets continue to erode. This disconnect in the world’s most valuable, liquid commodity market is a testament to Iran geopolitical risk that has created a supply shock premium on the markets, particularly after 100 VLCCs (supertankers) have now refused to load Iranian crude at Kharg Island in deference to draconian US/EU sanctions. This supply risk also explains the inexorable rise of the Brent-WTI premium to almost $19. EU sanctions preclude ship insurance, the reason Frontline and Nova Tankers, owners of two of the world’s most prominent tanker fleets, have now refused to load/transport Iranian crude. A sharp fall in Iran’s exports in inevitable, an eerie replay of the Seven Sister boycott of Mossadegh crude that culminated in a CIA coup that restored the Shah to his Peacock Throne in 1953. The supply-demand metrics for Brent flash a bearish SOS. Opec production is now at 30.9 MBD, the highest since the failure of Lehman. Saudi Arabia alone is now pumping almost 11 MBD, the highest since the onset of the Iran-Iraq war. This means Opec quotas, let alone, quota discipline in nonexistent. Meanwhile, the IEA has again cut global oil demand for the sixth consecutive month. Oil demand has actually contracted by 300,000 barrels/day in Q4 2011, the first contraction since the 2009 global recession. Libyan, Iraqi liquid fuel, Russian and Mexican crude is also hitting the market, so the risk of an inventory buildup is all too real at a time when a surge in US shale oil production (unemployment rate in North Dakota is three per cent, a black gold rush?) limits American imports. The reason Brent trades at stratospheric levels is the epic easy money policies of the Federal Reserve, the ECB and the Bank of Japan, despite the Molotov cocktails in Athens, Saudi Arabia’s refusal to play the role of Opec’s swing producer, the collapse in Indian industrial production and the decline in Chinese exports. The tidal waves of central bank liquidity are amplified by the Iran supply shock. It is entirely rational for Sama and GCC central banks to prefer to sell crude at current Brent levels, than invest in risk free Uncle Sam T-bills at 20 basis points. This is all the more true since post-Arab spring government spending and budget break evens have soared. Real dollar interest rates are negative and the threat of war in the Straits of Hormuz, not supply-demand curves, explain the surge in Brent. This is the reason I have tried my best to flag opportunities in high beta energy (Oxy, Schlumberger, Apache, Noble, etc) for our readers in Global Investing. Notice Noble is now 20-60, a vindication of my bullish thesis outlined only two weeks ago. The fate of Brent depends on Ben Bernanke and Ayatollah Khomeini until the oil market again refocuses on supply and demand. But Europe is now in recession, Club Med in another credit crunch. Brent can well rise to $130 but that makes the subsequent hit to oil demand all the more traumatic. A major fall in Brent is inevitable as the glut builds in OECD inventories. If the Iran crisis does not escalate into war, a $20-$25 fall in Brent is my base scenario in the next six months. This has to be the macro trade of 2012, if the stars are aligned right, dear Brutus. Risk rallies and easy money The tories are in power, the Queen will be at Ascot in June but all is definitely not well in the world’s financial empires. The Greek austerity deal has triggered a social explosion on the streets of Athens. Earnings shocks devastated the share prices of Credit Suisse, UBS, ING, Barclays and Macquarie Bank. The money centre bank shares have skyrocketed since December since they were the clearest beneficiaries of stronger economic growth data, were grossly underowned by investors and were the major beneficiaries of the ECB’s epic LTRO, that has caused tail risk of a European banking system collapse to plummet and interbank market sovereign fund risk spreads to decline. Yet liquidity driven rallies have boosted the share prices of the good, the bad and the ugly in global finance. Risk rallies are all too vulnerable to spikes in volatility as financial markets get sandbagged by negative news which deleveraging, debt crises and regulation/political attacks make almost inevitable. After all, the ECB repo under LTRO saw 523 eurozone banks bid for €489 billion. This is not exactly a bullish premonition for the sector. The US banks have no comparable systemic risk but the colossi of Wall Street are exposed to Europe, Federal Reserve bank stress tests, Basle Three and the political fallout from Dodd Frank, the Volcker Rule and homeowner debt relief programmes. Instrument banking remains mired in a revenue death spiral. FICC revenues fell by 25-35 per cent in UBS, Barclays Capital and UBS, Europe’s leading bulge bracket investment banks. So while LTRO acted as a game changer in international finance, akin to Hank Paulson’s Tarp, it does not negate the fact that European banks are still vulnerable to a high risk of Club Med debt contagion, recession, rising NPL and even political risks. HSBC under Stuart Gulliver has hardly been a winner for shareholders. Yet expectations for the biggest strategic makeover in UK banking are all too pessimistic even as management has executed on the new “think global, slash local” strategy. HSBC share performance is highly correlated with global liquidity metrics, which have improved after recent easing moves by the Fed, ECB, Bank of England, the PBOC and the Bank of Japan. With headcount shrinkage of 14,000 and the sale of no less than 20 global businesses, HSBC has definitely performed in Gulliver’s five filters strategy, loan/deposit ratio is a conservative 76 per cent and the exit from US credit cards/mortgages all suggest higher valuation metrics. HSBC also has valuable stakes in China’s Bank of Communications, Ping An and Industrial Bank and should benefit from the exit of European banks from Asia. HSBC New York ADR could be a value buy at 38 for a 45-48 target.