By Simon White, Bloomberg Markets live reporter and strategist
Oil is poised to rally due to rising excess liquidity, incrementally more easing in China and improving supply conditions.
It is often darkest before dawn, and nowhere in markets is that currently more true than in oil. A protracted selloff has frustrated many oil bulls, with Goldman Sachs and JP Morgan recently throwing in the towel and reducing their price forecasts.
Poor sentiment is usually a good sign that something else is going to happen. Contrarianism on its own, though, is not enough to confidently leap into a trade that the experts are leaping out of. But when such an opportunity arrives at the same time as multiple fundamental supports, what was merely “interesting” becomes “compelling.”
For oil, improving liquidity conditions are the game changer. Oil is a risk asset. While it must eventually adhere to the laws of supply and demand, in the medium term (3-6 months) it is typically more influenced by liquidity, specifically excess liquidity (defined as the difference between money growth and economic growth).
Risk assets are the marginal importers of this excess liquidity, which is why traders and investors should pay close attention to it. It captures the global liquidity that is surplus to the needs of the real economy, and therefore typically finds its way into asset markets.
As I noted last week, excess liquidity has bottomed and is now rising. This might seem counter-intuitive given central-bank rates are at decade-plus highs and still climbing, but excess liquidity is an inherently contrarian indicator. It is rising while inflation and growth are falling as the cycle moves into its late stages.
The chart below shows the turns in excess liquidity give an excellent lead on the turns in oil-price growth by 6-9 months, and that oil should soon start rising.
The positive outlook from a liquidity perspective is underpinned by the upturn in my leading indicator for oil. The indicator is not liquidity based, and instead is driven by the oil curve, growth data and crude supply. As the chart below shows, the indicator anticipates oil will soon begin to turn higher.
A key reason why oil has failed to rally is China. The effects on the economy of a draconian Covid policy have yet to be fully reversed, and have only been partly addressed by a series of restrained easing measures.
But China has started to increase its imports of oil (with news today of a major refiner buying barrels), perhaps taking advantage of low prices to add to its reserves. Whatever the reason, the trend is set to continue. The gradual easing in China is leading to easier liquidity conditions, embodied by rising real M1 growth. As the chart below shows, this points to China’s imports of oil continuing to rise.
Growth in China is spluttering, with youth unemployment reaching over 20%. There’s only so much of this the country can take, with rising joblessness, especially, seen as a major problem as it could lead to civil disorder and thus pose an existential threat to the system of government itself. It is likely China will have to ease more deeply and more broadly, further fueling oil prices.
Rising crude demand comes at a time of improving supply conditions. Bullish calls for oil were predicated on a dearth of capital investment and thus dwindling future supplies. After the slump in prices in the mid 2010s, oil and other commodity companies re-prioritized paying back investors over investing in new supply.
There was little response even after the rise in prices triggered by the Ukraine war, as higher prices came with higher volatility, deterring long-term investment. Dividends and buybacks rose in excess of new capital expenditure for North American commodity producers in the aggregate.
But the longer-term outlook is likely to be trumped by better medium-term supply conditions. Despite the recent rise in the EIA estimate of US crude stocks, OECD commercial inventories look to have peaked, easing what has been a formidable headwind for crude prices.
This comes at the same time as the recently-announced Saudi-led OPEC+ production cut. As Goldman notes, we have never seen an OPEC+ cut within two months of the prior cut when OECD commercial inventories are as low as they are today.
The ghost at the feast is a US recession. What happens if one hits (as it is likely to)? The usual assumption is that recessions are bad for oil. But that’s not typically the case. On average, oil tends to sell off before the recession, but then rally through it over the next six months.
The slowdown causes a rise in excess liquidity as central banks begin to ease, which supports oil prices until the impulse from excess liquidity begins to fade.
It has been a long night for oil, but the sky is beginning to brighten.
