It seems oil prices remain stuck in a very tight range and, more recently, in a  bearish trend. The lateral range of $50-55 was recently broken and the new long-term support level is closer to $47 than $50.

There are various reasons for this.

a) The OPEC-non OPEC deal is unsustainable. We read everywhere that compliance to the cuts is 90%, but this hides the fallacy of averages. Saudi Arabia is reducing output by a lot more than agreed (130kbpd cut above its agreed production), while Russia is at almost a third (118kbpd vs 300 agreed), Irak is also well below (85kbpd vs 250kbpd agreed), and Emirates, Kuwait, Venezuela, Algeria… all are between 50 and 60% compliance on the agreed cuts. Only Angola, out of the rest of the list ex-Saudi, is cutting more than announced. This reliance on Saudi Arabia doing all the work -again- will end up badly… as always.

Iran keeps pumping at record levels and Iraq is rising to record highs. Oil exports in February reached 3 mbpd, a level not seen since 1979. According to the IEA, Iraq will increase its output to 5.4 million barrels per day by 2022, which is significantly higher than the earlier estimates of an increase to 4.6 million bpd by 2021. Similarly, Iran is expected to boost production by 400,000 bpd to reach 4.15 million bpd production in 2022. These barrels are not only of mugh higher quality (Iran is very light crude), but more abundant as reserves have been underdeveloped for years.

b) US production is rising faster and stronger than expected. US oil production has increased by 400kbpd from the lows, surprising consensus and most international agencies, that thought that shale would not recover before Brent reached $65. According to Chevron, shale breakeven is now at the high $30s-low $40s, and OPEC has underestimated the process of strengthening balance sheets and improving the efficiency of the US companies. This is before any tax cuts from the new administration, that would lower the breakeven price even further.

c) Inventories remain elevated. At 66 days of supply, OECD inventories are at a 6-year high (55 days inJanuary  2011) and above the historical high end of the range (65 days). US crude inventories have soared as well, to a new record high. Crude inventories rose 8.2 million barrels in the week to March 3, compared with analysts’ expectations for a 2 million-barrel build.

d) Lack of “investment” is just the burst of a bubble. While many point to capex cuts as the driver of a new super cycle, few seem to understand that the monstrous increase in capex in Oil and Gas from 2004 to 2013 was created by the bubble of low interest rates and perception of ever-rising oil prices, not demand. Capex multiplied by more than three in real terms to more than $1 trillion per annum in a decade of excess, creating a very high level of structural overcapacity, close to 20%.

e) Demand and the USD. Oil demand growth estimates look, yet again, too optimistic. As we have seen almost every year since 2001, international agencies get used to correlations of growth and oil demand that simply do not work and have been broken for years. Efficiency, technology and substitution continue to improve exponentially, eating away the equivalent of one Sweden of potential demand growth every year. This technology and substitution has not stopped due to low oil prices, as OPEC expected. Solar, wind, electric vehicles and other alternatives continue to thrive despite lower fossil fuel.

A stronger US dollar and the Trump administration’s policy of “America first” also destroy the geopolitical premium attached to the oil price. The US can become fully energy independent by 2019, and a monetary policy that finally ends the destruction of currency as a target also supports a strong dollar that impacts the barrel, which trades in the US currency.

Even if the reader wants to hang on to bullish price expectations, you should agree with me that if oil prices remain rangebound despite the largest cut in history, it is because the market is not only very well supplied. It remains oversupplied.

Daniel Lacalle. PhD in Economics and author of “Life in the Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.

Image courtesy Google.

The biggest bubble in financial history is about to end.

With rate hikes, a stronger dollar and the return of inflation, bond inflows are normalizing, sell-off in negative yield fixed income continues, and real rates increase despite central planners’ financial repression. High-yield bond funds saw their biggest outflows since December 2014 last week, as investors withdrew $5.7bn, according to EPFR Global.

Meanwhile, the total value of negative-yielding sovereign bonds fell to $8.6 trillion as of March 1 from $9.1 trillion at the end of 2016.

Three factors are helping the burst of the bond bubble:

1. The price of oil falling to three-month lows on the evidence of the ineffectiveness of OPEC cuts, a record increase in inventories and a stronger dollar is helping to reduce the thirst for high-yield.
2. A strong “America First” policy needs a stronger US dollar. The US economy benefits from a strong dollar and rising rates, not the other way around. Believing that the US needs to weaken its currency is a fallacy repeated by mainstream economists. The US exports are relatively small, about 13% of its GDP, and its citizens have 80% of their wealth in deposits. The new administration knows it. They are their voters. The only ones that benefit from a weak dollar and low rates are bubbles, indebted and inefficient sectors. If a rise in rates of 0.25% negatively impacts a part of the economy, after more than 600 rate cuts, it means that such part of the economy is unsustainable. Increasing rates is essential to limit the exponential growth of bubbles and excesses.
3. The European Central Bank. The placebo effect of ECB policy has already passed. With more than € 1.3 trillion in excess liquidity and a dangerous environment where economic agents have become “used” to unsustainable rates to perpetuate low productivity sectors, it is inevitable that the central bank will begin to unwind its Monetary laughing gas sooner rather than later.

That dollar strength and US rate hikes, reinforced by the Trump administration’s capital repatriation policy, is exactly what the country needs if it really wants to “make America great again.” If you destroy the middle class with financial repression, you will not only lose its political support, but the policy will not work either.

Strong dollar, normalized rates and repatriation of capital create the vacuum effect. Higher demand for dollars is triggered and the attractiveness of low yield bonds outside the US is reduced.

… In Europe, we are not prepared for the bond bubble to deflate.

The vacuum effect can mean a loss of up to a $100 billion just from repatriations. If the top five technology companies repatriated half of their cash back to the US, it would mean more than $240 billion leaving the rest of the world and returning to the US.

But, moreover, rate hikes make it less attractive for investors to buy bonds from European and emerging countries.

At the moment, growth prospects in the Eurozone, and the US-European inflation differential keep the flow of investment in the European Union because in real terms it still offers a decent mix of risk and profitability. But the Eurozone has a problem when governments have to refinance more than a trillion euros and have become used to spending elsewhere the “savings” in interest expenses achieved due to artificially low rates.

Those savings have already been spent, and when rates rise, and it will happen, many countries do not seem to be sufficiently prepared. Same with many companies. The rise in inflation and rates, which has given some breathing air to banks, holds another side of the coin. Non-performing loans have not been adequately cleaned, and remain above 900 billion euro in the European financial system. Banks do not have enough capital cushion to undertake the deep provisions that would entail cleaning up such a hole and have relied on the recovery to try to sell these loans. The improvement in NIM (net income margin) coming from inflation and a rate increase does not compensate for the increase in NPLs and their provisions. A rate hike of 0.25% means an increase in NIMs of 17% for Eurozone banks, but the clean-up of NPLs would completely wipe out that benefit.

The European Central Bank should analyze the risk of fragility. Because it has not been reduced.

Europe continues to suffer from three factors: Industrial overcapacity, high indebtedness and excessive weight in the economy of low productivity sectors.

These sectors -industrial conglomerates, construction- have absorbed most of the new credit. The ECB and governments were too obsessed with increasing credit to the economy to worry about where that credit was going to. When Eurozone economies and companies are afraid of the impact of a hike of just 0.25%, it means we have a problem – really big.

Do you have a business? Are you prepared to pay 1-2% more for your financing in the next five years? Yes? Congratulations. You have nothing to worry about.

Do you have a variable rate mortgage? Are you prepared to pay a few hundred euros more per year in the next few years? Yes? You have no problem.

Do you have a country where net financing needs are going to continue to fall as rates rise? Yes? Congratulations, you are fine.

Do you think that the ECB will have to keep or lower rates because everyone is so entrapped that it needs to be more dovish? I wish you luck.

The big mistake of central banks has been to create bubbles, then deny them, and afterward try to perpetuate them with the same policy that created the initial problem. Lowering rates and increasing liquidity has been the only policy.

Now central banks face a new US administration that sees currency wars and beggar-thy-neighbor policies as what they are, assaults on the middle class. Financial repression did not work in the past, and failing to adapt economies to normalized rates is dangerous.

Investors should really pay attention because real and nominal losses are more than evident in bond portfolios.

EDITOR’S NOTE

This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the forthcoming Escape from the Central Bank Trap.

Courtesy @Hedgeye