Who Is Right Between Oil And Other Commodities: One Hedge Fund’s Opinion

From Francesco Filia of Fasanara Capital

So far in May, base metals and Oil decoupled markedly (chart attached below). While the Oil price kept rising and moved closer to 50$, base metals fell off a cliff and descended below March lows.

We believe that Oil is the errant outlier, helped by deep but temporary supply outages in Canada and Nigeria and all-time record speculative flows, and is more likely to catch down to other commodities going forward rather than the other way round. We look at Oil gyrations as short-term heavy volatility, within a long-term downward trend.

Supply disruptions in Canada and Nigeria held back 2mn b/d. Temporarily.
Speculation runs at record levels: NYMEX Crude Oil Non-Commercial Long Contracts at all-time highs (chart below)

On the other hand, weakness in commodities is consistent with fundamentals:

Weak aggregate demand (likely to stay shallow in the foreseeable future) vis-a-vis chronic global over-supply,
China inability to keep expanding credit at current pace and keep creating an illusion of demand the world over (1trn$ or 10% of GDP per quarter is unsustainable),
A stronger US Dollar, and the unease of the FED to talk it down, as current account deficit shrinks and only small hikes are priced in

As such, at present, we find the price action so far in May to come in confirmation of our underlying thesis, thus expect more weakness in commodities from here, and Oil to eventually give in.

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Extract from our latest Outlook
Investment Outlook 3rd May attached here

1. Strong US Dollar Factor:

The weak Dollar is the major factor propelling the reflation sentiment in the market – EMs and Commodities greeted it with enthusiasm. However, it seems to us more a story of appreciating Yen and Eur out of the failed attempts by the Boj and the ECB to reflate their economies, as markets doubt their capacity at negative rates. It is not the typical weak Dollar out of increasing US current account deficit and increasing spending / imports, positive for the world and inflation. We expect the USD to have another leg up in the months ahead. A stronger Dollar alone has the potential to revive January-type fears over Oil, CNH, EMs, leading to a risk off of global assets, including the S&P. We see drivers of USD strength as follows:

a. The FED took the steam off the Dollar by moving its expected path of tightening in 2016 from 4 hikes to 2 hikes only. The FED may become more dovish than that, but the market already discounts that. Of the 2 rate hikes planned, a tiny 20% is priced in at present. Not much headwind for the USD is left from FED’s communication. At the other end of the equation, after recent fails, the BoJ first and then the ECB will go back at it, trying again to reflate their stagnant economies, with the debasement of JPY and EUR either a working tool or a side effect.

b. A contracting current account deficit and budget deficit in the US will help strengthen the US Dollar. Recent trade balance numbers showed an unexpected marked improvement. The propensity to take on more debt for households and businesses may well be on a declining path. Savings rate for lower income brackets may rise as uncertainties loom large, the cost of retirement has gone up on zero rates environment, together with growing healthcare and education costs. Corporates desire for leverage, buybacks and M&As, may also deflate somewhat, as short rate rise, leverage ratios are now high (the median credit rating for S&P companies is now BB and declining, for a median net debt/ebitda above 3), regulation changes (inversion trades), pricing power is weak, excess capacity abounds. The public sector should fill the gap, but that is unlikely to happen in an election year. You can’t increase deficit if you do not take on more debt. If borrowing declines, the deficit declines, the US Dollar rallies.

c. Most likely, the relative performance of the US economy will continue to outclass growth in EMs, Europe and Japan. Technology is a huge plus for the US economy, their lead likely to outlast any speed-bump due to elections.

2. China factor:

In the first quarter of 2016, it only managed to keep GDP in shape by means of monumental 1trn$ credit expansion (a whopping 10% of GDP in one quarter); unsustainable pace, and clearly a Pyrrhic victory. Unsurprisingly, you cannot borrow 10% of GDP per quarter for long without a currency adjustment, whether desired or not. And generally, what is the point in selling reserves to defend the peg, thus doing monetary tightening, when you seek so desperately monetary expansion.

China’s slowdown will continue affecting commodities markets front and center, metals in primis. China has grown to become the world’s largest purchaser of aluminum, iron ore, zinc, nickel and copper, asking every year for more than double the needs o the US, Europe and Japan altogether. Incidentally, moreover, the speculative flows that determined massive volatility in RMB equity markets earlier on and possibly boosted propensity to currency outflows, are now to be seen in the commodity market. Not only then China buys a lot of metals, but speculative flows multiply those flows a few times over. Anecdotally, twice in the last few months, trading volumes in Iron Ore on the Dallan Commodities Exchange exceeded total China’s 2015 imports (950m tonnes), in a single day. Rebar trading volumes exceeded Iron Ore, across 100 million trading accounts. Authorities rushed to curb speculation through higher fees and more margin requirements, but we have seen how effective they were last time around. An epic unwind may loom large (Read).

Base Metals vs. Brent

In May, there has been a clear divergence between Oil and other commodities. We believe that Oil is the errant outlier, helped by deep but temporary supply outages in Canada and Nigeria, and is more likely to catch down to other commodities going forward rather than the other way round. We look at Oil gyrations as short-term heavy volatility, within a long-term downward trend.