Monday, February 01, 2016

Energy ($XOI) starting to fizzle out

You sort of had a sense that it was going to happen, like Manchester United putting in some underwhelming performance or Andy Murray not being able to win the Australian Open, that the recent spike in energy I think is coming to an obvious end. The fall in the first place has to do with very strong geopolitical forces jockeying for market-share, so honestly it's going to take a little more than some limp-wristed statements by Saudi Arabia and Russia that voluntary cuts are on the way. Saudi Arabia's plan is beginning to bear fruit so why would it stop now; evidence suggests Russian production is actually falling.

Looking at $XOI's chart might show us why now is an opportune moment to be selling or shorting energy. First of all, $XOI is in a bearish ascending wedge, and secondly, it's coming up against resistance from the lower-highs put in throughout December.
Looking at my XLE chart recently I also noticed that we are coming up against horizontal resistance from lows put in back in August and September.

Goldman Sachs gave some very salient points recently on why energy prices will continue to remain depressed for the foreseeable future:
  • We continue to view a coordinated production cut as highly unlikely and ultimately self-defeating. The decision made by OPEC in November 2014 and again in December 2015 to sustain production is the one that maximizes their revenues medium term. While fiscally difficult in the short term, it was nonetheless necessary in the face of strongly growing higher-cost non-OPEC production.
  • We believe that the spring 2015 rally in oil prices has increased the resolve of core OPEC producers to stick to their policy of sustaining production and let oil prices rebalance this market (as they have repeatedly commented in recent months).
  • Such a production cut would further require cooperation between OPEC members. And while Venezuela, Algeria and Iraq - which for the first time last week hinted at welcoming cuts - would agree to such a decision, Iran's production ramp up would likely be a significant hurdle to any OPEC action. While Iranian officials have commented on their desire to not flood the market, their production recovery target remains aggressive and their desire to regain market share steadfast.
  • For Russia, the desire to join a coordinated production cut would need to come from the government as our Russian energy analyst, Geydar Mamedov, estimates that Russian oil producers remain free cash flow positive even at $30/bbl given the concurrent Ruble depreciation (we continue to expect steady production growth in 2016 and 2017). The strain of low oil prices are visible at the government level however as $30/bbl oil prices would leave the 2016 federal budget deficit reaching 5% of GDP vs. the government's/President Putin's 3% target according to our Russian economist Clemens Graffe. Since oil taxation is progressive and causes the deficit to widen faster as oil prices decline, current prices raise the risk of a potential increase in oil taxation and in turn lower production, which should it occur, would be an incentive to have other countries cut output at the same time.
  • As a result, should a cut occur, its impact on inventories would matter most, just as the current non-OPEC guidance cuts will only support prices once inventories stop to build.
  • Most importantly, given the likely time necessary to enact such cuts, the continued large builds in US and global inventories and the fast pace at which US Gulf Coast spare storage capacity is filling, it may already be too late for OPEC producers to be able to prevent another large decline in prices. As a result, we reiterate our view that prices need to remain low enough to force fundamentals to create the adjustment back towards a new equilibrium with this inflection phase requiring oil prices to remain between $40/bbl (financial stress) and operational stress at $20/bbl (well-head cash costs) until 2H16 with the price lows of this phase likely still to be set.