Saudi Arabia engineered a short covering rally and cyclical bottom in Brent crude with its 15 May agreement with Russia to roll over last November’s oil output cuts for another nine months. The kingdom has, in essence, resumed its traditional role as the ‘swing producer’ of OPEC, a role that former Energy Minister Ali Al-Naimi had abandoned in November 2014 in a quest to protect downstream market share in Asia from Iraq and Iran.
This strategy failed after Brent crude plunged from $115 in the summer of 2014 to $28 in February 2016 even as the US Dollar Index rallied by 28% and the kingdom fought a costly war in Yemen. The kingdom changed its strategy under the leadership of Sheikh Khalid Al Falih and Prince Abdel Aziz bin Salman, at the OPEC ministerial meeting in November 2016. Saudi Arabia engineered a 1.2 million a barrel a day OPEC output cut and cooperated with Russia, Mexico, Oman and Azerbaijan to arrange another 600,000 barrels in non-OPEC cuts. This shift in Saudi strategy and intentions was enough to push Brent crude higher to $54 a barrel.
So it was a nasty surprise for the oil markets after speculators in black gold futures caused a 11% fall in both West Texas and Brent crude in late April and May 2017. The oil markets were spooked by bloated global inventories, rumours of Russian and Iraqi non-compliance, a surge in the US land rig count and shale oil output and a 30% fall in Dalian iron ore, a proxy for Chinese industrial growth. This was the context for the 15 May Saudi-Russian extension announcement.
The harsh reality of the world oil market is that US shale oil producers have added 900,000 barrels per day to their output since October 2016 alone. Even though Saudi, UAE, Kuwait and Qatari compliance on the November output cuts has been well over 90%, the surge in US shale oil output has largely offset the OPEC output cuts. This meteoric rise of hydraulic fracking technologies and electric vehicles/robotics has gutted the global influence of OPEC as the world oil market’s supplier of the last resort (OPEC) no longer controls the price of oil since the world’s next swing producer is the Permian Basin in Texas and the Bakken in North Dakota, the new kingdoms of shale. Term premia in the long dated forward West Texas futures markets and implied option volatility have both collapsed since last November’s OPEC output cut pact, prima facie evidence that the smart money expects far lower prices for crude oil in the next five years.
The US land oil rig count bottomed in June 2016 and has almost doubled in the past year. It is entirely possible that the US shale oil output could rise by 600–800,000 a barrel a year for the proximate future. Ominously for oil prices, the increase in the US rig count has begun to accelerate. In the last four months alone, the Baker Hughes land rig count has added 175 operating rigs. This means at least 500,000 of extra US shale oil is guaranteed to hit the oil market in the autumn and winter of 2017.
My analysis of West Texas long dated futures strip curves, oil option implied volatility and risk reversal skews and wet-barrel premia tells me that even if Saudi Arabia and Russia ‘stabilise’ oil prices after the OPEC conclave in Vienna, we could easily see another oil price crash this autumn as US shale oil output floods a glutted market now.
While integrated oil supermajors such as Chevron, Total and Occidental Petroleum offer 4–5.3% dividend yields, I am worried that their ambitions to dramatically increase their US shale oil acreage to preserve their dividend payouts and recoup their cost of capital means US output will surge whenever West Texas rise to $50. After all, this is exactly what happened since June 2016. No rally in the oil market is thus really sustainable since the 4000 odd US and Canadian shale oil exploration and production companies are financed by Wall Street high yield debt issuance and syndicated bank debt are forced to increase output even if global oil prices temporarily fall below their marginal cost of production. A paradigm shift has transformed the world oil market in the past decade. Yet make no mistake. The Age of Shale means long term oil prices could well be as low as $20 a barrel as Texas, not Saudi Arabia or Russia, is the planet’s new ‘swing producer’ of black gold.
Stock Pick – European shares are a global value magnet
Europe is the destination de jour for global fund managers enthralled by the developed world’s fastest growth Purchasing Manager indices, the sharp fall in political risk after Macron gutted the National Front in the French election, a potential 15% EPS growth momentum and the return of sustainable GDP growth. The IMF has upgraded its global growth forecast to 3.5% in 2017, nirvana for the Old World’s global corporate empires. Dr Mario Draghi has ruled out any imminent ECB ‘taper’. The German export colossus is on a roll. Spanish GDP growth will be 2.7%, the fastest in the EU, which itself could well deliver 2% growth. Germany, France and Benelux, Carolingian Europe, benefits disproportionately from a revenue growth cycle due to their high operating leverage business models.
True, the European equities theme is not new. I have been flagging the virtues of Europe after having made several due diligence (yeah right) visits to Munich, Garmisch, the Black Forest, the Cote d’Azur, Madrid, Andalucia and Veneto in the past year. My recommendations to invest in Dutch banks ING and ABN Amro, Spanish bank BBVA, French banks BNP/Soc Gen and UK bank Barclays all returned 20–30%, far above the Stoxx Euro 600’s 18% return in the past twelve months.
After the US Dollar Index soared 25% since mid-2014 while oil prices crashed from $115 to $28 Brent, it did not take a genius IQ to figure out that European financials would be a no brainer as long as Berlin and the ECB did not upset the quant easing applecart. Now Trump wants King Dollar down (whoa boy!). Yellen wants shway-shway monetary ‘normalisation’. The Euro Stoxx 600 trades at 15.6 times earnings, a discount to the S&P500’s 18 multiple. Despite Article 50, despite Macron’s En Marche’s need to win then National Assembly elections (the third round!), I still love European equities on any pullbacks on global markets.
True, Europe’s refugee crisis nightmare continues unabated, as do the civil wars in Ukraine, Syria and Iraq. The Old World is traumatized by the bloodiest and spectacular terrorist attack since the Red Brigades rampage of the 1970s. The horrific Manchester mass murder of teenagers and children only adds to the angst.
Unlike Wall Street’s money centre banks, European banks did not recapitalise and amass ‘fortress balance sheets’. Europe’s currency union did not lead to a banking or fiscal union. Greece’s disputes with the IMF, EU and Berlin could yet erupt into another Club Med sovereign debt crisis as could the election of the anti-capitalist, anti-Euro Cinque Stelle (Five Star) movement in the next Italian election. Europe’s discount to Wall Street is both significant and not without macroeconomic logic, though European companies offer some of the highest dividend yields on Planet Income.
European equities have a 90% correlation coefficient to the S&P500 so any sharp hit in American equities will have an immediate impact on Europe. This could happen if Trump’s latest Comeygate (or Putingate) scandal escalates into a constitutional crisis or US earnings peak/disappoint in the second quarter. However, net earnings in Europe are a staggering 40% below pre-2007 levels, so the runway to ‘profit normalisation’ is so long in the Old World that it is entirely possible that stock exchanges on both side of the Atlantic could ‘diverge’ in their performance, particularly if the euro tests and scales its May 2016 high of 1.16.
The defeat of Marine Le Pen in the French elections has removed an immediate existential threat to the future of the euro and the EU. The German election in September is less pivotal as the next Chancellor will either be Angela Merkel or the even more pro-euro SDP candidate Martin Schultz. The real danger to European equities will be the Italian elections, which must be held before May 2018.
The most obvious sector trade to capitalise on Europe’s economic growth momentum and continued ECB policy accommodation is to buy French banks since Societe Generale and BNP Paribas both trade below 0.9 times book value and 11 times earnings. Europe’s Stoxx 600 index, up 18% since last June, is no longer dirt cheap but I feel Swiss healthcare colossi Novartis and Roche Holdings are undervalued relative to their sheer excellence in research and thus earnings power. Europe’s consumer confidence surge will also benefit Unilever and Danone. A visit to Madrid and Seville earlier this year convinced me that Spain could well prove Europe’s Cinderella stock market, the reason I love Banco Santander, BBVA, the insurer Catalana Occidente and tourism’s Melia Hotels. The Melia Colon is the best hotel in all of Andalusia!
Market View – Argentina is also a frontier market fairytale!
Brazil’s Bovespa index, the real and its sovereign debt have plunged and soared in the last year in response to its political news flow rollercoaster. The resignation of Dilma Rousseff triggered Latin America’s most frenzied bull market in the real and the Bovespa in 2016. Now President Michel Temer’s systemic bribery allegations gutted Brazil’s financial markets. I was horrified to see the iShares Brazil country index fund (symbol EWZ) tank 17% in a single trading session while the Sao Paulo Borsa shut down. It is impossible to pontificate on Brazil as its latest sordid political drama plays out other than to reiterate my old Victorian surgeon’s motto: when in doubt, cut it out!
Ever since the Mexican peso devaluation of 1994, I learnt the hard way that cross-border contagion is an existential reality in Latin America. When financial Black Death hits the region, fund managers in Gringolandia do not sell what they want, they sell what they can as cross-asset margin calls cascade. So it did not surprise me to see my favourite Latin American stock market since late 2015, Argentina, get slammed in the Brazilian meltdown. However, any hit in Brazil is a chance for UAE investors to accumulate Argentina, my frontier market fairy tale along with Pakistan. Why?
One, political stability is as valuable as it is ephemeral in the Third World (now politely known as ’emerging markets’!). President Mauricio Macri is a pro–market reformer committed to economic globalisation who ended 12 years of Peronist socialist misrule under President Néstor Kirchner and his wife Cristina Fernández. The Argentine right, haunted by the memories of the ‘sala guerra’, the tragic dirty war under military dictator generals Viola, Videla and Galtieri, has embraced a moderate reformer and a team of ex JP Morgan Chase technocrats in the Casa Rosada. Hola amigos!
Two, Macri has not just talked the talk but walked the walk. He devalued the Argentina peso and abolished currency controls. He settled with Paris Club holdout creditors and guided Argentina’s return to the global capital markets with a wildly successful Eurobond in April 2016, up 12 points after I recommended it in this column as a must own US dollar new issue. Thanks to Macri’s reforms, Argentina has now issued $30 billion in foreign debt, a stellar track record for a nation that once precipitated history’s biggest sovereign default in 2001. Even Eva Perón in the Recoleta would be proud of the Argentina of 2017!
Three, since BP Securities in Buenos Aires is chaired by my old Chase training class ‘hermano’ Alejandro Allende, I have impeccable insights into the Argentina money game. Alex told me on the eve of Macri’s election that Argentine banks could be triple baggers under the new regime. Hence I was able to gift my readers Banco Macro ADR’s in New York, up 200% plus since Macri’s election. As I still tell my dad, if you think Wharton’s expensive, try ignorance! For Gulf investors still skeptical about Argentina, note that the Merval is up 48% in the last twelve months. 2016 was the year to do the Tango Argentino on the Rio Plata!
Four, Pakistan has been upgraded from frontier to emerging markets by Morgan Stanley Capital International (MSCI). Argentina is next. Stay tuned while I scan the smoke signals at MSCI.
Five, Argentina still faces monumental economic issues, a legacy of the failed Peronist decade and the hyperinflationary debt crises of the 1990s. Inflation is an awful 24%. The Peronistas and the hard left, the voice of the gauchos and the descamisados (poor), are still powerful in Congress. Macro’s 3.5% of GDP fiscal deficit target seems unrealistic in 2017. Argentina is Brazil’s largest trading partner and vulnerable to Chinese appetite for soft commodities and meat from the pampas. Yet as George Soros advised, the big money is often made when things go from Godawful to just plain awful.
Greek equities were leprosy for me since 2010, when Athens near defaulted on its sovereign debt. However, after a Great Depression scale economic slump and epic labour/pension/fiscal reforms, bailouts, the IMF, EU and Berlin have led to another emerging market Cinderella. In my youth, the Akti Meoli in Piraeus and the Grande Bretagne in Syntagma Square were my banker hangouts – plus Mykonos. It is time to return to the Hellenic morning of creation in the Greek isles!
This article was originally published in the Khaleej Times.
Image (c) iStockphoto
