Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Crude oil sees reduced war premium as demand slows
Ole Hansen
Head of Commodity Strategy
Summary: Crude oil futures trade lower for a fourth day as the war premium continues to deflate in response to easing fears of a wider Middle East war. Since Hamas’ October 7 attack on Israel, the market has in vain being trying to assess and price the risk of a potential, and in a worst case, major supply disruption, but so far, this geopolitical price premium has struggle to exceed five dollars. Not least because conditions have started to ease and it highlights the reason why geopolitical premium buyers currently express a low conviction rate.
Weekly COT update: Specs rush back into gold; muted oil market reaction to MidEast crisis
Crude oil futures trade lower for a fourth day as the war premium continues to deflate in response to easing fears of a wider Middle East war. Since Hamas’ October 7 attack on Israel, the market has in vain being trying to assess and price the risk of a potential, and in a worst case, major supply disruption, but so far, this geopolitical price premium has struggle to exceed five dollars. It highlights the difficulty in pricing a not yet realised disruption, knowing that an actual impact on supply, especially from Iran, may send prices sharply higher, while no impact would return the focus to demand which is currently going through a seasonal slowdown.
For now, intense diplomatic efforts to maintain stability across the Middle East seems to be working with talks between the US and Saudi Arabia being the latest move highlighting the intense efforts to avoid an Israeli ground invasion of Gaza. The main risk is still Iran, and its threat to open another front against Israel or attack its partners, not least after the US blamed Iran and its proxies for several drone and rocket attacks on US forces in the region.
We believe that the US appetite for another war, this time against Iran is limited, following failures in both Iraq and not least Afghanistan following the 9/11 attack. It is also worth noting that US dependency on Middle East crude has collapsed during the past decade with China and India taking over as the regions biggest customers. In addition, Middle East refineries are currently the destination for Russian crude that refineries elsewhere will and cannot buy due to sanctions and restrictions, so the interest in avoiding a conflict is broad with Iran the biggest exception.
As mentioned, while the main oil market focus stays on the Middle East, underlying fundamentals have started to ease with demand heading for a seasonal slowdown, potentially made worse by an ongoing economic slowdown. US Treasury yields have surged higher this month culminating last week when the 10-year yield touched 5%, the highest level since 2006, while at the short end the 2-year yield reached 5.25%, the highest since 2000. The surge in yields is pushing up mortgage rates, hurting borrowers while causing painful losses for many investment funds and banks that could, in turn, curb lending into the economy. It is also pushing up borrowing costs across the developed world and sucking money out of emerging markets.
The charts above show how conditions have eased significantly during the past week, and it highlights the reason geopolitical premium buyers currently express a low conviction rate and are quick to exit longs on any signs of price weakness. Refinery margins, especially for gasoline, have fallen as we approach the low demand season, thereby reducing demand for crude as profitability falls. In a few days, prompt WTI and Brent spreads have more than halved, as supply fears ease. In addition, the premium medium-sour Dubai crude commands over light-sweet Brent has fallen to a five-week low at $1 per barrel from a recent peak above $4, another sign that market remains relaxed about the risk of a Middle East disruption.
Later today, the EIA will release its weekly crude and fuel stock report and given the (high) frequency of this report, it normally attracts a great deal of attention from traders looking for fresh data to support their trading decisions. Last night the American Petroleum Institute released their report which, in line with EIA surveys, showed declines in all three, most notable a 4.2 million barrels decline in gasoline stocks.
While the upside potential remains impossible to predict, the only thing we can be certain about is the existence of a floor beneath the market. Having fought so hard to support the price, and in the process giving up revenues, Saudi Arabia and its Middle East neighbors are unlikely to accept much lower prices. This leads us to believe support in WTI and Brent has been established and will be defended ahead of $80 and, barring any disruptions, the upside for now seems equally limited while the bear steepening of the US yield curve continues to raise recession concerns. With that in mind, Brent is likely to settle into a mid-80’s to mid-$90s range, an area we for now would categorize as being a sweet spot, not too cold for producers and not too hot for consumers.
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