HEAD OF RESEARCH REVIEW
ICE Brent briefly moved above $80/bbl in early October as Iran, for a second time since April, took aim at Israel, launching some 200 ballistic missiles, exposing holes in Israel’s Iron Dome defence system. Israel initially pressed its advantage in southern Lebanon against Hezbollah and, through a chance encounter in Gaza, killed Hamas leader Yahya Sinwar, the architect of the 7 October 2023 terrorist attacks. In the early morning hours of Saturday, 26 October, Israel chose to strike back. The much-awaited retaliation was underwhelming, given initial vows of “lethal” and “surprising” retaliation. Israel stayed clear of oil infrastructure, nuclear, or leadership objectives. The US could not have hoped for a better outcome. The market could breathe a sigh of relief; the known unknown that was Israel’s eventual response was resolved, and Iran does not look, at the time of writing, like it wants to up the ante, albeit its recent rhetoric is on the more bellicose side. This morning, Brent was trading just under $75/bbl and is back to facing poor supply/demand fundamentals. Without a strong geopolitical premium to prop up the flat price, there is a good chance for oil to test a move into the high 60s eventually on negative economic data surprises.
What matters is the perceived risk to oil production and transit; once again, this has faded. This does not mean the market is now ignoring risk altogether, as evidenced in the options market. However, the perception of the risk has changed, perhaps thanks also to recent diplomatic activity between Iran and Saudi Arabia. The narrative has reverted to poor macroeconomic realities and implications for oil demand in the face of matching non-OPEC supply growth and a potential return of OPEC+ barrels. The narrative has also increasingly become concerned with the outcome of the US presidential election due on 5 November. The shift occurs against a background of money managers who are still hesitant to deploy any measurable length in oil.
On the economic front, unsurprisingly, China took centre stage. The latest figures showed the country’s Q3 GDP y/y growth at 4.6%, which would require a strong rebound in activity in Q4 to achieve 5% growth overall in 2024. Clinching that target, in our view, will be very difficult. Thus, the country’s oil demand growth in 2024 will likely end up closer to the International Energy Agency’s (IEA) conservative forecast of sub 200 kb/d than the OPEC Secretariat’s enthusiastic estimate of nearly 600 kb/d. After a barrage of monetary policy easing by the PBOC, more likely to help China’s financial sphere than its real economy, the market eagerly awaited the announcement of fiscal measures against a deflationary background. The market was disappointed: guidance from China’s Ministry of Finance on 12 October focused on plans to alleviate debt constraints for local governments and issue special CGBs to replenish core tier-1 capital of major state banks. The size of these programs was not disclosed at the time of writing.
However, specific support for consumption, in addition to existing vouchers or trade-in subsidies, was conspicuously missing. To gain more clarity, we would need to wait for the outcome of the National People’s Congress Standing Committee. New forecasts from the IMF revising its 2024 growth for China to 4.8% from a previous estimate of 5% (while keeping a forecast at 4.5% for 2025) alongside warnings from Managing Director Kristalina Georgieva of China’s growth potentially decelerating “way below 4%” if “it does not move” toward economic reform did not help lift sentiment. Economic weakness in China was accompanied by more disappointment in Eurozone PMI readings. The Eurozone’s flash October composite index stabilised but was in contractionary territory. Germany’s reading ticked higher but is still contracting, while France’s data exceeded expectations. But it is towards the US that the market is focusing its attention. Better-than-expected data and US ‘economic exceptionalism’ of late suggest the Fed will be in no rush to cut rates and is most likely to look past the weakness in the ISM manufacturing and payroll numbers for October due to exceptional factors, including hurricanes and a strike at Boeing. A slow easing cycle, or even the Fed entertaining ideas of a pause, would moderate risk appetite at the very least.
Given the above, global oil demand cannot be expected to produce any upside surprise for Q4 nor Q1 next year, leaving the question of the return of OPEC+ barrels in plain sight as non-OPEC supply growth is expected to match demand growth. OPEC+ decided to delay a potential return of its barrels to the end of December. Market conditions won out. While the IEA’s global balances show implied stock builds for Q4 and each quarter in 2025 if OPEC+ cuts are kept in place, this does not preclude OPEC+ from eventually tapering voluntary output cuts, using the pretext of low OECD crude stocks, which are at the lower end of their recent five-year range. OPEC might hope that any ensuing oil supply surplus may weaken the forward curve’s shape but spare flat price from falling precariously.
Geopolitics is not all about the Middle East or the war in Ukraine, where North Korean soldiers have popped up to lend a hand to Russia. The US presidential race and its potential fallouts are front and centre of the agenda. While polling data give the lead to VP Kamala Harris, the betting markets favour former president Donald Trump. With Mr Trump gaining an edge, according to the bookies, the financial markets seem to have adopted the story that his presidency will lead to much higher debt issuance than that of Ms Harris (at least according to the Committee for a Responsible Federal Budget) and consequently will prove more inflationary if implemented. Pundits point to record gold and silver prices and higher bond yields as testimony to this prognostication alongside the selling of prominent family offices’ US bond holdings.
Portfolio hedging relative to this event risk and the flow it generates is one reason behind the recent increase in yields. If market-based measures of US inflation expectations like the 5-year breakeven, 5-year inflation swaps have steadily risen since the beginning of September, they did not noticeably jump higher in October in unison with betting markets handing the victory to Mr Trump. Instead, rates of TIPs (a proxy for the real rate) have improved with better US economic data, driving the nominal yields higher.
If inflation expectations do move higher with a Trump win, then perhaps oil is likely to be used, like gold, as a hedge. However, the implications of a second Trump presidency for oil are not so straightforward, notwithstanding the above. Deregulation in the oil sector can help boost production and exports, albeit the days of ‘drill baby drill’ in the US shale patch are likely behind us. On the other hand, foreign policy can be a double-edged sword. Countries like Venezuela and Iran may come under more coercive measures and sanction implementation despite their efforts to cosy up to BRICS countries. The course of the war in Ukraine may change if Mr Trump can broker a deal with Russia, changing the global energy outlook. And what of the Middle East? Mr Trump’s relations with Saudi Arabia and Israel are very different from those of the Biden-Harris administration. Foreign policy also extends to economic choices and the escalation of tit-for-tat tariff measures, impacting economic growth globally. The oil market faces great uncertainty. Pragmatism would suggest that investors wait to see where the chips fall before plotting their course of action, thus likely keeping positioning relatively neutral while waiting for concrete policy announcements by the victor.
