July '23

Oil in 2H23, Market Structure, Natural Gas, Turkey, China's Export Controls, Black Sea Grain Deal.

July '23

Oil in 2H23: Fundamentals Will Matter

So what: The oil market will move into deficit in 2H, and the last two times the supply and demand imbalance was this significant, oil prices rallied by 50%.

Breaking the Range?

Earlier in April, we argued that oil prices would continue to trade rangebound for 3-6 months as China’s reopening was mixed and supply and demand dynamics were not favorable until the second half. Fast forward to mid-July, and some strong tailwinds are building for oil in the short term:

Keep an eye on the range.

Self-Inflicted Wound for Equity Markets?

So What: We look at two different strategies that help retail and professional investors hedge both macro and market structure risk without necessarily needing to perfectly time the top of the market.

In a recent Lykeion ‘Ides of Macro’ podcast, Cem Karsan of Kai Volatility Advisors outlined a scenario in which today’s market structure could pose the biggest threat to risk assets.

Cem argues that market structure (i.e. how we invest and the instruments we use for that purpose) is now more influential on the performance of markets than the interplay between valuation and macro factors.

There have been many instances over the last 25 years where market structure has played an active role in the events that have unfolded (either as a trigger or as an enhancer) – the Asia Crisis and LTCM collapse in 1997-1998 (structured product liquidation event), the Chinese Yuan devaluation in 2015-16 (investors were extremely short volatility), and Volmaggedon in 2017-2018 (the rise in volatility eventually triggered a liquidation event in some short volatility products like the XIV ETF that had become increasingly crowded over the previous few months).

We’re now seeing a significant number of red flags that reminds us of past events:

Does the market need an exogenous shock, driven by macro factors, or can the distortion in structure lead to its own demise?

Given that the answer right now is “we don’t know”, there are two ways, according to Cem, to position for these risks without spending too much on protection or going underweight the market whilst it continues to move higher.

Delta Neutral Calls (for professionals):

As you can see, it’s an investment style that needs constant monitoring. There’s another solution though.

Stock Replacement (easier strategy):

The key point here is that we have no idea whether a macro event or market structure itself will topple the market. At the beginning of the year, we argued that 2023 was a very difficult macro environment to call - it remains so today, but investors should think about initiating protection when they can, rather than when they need to.

Natural Gas Looks Cheap

So what: There is a significant upside in natural gas prices for the rest of the year.

Natural Gas Prices are at Historically Low Levels

This is despite the fact that according to the IEA, global natural gas markets are relatively tight. Just because the European Union was able to find alternatives to Russian natural gas does not mean the situation is resolved.

After all, EU member states are still sourcing ~17% of natural gas imports from Russia via pipeline. And despite increases in global LNG supply, they are comfortably exceeded by the reduction of Russian pipeline flows to Europe (those flows cannot be rerouted to China with the current pipeline infrastructure available).

Both the IEA and the EIA are projecting small increases in natural gas prices through the end of the year. Note that Asian spot LNG and TTF prices are expected to remain significantly above their historic averages and more than double the price of Henry Hub prices for the remainder of the year.

A heatwave in the Southern part of the United States notwithstanding, thus far summer temperatures in the U.S. have been relatively mild. It is of course possible that weather continues to be favorable from a natural gas supply perspective – but the world is coming off a historically warm winter in Europe and now the U.S. summer has so far been mild in many parts of the country.

Even without an adverse weather event, the EIA expects natural gas prices to rise this summer on high electricity demand. The U.S. also continues to eschew coal in favor of natural gas, a reflection of ample natural gas supplies as well as top-down U.S. government policies seeking to reduce U.S. dependence on coal.

There are two other significant developments that could cause a significant spike in U.S. natural gas prices in particular.

The first is that U.S. natural gas production might be peaking. Perma-bulls Goehring and Rozencwajg have pointed out that U.S. natural gas production growth has come from three primary basins over the past five years – Marcellus, Haynesville, and the Permian. G&R believe all three are at or close to their peak production, with signs of depletion at “Mighty Marcellus” and the Permian already evident.

The second development is U.S. export capacity is set to increase by roughly 6 bcf annually over the next 18 months (for frame of reference, that’s equivalent to about 40% of current U.S. exports). New LNG export facilities at Plaquemines (my neck of the woods!), Corpus Christi Stage III, and Golden Pass will mean that U.S. natural gas exporters will have even more opportunity to sell LNG on the spot market to Asian and European buyers, who will pay far higher prices than the U.S. consumer.

The convergence of global natural gas prices could mean slightly lower prices in Asia and Europe – but would also mean higher prices for the U.S. consumer.

Last summer’s hysteria and the subsequent lack of a crisis allowed both the U.S. and Europe to replenish natural gas storage levels… but producers are already responding to lower prices, and this will constrain supply. Russian gas has limited markets willing to accept it. Initial signs of depletion in the U.S. are concerning even as the U.S. gears up to significantly expand its export capacity, despite forecasts of increasing natural gas demand in the U.S. There is a glut of LNG projects coming online in 2025 and 2026… but in the meantime, natural gas remains in high demand, so high that the notion it will stay close to a 25-year low strains credulity.

Turkey's About Face on Sweden

So what: Turkey agreed to withdraw its objections to Sweden’s joining NATO (a symbolic move towards the West) and is taking the necessary economic steps to tame inflation. Our bull thesis continues to build in the right direction.

Symbolic Move Towards the West

In our May 2023 edition, we claimed that “even a semblance of normalcy in Turkish markets could represent the most promising emerging market opportunity of this decade.”

After months of stalling tactics and melodrama, Turkish President Recep Tayyip Erdoğan agreed to withdraw Turkey’s objections to Sweden’s joining NATO.

Turkey positions itself as a pragmatic actor, capable of having relations with both the West and Russia. Despite Erdoğan hosting Ukrainian President Vladimir Zelensky for talks in Istanbul just recently, Erdoğan and Putin are still planning a one-on-one meeting in August (dates “have not been defined yet”). Russia is against Sweden’s accession to NATO, but Putin’s spokesman Dmitry Peskov noted recently that Russia understood Turkey had to fulfill its NATO obligations and that Moscow wanted to “continue to build mutually beneficial relations with Ankara despite all disagreements.” (If only Russia were always so agreeable and understanding about neighboring countries making decisions with which it disagrees!)

Economic Progress

Arguably more interesting however are the steps Erdoğan has taken to right the ship of the Turkish economy.

EU membership is likely not in the cards for Turkey – too much water under that bridge – but concessions on visas and a customs union upgrade could be a boon for Turkish companies that might have been concerned about Erdoğan’s presidency, either due to his need to tighten policy or risking ties with Western markets.

It is impossible to quantify how Erdoğan’s about face helps strengthen the value of the lira – but both his symbolic moves toward the West and the concessions he has wrung out will have more positive impact than all the desperate central bank interventions in the world.

The question now is whether Erdoğan will stay the course.

All in all, the case in favor of adding exposure to Turkey continues to gain momentum. Our starting pitch can be found in our May publication.

China’s Export Controls: A Lose-Lose

So what: The trade war between the U.S. and its allies versus China is escalating once again, with bans being announced or threatened in the semiconductor supply chain. Whilst everyone is set to lose (and tech companies are set to see input prices rise), China has the least amount of leverage in the long term (rare-earth metals aren’t that rare).

Trade War Slowly Escalates

Context – Semiconductor Manufacturing Supply Chain

This sounds scary – but though China has real leverage, that leverage is ephemeral. The problem for China is that gallium and germanium, despite being dubbed rare-earth metals, are not rare in and of themselves. China has achieved a dominant position in global supply chains due to its ability and willingness to mine and refine these metals cheaply, often at significant environmental costs. The U.S. has substantial germanium reserves (germanium is produced as a byproduct of zinc) and though gallium occurs in small concentrations, it is often a byproduct of processing bauxite, the raw material that is refined into aluminum.

Also, the West can, with money and time, replicate China’s mineral dominance. The same is not true of advanced GPUs, cloud services, and DUV/EUV lithography equipment – for which China is extremely dependent on Western imports. China cannot readily mine GPUs from the Democratic Republic of Congo; it cannot source DUV/EUV equipment from Myanmar. Everybody loses in de-globalization – but China loses most of all.

Key takeaway: China is only likely to ban exports if it does not secure concessions from the U.S. and its allies on DUV equipment and other critical stacks of semiconductor supply chains for which China is still dependent on foreign sources.

The End of the Black Sea Grain Deal

So what: The grain deal was already defunct, and Black Sea disruption was already priced into markets. What’s not priced in is bad weather and rising demand. Add in a little Black Sea disruption to that picture and suddenly wheat prices look like they could go higher.

Grain Deal

After months of threats, Russia canceled the so-called “Istanbul Accords,” which established a maritime humanitarian corridor in the Black Sea to ship grain from Ukraine to global markets. After a quick ~4% spike in wheat futures, wheat closed the day below where it started. “Mr. Market” is unimpressed with Russia’s decision.

But as the market seems to have already priced in the Black Sea developments, what it has not priced in is the incremental demand the market could see in the coming months. Some key ideas to keep front and center:

It’s still early days, and the latest data from the normally reliable USDA does not back up this thesis so far.

But investors are meant to look at the future, not the present, and the USDA might be underestimating what the combination of weather concerns, disruptions in the Black Sea, and incremental demand could have on a fairly tight supply-demand balance. If investors wait for the imbalance to show up in USDA reports before they put on the trade, it might be already too late.


Published in: Research

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