July '23

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

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:

  • Fundamentals, according to Rystad (which, for us, are some of the best analysts in the energy world), are about to turn bullish as stocks start being drawn from June onwards as demand outpaces supply by 2.4 million barrels per day on average in 2H, driven by OPEC+ cuts, global aviation recovery, and China’s economic recovery (we wrote about it last month). The last two times the market was this undersupplied, oil moved from $51 to $75/barrel (up 47%) between 2017 and 2018, and from $44 to $69/barrel (up 57%) between 2H20 and 1H21.

  • The pace of interest rate increases will slow down from 1H (potentially even turns negative before the end of the year). Interest rates matter significantly for the physical market as they help determine storage costs (higher interest rates increase storage costs, and thus incentivize de-stocking). In fact, the IEA has shown evidence of destocking as crude and condensate floating storage volumes have declined from 80 million barrels to 65 million barrels in April, the lowest level since early 2020.

  • Speculative positioning within oil markets is now at the lowest since the peak of the pandemic, which probably means that recession fears are very well priced in.

  • Production of a few fringe producers (which we believe might very well be the catalyst to send prices higher given how tight the market is) like Iran and Lybia might undershoot estimates. (1) According to S&P Global, a source at Iraq’s state oil marketer SOMO said that Iraqi oil production “may be affected by a deal to pay for Iranian gas imports by bartering fuel oil and crude from Baghdad.” (2) In Lybia, as much as 330,000-360,000 barrels of oil per day worth of output was shut down in a protest against the abduction of a former finance minister, and whilst most production has resumed operations, it displays instances of how unexpected factors might drive the market in further deficit.

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.

  • Whilst most analysts are looking for an exogenous macro shock to trigger a recession, Cem is also prepared for equity markets to suffer a self-inflicted wound (driven by market structure dynamics) which could then be the catalyst for a deeper macro event.

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:

  • Options volumes have hit record levels.

  • Inflows to structured products have been rising.

  • Passive flows have re-ignited the performance of a small hand full of stocks.

  • Individual stocks have a wide range of volatility, but the S&P500 looks to be calm on the surface (relatively low volatility). The calm surface is hiding a significant amount of internal turbulence.

  • Volatility has not fallen as much as would be expected given the magnitude of the current rally (you can listen to the podcast for an explanation of fixed strike volatility).

  • Some of the single stock upside moves are becoming parabolic (often seen in the final throes of a structural, rather than valuation rally).

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):

  • Delta Neutral positions focus on minimizing the options’ price movements in relation to the underlying asset and instead focus on volatility change. This can be done by simultaneously being long and short a certain option.

  • Being long a call on the S&P500, for example, gives exposure to both the upside in the market and volatility, which often rises into a structural market peak. In order to reduce market exposure, the call is then hedged out with a short position. If the market suddenly implodes, volatility should also rise, and given that the market exposure is hedged, investors should be able to profit from the rise in volatility.

  • Cem does not keep the position consistently neutral. Given the expected upside trend into the peak (which is probably not in place yet), he will allow the call to collect additional delta (or market performance), whilst hopefully seeing its volatility stay bid.

  • If and when the market collapses, volatility will rapidly rise on the long call (adding a profit to the position and offsetting some of the losses from the market going down) – but once that takes place, Cem argues that investors should rapidly add to the short stock position in order to fully hedge market exposure.

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

Stock Replacement (easier strategy):

  • For individual investors, a similar trade is stock replacement. Instead of kicking off with a long call and a short stock position, stock replacement requires the investor to start with a long stock position only.

  • Let’s say an investor owns the S&P via the SPY ETF. They would sell the ETF and bank the cash. That cash should then be used to lock in a decent yield in a secure money market fund.

  • The long stock position previously held is replaced by a long call on the SPY, so that the investor still has exposure to the upside.

  • If the market continues to rally, then investors will still participate in the move.

  • If the market collapses, the investor is still long volatility via the long call. Whilst we should expect the call to lose value as the market falls, the losses are capped at the cost of the call option, but now investors have dry powder (in money market funds) to start re-engaging into the dip.

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

  • U.S. Henry Hub spot prices are almost as low as they have been at any point in the last 25 years.

  • TTF prices (European equivalent to Henry Hub) have risen slightly since the lows of March 2023, but are still nowhere near last summer’s hysteria-driven highs.

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.

  • This seems a little speculative – but there is no denying that U.S. natural gas production is not forecast to keep up with the breakneck pace of previous years in 2024. The EIA projects an annual change of just 0.4 bcf in 2024, compared to 4.7 in 2023 and 4.4 in 2022. U.S. dry natural gas production is also forecast to plateau over the next 18 months. And one does not need a fancy “neutral network” a la G&R to count rigs and see that fewer are at work in the U.S. than last year.

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.

  • As recently as three weeks ago, Erdoğan was busy warning Sweden that recent protests that featured Quran-burning in Sweden would delay its accession to the world’s largest military alliance still further. But in the end, the latest NATO summit was anticlimactic.

  • Turkey’s parliament must still ratify Sweden’s joining NATO, and Hungary must also approve Sweden’s membership, but these are technicalities – the upshot is that NATO has a 32nd member, and Sweden has abandoned neutrality for the first time since the Napoleonic wars of the 19th century.

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.

  • In the last month, Turkey has raised interest rates by 6.5% and directed Turkey’s Central Bank to stop propping up the Turkish lira. The lira has weakened as a result – but Turkey’s net reserves climbed ~$14 billion in June.

  • When not engaged in shuttle diplomacy between the West, Ukraine, and Russia, Erdoğan has been touring the Gulf region and has secured $10 billion of investment from Saudi Arabia, the UAE, and Qatar, with more potentially to come.

  • Erdoğan has even revealed plans to increase taxes on corporations and banks. Gone is the populist campaigner, and in is the CEO entrusting the future of the economy to orthodox figures like Mehmet Şimşek (Minister of Finance) and ​​Hafize Gaye Erkan (Governor of Turkey’s central bank).

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.

  • After all, Naci Ağbal (former governor of the Turkish central bank) also tried to restore normalcy to Turkish monetary policy in November 2020, only to be unceremoniously sacked by March of the following year.

  • Timothy Ash is much less optimistic than we are, but in an excellent post on his Substack about this subject, he notes that “credible sources [indicate] it was not the rate hiking that cost him his job, but the fact that he had threatened an investigation of the $128bn in lost FX reserves used to defend the lira.”

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

  • On June 27th, The WSJ reported that the White House is considering new restrictions on exports of artificial intelligence chips to China. The U.S. is also considering restricting the leasing of cloud services to Chinese artificial intelligence companies, which reportedly helped several U.S. companies avoid previous U.S. export bans on advanced chips.

  • On June 30th, the Dutch government announced new export control measures on advanced semiconductor manufacturing equipment. The Netherlands had already restricted exports of extreme ultraviolet lithography machines (EUV) to China. The new restrictions require Dutch companies to receive Dutch government approval for exports of deep ultraviolet lithography (DUV) systems as of September 1st.

  • On July 3rd, China’s Ministry of Commerce and the General Administration of Customs announced new export controls on gallium and germanium (key semiconductor input materials), as well as associated products.

  • On July 6th, China’s Ministry of Commerce emphasized that the new export controls are not a blanket ban on exports. Chinese exporters must receive approval from the Chinese government to export gallium and germanium products after August 1st. China insists its controls are meant for “legal purposes” and “to safeguard national security and better fulfill international obligations.”

Context – Semiconductor Manufacturing Supply Chain

  • China was responsible for ~98% of gallium production and ~67% of germanium production in 2021.

  • China accounted for 53% of U.S. gallium and germanium imports in 2021, despite the U.S. imposing higher tariffs on them in 2019.

  • Gallium is used in gallium arsenide and gallium nitride wagers for semiconductor wafers, optoelectronic devices, and solar cells. Germanium is critical for use in fiber optics, infrared optics, and solar electric applications; germanium dioxide isa critical element for semiconductor manufacturing. In simple words, both are critical materials for semiconductor manufacturing.

  • If China imposes export bans on gallium and germanium, it will materially impact semiconductor manufacturing and telecom equipment companies around the world.

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.

  • Russia has threatened to cancel the deal numerous times. (It actually did cancel the deal last November, only to reinstate it after grain ships continued along their merry way despite Russia’s threats and after developing countries harshly criticized Moscow for its moves).

  • The importance of the Black Sea corridor has also declined since it was implemented in July 2022. In May of this year, Ukraine shipped more crops by river ports, rail, and road than by major Black Sea ports.

  • Due to Russian prevarications and delays, fewer ships were being cleared daily – in June, less than 2 ships were cleared a day on average (compared to over 10 a day last September).

  • Ukraine says it will continue grain exports, and indeed, the country has already established a $547 million insurance fund to compensate companies with vessels going to Black Sea ports.

  • Ultimately, the real question is if shipping companies will traverse and if insurance companies will insure ships in the Black Sea without the backing of an international agreement.

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:

  • Weather conditions throughout the world have been ridiculously hot – and that is beginning to weigh on projections about wheat conditions, even in Kazakhstan and eastern Russia.

  • Sudan is reeling from a civil war and Ethiopia is attempting to recover from one – demand may come from unexpected sources (i.e. aid organizations or places where we don’t have good data).

  • China has been on a grain buying spree and there are reports of very poor weather conditions there as well.

  • Most concerning is that rice prices in Asia surged to the highest level in more than two years. India is so concerned that it is reportedly considering a plan that would ban 80% of its rice exports.

  • Last year, as our friend Dan Basse of AgResource has noted, the world avoided a global “Arab Spring” type catastrophe because rice saved the day (rice prices stayed low last year, which meant food prices across the board didn’t all shoot up with the other grains). The surge in rice prices could mean more demand for wheat as a result.

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

  • In its July 2023 update, USDA projected 2023/24 global wheat production at 796.7 MMT against global wheat consumption at 795.8 MMT.

  • Just last month, the USDA revised down its season-average farm price by $0.30 per bushel to $7.70 due to “expectations of larger competitor supplies and slightly larger domestic production also support the reduction in the projected price.”

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.