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The Aftermath of the Qatar Ultimatum

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The ultimatum that Saudi Arabia and its allies gave to Qatar expired on Monday, and the leaders of the nations participating in the “diplomatic blockade” gathered in Cairo yesterday to discuss the answer by the Gulf state. Investors all over the world were watching carefully, as the event had the outside chance of a significant risk event, with the Irani-Saudi-Turkish power struggle being in the background of the chain of events. The crude oil and natural gas markets are in the forefront of the crisis as well, and the prices of those crucial commodities were closely following the events in the past few weeks.

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Qatar Calls the Bluff?

As Qatar dismissed the demands of the Saudi alliance, the blockading nations faced a situation where they needed to show strength without triggering anything that they didn’t want in the first place. Yesterday they decided to “maintain the sanctions” but did not escalate the crisis for now, despite stating that they would take further steps in the appropriate time, and saying that Qatar’s answer lacked any substance whatsoever.

We would say that Qatar “won” this round by reading the signs well, as the superpowers verbally intervened, trying to calm tensions and avoid a regional conflict that could destabilize the energy complex and the whole Middle East. That might be the reason of this kind of pointless ultimatum that first seemed to be a “casus belli” for more drastic measures.

The Oil Price Tango of Saudi Arabia

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The OPEC’s oil production cut, that was aimed to stabilize the energy segment is still in jeopardy, as Iran is one of the most crucial players in the deal, as the country is still in the ramp-up phase following the lift of the Western sanctions. On an interesting note, it was precisely Saudi-Arabia who launched a price war against the shale industry in 2016, driving crude prices down below $30 per barrel. Now the kingdom got an unexpected help from the global central banks, in the form of rising yields, as the leveraged players in the rising shale industry already started to curb their expansion as credit conditions started tightening.

What Happens Next?

Oil already staged a strong rally in the face of the risk-off shift of the last few days suggesting that investors are removing their worst case scenario bets that would be the collapse of the fragile OPEC deal. That said, we expect oil to remain rangebound in the coming months, as the supply situation is only partly determined by the OPEC, and the slightly shaky shale industry still gives a flexibilty to global production that was impossible in the previous decades. The 4-week production average of the US tells the story, as in the last couple of years the output

The 4-week production average of the US tells the story, as in the last couple of years the output remarkably followed the moves in the price of oil, while before that there was a very low correlation. That fact should cap the price of the crucial commodity and it is unlikely that we see the per barrel price go over $60 anytime soon, barring a full-blown default wave in the sector.

Who Will Rule the Middle East?

The more pressing issue for the world is the question of the precarious balance of the region that could turn upside down if oil and natural gas prices remain “lower for longer”. With the new leadership of Saudi Arabia, the strong but politically divided Turkey, and the recovering Iran all in for dominance, the Qatar crisis might be an important step towards a solution- for better or worse. But for now, the imminent threat of a major conflict seems to be low, and that could cause a sigh of relief across the globe.

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Analysis

Will Crude Oil Reach $68 a Barrel in 2018?

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Crude oil prices are likely to climb close to $68 per barrel mark in 2018. We believe that oil supply will be hit due to a few geopolitical issues if they play out as we expect. Additionally, though high crude prices will be a strong incentive for the shale oil drillers to pump more, their increase is unlikely to tilt the deficit into oversupply.

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Key observations

  1. The OPEC production cut is tilting the crude oil markets to a balance
  2. Rise in the shale oil production is unlikely to equal the increase in demand in 2018
  3. The geopolitical issues can tilt the markets into a deficit
  4. If crude oil breaks out of $55 per barrel, a move to $68 is likely

What are the current market conditions?

OPEC oil production cuts

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The November 2016 production cut by OPEC and its allies is helping the market stabilize. The US crude stockpiles have been decreasing over the past few months, which indicates that the OPEC cuts are having their desired effect, albeit slowly.

The stockpiles in the Organisation for Economic Co-operation and Development (OECD) nations is down to just under 3 billion barrels, which is roughly 171 million barrels above the 5-year average. The OPEC wants to bring the inventory levels below the 5-year average.

Reports suggest that the OPEC and its allies will extend the deal, which is set to expire in March 2018 by another 9-months. However, the oil cartel is unlikely to deepen the cuts. In the September quarter, it had produced 32.9 million barrels per day (bpd), as against 33.4 million bpd production in November 2016, prior to the production cut agreement.

In the fourth quarter of this year, the OPEC production is expected to further decline to 32.7 million bpd.

US shale oil production

The main threat to any recovery in crude oil prices is the ever-increasing production of the US shale oil drillers. US crude oil production, which averaged about 9.2 million bpd in the first quarter of this year has increased to 9.56 million bpd by the third-quarter.

The US Energy Information Administration (EIA) expects the average US crude oil production to increase to 9.9 million bpd in 2018, compared to 9.2 million bpd in 2017. That is an addition of 700,000 bpd of supply.

On the other hand, Investment bank Tudor, Pickering, Holt & Co (TPH) expects US crude oil production to reach 10.2 million barrels in 2018.

So, on an average, crude oil production by the shale oil drillers is expected to increase by 700,000 bpd to 1 million bpd.

Demand increase in 2018

The global economy is growing at a decent pace, which is expected to increase the demand for crude oil. The US EIA expects the global demand to increase by 1.6 million bpd in 2018.

Therefore, with everything else being equal, this will lead to a faster reduction in crude oil inventory and an improvement in sentiment, but not a large increase in price.

So, why do we expect crude oil prices to increase next year?

What are the events that have changed in the recent past that warrant a change in our view?

For the past two years, oil prices have not responded to geopolitical tensions because of the supply glut.

However, next year, when the markets are in a balance, any geopolitical event that can have an effect on the supply side will tilt the market to a deficit, resulting in a rally in oil prices. What are these events?

The Iran sanctions

President Donald Trump has been a critic of the deal between the US and Iran, which led to lifting of sanctions on the Islamic nation. The deal is called the Joint Comprehensive Plan of Action (JCPOA). As a result of this deal, Iran was able to resume its exports, which have skyrocketed from about 1 million bpd in 2013 to about 2.3 million bpd in September 2017.

President Trump decertified the deal on October 13 but has still not quit the deal. He wants the deal to be renegotiated, however, the remaining countries who were party to the deal and Iran are unwilling to do so.

This creates a tension between the US and Iran. Chances are that President Trump will withdraw from the deal sometime next year to fulfill his pre-election promise of ripping the deal apart.

What are the repercussions if the US quits the deal?

Presently, the EU nations are not in favor of scrapping the deal with Iran. If the US unilaterally withdraws from the deal, Iran’s exports are unlikely to have an immediate effect, until the EU decides to support it. After all, EU has been the major consumer of Iranian oil since sanctions were lifted.

However, Iran’s fields are aging. They need fresh investments to keep the oil flowing at the current rate. If the US quits the deal, it is unlikely that major oil companies, that have operations in the US will enter Iran. This can limit the capital flows to the Islamic nation’s oil sector.

As an immediate effect, the US sanctions will “put at risk a few hundred thousand barrels of Iranian exports,” Goldman Sachs wrote in a research note. However, these are only estimates and the real impact will be known only after the US withdraws from the deal. Due to the uncertainty, the markets are likely to boost prices higher, until it gets a clear picture of the effects.

Geopolitical tensions in the gulf can lead to a severe shortage of oil

The northern Iraq region – Kurdistan – is a semi-autonomous region, which recently declared Independence from Iraq. This has led to a conflict between the two. While the Iraqi forces have declared their victory in the important oil-rich region of Kirkuk, the victory is not final because the Kurdish army did not put up a fight initially to defend the oil-rich region.

However, both the Kurdish peshmerga and the Iraqi army have been trained by the US. Therefore, if the conflict is not resolved quickly, through a dialogue, it can turn bloody and lead to disruption of about 600,000 bpd of oil supply.

“Oil prices could spike a lot higher on this development because this time is different, after years of war in the region. The battle, finally, is for the oil, and no other reason. In other words, here we go,” John Kilduff, partner at energy-focused investment manager Again Capital, told CNBC.

Unless a permanent solution is reached, we expect these issues to linger on and again crop up in 2018, propping prices higher.

What does the chart forecast?

The WTI crude has been broadly trading in a range of $42 and $55. Oil has taken support close to the $42 levels four times in the past year and a half. Therefore, this is a strong support level and can be used as a stop loss for our positions.

On the upside, the zone between $50 and $55 has been a strong resistance. Oil has struggled to breakout of this zone. However, if any geopolitical event triggers a breakout above $55, a rally to $68 levels is likely, which is the minimum target objective of a breakout from the range.

How can we benefit, if crude rallies according to our expectations?

The best way to benefit from the rise in crude oil is to trade the oil futures, but due to their volatility, it is not advisable to hold it for the long-term.

The oil-based ETFs can offer an opportunity to take a position in oil. Individual energy stocks are also another means of benefitting from a rally in crude oil.

We shall soon identify the best oil-based ETF and stocks that can offer good returns in 2018.

Risk to our analysis

Our analysis is based on the assumption that the existing geopolitical issues are unlikely to be sorted out within the next year. However, a good dialogue can easily put an end to these, thereby invalidating any risk-premium to crude oil.

Also, consistent high prices above $50 can increase the US shale oil production, much higher than the currently anticipated levels. This will prevent the markets from balancing out.

Due to infighting among its members, the OPEC and its allies can opt out of the production cut deal,  which will boost supply and can lead to a crash in crude oil prices.

Featured image courtesy of Shutterstock. 

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Commodities

A Sweet Trade

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Chocolates, the word itself is enough to elevate the mood because almost everyone loves them. Therefore, along with sweetening the taste buds, we have searched for a trade that is likely to sweeten the portfolio in the medium-term.

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Key points

  1. Cocoa prices are quoting near multi-year lows due to over supply
  2. Demand for cocoa products, however, remains strong
  3. History shows that cocoa production is cyclic in nature
  4. The top two producers are taking steps to support prices and avoid a glut in the future
  5. The risk to reward ratio looks attractive for a long-term trade

Cocoa, the main ingredient in chocolate making is quoting near its yearly low. However, we believe that the bottom is in place and cocoa is likely to rally in the medium-term.

What are the uses of cocoa

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Cocoa is derived from the cocoa bean and has a history of more than 5000 years. Cocoa is mainly used for making chocolates and its derivatives, something that everybody loves.

So, when cocoa is used for making such a popular product, why is its price quoting near yearly lows?

Price of every commodity is determined by the dynamics of demand and supply. In the case of cocoa, let’s see whether people have suddenly started disliking chocolates or are farmers growing cocoa in large quantities, causing a supply glut.

Chocolate consumption and cocoa production details

Source: Statista.com

The retail consumption of chocolate confectionery globally has seen a gradual uptrend from about 6.946 million tons in 2012/2013 to about 7.3 million tons in 2015/2016. The growth is likely to continue and consumption is expected to reach 7.696 million tons by 2018/2019, according to Statista.com. Between 2007 to 2015, the chocolate market had a compound annual growth rate (CAGR) of +2.3%, according to IndexBox.

Who were the major consumers?

In terms of total consumption, US is the clear leader followed by the UK and France. The world’s top two most populated nations, India and China are far behind. This shows that there is enough scope of growth.

But, is there any proof to show that chocolates have attracted new enjoyers other than the traditional consumers?

To understand this, let’s look at the per capita consumption.

Traditionally, Europe has been a large consumer of chocolates. In 2015, Switzerland was the global leader with a per capita consumption of 8.8 kilograms, closely followed by Germany at 8.4 kilograms. However, according to global market intelligence agency Mintel, sales were flat in the US, UK, Germany, and France between 2015 and 2016.

Nevertheless, while the traditional consumers are plateauing, new consumers are warming up to chocolates and its derivatives.

Russia’s cocoa consumption had an annual growth of 18.1% between 2007 and 2015, which has propelled its per capita consumption to 7.3 kilograms, the third highest in the world.

Similarly, the analysts now expect India to provide the next leg of growth. From 2015 to 2016, India’s chocolate confectionery in retail markets grew by 13%. It is not a one-off growth number because between 2011 to 2015, India recorded a CAGR of 19.9% and the growth is only expected to improve to a CAGR of 20.6% between 2016 to 2020, according to Mintel.

So, it is safe to assume that the growth in chocolate sales is likely to continue for the next few years. Now, let’s look at the supply picture.

Who are the major suppliers of cocoa in the world?

While cocoa consumption is a feature around the world, the production is concentrated in West Africa, which produces about 70% of the world’s cocoa. The world leader in production is Côte d’Ivoire, which alone produces about 30% of the total global production.

The next largest producer is Ghana, which accounts for above 20% of the world’s cocoa production. Third is Indonesia, which is comparatively a newcomer to the group. However, its farms are being infested by the ‘pod bearer insect’, which has resulted in poor roots and poor-quality cocoa bean, severely limiting their rise as a cocoa superpower.

Cocoa bean production over the past decade?

Similar to the consumption of chocolates, cocoa production has increased sharply over the past decade. However, the rise has not been constant. 2010/11 and 2013/14 were bumper years, which were followed by a dip in the following two years.

Including the forecast for 2016/17, there have been five years when production increased, while production fell in the other five years. Nevertheless, the percentage of rise during the up years has been greater than the fall during down years, therefore, production has more or less kept up pace with the increased consumption of cocoa-based products.

The cocoa market keeps shifting from surplus to deficit, as seen in the chart above. Therefore, it is safe to assume that the markets will again fall into a deficit, which will be bullish for cocoa prices. Let’s see the supply and consumption pattern for this year.

So, what is the latest demand and supply situation?

In 2016/17, the International Cocoa Organization expects the global production to increase sharply over 2015/2016, contributing to a global surplus of 371,000 tonnes. A bumper crop in West Africa is likely to keep prices depressed in the near term. Ivory Coast’s bean arrival at the ports from the start of the season to August 20, was 12.6% higher than the previous year.

As a result, Rabobank believes cocoa prices are unlikely to rally a lot above $2000 per MT in the short-term, however, they are bullish in the long-term due to increasing demand.

“The further we go in time, the more bullish our forecast gets,” said Carlos Mera, a commodities analyst with the bank, reports confectionerynews.

In September, the ICCO said: “Major chocolate manufacturers have generally reported improved sales volumes and the low international cocoa beans price is anticipated to encourage cocoa processing activities.”

The sales of candy in the US was up 1.4% year over year and the trend was showing signs of improvement, as the latest four weeks sales increased 2.8% year over year, according to IRI/Bloomberg Intelligence, the Morningstar reported on August 25.

Low prices are pinching the major producers

Ivory Coast and Ghana, which account for over 60% of the global supply of cocoa are struggling due to the fall in cocoa prices. Therefore, they plan to build warehouses to stock the beans during bumper crop season and release them in the market, according to the demand, thereby increasing their influence over cocoa pricing.

“Must we continue on this path, flooding the market with beans in abundance and driving down prices to the detriment of our economies and people? We don’t think so,” said Narcisse Sepy Yessoh, chief of staff to Ivory Coast Trade Minister Souleymane Diarrassouba, reports Reuters.

They have sought a loan of $1.2 billion from the African Development Bank for the above activity, which is likely to be approved by the end of this year and the stocking is likely to start in the 2018/2019 season.

This will put a floor beneath cocoa prices in the medium-term.

How does the technical picture look?

The long-term chart of cocoa futures shows a trading range between $1800 to $3400. This is a well-defined range. An attempt to breakout the range failed in 2011, similarly, attempts to breakdown of the range failed between May and July of this year.

The risk to reward ratio to play the range is attractive. We have a well-defined stop loss below the lows of the range, whereas, our target objective is a rally back to the upper end of the range. However, it will be difficult for the readers to hold cocoa futures for the long-term. Therefore, the next best way is to play it through the two available ETNs, NIB and CHOC.

As NIB is more liquid, we prefer to invest in it. Let’s look at its chart.

Unlike cocoa futures, NIB broke below the lows made in end-2011 and formed a new low at $21.17. It has formed a bearish descending triangle pattern, which will complete on a close below the $21.17 levels. Therefore, we shall initiate 50% of our trade when NIB breaks out of the triangle and 50% of the positions on dips. Let’s determine the specific levels from the daily charts.

NIB has fallen below the $22 levels four times since May of this year. The downtrend line has been a major hurdle to cross. On Friday, NIB again returned from the downtrend line. Therefore, if it again falls closer to $22 levels, a long position with 50% allocation can be initiated. The remaining 50% position can be initiated on a breakout of the descending triangle pattern. The positions can be closed if NIB breaks down and closes below 21 for three days in a row. Once NIB breaks out of $27 levels, its next technical target is $33, though its long-term target remains $45.

 

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How have various asset classes performed during previous wars

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North Korea, the dictator ruled nation has been threatening the US and its allies with a possible missile attack, which may also have a nuclear warhead on it. The experts are divided on the actual capability of North Korea to undertake the attacks, however, its leader, Kim Jong-un leaves no opportunity to provoke the US and its allies.

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Key points

  1. Stocks perform better than average when the conflict starts
  2. Gold rallies before the start of the conflict
  3. Bonds have underperformed stocks during previous wars
  4. The US dollar has fallen on few occasions during a conflict
  5. The current war, if it starts, can severely impact electronic goods
  6. The US national debt is likely to balloon if US involves itself in South Korea’s reconstruction after the war ends

Though North Korea’s military prowess is nothing great to write home about, it can still cause extensive damage to millions of civilian lives and the economy of its neighbor South Korea, to some extent Japan and the US territory of Guam. However, in this article, we shall restrict ourselves to the impact of the war on various asset classes and the world economy. We shall use the historical evidence to arrive at our conclusion.

How does the US stock market perform during wars?

The US has fought several wars since 1960 as shown above. While a few ended quickly, others have been a long-drawn affair. Notwithstanding, Barron’s has outlined the effect of the following seven major hostilities on the Dow Jones Industrial Average since early 1980s.

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Serial No War Year
01 The US invasion of Grenada 1983
02 The US invasion of Panama 1989
03 The first Gulf War 1991
04 The US bombing of Kosovo 1999
05 The US War of Afghanistan 2001
06 The second Gulf War 2003
07 The US bombing of Libya 2011

Source: Barron’s

The markets hate uncertainty; a proof of this is the average 0.6% drop in the Dow a month prior to the start of the conflict.

However, once the conflict commenced, the Dow quickly turned direction, rising 4% in the first month. The rally did not stop there. Over the next three months, the Dow rose an average 6.7%, and the gains swelled to 7.2% after six months of the start of the conflict.

Therefore, if history repeats itself, a war between the US and North Korea – if it were to happen – will not start the next bear market.

How does gold perform during wars?

Gold is considered as a safe haven during times of uncertainty. Therefore, the yellow metal has rallied from about $1260/toz to about $1360/toz levels, as tensions escalated between North Korea and the US.

But, will gold continue its rally if the war starts?

Economists at Capital Economics have analyzed gold’s performance since 1985, during military conflicts, acts of terror and political tension.

They established that “over the past forty odd years, the price of gold has on average risen by 4.1% in the six months prior to a conflict turning into a full-blown war. However, it barely moved in the months following the event. This makes sense as gold thrives in periods of elevated uncertainty and the start of an armed conflict partly erases that.”

Performance of long-term bonds during wars

Though bonds are also considered as a safe haven investment, their performance has lagged their historical average during wars, according to a study by the CFA Institute. The possible reasons are an increase in inflation during war times and the second is the higher borrowing by the government to fund the war. Due to these two, bond prices fall. Therefore, selling out of stocks and buying bonds fearing a conflict might not prove to be a good strategy. The only aberration was during the gulf war when bonds beat stocks, albeit marginally.

How does the war affect the US dollar?

The evidence of the past three decades shows that the US dollar weakens during war, according to Kathy Lien, Managing Director of FX Strategy for BK Asset Management. The US dollar fell 5% when the Libyan war started and fell 9% during the first three months of the second gulf war. The dollar was weak even during the first gulf war.

However, this time, the situation is more complex and a lot of currency movements will depend on whether China actively involves itself in the war or remains neutral. The Australian dollar, the New Zealand dollar, and the Japanese Yen will see large moves if China supports North Korea directly during the war, else the movement in the currencies is likely to be comparatively subdued.

“As the tensions grow the dollar will suffer and the actual announcement of war could take USD/JPY to 105 but if it’s a swift victory the pair would also recover quickly,” said Kathy.

Though historical evidence gives us some idea about the possibilities, every new war is different because it involves different nations and affects different asset classes.

What sectors will be affected if a war with North Korea takes place?

Commodities

North Korea, in itself, can’t impact commodity prices. However, it is surrounded by nations that are major consumers of commodities. China is one of the major consumers of commodities, however, it is unlikely that the war will impact China’s consumption materially.

South Korea is a major importer of coal and exporter of steel. Both these commodities will be majorly impacted because South Korea will be severely affected if a war breaks out. Similarly, liquified natural gas prices will be affected, as Japan is its largest importer in the world.

The seaborne trade will also be severely affected because China, South Korea, and Japan receive about one-third of the global seaborne crude supplies. Similarly, 84% of the world’s iron ore and 47% of the metallurgical coal reaches the shores of these three nations through the seaborne route.

The agricultural commodities will also be affected because China is a major importer of rice and soybeans while Japan is of corn.

Economic costs of the war

War has both a direct and an indirect impact on the economy. South Korea is a hub for manufacturing liquid crystal displays, semiconductors, and cars. A war will impact these activities, leading to a shortage across the globe. The alternative suppliers can’t bridge the gap in such a short span of time.  Therefore, prices of various electronic products are likely to rise significantly, which will impact the developed economies, including the US.

“U.S. spending on electronic items, including smart phones, cameras, tablets and computers accounts for roughly 1 percent of the consumer price inflation basket. If a war in Korea caused prices of these items to double, it would add 1 percentage point to U.S. inflation,” a report by the research consultancy Capital Economics warned, reports CNBC.

If inflation rises sharply, the Central Banks will be forced to raise interest rates, jeopardizing the fledgling global economic recovery.

Additionally, if South Korea’s gross domestic product (GDP) falls by about 50% due to war, it will reduce the global GDP by 1 percentage point, according to the report.

Once the war ends, South Korea will need huge capital to rebuild its infrastructure. If the US involves itself and ends up spending the same amount as it did in Iraq and Afghanistan, then the federal debt will reach 105% of GDP, the economists at Capital Economics warned.

Conclusion

Though historical evidence suggests that the equity market returns are better than average during a war, the situation might be different this time because of the nations involved. Any jolt to the weak economic recovery across the globe will dent the confidence of the investors. Therefore, we don’t expect the stock markets to rise substantially during the war.

Gold’s performance is somewhat neutral and it can be used to protect the value of the portfolio. Therefore, selling some overvalued stocks and buying gold might be a good strategy if a war seems imminent.

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