By Ole Hansen
Hedge funds and oil traders in general have had a difficult quarter, particularly given the Opec/non-Opec production cut deal’s failure to boost prices. The outlook for gold, however, is more bullish given geopolitical uncertainties and policy risks.
“We maintain a bullish outlook for gold in the belief that the risk to the US economy is currently skewed to the downside.”
“We are lowering our end-of-year forecast on Brent crude oil to $53/b”
“Global demand for oil will continue to rise well into the next decade”
The second quarter of 2017 proved to be very challenging for oil as technological developments in the US and reduced tensions in Nigeria and Libya helped trigger a strong rise in global production. This helped offset production cuts from other Organization of the Petroleum Exporting Countries members and Russia, thereby further obstructing progress towards a balanced market.
Renewed weakness in June saw the prices of both WTI and Brent crude slump below $50/barrel, wiping out all of the gains seen following last year’s decision by a group of Opec and non-Opec producers to cut production.
While compliance has been high, the impact has so far been limited with producers not slashing exports by the same quantity as they cut output.
During the third quarter, Opec’s ability to maintain exports should be tempered by the need to keep more oil at home to meet increased domestic demand during the peak summer months. In the US, production growth during Q2 fell by more than half compared to Q1, a potential first sign that US producers are not prepared or able to keep up production at any price.
These developments have left Opec with a window of opportunity; if successful, the price of Brent crude oil is likely to rally back towards $55/b during the coming months before renewed weakness sets in as the focus turns to 2018 and the potential risk of additional barrels hitting the market if Opec and Russia fail to extend the production cut deal beyond Q1’18.
On that assumption, we are lowering our end-of-year forecast on Brent crude oil from $58/b in Q2 down to $53/b.
Hedge funds have so far experienced a very difficult year. The November agreement to cut production triggered a surge in speculative demand for oil. This culminated during February when funds ended up holding almost 1 billion barrels of oil in the belief that a floor had been created and that the path of least resistance was higher.
Three consecutive selloffs, coming as the Opec expectations premium deflated, have resulted in potential buyers stepping aside – thereby leaving short-sellers back in control.
This situation will remain until inventory data begin to show solid signs of improving. The hunger for up-to-date information has resulted in the Weekly Petroleum Status Report from the US Energy Information Administration receiving a great deal of attention.
Inadvertently, in fact, the EIA has almost taken on the role of proxy for the global market despite only providing data on the US.
Global demand for oil will continue to rise well into the next decade and with that comes pressure on energy companies to find new oil to replace maturing wells and meet the increased demand. During the next two to three years, this process is unlikely to cause any problems with non-Opec growth next year alone being enough to meet rising demand.
Further out, a stable-to-higher price will be required with the big unknown and potential drag on demand being the speed with which we move away from combustion engines towards electricity and gas.
We maintain a bullish outlook for gold in the belief that the risk to the US economy is currently skewed to the downside. This has the potential of leaving the US Federal Open Market Committee too optimistic on rate hikes, something the bond market is already signalling through a flatter yield curve as longer-dated bonds remain in demand.
Inflation expectations as seen through 10-year breakevens have dropped to a seven-month low and while this may be seen as gold-negative, it also reduces the need for higher rates thereby ensuring that real yields – a key driver for gold – remain subdued.
Investment demand for exchange-traded products has been rising steadily throughout the year. Investors both institutional and retail are looking for diversification and a potential hedge against the perceived mispricing of financial risks as can be seen in the divergence between elevated stocks and low volatility against rising economic policy uncertainty.
Uncertainty about president Trump’s ability to get his growth-friendly policies back on track, together with several geopolitical risks, have also increased the demand for safe-haven assets such as gold.
Hedge funds were strong buyers of gold in early June as the prospect of breaking the downtrend since 2011 grew. The failure to break $1,300/oz and the hawkish comments at the June 14 FOMC meeting, however, left it exposed to another correction which we view as a buying opportunity given our medium-term outlook.
We stick to our end-of-year forecast of $1,325/oz on gold with the risk potentially skewed to the upside in the belief that a break above $1,300/oz is likely to attract renewed interest from momentum and macro funds.
Ole Hansen is the Head of Commodity Strategy at Saxo Bank