(MEMO) Memo - It Can't Be That Simple (Part 2)

On Dec 14, 2023, I published a piece titled, "Memo - It Can't Be That Simple." At the time, I wrote that the Fed interest rate hikes that started in mid-2022 coupled with elevated oil prices caused oil demand to surprise to the downside. More specifically, this is what I said:

The problem with being a specialist from time to time is that you are so into the weeds, you forget you are in the forest. In the case of the oil market, I even wrote on June 10 that the odds of demand surprising to the upside was minimal, and as a result, one should not expect a super tight market. But my bias led me to believe that the Fed was going to be unsuccessful in fending off elevated oil prices. On the other hand, I also knew that the US SPR release was real and those were real supplies. In hindsight, a more aggressive reduction in risk was appropriate given the "dark macro clouds" I saw on the horizon, and that was the simple mistake I made.

In essence, the lesson of don't fight the Fed rings true once again. While I'm not writing this as a mea culpa piece, looking back, it was just that straightforward. If the odds of demand surprising to the upside are nonexistent, it's likely time to step aside.

Fast forwarding to today, the market is pricing in a higher probability for a 0.5% cut than a 0.25% cut. Whether or not it's 0.5% or 0.25% is beside the point, the real conclusion you should arrive at is that the Fed views its effort in fighting off inflation as successful.

What's particularly interesting about the timing of all this is that the oil market is now finally buying into the weak oil demand thesis. While we thought at the start of 2024 that oil demand had the possibility of surprising to the upside, we were completely off on China, and the subsequent downward revision in demand.

With the consensus now firmly believing that oil demand will disappoint in 2025, we think the market has gone too far. If I take a step back and look at the bigger picture, this is the start of the Fed reducing interest rates. The market expects that by the middle of 2025, the Fed Fund's rate will be down close to ~3%. If that's the case, the outlook for oil demand is likely to surprise to the upside barring any unforeseen macro shocks.