Thinking Out Loud - What Am I Seeing This Year?
Note: This article was first published to subscribers on Jan 24, 2023.
Please read last year's thinking out loud piece published on March 7, 2022.
With all things related to the act of predicting, there's a very high likelihood I will be wrong. But these write-ups are meant to help readers understand how I am viewing the market this year. Similar to the write-up we wrote last year in March, these thinking out loud pieces can also serve as good tools to go back and see where we got things right and where we got things wrong.
I think in order for me to explain what I am seeing, we have to first understand the environment we are in today.
Global recession fears remain.
Fed continues to tighten with more hikes on the horizon.
Inflation estimates are starting to drop.
OPEC+ reduced production in its October 2022 meeting and won't be changing its policy until June at the earliest.
Russian crude exports have not fallen yet.
China has abandoned its zero COVID policy. Reopening is in full force along with stimulus to the economy coming.
US shale oil production has grown and exiting 2022 at around ~12.4 million b/d, but the pace of growth is expected to materially slow by H2 2023.
Non-OPEC ex-US supplies are facing material headwinds as long-cycle capex projects fall off.
Energy was the best-performing sector in 2022 with the tech sector being the worst.
With all of that being said, there are two important themes we need to get right this year:
China's rebound in oil demand.
Fed policy, or more importantly, the market's perception of the Fed's policy.
Why are these two themes the most important?
Because in many ways, demand is the ultimate swing variable this year, once again, for the oil market. Similar to 2022 when we said that demand was the key variant perception, this year is no different, but this time, the variable is in one country's hands.
By our estimate, a successful China reopening could imply a swing of ~2 million b/d for the oil market balance. The swing is rather steep and will have important consequences for 1) global inflation expectations and 2) what the Fed will have to do in response.
By now, most analysts are expecting inflation to drop severely in the coming months. In addition, it's important to remember that by March 2022, oil prices had already eclipsed $100/bbl, and by June 2022, consumers were facing $120 crude + $60/bbl refining margin.
So if we assume the status quo today, there is a rather big drop in just the energy part of the equation, not to mention other aspects of the inflation equation (such as rent and wages, for example).
This means that over the coming months, the market will be fueled by the speculation that the Fed will have to stop its rate hikes soon. This coupled with inflation reports coming in softer and softer month after month will further add fuel to that fire. A more dovish Fed will be perceived bullishly by the market, especially after the brutal beating it took in 2022. Many of the overly sold tech names are in the process of staging a rebound and we are seeing that. One caveat that people forget when comparing 2000 to 2022 is that the US economy was in a real recession by the end of 2000. This actually prompted the Fed to cut interest rates. This has not occurred this time around, which leads me to believe the two timelines won't match.
As a result, I see tech stocks performing well in the first half of the year. Many of the oversold names will rebound prompting more investors to want to pile back in. This FOMO effect will have disastrous implications later this year when inflation surges back (more on this later).
But this is why this year boils down to two themes. As the first half of the year gravitates toward the idea that inflation is cooling down, the oil market has something else in store. If China's reopening is real and the demand response is real, then what will happen is the global product market will further tighten. Couple that with SPR ending and what we end up with is a tight product market that leads to a higher crude market. Prices will start to surge post the Q1 slowdown.
And looking at global refining margins today, it tells me that the eventual demand response is real, and refineries are being "rewarded" if they can produce more today.
So just as the market gets comfortable with the idea that the Fed will pause and inflation is dying down, the product market tightness resulting from the Chinese demand rebound will send crude back above $100/bbl. This will prompt the market to start worrying about the rebound in inflation, which implies that the Fed can't just stop hiking rates.
Now one variable we don't know about through this process is how much will China use its commercial crude storage to fend off rising prices. In addition, there's also the unknown variable of if Iranian sanctions will be lifted in the event of a crude rally.
If we assume that China starts to use its SPR as oil prices eclipse $100/bbl, then for much of Q3, we can expect prices to be rangebound. China is the largest crude importer in the world, so when it sneezes, the oil market catches a cold. But there will be a limit to how much China will use its SPR. We saw that in 2021 when it only used it for one quarter before stopping. This prompted prices to surge in Q4. We think a similar playbook is likely to occur this time.
Now as we think this through, if what we are saying comes to fruition (tight product leading to higher crude), then the broader market and tech will start to materially underperform in the 2nd half of the year. The issue this time around is that we know high oil prices will destroy demand, and we saw that in 2022 when gasoline demand started to surprise to the downside.
And since we don't have a global coordinated SPR event this time to fend off such an event, the increase in oil this time around will likely send the global economy into a recession. Again, because the price spike will come from a higher-than-expected demand response, a demand decrease will have crippling effects on oil prices as well.
At this point in the cycle, we are not disillusioned by the fact that oil prices have to linearly increase over the coming years. It is perfectly normal to have dramatic swings from peak to trough and given the way the oil market is lined up (structural supply deficit), we think the price spike will be so severe and real that demand destruction is almost inevitable.
There is, however, one scenario that could prevent us from entering a major price spike before year-end. OPEC+ would have to completely change its production policy in June. Saudi would have to use its available spare capacity in Q4, but given the timing and delay resulting from the Q1 2023 build, we think this is a low-likelihood event. As a result, we wouldn't put much weight on OPEC+ increasing production in H2 2023.
With all that said, the oil price spike in Q4 2023 will ripple into 2024. We won't know how demand responds exactly and we won't know how high the market pushes oil up, so these will require us to make real-time adjustments. But at this moment in time, this looks like the path we are headed towards assuming China's demand rebound is real.
Conclusion
Dropping inflation estimates and a potentially dovish Fed should help the market and tech sector perform well in H1 2023. The Q1 2023 build-in oil market balance will result in product outperforming crude followed by crude outperformance starting in Q2 2023. If China's oil demand rebound is real, then the product tightness will send crude above $100/bbl by sometime in late Q2 2023. As oil prices surge, the perception on inflation will change yet again, and the market's perception of the Fed policy response will change. This will serve as a major headwind on the broader market and the tech sector.
As oil rallies and other sectors underperform, energy stocks should once again outperform. In Q3, if oil does rally to the extent of our expectation, then China will likely use its SPR to keep prices in check, but this will only last so long. And the moment China stops using its SPR, crude prices will surge once again. This will result in market participants expecting an imminent global recession on the horizon.
This is how I am currently thinking about the market this year, and like all things in life, we don't know what we don't know. So you can fully expect us to change our analysis along the way.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.