Riyadh — iStock.com/HansMusa
How high could the crude oil market go after 5% of global output was taken out by 10 unmanned drones striking at the largest oil processing facility in Saudi Arabia and the second largest oil field? The answer is unknowable. Any price spike will be a consequence of how fast oil production is restored and whether the fingers pointed at Iran will result in military escalation. Iran has denied any involvement in the event.
The oil price was rather weak before this bombing and questions must be raised as to how this military escalation is related to the Saudi Aramco IPO. While geopolitical risks do lower the valuation of the IPO, would the higher price of oil raise the overall value of Aramco at a lower multiple? In other words, who benefits from this strike – the Iranians, the Saudis, or the hardliners that want a war with Iran at any cost?
If one were to look at the PHLX Oil Service Index performance in 2019, one would see that it had taken out all kinds of key levels to the downside and was leading the oil price lower. The oil price had topped out in early May and was seeing declining peaks, which is bearish, but the summer driving season (which ends this month), was keeping it afloat. Does a Saudi Aramco IPO in the seasonally weak September-to-March period make sense? An oil price spike before the IPO would help, one would think.
Personally, I think the weakness in the oil price was one of the main drivers in the mess in the Chinese economy. While some of the weakness can be attributed to the surging U.S. oil production, the other side of the price equation is demand. And China is the largest importer of crude oil in the world.
It is not well understood outside of trading circles that industrial metals are heavily correlated to the price of crude oil, and, as far as I know, there is no shale drilling boom when it comes to industrial metals, where China is also the number one buyer on global markets. Still, they are notably weak.
Implications for Bond Prices if There is a Military Escalation
A military intervention with Iran will mean sharply higher oil prices, even if the global economy is weak. It will also mean sharply higher Treasury bond prices. In September, the 10-year Treasury yield is up from 1.43% to 1.90%. If there is a Chinese trade deal, the 10-year can go to 2.30%, but without a Chinese trade deal and with an Iranian military intervention, the 10-year yield could hit new 52-week lows.
Let me say flat out that I do not believe the U.S. economy is so weak that the 10-year should be under 2%, but with the ECB’s QE in overdrive, no Chinese trade deal, and an Iranian military intervention, interest rates can drop rather dramatically. The reverse will happen if all benign outcomes materialize.
The reason why I don’t think the economy is weak is that the junk bond market is doing rather well, with junk bond prices showing a fresh 52-week high. That would not be happening if the U.S. economy were weak. Junk bond prices are partly about interest rates, but to a larger degree they are about the health of the economy, or the price of credit risk. As far as I am concerned, the price of credit risk is low.
I have had a lot of conversations with clients about the recent inverted yield curve in the U.S. Treasury market. Does it indicate a coming recession? It could, but I do not believe this is a “kosher” inversion.
Let me elaborate. There has never been a time in the history of the United States bond market when there has been anywhere close to $17 trillion of negative-yielding global bonds while a U.S. yield curve has been inverted. It can be argued that because there is so much negative-yielding global debt the U.S. yield curve is inverted, as German bunds, for example, are pulling Treasury yields lower.
In the developed world, the U.S. has the highest interest rates. If all developed interest rates were headed to zero, how could the U.S. manage to have higher interest rates, given the global flows of capital?
I do not believe it is possible.
Equities Contributor: Ivan Martchev
Source: Equities News