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Saxo Bank: Oil will recover, but not yet

Oil&Gas Materials 6 April 2016 12:33 (UTC +04:00)
The first quarter of 2016 provided a level of volatility and uncertainty that most traders and investors would like to forget as soon as possible.
Saxo Bank: Oil will recover, but not yet

By Ole Hansen, Head of Commodity Strategy at Saxo Bank

The first quarter of 2016 provided a level of volatility and uncertainty that most traders and investors would like to forget as soon as possible. During January, oil markets took center stage and as crude continued its month-long descent into the abyss, global stocks and credit markets took fright and ran for cover. As a result of these developments, doves ascended to the heights of the US Federal Reserve almost before the dust from the first rate hike in years had settled. Where oddsmakers once expected four rate hikes this year, the chances of just one have now been put at a mere 54 percent.

These developments have forced many investors to do a 180 on their outlook for the US dollar. Many now increasingly see the greenback's likely trajectory as heading lower and these developments helped support a recovery among emerging market currencies and bonds while also lending a helping hand to commodities.

Since the lows, crude oil has rallied by more than 40 percent but most of the recovery has primarily been driven by short-covering. Despite showing signs of improving, fundamentals are not yet strong enough to support a sustained recovery and this should result in some sideways action during the second quarter.

Out of this market turmoil, then, a golden phoenix rose from the ashes. Investors reconnected with the yellow metal en masse, with total holdings in exchange-traded funds jumping by 300 tonnes. After the initial strong rally into February, gold stabilized and despite a strong finish for stocks and credit markets, it nevertheless managed its best quarterly performance in three decades.

As we enter the second quarter, the continued collapse in global bond yields combined with the increased risk of a fading dollar should provide gold with enough support to withstand any bouts of profit-taking.

The industrial metal industry was cheered by the Chinese Congress in mid-March as it led the market to believe that additional major investment projects would help stabilize demand from the world's largest consumer. But after years of overinvestment in anticipation of a continued rise in global demand, the industry remains stuck with overcapacity. Despite being addressed, this probably needs to be reduced further before industrial metals can embark on a sustained recovery.

Gold the big winner as investors seek alternatives

Having seen its best quarterly performance in three decades, it would make sense for gold to take stock and consolidate during the coming quarter. We see a risk of the downside being tested but do not expect the key band of support between $1,165/oz and $1,195/oz to be broken.

The main reason why this time is different than previous recovery attempts - apart from fading dollar strength - is the rising number of government and corporate bonds yielding less than 0 percent.

This development, which has been supported by the introduction of negative central bank rates, will not go away any time soon. It forces money managers, large and small, to look at alternative investments, one of which is gold.

After hitting a 12-year low back in January, crude oil managed to recover strongly on a combination of verbal intervention from squeezed oil producers and emerging signs that US production had resumed its downtrend. Global inventories remain at historical highs and in the US, a similar stockpile was last seen during the depression some 80 years ago. Oversupplied markets remain a challenge to investors looking to get long and benefit from the expected recovery over the coming years.

The contango spread or discount between the near-month and subsequent futures have, during this past three months, been most elevated in WTI crude. As an investor in either futures or exchange-traded products, contango erodes the return on your investment. As a result of the difference in contango, WTI crude has been underperforming Brent by around 11 percent so far this year.

Apart from the weaker dollar, the market has also been buoyed by expectations that major oil producers in and outside of OPEC would agree to freeze production at a meeting in Doha on April 17. Comments from Saudi Prince Mohammed bin Salman on Friday, however, soured the sentiment. In an interview, he reiterated Saudi Arabia's stance that it would only agree to a production freeze if all participants - including Iran - joined in.

The insistence on Iran's inclusion means a deal could be hanging in the balance and the risk of the meeting being cancelled has risen. Having begun to price in a recovery, investors may once again find that they have jumped the gun to early. This is of particular note given the news from Libya that three export harbors may soon re-open, thereby potentially adding to OPEC's accumulative production (which rose in March).

Crude oil will eventually have to move higher - and it will - but the path to recovery continues to be a bumpy one. As the second quarter kicks off, we conclude that a low in the oil price has been found but that recovery may still be months away.

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