Eurozone and German inflation has surprised to the upside recently against the backdrop of oil (and those euro parity forecasts) defying the consensus. We’ve seen some brutal portfolio repositioning, particularly in German bunds – the sudden burst of volatility reflects an upward shift in implied inflation expectations in recent weeks and some very crowded positioning unwinding. After the Wall Street analyst herd panicked back in February with forecasts as low as $20-30 a barrel, we suggested taking advantage of consensus bearishness to opportunistically add credit and equity E&P weightings ahead of a rally in prices and a likely M&A boom. In fact, we thought that global energy, alongside Japanese and Eurozone equities and the MSCI China, ranked among the best risk adjusted return profiles for 2015 back in December.
Oil majors having failed to book significant new reserves had been slashing capex since 2013 and have little choice but to acquire them – the Shell/BG deal will be the first of many. It looks like demand was up about 1.7m bpd y/y in Q1 versus consensus estimates of less than 1m bpd and the market is beginning to tighten even before US output growth now inevitably slows in coming months. Global output is still outrunning demand by about 1.5m bpd and record US inventories are still growing, albeit at a slowing pace.
The rally is capped by the ability of the US shale sector as the new global ‘swing producer’ to access funding at prices much above about $70/bl (at which level it would be profitable on a marginal cost basis but net cash negative and reliant on external funding) on WTI and restore output growth. We’re certainly not going to re-test last year’s highs for the foreseeable future and huge volumes stored to take advantage of what was in Q1 a very lucrative contango price curve is an overhang, but nonetheless, the end of oil’s freefall phase will change market perceptions far beyond the (outperforming) energy sector.
A resurgence in US auto mileage and recent monetary easing across emerging economies (not least China, where energy intensive fixed investment is likely bottoming near term led by Tier-1 housing) supports ongoing demand upside in coming months as US output growth slows. We expected Brent oil to reach a $70-80 trading range by year end, and the only surprise is the speed of the rally – if sustained through this summer, it has significant asset allocation implications. Our non-consensus call in December was for the US 10-year yield to breach 2% in Q1 and 3% by Q4 (and the S&P 500 to consistently underperform the MSCI World ex US). We could see a sustained period of bond market volatility through the rest of this year, as the CPI impact of last year’s oil crash begins to drop out, as well as a shift in emerging market FX risk profiles undermining the until now highly profitable short EM commodity exporter/long importer strategy.
The broad CRB index bears watching, because the rally in oil is being joined by other industrial commodities such as copper (which has seen its longest rally in a decade) and industrial input costs and producer price inflation (or rather deflation in many major economies) are now likely bottoming…