Gold Up Oil Down Fundamentals Win

GOLD UP OIL DOWN – FUNDAMENTALS WIN

Andrew McKillop

WTI BRENT ARBITRAGE IS A RELIC

On February 8 this year Reuters reported that east hemisphere benchmark crude Brent commanded a premium of over $23 a barrel against US benchmark WTI. As of 11 July, with WTI prices soaring past $106 a barrel to reach their highest since March 2012, the premium is down 90% to $2.15 a barrel.

Although it took a while for oil traders to adjust their minds to reality, they did adjust – downwards.

The same gravity-pull of real fundamentals will also apply to the oversized triple-digit dollar prices for both Brent and WTI, but again with time. Another distorted “arb trade”, between physical bullion prices and “paper gold” ETFs with their related instruments is also set to adjust – upwards.

In a real sign of the times for oil’s longstanding “arb” trading and its former highly profitable role for market manipulators, Goldman Sachs said in early July it had closed down its spread trade recommendations after the ICE Brent-Nymex WTI premium fell below its target of $5 a barrel. Goldman tried to save face by claiming the premium would be back above $5, “sometime”.

This may not at all be the case, due to basic fundamentals. The same real world surely and certainly applies to gold. Here, the “arb trade” focuses the clash of physical bullion demand, especially strong in Asia, and the supply of “paper gold” ETFs and related instruments, especially strong in Western and other stock exchanges.

HISTORICAL BASE OF THE BRENT PREMIUM

Oil analysts charting and predicting the now-almost-disappeared Brent premium drew on factors that featured concern about stockpiles of crude at the US Nymex basing point at Cushing, Oklahoma. They also took a look at refinery utilisation and pipeline or rail transport infrastructure issues inside North America, but the WTI-Brent spread mainly reflected big-picture fundamentals, with a major role in determining the directional flow of world crude exports.

Bringing in the Baltic Dry Index for shipping freight rates – the BDI at present weakly recovering from extreme lows through its “annus horribilis” of 2012 – and using the WTI-Brent spread, major Middle-Eastern and African producers decided whether to ship their crude to Asia and Europe, or to the USA.

The EUR premium against the USD, or dollar discount against the euro, also shaped their decision.

Since 2009, accelerating all the time, the shale energy revolution in the US producing ultra light low sulphur crude and condensates, and the very slow recovery of US domestic oil demand, are signaling a future where eastern hemisphere crude producers will no longer have the luxury of choosing their market. They will be market takers and price takers – a revolutionary change! Inside OPEC this clear threat is taken seriously. Some of the hardest hit members like Nigeria producing very light low sulphur crudes, similar to WTI, are seeing their US-destination shipments fall like a stone – by more than 25% so far this year – falling just like the Brent premium.

Brent serves as the benchmark for markets including Europe, Japan, India and China. The long and steep decline in EU27 and Japanese oil demand was more than just compensated, for years, by the ever-growing oil consumption and fast import demand growth of the Asian Locomotive economies – but that has seriously tailed off.

Forward signals are looking increasingly negative for Chinese and Indian import demand recovery. Conversely oil demand recovery potential in the developed countries, we can say, is somewhat less unrealistic in the US than in Europe and Japan. The readout is that any discount for WTI against Brent has even less reason to exist, taking demand trends into account.

GOLD UP, OIL DOWN

For weeks we have gotten used to the “New Abnormal”. Gold pushes down and oil pulls up – but pushing or pulling on either of these two strings has limits.

In recent weeks we saw gold prices slashed and slashed again. Each recovery was only a false dawn, while oil floated high and free, escaping the commodities carnage – standing out like a sore thumb among the commodities. The lifetime for this game, however, is not unlimited – or set by Goldman Sachs – but is set by fundamentals.

Unlike global oil demand, physical gold demand is impressive. Data from Wikileaks and other sources suggest Hong Kong-plus-China buying in Jan 2012-May 2013 printed 1500 tons. Oil demand is conversely a never-ending tale of large stocks, rising output and real world decline in most major markets – countered only by hopeful reports of “recovery coming”, most recently from OPEC, predictably relayed by the IEA, which perhaps not known to some has a “high oil price mandate”.

The potential for a major gold and oil price turnaround is making itself felt. Fundamentals are in no way bearish for gold, but those for oil are even more bearish than they were, for example, in April when WTI prices dipped below $90 a barrel several times. To be sure, when the speculative trading machine runs only in advance mode, finding reverse gear is difficult. Exactly the same is also shown by the big picture of equities, floating high and free from trifling details such as real world economic data, P/Es or the Fed’s taper down threat.

Like equities and oil for the bulls, the gold price rout for the bears reinforced itself with the easy money made from the one-way-down story of bear attack.

For oil, the Speculators have added a premium to oil prices and car fuel costs at the pump, maybe enough to seriously influence consumer habits this summer driving season, but they have also set a discount price window for physical gold. In Asian markets, notably, gold at bargain prices has proven, and is proving attractive – while Chinese and Indian buying of “classic commodities” like iron ore and oil have wilted.

TAILWINDS RISING

Add in China’s now serious and open banking solvency issues, plus its “shadow banking” crisis, and physical gold buying by private citizens is easy to understand.

An emerging currency crisis of emerging market economies is becoming clearer every day, harder to deny each day – providing a likely boost to the dollar. Surely to the discomfort of Ben Bernanke, a stronger dollar will add its own headwinds for the Brent and WTI price in dollars. The anticipation of a stronger US dollar, in Asia, will speed short-term demand for gold.

Overall, headwinds for the oil market are numerous. Themes taken as New Normal for years, including the BRIC-emerging markets commodity supercycle, the supposed unstoppable growth of China’s oil demand, the supposed unstoppable US dependence on oil imports, the always weak US dollar, the disconnect between supply-demand fundamentals and oil prices – are all under attack. New paradigms are replacing these relics.

Current gold price and oil prices are unrealistic, to say the least. WTI in the high-eighties, Brent about the same, and gold closing back to $1500 are the outlook. Only the timetable for adjustment is clouded and while the change can be rapid – like the more than 90% fall of the Brent premium in 5 months – the adjustment to reality may be fought by the Speculators who profit from New Abnormal.