Oil, Sticker Shock, and Upward Pressure on Yields

  • A perfect three-pronged storm is brewing:  oil, the labor market, and fiscal policy in the US will soon propel inflation notably higher than appreciated by overly complacent economists and analysts stuck in a delusion of “low-flation” recency bias.
  • Just this past Friday afternoon–Friday afternoons being the most notorious time to quietly dump toxic news sludge into the market–Saudi Arabia went back on months of false promises and said they would explicitly attempt to push crude oil to “at least” $80 USD per barrel this year. Saudi officials had previously provided (in our opinion disingenuous) language signaling that it is the so-called “market’s” role to dictate oil prices and they were simply there to lend a friendly helping hand in “rebalancing excess supply.” One could be excused for believing that was all a bunch of fuzzy non-sense to distract others from the fact that the famous oil cartel was doubling down on its remaining clout to manipulate market prices higher through coordinated supply fixing amongst major producers. Fact: this type of market manipulation is most commonly met with extraordinary penalties or even prison sentences in most other industries.
  • Thus, in order to not set off alarms in the sphere of public opinion immediately after announcing the supply cut deal, which happened to be announced in my presence as an Analyst at the OPEC Secretariat in Vienna in late 2016, Saudi Oil Minister Al-Falih and company played it cool. They did not mention an effort to manipulate prices. They did not even mention specific energy prices at all. The cartel kept communications at a wonky, technocratic, almost sleepy level with a host of production metric numbers and calm, altruistic sounding statements almost as if they were courageously doing the rest of the world a favor instead of protecting their own government finances.
  • If you follow the OPEC statements over a number of months, officials very gracefully glided towards clearer and firmer statements of explicit price manipulation. Instead of dancing around the topic, let’s introduce perhaps a rhetorical price range of where the market might decide on its own should reflect the supply cuts. No outright political scorn on the world stage? Great. Next, introduce an even higher target range. Then, an outright explicit target paired with an observably higher number of “at least” $80 USD per barrel. Now we’re talking. Turn the black gold ATM machines back on like the good old days before 2014, at least from their perspective.
  • But how about the US shale production story of ratcheting up drilling to “fill the OPEC supply gap?” The big US oilers are stuck in a 2014-2016 risk-averse mindset of minimizing new cash outlays and are only investing in capex at a roughly 7% annual growth rate. That’s not going to cut it in terms of pioneering new oil field discoveries 2-3 years down the road. Especially as OPEC/non-OPEC group compliance surges to over 160% of the cuts promised, Venezuela’s state of desperation all but chokes off supply there, and Russia sees higher oil as a welcomed hedge against emerging market capital outflows and sanctions. Not to mention the potential plug-pulling of the Iran nuclear deal by Mr. Trump and related follow-up sanctions, which are not even included yet in our assumptions. Since demand is still rising steadily and there are several drivers limiting supply, oil is moving higher. Perhaps much higher if USD doesn’t strengthen too quickly from the EM capital outflows we currently anticipate near term.
  • Headline Unemployment has fallen below a 4 handle in the United States. Countless hiring manager surveys are signaling difficulties obtaining new talent and even retaining existing talent. That means pay up to maintain a competitive labor force or lose out to competitors filling orders you can’t. 3.9% smells inflationary to us. Imagine 3.5%. The Phillips Curve isn’t dead just yet.
  • Finally, it goes without saying fiscal policy in the US is akin to throwing gas on a forest fire. Tax cuts, some regulatory slimming, massive deficit spending, all occurring deep into a 9-year expansion at full employment.
  • How about tariffs? Depending on the breadth and deepness of actual implementation, they should have an appreciable inflationary impact unless they are so extensive that they kill the entire global economy. We don’t see that as likely at this time but are monitoring the situation like everybody else. The tariff negotiation stand-offs will probably lead to the type of price hikes which don’t immediately crush economic growth but will still fan the flames at a highly inconvenient time.

Bottom line: Prices are headed higher–probably much higher–than currently anticipated by global market participants. We are highly confident this will be met with downplaying and denial for the most part by policymakers, leaving ample opportunity for investors to front run delayed market reactions.

Gold is not yet a clear buy as one might suspect with higher inflation. This is due to the risk of sharply higher interest rates still on the table. Higher real interest rates are an enemy to gold. We see two catalysts on the horizon to watch on the gold longs front. First, if higher interest rates harm economic strength enough to slow the expected trajectory of more front-end rate rises, gold can be bought in our view. Second, if the market begins to lose faith that the Fed will protect its already blurry mandate of stable prices, gold will smell blood in the water so to speak and catapult higher.

US Treasuries are highly vulnerable. Bond proxies such as utilities and REITS are also high-risk holdings. We like long crude oil on dips and the commodity sector in general.