Nervous Energy

Remember when MBS was a dirty word in the financial markets? Markets are focussed on these letters again, but with a twist. This current crisis has been generated by Mohammed Bin Salman (MBS), the crown prince and heir apparent of the Saudi Arabian throne.

His recent unexpected and draconian actions have generated a fear premium in the global energy market. This week's sweeping round-up of political and business leaders is mostly political in intent, aimed at removing those elements who have obviously been on the wrong side of the new regime. The Saudi royal family is vast in numbers and full of intrigue. The internecine machinations are impossible to predict or evaluate, given the opaque nature of this powerful and firmly entrenched monarchy. This has quickly created accelerated angst in the oil market.

This move, combined with his pointed accusations against Iran in the Yemeni proxy war, has pushed the front end of the energy curve into significant backwardation. Speculative long positions have increased rapidly. But does this event represent a durable restoration of the bull market in energy?

Initially, the rally in energy was fundamentally justified. Long-suffering Energy stocks have performed well since I noted their budding recovery in my "Endless Summer" post of September 26th. Signs of an upward revision to global energy demand, combined with a decline in inventories had given the long suffering energy bulls free reign to chase the rally in crude.

This most recent upside power move, however, has created some downside risk. Breathless talking-head commentators, eager for fresh meat in the relentless search for breaking news, have been cheerleading the rally. With tech and momentum stocks in nose-bleed territory, the rotation to value rich energy made eminent sense.

But is it sustainable?

During the long bear market in energy that followed the 1986 price collapse, there were many trading rallies prompted by supply cut fears. Most prominent among these was the panic buying that preceded the U.S. arms build-up prior to the Kuwait war in 1990. These run-ups were all doomed to failure as the fundamentals caught up with the fear trade. We are too early in the long term commodity cycle for a lasting price regime change.

Oil fundamentals are pinned down to an immutable law in commodities markets. The marginal (not average) cost of production sets the price over the long run. Once the price of a commodity rises above that level, you are asking for trouble. I believe that level is at hand. There is plenty of $60 oil in the world. With recent technology improvements in Oil Sands, even this supply has marginal costs comfortably below that level.

Watch for a rapid rise in U.S. inventories from increased shale production in the next few months. Combined with the upcoming seasonal weakness, (see chart below), and the recipe for a pullback is in place.

At the risk of being early, I am fading the trade and am trimming my energy stocks.

Risk Model: 4/5 - Risk On

The XIU RSI is the lone risk off signal after the energy related run. The Canadian market, however, can stay overbought for longer given how far behind we are in the global reflation race. Bull/Bear sentiment is supportive and the VIX is moribund. Copper/Gold is in a structural bull phase. Interestingly, Google search stats for "Bitcoin" now exceed those for "Gold". Maybe I should backtest that as a risk indicator?