Bleet

August 19, 2024

Last night’s note repeats a conclusion communicated in our Bleets on Jul 22 and 29: commodity markets signal the FOMC should (have) cut the Fed Funds rate at the July 31 meeting. Opting for delay left the Fed vulnerable to the subsequent carry trade unwind and perceptions (and possibly the reality) of having fallen behind as labor, inflation, and earnings reports confirmed slowing growth.

As our work forewarned, vulnerability to liquidity effects in this macro context swiftly roiled investor confidence, positioning, and perception as “the cruelest month” unfolded (Aug 1-5). As expected, this tension has reemerged again in "the cruelest week in the cruelest month" (today is Day 5 of that week). Today's news of a potentially viable ceasefire deal in the Hamas-Israel conflict arrives one day before expiry of the Sep-24 NYM WTI crude oil contract (CLU4). The potential for easier transit of oil supply through the Red Sea is motivating accelerated sales of these futures before they cease to exist tomorrow. The sudden surge in volatility generally in the past three weeks has benefitted long vol strategies across asset classes, including our idea to pounce on owning long ATM straddles at 22% implied vol in prompt crude oil (long run avg IV = 33%). The potential for slackening geopolitical risk has been one of the rationales for owning the oil puts. However, take care. These opportunities have also required fast reflexes to monetize value, as algorithms and skilled traders have been quick to sell the spikes and buy the swoons.

Turmoil in financial markets also fed bearish priors about demand. Investor sentiment whipsawed toward left tails, creating new opportunities for commodity options traders to buy long calls at good value on strikes and vols. In oil futures markets, the bruised psyche and frantic trading of investors contrasts sharply against the sanguine behavior of producers and consumers operating in the real-world physical markets.

We can quantify and visualize this. An update of Risk Perception Indices (RPIs) for investors and hedgers in the Brent crude oil market neatly illustrates this disconnect (chart below). Oil hedgers have become subtly more cautious about downside price risks in recent weeks, but even now they are still far more confident than oil investors about the durability of economic expansion. Investors' fear is close to rock-bottom lows. This is probably a valid contrarian indicator.

Likewise, our mapping of oil options premia to cash market fundamentals concludes the oil market as a whole now assigns only a 5 percent risk to U.S. recession within the next three months and about 25 percent in the next 15 months. This risk assessment seems reasonable to us. Notably, the same mapping also assigns a 5 percent probability to >$97 WTI by yearend in a price spike scenario. “Recession” and “$100 oil” are more or less equally likely risks in the short run.

What does it all mean? Five ideas for your consideration: (1) commodity investors now look overly focused on demand-driven downside risks—the pain trade here appears to be higher prices not lower prices, (2) one likely catalyst for higher is the long-awaited first rate cut from FOMC, in global markets that now have seen first cuts by SNB, ECB, BOE, RBNZ, and others, (3) it’s safer here to place long petroleum risk in crude than products, especially as the imminent CLU4 expiry accentuates selling flow and creates the perception of a more durable selloff that is instead more likely to quickly find demand at these prices and below, (4) premia on OTM gold call options will likely provide useful timing guidance for catching next advances in global markets heading into Sep 18 and beyond (we are watching the $2800s on GCZ4), and (5) gold remains in the more bullish regime it upshifted into in December 2023, with projected rolling 12M total returns at +10 to +15 percent (call it +13% mid).

On this last point, investors should take note that about half this return is already built into the CMX gold futures curve, which is arbing against marginal production cost. Most producers operate below marginal cost, by definition. These facts continue to make gold-mining equities the superior gold exposure for most investors. We continue to spotlight Antofagasta (ANTO LN) as a long-run idiosyncratic beneficiary of the favorable economics across gold and copper. For levered exposure while minimizing idiosyncratic risk, we continue to spotlight the junior gold miners ETF (GDXJ). GDXJ is now fetching a price above $47 vs trading around $31 when we flagged it in late Feb-24. Owning GDXJ also usefully picks up some silver risk.