The West Texas Intermediate Crude Oil price declined from a peak daily close of $54.04(02/27/2017) to a trough daily close at $42.53 (06/22/2017), a decline of 22%. This was, in part, caused by the net-long speculative positioning in oil futures that were put on after OPEC agreed to reduce output for the first time in eight years in November of 2016 being unwound. This liquidation began in March 2017 as global oil inventories proved more resilient than most analysts had anticipated (below).
Analysts appear to have revised down their estimate for yearend 2017 WTIC prices. In fact, many sell side analysts appear to have capitulated and stated that oil may break $40 per barrel since risk remains to the downside. We believe that the en masse downgrade of oil service and exploration / production firms by sell-side analysts is indicative of a contrarian buy signal.
Over the last two weeks US inventories have begun to decline at an accelerating rate, while new-well productivity gains in the prolific Permian basin have declined (below).
This indicates that, without the addition of rigs to this basin, total basin production would have declined since the start of 2016. The recent decrease in oil prices should lead to the deceleration in the rate that rigs are deployed, which could cause total US production to underwhelm analyst estimates and support oil prices. In fact, we expect oil prices to close the year somewhere between $55.00 and $60.00 per barrel. This could catalyze inflation expectations higher, which would lead to a pickup in the moribund inflation level and pressure bond prices.
This is due to the high correlation between WTIC oil prices and the 5-Year, 5-Year Forward swaps, a proxy for inflation expectations (below).
The coefficient of determination (R2) where inflation expectations are the dependent variable and oil prices are the independent variable registers 0.71. This indicates that 71% of the level of inflation expectations are dependent on the price of WTIC.
We performed a simple exercise to determine where inflation expectation could end up if oil ends the year in our forecasted range of $55.00-60.00 per barrel. To do this we determined the percent advance that oil would make from its 2017 trough to our high and low estimates. We then adjusted that percent change by our R2 calculation to determine what percent change inflation expectations should experience due to the increase in oil prices, which allowed us to forecast a range for inflation expectations (below).
We expect that, if our oil forecast come to fruition, the 5-Year, 5-Year Forward Rate of Inflation Expectations will advance by approximately 37 to 52 basis points to a range of 2.15 to 2.30. Since inflation expectations are known to lead inflation, we expect that a comparable increase in the 10-year Treasury yield could ensue caused by an increase inflation component. This forecast could be enhanced or dampened by extraneous factors that are responsible for the, approximately, 30% of movement of inflation expectations not explained by the price level of WTIC. As per our previous writings, given that the US economy is growing above potential and that the U3 unemployment rate is below the Fed's estimation of NAIRU, we would expect surprises to remain to the upside. This leads us to expect Treasury Inflation Protection Securities to outperform nominal Treasuries.