TheChek News Flow

Oil outlook suggests the only way is up for bond yields

If debt market crumbles it might be better to own oil-related ETFs and stocks

Fossil fuels have suffered over the past year as a Covid-induced fall in energy demand compounded longer-term pressures on the industry. At the same time, however, many people have decided a car offers a safety bubble in the pandemic, supporting a resurgence in sales — most of them still petrol-powered.

Oil markets are caught between these two notions: one bearish, the other bullish. In the year ahead, bulls should win out. When that happens, look for inflation expectations to rise, sending bond prices lower and yields higher.

Crude prices have swung wildly over the past six months. A collapse in oil consumption sent the market into a deep slump before the world’s largest producers agreed to slash output to adjust to the new reality. Supply and demand have this summer again found an equilibrium.

Opec and Russia in April agreed to an output cut of 9.7m barrels a day, about a tenth of global output. Add to that a 2m b/d drop in production from US oil explorers in the second quarter of this year and the conditions were in place for the supply overhang to evaporate.

That rebalancing kicked in from June, according to estimates by Rystad Energy. Traders, anticipating this, sent Brent prices to around $45 per barrel, more than double the April low.

But the world’s biggest producers will take their time before fully opening the taps. Consumption is still down a tenth from the end of 2019, although that should change as the economic effects of the crisis diminish in the coming year.

Most Opec watchers have focused on the relationship between Saudi Arabia and Russia, but the behaviour of the US private producers also warrants monitoring. As of the end of July, American onshore and offshore production had yet to rebound from two-year lows.

The country’s onshore shale drillers can reverse direction reasonably quickly, unlike those in offshore areas such as the Gulf of Mexico. But there are no obvious signs of a resurgence in drilling activity in key shale areas such as the Permian formation, which covers parts of Texas and New Mexico. That region provides about 40 per cent of total US output.

The number of drilling rigs used there has fallen to a four-year low, according to the Energy Information Administration. The army of workers in US oilfield services has fallen back to 2010 levels, notes Rystad. All this suggests supply will not snap back swiftly.

US exploration and production companies also have more debt than ever on their balance sheets. Total borrowing, secured and unsecured, totalled about $170bn by the end of July, according to Texas law firm Haynes and Boone.

That is much more than double the amount from four years ago, when oil traded at a similar level. It seems unlikely that these drillers can support so much extra debt given that their cash flow — in most cases — has not risen accordingly.

This all comes at a time when some of the world’s largest oil companies have promised to cut capital spending or production, or both, threatening to crimp supply. Saudi Aramco this week said capex will fall about a third this year to save cash. BP not only forecasts less spending but said its upstream production would fall for the next five years, at least.

The world’s oil supermajors including Royal Dutch Shell and Chevron have slashed the value of the oil and natural gas assets on their balance sheets, leading to significant accounting losses.

But quite a few still expect crude prices to rise over the next couple of years towards $60 per barrel. If oil hits that level, the accompanying rise in inflation should cause bonds to sell off — fixed-coupon bond prices usually fall when inflation rises — and yields to rise.

A similar oil rebound in 2016 preceded a two-year bear market for bonds. Ten-year US Treasury yields as well as those of German Bunds have already picked up this month.

Oil can also affect inflation disproportionately. Energy has an 8 per cent weighting in the US consumer price index basket and the sector’s prices have much greater volatility than most other CPI inputs. This tends to give oil an outsized impact on that measure of inflation.

A 10 per cent jump in the crude price raises inflation indices by between 0.5 to 1 per cent, depending on the country, according to a recent paper from the International Association for Energy Economics.

If bond markets do crumble because of a resetting of the oil price, it might be better to own oil-related exchange traded funds and stocks rather than those tied to gold, a recent favourite. The precious metal’s price has moved inversely with real US bond yields, which turned negative this year. If real yields started to move higher, gold’s glittering run would end.

The price of oil offers a barometer on economic activity. Right now, it is rising.

Nikkei +0.10% Hang Seng -0.02% CSI +0.55% Shanghai +0.27% Shenzen +0.25%

Eur$ 1.1817 CNH 6.9435 CNY 6.9460 JPY 106.85 GBP 1.3068 CHF 0.9102 RUB 73.0045 WTI$ 42.39 +0.36%

S&P +0.23% Nasdaq EuroStoxx -0.33% FTSE -0.09% Dax -0.23% SMI -0.07%

Macro :

- Fund Flows to Developed Market Stocks Surge as Bonds Cool: Citi

- Fund Flows Head for U.S. Stocks, Credit, Linkers, Jefferies Says

- SocGen Quant Says Stocks Face Slump Even If Vaccine Is Found

- Italy Reports Most New Virus Cases in a Week as Numbers Inch Up

Keep ane eye on :

- ARL GY : Aareal Bank Sells 30% Stake IT Subsidiary for EU260 Million

- AAG GY : Aumann First Half Adj Ebit Loss EU3.21 Mln

- CEC GY : Ceconomy Third Quarter Sales EU4.11 Bln, -10% Y/y

- CLNX SM : Cellnex Says All New Shares Subscribed in Capital Increase

- DAI GY : Daimler Paying Over $2 Billion to Settle U.S. Diesel Issues (1)

- EDF FP : UAE’s Masdar Buys Stake in EDF Renewable-Energy Projects in U.S.

- EKT SM : Euskaltel to Explore Sale of Cable Network, Expansion Says

- FLOW NA : Flow Traders Second Quarter Net Trading Income Misses Estimates

- H24 GY : Home24 Sees Full Year Rev. Ex-FX +25% to +35%, Saw At Least +15%

- KCO GY : Kloeckner Second Quarter Adjusted Ebitda EU11 Mln, -78% Y/y

- LHA GY : Lufthansa Halts Talks With Union After Failing to Secure Pay Cut

- DRLCO DC : Maersk Drilling 1H Ebitda Ex Items Beats Est.; Outlook Kept (1)

- NVAX US : U.K. Govt. to Buy 60m Doses of Novavax’s Covid Vaccine Candidate

- OLT NO : Olav Thon Eiendomsselskap 2Q Rental Income NOK723 Mln, -3.2% Y/y

- SEM AV : Semperit First Half Ebitda EU57.6 Mln, +47% Y/y

- TKA GY : Thyssenkrupp Drops After Warning Loss Will Further Burn Cash (3)

- FP FP : Mozambique Denies Insurgents Control Key LNG Port Town

- UBXN SW : SIX Exchange Regulation Starts Probe Against U-Blox

- VAR1 GY : Varta First Half Revenue EU390.7 Mln

- VOW3 GY : Europe Electric-Car Subsidies Have Market Exceeding China Sales

- WUW GY : W&W First Half Net Income EU107.0 Mln, -39% Y/y

* Bpost Raised to Buy at Jefferies; PT 10 euros

* E.On Raised to Buy at Deutsche Bank; PT 10.90 euros

* Freenet Raised to Equal-Weight at Barclays; PT 20 euros

Sudden breakthroughs in AI could hold the key to digital progress

TikTok’s recommendation algorithm and OpenAI’s language model are exemplars of key tipping points in deep learning

With the steady pace at which the building blocks of computing technology advance, it is easy to be lulled into a belief in the incremental and predictable nature of digital progress. But that doesn’t take account of the sudden and disruptive new applications that suddenly become possible along the way.

There have been few fields that make this case as clearly as deep learning, the main technique behind recent advances in AI. This is a technology that has been many years in the making: it was just a case of waiting for computing power to become abundant and cheap enough, and for data to become available in large enough quantities to train the systems. At that point, the algorithms would start to bootstrap themselves.

Two highly visible current examples have shown just how disruptive the results can be when the technology reaches a critical point. The first case, involving data and algorithms, is TikTok. The huge success of the Chinese-owned app at the centre of a political storm in the US can be traced to many things. Among them are its slick automated editing, freeing of “watermarked” videos to travel beyond its own network, and a format that touched a nerve with its target audience.

But the thing that has excited the techies most has been its use of AI to serve up the videos that are most likely to keep its audience hooked. The results of its personalisation technology have been addictive, yielding the heightened engagement that is gold dust to a social media company.

When deep learning systems first reached the mainstream, there seemed to be a real risk that start-ups would struggle to compete. Big companies with access to masses of data and computing power would be able to train the most effective models, in turn bringing them more users (and data) and ensuring an unassailable lead.

It turns out that a viral app can act as the flywheel. Recommendation systems have been around for years, but TikTok was still able to achieve meaningful lift-off.

Microsoft, with one of the biggest AI research efforts in the world, is now hoping to buy part or all of the upstart, partly to get access to its deep learning insights — though a White House seemingly bent on barring the app from the US could thwart the effort.

The second example of the sudden breakthroughs that have come from steady advances in the building blocks of AI involves hardware, and it also touches on Microsoft. OpenAI — a San Francisco research organisation that received a $1bn investment from the software company last year — recently released a new, large-scale language system, known as GPT-3, to an invited audience.

There is a race on to build ever-larger language models, where massive volumes of text are ingested by systems that use them to try to gain a better understanding of how language works. OpenAI’s own GPT-2 was one of the first to use the technology for automated writing. Google’s version of the technology, called BERT, now works so well that it has been put to work in the company’s search engine, acting invisibly in the background to decipher what searchers mean with their more complex queries.

What would happen if you threw even more computing power at the problem? That is the whole idea behind OpenAI’s research programme, and the reason it took the investment from Microsoft, much of it “in kind” in the form of technology. Earlier this year, the software company revealed that it had built what it claimed was the world’s fifth most powerful supercomputer, to be used exclusively by OpenAI.

The result of all this hardware — along with further adaptations to the algorithms — is an automated writing system that can reportedly do a passable impression of a real person on almost any topic. That may sound like a gimmick with few practical applications, other than spewing out reams of realistic-sounding fake news. But it could eventually lead to the automation of many simple text-based tasks where humans are currently required. By mining the sum of human knowledge, it could also make connections and yield insights that humans haven’t thought of.

The thought experiment involving an infinite number of monkeys, hammering away at an infinite number of typewriters, posits that one of them must eventually write the complete works of Shakespeare. Far more interesting, though, could be the many other things the monkeys would come up with along the way, including the oeuvres of writers who never existed.

It would still take human intelligence to “understand” the systems’ mindless output. But as with TikTok’s recommendation engine, the results, if properly channelled, could be significant.

Exclusion of property owners from lending support programme is unjust, critics claim

Analysts in one of the primary markets for financing US commercial real estate are calling for an expansion to the Federal Reserve’s flagship lending scheme to help property owners whose businesses have been crushed by coronavirus.

The Fed’s Main Street Lending Programme was set up as part of the $2.2tn Cares Act, and was designed to help struggling midsized businesses that were in a sound financial condition before Covid-19 struck. The programme currently prohibits loans to businesses owned by developers and landlords who do not “actively use or occupy” buildings acquired or improved with loan proceeds — meaning that the facility, which has been in operation for a couple of months, effectively cannot be tapped by property owners.

That exclusion is causing undue pain to borrowers whose loans underpin the $1.2tn market for commercial mortgage-backed securities, according to analysts.

The market has come under strain since the onset of coronavirus caused a collapse in bookings at hotels and a rapid decline in visits to shopping malls, threatening borrowers’ ability to repay their loans.

Republican senator Mike Crapo, chairman of the Senate Banking Committee, sent a letter to Treasury secretary Steven Mnuchin at the end of July recommending that the MSLP be opened up to commercial real estate. 

Such a move would make sense, said Alan Todd, a strategist at Bank of America, noting that the facility “would be very helpful” for troubled CMBS and CRE borrowers.

He added: “As the list of congressional leaders appealing to Mnuchin and [Fed chairman] Powell to support the CRE market grows, so too does the likelihood that the Fed and Treasury will ultimately intervene. We view this as undeniably positive for commercial real estate and for the CMBS market.”

However, relaxation of the facility to allow real estate loans is not a “slam dunk,” said Lea Overby, CMBS analyst at Wells Fargo.

CMBS loan documentation typically restricts property owners’ ability to take on extra debt on top of their mortgage. That means that to apply for a loan under the MSLP, many borrowers would need to seek approval for the servicers of the securities.

Still, analysts say workarounds are possible, and see an extension of the MSLP as a better option than other relief measures on the table.

In particular, some object to the Helping Open Properties Endeavor, or “Hope” Act, which was introduced in the House of Representatives at the end of July by Texas Republican and former real estate investment banker Van Taylor, Florida Democrat Al Lawson and Republican Andy Barr. 

The bill proposes that the federal government take a preferred equity stake in struggling properties. Preferred equity is similar to a fixed-rate loan but sits subordinate to the existing mortgage. 

Businesses were “forced to shut down by the government, through no fault of their own,” said Mr Taylor. “They don’t need a bailout, but they do need flexibility and support to keep their doors open.”

However, the proposal would mean that debt investors in CMBS deals backed by mortgages on the properties the government invests in would be paid first if things turned sour.

“Taxpayers will have to foot the bill if it fails,” said Gunter Seeger, a fixed income portfolio manager at PineBridge Investments. “We don’t think that is a workable solution.”

The Hope Act is currently stalled in the House and analysts see the likelihood of it passing into law as slim.

As a result, some are throwing their support behind amending the MSLP.

“I think it’s a much better way to go about doing it, rather than having very explicit government ownership behind debt investors. I am not thrilled with the optics on that one,” said Ms Overby of Wells.