Will OPEC regain its power?

This week on Talking Finance:

• Romano Sala Tenna, Portfolio Manager at Katana Asset Management, runs through what's going on with the oil market at the moment;
• Diana Mousina, Senior Economist, Multi-Asset Group at AMP Capital, shares her thoughts on how the economy is tracking;
• Evan Lucas, Chief Market Strategist at InvestSMART, checks the pulse of the markets; and
• Malcolm Farr, National political editor for news.com.au, runs through the latest political news.

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AK: I’m Alan Kohler and welcome to Talking Finance. This week we’re sitting in the aftermath of the attacks on the Saudi Arabian oilfields on the weekend and what’s going on with the oil market. It’s eased off a bit last night, but obviously markets are still on edge, wondering about what’s going to happen. Also, we’ve got the Fed coming up tomorrow, Fed rate cut expected tomorrow. We had the ECB last week and we had the minutes from the RBA yesterday, so there’s plenty to talk about, but let’s start with the oil market. We’re going to talk to Romano Sala Tenna from Katana Asset Management in Perth. He's a pretty good oil analyst and brings us up to date with what’s going on there.

On the economy, we’ve got Diana Mousina, who’s going to tell us what’s going on with central banks and what’s likely to happen there. On the markets, Evan Lucas, Chief Market Strategist with InvestSMART. And on politics, we’ve got Malcolm Farr, National Political Editor of News.com.au.

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AK: Now to bring us up to date with what’s going on in the oil market, here’s Romano Sala Tenna at Katana Asset Management. Romano, the oil price came off last night, so it seems like the big concerns about the Saudi attacks on the weekend have dissipated, but do you think that there’s something more permanent likely to go into the oil price?

RST: Look, I do, I agree. I’m a bit surprised at just how quickly the heat has come out of the oil price. Obviously the comments by the newly appointed Saudi Arabian Minister for Energy have soothed the market somewhat, saying that production should be fully restored by the end of the month, whether that’s the case or not, we’ll wait and see. But I’m a bit surprised that the heat’s come out of the oil price so quickly. It is still trading at sort of 6-7 per cent above where it was pre the attacks and whilst I think short-term a bit more of the heat might come out, I do think we’re going to see moving forward a permanent premium now built into the oil price.

AK: Is that specifically about the potential for attacks on Saudi for installations or a more general kind of premium built in because of rising tensions in general in the Middle East concerning Iran, Saudi and Yemen and so on?

RST: Yeah, probably a bit of both there. There’s no doubt there’s been simmering tensions for as far back as OPEC was originally formed. They’ve waxed and waned in terms of the level of intensity. What we’re seeing now though is a series of events which you can probably trace back to more recently starting the attacks on a number of oil tankers in the Gulf, followed by shooting down the US drone, followed by attacks on Saudi oilfields and facilities through the Houthi Rebels as a proxy. What we’re seeing now though is certainly an escalation of that. The intel, whilst it’s still very fluid, does seem to indicate that at least some of the launch locations were in Iranian territory and the level of sophistication involving both cruise missiles and drones and the scale of it, indicates that it’s something more than just what’s coming out of the Yemeni Rebels. So, I do think that we’re seeing an escalation and it’s hard to see how things de-escalate from here before they get worse.

AK: Well, if Iran did send the missiles over into Saudi Arabia, then surely there’s got to be a chance of some sort of war?

RST: Well, yes and no. I mean, I think what this also does is it highlights just how exposed Saudi Arabian facilities are, and I think if we’re going to see a military response I think it’s some way off because I think they need to do quite a bit of work to establish better barriers there. I think the most logical initial response will be through the UN. Saudi’s called UN inspectors in there to help them assist with an investigation. I think the real impetus behind that is to have a mandate at that level, which increases the level of sanctions on Iran. And I think that would be the more likely initial response.

You can’t rule out anything of course. We’ve seen in the past that we’ve got a couple of hot heads there, literally, so anything is possible. But I think in the light of day, the more considered response initially at least will be through sanctions. You wouldn’t expect to see another attack for some time, I think you’d expect to see at least the coming weeks and a month or two, you’d see a bit of a lull in activity there and the oil price might come back further. But this has certainly emboldened Iran in terms of their, a) capabilities, and b) perhaps their confidence.

AK: I suppose to a large extent, it comes down to what America is likely to do and in particular, Donald Trump.

RST: It certainly does, I mean there’s no way that Saudi’s going to take on the might of the Iranian military without the confidence that America’s got their back, absolutely, and you’ve got the fleet sitting in their port there… In the past too, Trump has made it clear – and again, this can always change as we know these things, but he’s made it pretty clear that the line in the sand at the moment for military action against Iran is an attack or US military fatality. If there was any escalation conflict and we did see US military casualties then I think you would very quickly see things escalate further from there. But at the moment, that’s not our base case, that’s certainly a possibility, but the base case at the moment is that we now see Saudi and the US and its allies push for heightened sanctions.

AK: Do you think that in the light of all of this – and is your approach at Katana Asset Management, is your thinking that owning energy stocks is a good buffer, a good hedge against potential problems?

RST: It certainly is, and we’ve been saying for a number of years now that the oil market is heavily under-backed and under-supported. If you look at a best case scenario, we’ve probably got about 2.5 per cent of global production as a buffer, which at 2.5 million barrels roughly a day sounds like a lot. But put it in perspective, that’s 2.5 per cent of daily global usage is the buffer at the moment. Even more scarily and of more concern than that is that most of that buffer lies in onshore domestic OPEC producing oil fields. So, yes, we’ve been saying for some time it doesn’t take a lot of supply.

I mean, you shut down the Strait of Hormuz or you do something like that and in a very quick period of time you’re going to see the global supply chain shut down. I mean, I think at best, most countries, Australia included, have probably got something in the vicinity of about 30 days of reserves give or take and we’re seeing Saudi Arabia numbers come out of there at the moment, is a current disruption I’ve got about three days of supply, but if all their supply was taken offline that’s around about 15 to 18 days of production.

AK: I think one of the reasons the market’s become complacent is the fact the US has become the world’s largest producer of oil and OPEC has therefore lost its power. Do you think that we’re heading for some sort of reform of OPEC, perhaps bringing in other countries into it in order for OPEC to regain its power?

RST: Well, OPEC have certainly done that of course, they bought Russia and a number of other allies in there, and between Russia, Saudi and the US you can sort of throw a handkerchief over who the largest producer or exporter is on any given day. Russia coming to the mix is certainly the evolution of OPEC and that’s taken place. I think what people are missing though is that on our analysis what’s happening in the US is a temporary dynamic, it’s not a structural change. And by that I mean, look at the latest data coming out of the Permian Basin, which is the most prolific oil producing basin in the US and the most “profitable”, what we’ve seen there is the last couple of months production has actually rolled over and we’ve sort of seen declines there.

Our view is that shale is a temporary phenomena, it’s not a structural shift. The degree to which they’re able to track further onshore gains is questionable, we would question the economics of a very large proportion of shale production out of the US and it’s been ongoing drilling that has really been used to repay previous financing. ‘Ponzi’ is probably a bit of a dramatic term but we do see that a lot of the production out of the US is unsustainable and certainly we’re now starting to see that peak in the Permian. It would be nice to think that that could change at the moment out of the Middle East, absolutely. The reality is that’s probably a temporary thing and we’re going to see a reliance on the Middle East in the coming five to seven years. Sorry, Alan – I think the big hope for us is the switch to EVs. Even though it only counts for a percentage of 18 to 20 per cent of global use of oil, I think that’s the big hope for the world to sort of move away from a dependence on Middle East and crude supplies.

AK: Excellent. Good to talk to you, Romano, thanks very much.

RST: My pleasure, Alan, thank you.

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AK: Now to bring us up to date on the economy here is Diana Mousina who is Senior Economist in the Multi Asset Group at AMP Capital. Diana, what happened to the probability of an RBA cut after the minutes came out yesterday?

DM: What we saw was that the probability of a cut in October by the RBA is now at about 42 per cent, before the minutes it was less than 10 per cent, I think about 7 per cent the last time I looked at it. There’s always a danger of reading too much into what the RBA is saying and obviously the market took it as a much more dovish statement however I don’t think it was significantly more dovish but we’ve been expecting the RBA to cut in October and November for a while now. If you’ve just been reading the RBA commentary and you forecast what the RBA is going to do then you probably wouldn’t have gotten it right. Sometimes I think that maybe looking at the minutes can be a bit self-defeating.

AK: Right. You would probably think that 42 per cent is low, wouldn’t you?

DM: Usually they tend to go if the market pricing isn’t at about 50 per cent or more, we have a pretty significant labour release tomorrow and we know that the RBA is focussing on where the unemployment rate is going. We’ve had really mixed labour market reads over the past two months, the trend is the unemployment rate has been going up but employment growth has still been pretty good. It’s been pretty hard to read so I think that tomorrow is quite important and the market’s numbers will move quite significantly on the back of that. We’ve had a pretty volatile week with movements in the oil price, increase in yield globally as well. The market still has a lot more room to move before the October RBA meeting.

AK: What’s your view about the oil price, speaking of that, a few days after the attacks on Saudi Arabia?

DM: I think that it could probably still track higher in the near term but it probably won’t be such a dampening impact on growth as it has been in other periods when there’s been a big spike in oil price because it needs to go much higher to see that risk for a global recession. Normally when the oil price doubles that’s normally when you tend to see the negative impact to global growth. We’re not there yet and even though it will lift headline inflation in the near term I don’t think it will be necessarily the reason for another round of weakness in the global economy.

I actually think that the global economy, to quote RBA Governor Phil Lowe even though he was talking about Australia, I think the global economy is at a bit of a gentle turning point. We’ve seen more positive data recently, inflation expectations are rising. I think the risk of a global recession has gone down a lot.

AK: In fact, we’re seeing that in bond yields aren’t we?

DM: That’s right. US bond yields the ten year has had a pretty big rise over the past week. The US yield curve is still inverted in some measures if you look at for example the ten year versus the Fed funds rate but when you look at the two year ten year which probably the best reliable indicator for a recession that’s not inverted anymore. I think that all the central bank stimulus that’s been going on, and that is still going to happen as the Fed will cut rates tomorrow, the Bank of Japan will probably do more, the ECB really impressed markets last week, the RBA is going to cut so I think that all the stimulus is really helping global markets and of course what’s happening in China as well, they’ve been doing a lot of stimulus there.

AK: You’re still confident of an RBA cut in October are you?

DM: We are still confident that the RBA will cut rates in October, we think that the Australian economy still needs more stimulus, the GDP for the June quarter shows that the economy grew by only 1.4 per cent over the past year which is well below population growth in Australia which is 1.5 per cent. Clearly more needs to be done. We are getting more tax cuts flowing through into the data but that should show up in the August retail sales numbers and in September but it will be a bit of a sugar hit.

It’s not going to last forever because we still have the situation where wages growth is low, consumer sentiment is negative and even though home prices are starting to tick back up I’m not sure that that will be sustainable. There might just be some upside momentum in the housing market for next few months. We still think that Australia is very much stuck in a low gear type of growth environment.

AK: Thanks very much Diana, great to talk.

DM: Thank you, thanks so much.

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AK: And now to tell us about all the market action, here’s Evan Lucas, Chief Market Strategist at InvestSMART. Evan, our market’s up nine days out of ten, six days in a row. Is it helped by the oil situation, our energy stocks doing well, or is there more to it?

EL: Partly, and certainly the one to really highlight there is the reaction that’s happened inside BHP. One of their four pillars is their petroleum business which has actually been a bit of a drag on it for the last two to three years, and it’s part of the reason why on Monday particularly, you saw it jump up over 6 per cent and it hasn’t really given back any of those gains, even with the news coming over night, particularly with the Saudi’s suggesting they can actually turn supply back on to basically pre the attack levels. You also look at it, it has gone through to the energy space.

It’s interesting that the ASX has managed to buck global trends. The US has had a fluctuating week, it’s been up and down, Europe is slightly more negative. Asia has also been fluctuating off the back of not just the oil issues, but more news out of China. I think possibly for me, what was slightly missed this week by markets and by a few others, were the [Chung’s] comments that he said very publicly, that China’s ability to grow at 6 per cent per annum for the next decade and so on and so forth is going to become basically impossible and is unsustainable and that they’ll start to revise down their expectations.

It's impressive that we have made nine out of ten days up, only very slightly, but maybe you could argue that there’s also what’s going on in the US with the switch between value and growth, but realistically the stocks that are supporting us this week are growth stocks, not value stocks.

AK: Yes, well the markets generally – I mean, our market’s stronger than most, but markets all over the place are reasonably strong. I mean certainly not responding, we’ve had a fairly strong run up in bond yields over the last couple of weeks which has been quite interesting, but the equities have held up and I wonder whether that’s basically a central bank story with easing still going on everywhere. Last week, ECB, tomorrow the Fed, fairly dovish comments in the minutes from the RBA yesterday. Do you think it’s largely a central bank story?

EL: Yes, I do, and that’s been a theme of pretty much the last 52 weeks. I was going to say 2019, but it’s been longer than that, basically since Christmas last year when…

AK: How about the last ten years?

EL: Yes, well that’s very true as well, isn’t it? I mean, everybody talks around – particularly here in Australia – the impact on housing that you’ve seen with regards to monetary policy stimulus, etcetera, etcetera… It’s not just that it’s asset classes in general. If you look at equities and what has happened to equities, for us here in Australia since we started seeing rates being cut from 4.75 per cent - remember all the way back there in 2011? All the way down to where we are now, that the ASX has absolutely boomed from that and the last 50 bips that have come out in June and July had pushed our market to an a new record all time high on July 30. I mean, we’re about 150 points off it but it’s not that far away when you think about what it is. All of that shows you that there is arguments that bottom-up things are a little bit lacklustre. Earnings season was pretty here nor there, outlook is fairly muted, but the markets are going up because there is more and more stimulus coming in. The Fed is clearly one to point to but what happened last week with he ECB is a case in point that the stimulus measures coming from central banks is not going to basically dry up at least in the next 24 months. And realistically, what the ECB is suggesting to you, it could be for the next five years.

And coming back home, what scenario sees the RBA reversing its current trend and what most economists believe is a most likely scenario by this time next year that we have a cash rate of 0.5 per cent, how do they actually start justifying any sort of rate rises. That’s the sort of thing that catches my attention. Equities know this, equity investors know this and the history, as you rightly pointed out, Alan, over the last ten years, is that equity investors know that asset classes have benefitted from monetary policy and that’s why equities continue to go up despite possible underlying fundamentals not justifying that.

AK: Yes, so it’s basically the central bank put, isn’t it, the Fed put that is continuing to support equities.

EL: Yeah, and it’s not going away any time soon. That’s why the interesting thing also is that if you look at the US – and let’s just concentrate very quickly on what’s going on in the US, the US is in a fairly reasonable position. I mean, if you look at the unemployment rate, if you look at the non-fund payrolls, yes it started to slow. But over the last five years, it’s still basically averaging 200,000 jobs created every month. The wage price index is something that the rest of the world would kill for. The only thing they’re slightly missing is inflation and it’s not by a huge margin. I understand this mid-cycle tweak that Jay Powell is arguing, but what the President wants and what the market is pushing the Fed to do seems slightly unjustified considering their economy.

AK: That’s right. Really, what we still have, as we’ve had all year, is this sort of golden period of central bank easing and relatively strong economies, or at least not recessionary economies. So we have recessionary monetary policies but no recession.

EL: Yeah, and that’s the interesting whole conundrum in this, is it’s trying to stave off the possibility of a recession globally and then the slowdown that is. You’re right, even here in Australia, although our GDP that we just saw in 2Q was shocking – let’s not get away from that – it’s still not at a level that you could really argue that is absolutely dire. Even just on an argument you could make the same in Europe, they only grew at 0.2 per cent quarter on quarter. Germany is case in point, they are facing a perfect storm and will go into a technical recession but they’re likely to bounce out of it in Q3 and Q4. The US-China trade issue will bumble along and you’ll probably see the way through it, but in the main – this is the other argument around this whole point, is it’s a fulfilling cycle. If you continue to basically make monetary policy, perfectly put, as basically the put.

It also is a fulfilling cycle that the one thing we’ve been describing all year is the bond market is reacting to the malaise that is the global economy, the equity market is reacting to what they see is the cure to that malaise, which is monetary policy changes to accommodation, and there is no end in sight to that at all, and that is where this interesting sort of Goldie-Locks period – your words there, Alan, from before – is that bonds are appreciating and so are equities for those two main reasons, and they are unlikely to change any time soon.

AK: Excellent. Good on you, Evan, thanks a lot.

EL: Thank you very much, Alan.

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[Parliament audio clip]

AK: Now for the latest in politics here is Malcom Farr, National Political Editor of News.com.au. Malcom, I note that we’ve got a treasury laws amendment (prohibiting energy market misconduct) bill being introduced to require retailers to pass on electricity supply chain cost savings, basically bossing them around. What’s going on with this government, they’re pretty Marxist aren’t they?

MF: It is a pretty big Marxist tendency going through this government, one that if it had appeared in a Labor government would have been howled down and prosecuted with great vigour by the usual sources. This one is very interesting, for one thing it’s the best the government can do to create the illusion it has an energy policy because as you remember when Josh Frydenberg was Energy Minister he got the NEG, the National Energy Guarantee, through cabinet and through three joint party meetings only to see it undone by a coal rump within the Coalition.

This is what we now are headed for with the government intruding on business in two areas. Essentially, it’s going to sick the ACCC onto any anti-competitive practices which would then be referred to the federal court but secondly the Energy Minister would have the power under certain circumstances to direct the prices charged by an energy company for as much as three years. These are pretty drastic measures and it’s quite likely they would never be used, they might just sit there dormant, maybe they have a scary power, maybe they are just there to create the illusion the government has an energy policy.

But it does come along with a comment by Ben Morton, who is the Prime Minister’s Assistant Minister and something of a muse to him essentially saying that corporations should get out of the social policy area and just concentrate on helping their employees and shareholders and customers. It’s essentially saying that looking after Climate Change and other non-business – well, that’s open to interpretation, but other areas is a distraction from the main game of business. What we’re seeing when you add it all up including things like Matt Canavan a couple of years ago berating banks for not funding Adani this really is a government that wants to boss around the bosses in a way that Labor would never even pretend to do.

AK: What the government either is ignoring or doesn’t realise is that the employees and customers, and to an increasing extent shareholders of these companies, want the companies to do something about Climate Change. The government is kind of doing anything to avoid doing something about Climate Change.

MF: It is. This is one of the areas, there have been several, in which the business sector has been leading the government towards better policy on Climate Change and relations with China I would suggest is another one. We’ve got to accept that there is a big industry groups meeting in Canberra this week and last week and the government wants to set an agenda for them, wants to open a debate with them, because it really needs some action on the economic front from them essentially saying back us on industrial relations and other matters, stick to your prime job or stick to your knitting as Petter Dutton told Alan Joyce of Qantas, and let’s get this done. Then maybe later you can worry about Climate Change and same sex marriage. Because, it needs a bit of economic activity at the moment and perhaps it’s blaming these so called distractions for the absence of any great effort in that sector.

AK: Just before I let you go, Malcolm, has the Gladys Liu affair petered out do you think or is there a lasting damage from that thing?

MF: There are increasing reports about the Liberal Party funding courtesy of Ms Liu and that will be examined, there’s also a challenge that will go before the federal court over the signage in her seat of Chisolm and another seat in Chinese language that was a bit misleading so the allegation says. The government is going to stand by her, Mathias Cormann has made that clear in the senate, Scott Morrison has made that clear and unless there is a big whopping smoking cannon appearing over the next few days one could imagine that the government will have to swallow the embarrassment of the Liu affair as best it can and hope that events such as the Prime Minister’s visit to Washington will swamp any reference to her.

AK: Do we think that when the Prime Minister does go to Washington to be state dined by the President that they’ll put it on him to support the US in unequivocal terms again in its battle against China? Which is kind of a bit at odds in a way. It’s a very complicated and difficult area, one would think, for the Prime Minister.

MF: Yes. I don’t think he’s going to race into any active antagonism towards China much as President Trump might urge him to. Australia is in a special position, both as a trading partner with China but also as an influential middle power in the region. I don’t think Scott Morrison is in a mood to be stampeded by President Trump into any hasty action. Obviously, it’s good to get on with the most powerful leader in the world as the President is and it’s sort of interesting to have to explain to a young colleague a couple of days ago the slang meaning of to duchess someone means, I think, Alan, you would recognise the term and I think we’re going to see some exemplary duchessing going on in Washington and Ohio over the next week or so.

AK: Indeed, it will be good to watch. Thanks, Malcolm.

MF: Pleasure, sir.

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AK: This week’s birthday is my favourite singer of all time, Leonard Cohen, who would have turned 85 this coming Saturday, except he died three years ago at the age of 82, after a pretty good innings, it has to be said. Here is a bit of Boogie Street, one of my favourite Leonard Cohen numbers.

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AK: That’s it for Talking Finance this week, I’ll talk to you next week.

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