Oil volatility probes the downside

This is an essential breakdown before any Fed pivot. Recent price volatility has been leaning to the downside so we are getting there barring any further supply shocks. The Fed needs sub-$80 oil and preferably sub-$60 because it’s going to pop the moment it flips. Any lower would shut off US which it will not want to do. Barclays with the note.

Trade growing oil downside risk on escalating recession fears

Energy equities – the only US sector with still positive YTD performance – has recorded a sharp sell-off over the past month. For instance, consider that on a volatility-adjusted basis, Energy saw the second worst return across sectors (only second to Materials) (Figure 1). Indeed, the S&P Energy Select sector Index has just experienced the fourth largest drawdown in any nonoverlapping 1m period since data start in Jan-90 (see Figure 2).

The sell-off in energy equities is also large when compared against the recent performance of oil. For instance, for most of this year the cumulative YTD performance of energy equity (expressed in sigma terms) was highly comparable to Brent front month futures. However, during the last sell-off, the two have significantly decoupled. As a result, while at ~48%, Brent YTD performance still translates to an extremely high sigma move of 2.05, Energy equity performance is now considerably lower(1.34 sigma move) (see Figure 3). Indeed, while the 2yr down-beta of Energy equity to Brent front month futures has ranged between 0.2 and 0.8 over the past 10yrs, Energy equity has fallen 2.9x as much during the last sell-off (see Figure 4). This is also clearly visible when plotting historical 3-week returns for S5ENRS (Energy Select sector) against Brent: the recent underperformance is historically large (see Figure 5).

Coincidentally, this underperformance is in line with recent ETF flows, whereby energy-equity ETFs saw substantial outflows (as a %-age of total AUM) compared to, for instance, USO (see Figure 6). In another sign of relative bearishness, normalized 25-delta downside skew appears to be generally very steep on energy-equity ETFs, while historically flat on USO (see Figure 7).

Compared to commodity, energy-related equity has naturally a higher beta to the broad equity market. As such, it is plausible that the recent underperformance of energy-equity is due to growing recessionary fears causing more of a classic ‘macro’ shock with little differentiation across different sector idiosyncrasies. On the commodity side supply factors may still be supportive for the moment. However, we note that should recessionary fears materialize, oil is naturally not immune to a sharp sell-off (Figure 9). Importantly, attribution analysis also shows that supply factors are starting to contribute negatively to Brent prices (Figure 8).

 

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