The litmus test for the global economy

China’s lockdown makes global debt crisis now almost certain

Beijing has a population of 21.5 million, but you wouldn’t know it from this BBC video from last Thursday.  Normally busy streets and transport systems are eerily empty, with food deliveries often the main traffic on the roads.

It’s the same picture in industry, with the Baidu Migration Index reporting only 26% of migrant workers had returned to work across 19 sample cities by 19 February, compared with 101% a year earlier.

The position is even worse in Hubei province, the most important industrial manufacturing province in the country, as this South China Morning Post video, also from last Thursday, confirms.


China is clearly nowhere near getting “back to normal”, as the SCMP reports:

“Choked off from suppliers, workers, and logistics networks, China’s manufacturing base is facing a multitude of unprecedented challenges, as coronavirus containment efforts hamper factories’ efforts to reopen. 

“Many of those that have been granted permission to resume operations face critical shortages of staff, with huge swathes of China still under lockdown and some local workers afraid to leave their homes. Others cannot access the materials needed to make their products, and even if they could, the shutdown of shops and marketplaces around China means demand has been sapped. 

“Those who manage to assail the challenges, meanwhile, have found that trucking, shipping and freight services are thin on the ground, as China’s famed logistical machine also struggles to find workers and navigate provincial border checkpoints that have popped up across the country.”

Cash-flow is also drying up at thousands of companies, large and small.  It is now a month since the emergency began. Bloomberg reports, for example, that the Hainan provincial government is in talks to takeover HNA’s $143bn airline to property development business empire.

THE LOCKDOWN CONTINUES TO HAVE MAJOR IMPACT ON THE ECONOMY
It would be nice to believe that the epidemic will have no impact on China’s economy. But common sense tells us this can’t be true. We just have to ask ourselves 5 obvious questions.  What would happen to:

  1. Our own country’s economy, if our capital and a major manufacturing base shutdown for a month?
  2. Businesses, large and small, if orders stopped and transport was severely disrupted?
  3. Imports and exports, if critical shipping schedules and flights were cancelled?
  4. Cash-flow, if the above happened and we still had to pay interest bills on debt?
  5. Supply chains, if workers at one or more partners couldn’t get to work for a month?

South Korea’s president Moon-Jae has given the obvious answer as the Financial Times reports:

“We should take all possible measures we can think of” to support the economy, Mr Moon told a cabinet meeting on Tuesday. “The current situation is more serious than we thought . . . we need to take emergency steps in this time of emergency.”

Of course, ‘this time may be different’. But common sense tells us that China’s economy is under enormous pressure today. The charts above highlight the range of areas that are affected:

  • Property sales are down 79%, with Evergrande offering 22% discounts through March
  • Construction is 25% of GDP, with Fitch identifying 6 developers with high risk of default
  • Ports are often at a standstill – and many shippers have simply stopped calling at Chinese ports
  • Car sales collapsed by 92% in the world’s largest auto market in the first two weeks of February

5 LIKELY IMPACTS FROM THE LOCKDOWN
1. Domestic sales.  Thousands of stores have been shut since the epidemic began, and people are understandably too scared to venture out – even if this was allowed. So we must assume most areas of domestic consumption are being hit.

2. Imports for manufacturing. Chemicals are an excellent guide to the overall position, as the charts show based on Trade Data Monitor data. Given the shipping problems, large volumes of cancelled imports must now be sitting in suppliers’ tanks and warehouses, waiting to find a new market

3. Exports as part of supply chains. Apple’s profit warning highlights how even major companies have been caught out, as they cannot obtain the component supplies on which their global sales depend. Car and electronics companies are probably most at risk, and we will no doubt see more profit warnings as companies realise inventory is running short

4. Domestic suppliers. There is little data available about the virus’ impact on smaller Chinese companies. But presumably many have already gone bust, especially if they were unlucky enough to be in the centre of the downturn, such as those in Hubei and Wuhan

5. Oil and currency markets.  Caixin reports that Chinese refinery runs are at just 10mbd, compared to an average 13mbd in 2019:

“The deepening run cuts belie optimism that the impact of the epidemic may have peaked, a sentiment that’s helped spur a recovery in oil prices over the last week and a half. Many people are still trapped in their homes and unable to go to work, while curbs on travel have pummeled demand for transport fuels.”

Currency markets are also realising the worst may yet be to come.  Companies such as HNA have been major borrowers in the offshore dollar market – hoping to take advantage of low US interest rates. But as we have seen many times before, when the currency starts to fall, those debts quickly become impossible to service.

A GLOBAL DEBT CRISIS SEEMS ALMOST INEVITABLE
Observers such as myself have warned about this problem for years.  Earlier this month, an international G20 task force of currency experts warned:

“Central banks have lost control of global liquidity. The dollarised international financial system has become treacherously unstable and vulnerable to a sudden reversal in capital flows.  A decade of ultra-low interest rates and quantitative easing has flooded the globe with highly unstable forms of funding denominated in dollars, with no guarantor standing behind them. Glaring currency and maturity mismatches have accumulated.

“This structure is prone to an abrupt “dollar crunch” should borrowers in China, east Asia, emerging markets, or even parts of Europe suddenly start scrambling for scarce US currency to repay bonds and loans in a crisis.”

Central banks and governments either didn’t realise the risks or, more likely, simply hoped the problem would only hit once they had left the job.  But today, this “dollar crunch” may well be about to arrive:

  • After a brief rally, the Rmb has gone back below Rmb 7: US$ 1
  • This will make it even more impossible for many companies to repay their dollar loans

Many western pension funds felt forced to rush into the offshore dollar market in a ‘search for yield’. Zero rate interest policies meant they couldn’t get the level of yield they needed to fund future pensions in ‘safer’ markets at home. And employers weren’t willing to fill the gap, as this would have hit their earnings and share prices.

Unfortunately, as I noted 18 months ago, Ernest Hemingway’s The Sun also Rises probably describes the end-game we have entered:

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

Polyethylene’s crisis will create Winners and Losers

Polyethylene markets (PE) are moving into a crisis, with margins in NE Asia already negative, as I have been forecasting.  Scenario planning is now a matter of potential life or death for companies likely to be impacted over the next 12-18 months.

The collapse in margins is already quite dramatic as the chart based on ICIS data shows:

  • NEA margins were $657/t in January 2017, and are now -$100/t; SE Asian margins have fallen from $909/t to $103/t
  • NW Europe margins  are down from $739/t to $300/t; US Gulf margins are down from $965/t to $603/t: Middle East margins are down from $1125/t to $833/t

The same pattern is also true for the other main grade, High Density PE (HDPE).

And, of course, today is only the start of the problems. As the second chart shows, there are vast amounts of new product coming online between 2019 – 2021 in both LLDPE and HDPE:

  • LLDPE: China is adding 3.4 million tonnes; USA 1.8Mt; Russia and S Korea 800kt each; with India, Oman, Malaysia and Indonesia also adding capacity
  • HDPE: China is adding 4.4Mt; USA 1.9Mt, S Korea 900kt, Russia 700kt; with India, Oman, Malaysia, Indonesia, Philippines, Iran and Azerbaijan also adding

The problem is that the fundamental assumptions behind the shale gas investments were simply wrong:

  • Oil was most unlikely to always be >$100/bbl, providing a feedstock advantage with shale gas
  • China wasn’t likely to be growing at double-digit rates, and always importing more petchems
  • Globalisation was already ending, meaning that plants couldn’t be sited half-way across the world from their market
  • Plastics will not always be the material of choice for single-use packaging applications

Essentially what happened is that companies stopped planning for themselves and allowed Wall Street to set their strategy, as one CEO told me:

“You may be right, but every time I mention shale on an earnings call, the share price goes up $5.” 

It is now too late to wind back the clock.  The US product from the integrated players has to go somewhere as their ethane feedstock is essentially a distressed product. If they don’t use the ethane to make ethylene and its derivatives, they cannot produce the shale gas.

The result is shown in the charts above, based on data from Trade Data Monitor

  • 2019 has seen vast amounts of new US ethylene-based exports, and more is still to come
  • Most of it was exported as PE, where exports have risen 85% so far this year versus 2018
  • The trade war means exports to China have actually dropped, so Europe, SEA and NEA have suffered major disruption
  • US PE exports to these regions were up 98%, 240% and 246% respectively, causing margins to start their collapse

The world is therefore starting to divide into Winners and Losers, as the chart suggests.  Non-integrated ethylene producers around the world are particularly at risk:

  • They have to buy their feedstock at market prices, and they will have to sell into an increasingly over-supplied market
  • As a result, it is quite likely that their margins will become negative – as they have done before in periods of over-supply
  • At this point, integrated producers have the advantage as they are still making money upstream on oil/gas/refining

But there are also wider risks for European and Asian consumers down all the major value chains, as they will be impacted by lower cracker rates.

Scenario analysis must now be a top priority for potential Loser companies.  There really is very little time left, as the margins chart confirms.

Oil markets hold their ‘flag shape’ for the moment, as recession risks mount

Oil markets can’t quite make up their mind as to what they want to do, as the chart confirms. The are trapped in a major ‘flag shape’.

Every time they want to move sharply lower, the bulls jump in to buy on hopes of a major US-China trade deal and a strong economy. But when they want to make new highs, the bears start selling again.

Its been a long journey  for the flag, stretching back to the pre-Crisis peaks at nearly $150/bbl in the summer of 2008. And the bottom of the flag was made back in 2016, after the last collapse from 2014 $115/bbl peak.

Recent weeks have seen the bulls jump back in, when prices again threatened to break the flag’s floor below $60/bbl. And, of course, OPEC keeps making noises about further output cuts in an effort to talk prices higher.

But as the charts from the International Energy Agency’s latest monthly report confirm:

“The OPEC+ countries face a major challenge in 2020 as demand for their crude is expected to fall sharply.”

This is OPEC’s problem when it aims for higher prices than the market will bear. Other producers, inside and outside OPEC, always take advantage of the opportunity to sell more volume. And once they have spent the capital on drilling new wells, the only factor holding them back is the actual production cost.

Capital-intensive industries like oil have always had this problem. They raise capital from investors when prices are high – but high prices naturally choke off demand growth, and so the new wells come on stream just when the market is falling. Next year the IEA suggests will see 2.3mbd of new volume come on stream from the US, Canada, Brazil, Norway and Guyana as a result.

OPEC’s high prices have already impacted demand, as the IEA notes:

Sluggish refinery activity in the first three quarters has caused crude oil demand to fall in 2019 for the first time since 2009.”

OPEC has had a bit of a free pass until recently, though, in respect of the new volumes from the USA. As the chart shows, the shale drilling programme led to a major volume of “drilled but uncompleted wells”. In other words, producers drilled lots of wells, but the pipelines weren’t in place to then take the new oil to potential markets.

But now the situation is changing, particularly in the prolific Permian basin region, as Argus report:

“The Permian basin has been a juggernaut for US producers, with output quadrupling from under 1mbd in 2010 to more than 4.5mbd in October.  US midstream developers have responded with a wave of new long-haul pipelines to shuttle the torrent of supply to Houston, Corpus Christi and beyond.

“The 670kbd Cactus 2 and the 400kbd Epic line went into service in August moving Permian crude to the Corpus Christi area. Phillips 66’s 900kbd Gray Oak pipeline is expected to enter service this month, moving Permian basin crude to Corpus Christi, Texas, for export.”

As a result, some of that oil trapped in drilled but uncompleted wells is starting to come to market. So if OPEC wants to keep prices high, it will either have to cut output further, or hope that the world economy starts to pick up.

But the news on the economic front is not good, as everyone outside the financial world knows.  Central banks are still busy pumping out $bns to keep stock markets moving higher. But in the real world outside Wall Street, high oil prices, trade wars, Brexit uncertainty and many other factors are making recession almost a certainty.

As the chart shows, there is a high correlation between the level of oil prices and global GDP growth. Once oil takes ~3% of GDP, consumers start to cut back on other purchases. They have to drive to work and keep their homes warm in winter. And with inflation weak, their incomes aren’t rising to pay the extra costs.

The US sums up the general weakness.  The impact of President Trump’s tax cuts has long disappeared. And now concerns are refocusing on the debt that it has left behind. As the function of debt is to bring forward demand from the future, growth must now reduce.  US GDP growth was just 1.9% in Q3, and the latest Q4 forecast from the Atlanta Fed is just 0.3% .

Its still too early to forecast which way prices will go, when they finally break out of the flag shape. But their failure to break upwards in the summer, when the bulls were confidently forecasting war with Iran, suggests the balance of risks is now tilting to the downside.

Oil market weakness suggests recession now more likely than Middle East war

Oil markets remain poised between fear of recession and fear of a US attack on Iran. But gradually it seems that fears about a war are reducing, whilst President Trump’s decision to ramp up the trade war with China makes recession far more likely.

The chart of Brent prices captures the current uncertainties:

  • It shows monthly prices for Brent since 1983 and highlights the conflicting risks
  • The bulls have been battling to push prices higher, but their confidence is weakening
  • The bears were hurt by the stimulus from US tax cuts and OPEC output cuts
  • But June’s abandonment of the Iran attack lifted their confidence

As a member of the President’s national security advisory team has noted:

“This is a president who was elected to get us out of war. He doesn’t want war with Iran.”

With fears about a potential war reducing, at least for the moment, attention has instead turned to issues of supply and demand.  And here, again, the balance of different factors has turned negative:

  • As the second chart shows, supply from the 3 major countries remains at a high level
  • The US is the largest producer, and August’s output is now recovering after the slowdown in the Gulf of Mexico due to Hurricane Barry, and the EIA is forecasting new record highs this year and 2020
  • 3 new pipelines are also coming online during H2, which will boost US oil export potential
  • Meanwhile Russia, as usual, has failed to follow through on its commitment to the OPEC cuts. Its output rose by 2% in January-July versus 2018, despite May/June’s contamination problems
  • As always with OPEC output cuts, Saudi Arabia has been forced to fill the gap. Its volume dipped to 9.8mbd in July, well below the 11mbd peak last November

Overall, global supply has remained strong with EIA estimating Q2 output at 100.6mbd versus 99.8mbd in Q2 last year. Contrary to last year’s optimism over global economic recovery, EIA suggests Q2 consumption only rose to 100.3mbd, versus 99.6mbd in Q2 last year.

And the normally bullish International Energy Agency last week cut its demand forecast for this year and 2020 warning:

“The outlook is fragile with a greater likelihood of a downward revision than an upward one…Under our current assumptions, in 2020, the oil market will be well supplied.”

The third chart, from Orbital Insight, highlights the changes that have been taking place in inventory levels in the major regions.

Generated from satellite images of floating roof tank farms, it is based on estimates of the volume of oil in each tank, which are then aggregated to regional or country level.

Oil markets are by nature opaque. But Orbital’s data does show a very high correlation with EIA’s estimates for  Cushing – where the official data is very reliable.

As discussed here many times before, the chemical industry is the best leading indicator for the global economy, due to its wide range of applications and geographic coverage.  The fourth chart shows the steady downward trend since December 2017 in the data on Capacity Utilisation from the American Chemistry Council.

Q2 has shown the usual seasonal ‘bounce’,  but key end-user markets such as electronics, autos and housing are also clearly weakening, as discussed last week for smartphones.  And Bloomberg has reported that US inventory levels at major warehouses are close to being full.

I suggested back in May that prudent companies would develop a scenario approach that planned for both war and recession, given that the outcome was then essentially unknowable.

Today, both scenarios are clearly still possible. But it would seem sensible to now step up planning for recession, given the downbeat signals from oil and chemical markets.

 

 

 

Recession risk rises as Iran tensions and US-China trade war build

Oil markets are once again uneasily balanced between two completely different outcomes – and one again involves Iran.

Back in the summer of 2008, markets were dominated by the potential for an Israeli attack on Iranian nuclear facilities, as I summarised at the time:

“Nothing is certain in life, except death and taxes. But it is hard to see markets becoming less volatile until either an attack takes place, or a peaceful solution is confirmed. And with oil now around $150/bbl, two quite different outcomes seem possible:

• In the event of an Israeli attack, prices might well rise $50/bbl to reach $200/bbl, at least temporarily

• But if diplomacy works, they could easily fall $50/bbl to $100/bbl”

In the event, an attack was never launched and prices quickly fell back to $100/bbl – and then lower as the financial crisis began.

Today, Brent’s uneasy balance around $70/bbl reflects even more complex fears:

  • One set of worries focuses on potential supply disruption from a war in the Middle East
  • The other agonises over the US-China trade war and the rising risk of recession

It is, of course, possible that both fears could be realised if war did break out in the Gulf and oil prices then rose above $100/bbl.

The issue is highlighted in the Reuters chart on the left, which shows that Brent has moved from a contango of $1/bbl at the beginning of the year into a backwardation of nearly $4/bbl on the 6-month calendar spread. As they note:

“Backwardation is associated with periods of under-supply and falling inventories, while contango is associated with the opposite, so the current backwardation implies stocks are expected to fall sharply.”

But as the second Reuters chart confirms, traders are also aware that forecasts for oil demand are based on optimistic IMF forecasts for global growth. And recent hedge fund positioning confirms that caution may be starting to appear.

Traders are also aware of the key message from the above chart, which shows that periods when oil prices cost 3% of global GDP have almost always led to recession.  The only exception was after the financial crisis when central banks were printing as much money as possible to boost liquidity.

The reason is that consumers only have a certain amount of discretionary income.  If oil prices are low, then they have spare cash to buy the products and services that create economic growth. But if prices are high, their cash is instead spent on transport and heating/cooling costs, and so the economy slows.

“To govern is to choose” and President Trump therefore has some hard choices ahead:

  • His trade war with China currently appeals to many voters, Democrat and Republican.  But will that support continue as the costs bite?  The New York Federal Reserve reported on Friday that the latest round of tariffs will cost the average American household $831/year
  • Similarly, many voters favour taking a hard line with Iran.  But average US gasoline prices are already $2.94/gal as the US driving season starts this weekend, and today’s high prices will particularly impact the President’s core blue collar and rural voters

History doesn’t repeat, but it often rhymes as the famous American writer, Mark Twain, noted. If the President now chooses to fight a trade war with China and a real war with Iran, then he risks losing popularity very quickly as the costs in terms of lives and cash become more apparent.  Yet as we have seen since Lyndon Johnson’s time, this is usually something that politicians only learn after the event.

Investors and companies therefore have little to lose, and potentially much to gain, by accepting that we can only guess at how the two situations may play out.  Developing a scenario approach that plans for all the possible outcomes – as in 2008 – is much the most prudent option.

Déjà vu all over again for oil markets as recession risks rise

Back in 2015, veteran Saudi Oil Minister Ali  Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.

As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4.  But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand.  And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.

Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:

  • Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
  • But its short-term need is to support prices by cutting production, in order to fund its spending priorities

The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past.  It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.

The reason is that high oil prices reduce discretionary spending.  Consumers have to drive to work and keep their homes warm (and cool in the summer).  So if oil prices are high, they have to cut back in other areas, slowing the economy.

CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014

There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.

They were creating tens of $tns of free cash to support consumer spending.  But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report.  It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:

“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.

SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS

Oil prices are therefore now on a roller-coaster ride:

  • Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
  • The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December

Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd).  But as always, its “allies” have let it down.  So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.

Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:

Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds.  As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.

But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.

Companies and investors therefore need to be very cautious.  Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.

Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.

 

*Total cost is number of barrels used multiplied by their cost