Group think on oil prices puts company profits at risk

Brent Nov15Shell Chemicals General Manager, Kate Johnson, asked a great question at our Conference last week, to which not a single hand went up in reply, as everyone had forecast an oil price around $100/bbl :

How many of your companies used $60/bbl as their oil price forecast in the 2015 Budget?”

“Group think” is clearly alive and well in the chemical industry.  And according to some delegates, it means that executives routinely refuse to mention the potential for low oil prices within their company.  This would “only cause trouble”, said one, “as it would undermine the investment case for our US projects”.

Budgets and strategies are, of course, supposed to be about reality.  And one topic on which everyone agreed at the Conference was that we were seeing chaos in both feedstock and end-product markets:

  • Chaos in the feedstock markets caused by the ongoing collapse of oil prices, combined with the collapse of natural gas and coal prices, due to over-supply
  • Chaos in end-product markets caused by China’s decision to move away from its previous stimulus policies, and by the drop in demand linked to the ageing of the global population

Is it sensible, therefore for companies and investors to continue to ignore the impact of these factors on their likely future sales and profits?  Or, to put it another way, how much money have they lost this year by having failed to prepare for the impact of over-supplied energy markets and the demand downturn?

This, of course, is why we have launched our 5 Critical Questions Study with ICIS, to look at the potential impact of different Scenarios:

  • Clearly it would be foolish to ignore the fact that Brent prices have been around $50/bbl for most of this year
  • It would also be foolish to ignore that they were at $100/bbl before this
  • But isn’t it equally foolish to ignore that, as the chart shows, they have averaged much lower prices over history?

They have averaged $34/bbl in $2015 since 1861 when BP data begins.  And they average just $24/bbl if one leaves out the price peaks due to the OPEC crisis and recent central bank liquidity programmes.

Developments in the US oil sector also confirm the danger of indulging in wishful thinking over prices.  As Reuters reported, CEOs learnt a painful lesson earlier this year, when they failed to hedge their production at higher prices:

“Oil producers’ rapid response to the latest move upward comes in contrast to the second quarter, when a moderate price recovery was met with only modest hedging interest as many executives bet – wrongly – that the worst was already behind them….for some, hedging is now less an insurance policy than a lifeline as those who have scrimped on protection watched with despair oil prices shuffling between $43 and $48 for six weeks.

Other key indicators are also indicating the potential for further price weakness:

  • US oil companies routinely sell off inventory in December to avoid year-end taxes
  • Inventories for US natural gas (which competes with oil) have risen to all-time highs of 4tn cu ft
  • There are queues of oil tankers waiting to discharge at many major ports
  • Iran has said it will continue to increase production even if prices drop to $20/bbl
  • The International Energy Agency says global inventories are at a record 3bn barrels (a month’s world supply)
  • Iraq is already selling its heavy crude at $30/bbl for December as it ramps up exports

Plus of course, there is ample evidence from other commodity markets that China’s slowdown is causing prices to return to historical levels, or lower.  The Baltic Dry Index, which reflects demand for copper, iron ore, fertiliser and other commodities is now trading at all-time low.

Of course, oil markets are always full of surprises.  But is it really sensible for companies to refuse to even consider perfectly reasonable oil price Scenarios?

WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments: 
Brent crude oil, down 58%
Naphtha Europe, down 52%. “Naphtha refining margins rose to a near five-year high this week on the back of high-volume exports to Asia, and helped by a fresh wave of West African gasoline demand.”
Benzene Europe, down 56%. “US benzene markets as well as crude oil and energy movements have steered prices.”
PTA China, down 41%. “An increase in export volumes is expected next year as China looks for sales outlets for locally-produced product”
HDPE US export, down 33%. “Prices for domestic exports moved up on thinning supply”
¥:$, down 20%
S&P 500 stock market index, up 7%

Stock market volatility surges as margin debt hits danger level

NYSE margin Aug15

Global stock markets turned in a vintage experience last week for those who like horror movies.

Continued sell-offs in China finally convinced some financial investors, and some senior Western policymakers, that its economy might not be quite as strong as they had assumed.  The ensuing panic led to record profits for the high frequency traders (HFTs), as the Dow Jones Index fell 1000 points at one very scary moment – and then recovered.

The market recovery was led by Ray Dalio, boss of the world’s largest hedge fund, Bridgewater Associates, who forecast that the US Federal Reserve would not raise rates – and would instead launch yet another round of Quantitative Easing:

We are saying that we believe that there will be a big easing before a big tightening

And almost immediately, the head of the New York Fed rushed to assure investors that, indeed, bursting the stock market bubble was the last thing on the Fed’s mind, saying that:

the argument for tightening monetary policy as early as September seems less compelling to me [now] than it was a few weeks ago”. 

This highlights how the role of stock markets has changed completely due to the Fed’s money-printing.  They used to be a place where companies would go to raise money to expand their business.  But today, companies have become the biggest buyers on Wall Street.  Goldman Sachs report that share buybacks are running at a $600bn rate – around 30% of companies’ total cash spending.

STOCK MARKETS NEED MORE QE TO RESUME THEIR RISE
The Fed, like other central banks, has counted on creating a ‘wealth effect‘ via ever-rising stock markets to create economic recovery.   In turn, this has encouraged hedge funds like Bridgewater to borrow heavily in the belief that the Fed would never let markets fall.

But one day, all this borrowing has to be repaid.  And so Fed governors have recently tried to boost the market via speeches and press comments rather than new money-printing.  But whilst talk can stop markets falling, it can’t push them higher.  As the above chart on New York Stock Exchange margin debt shows, the S&P 500 peaked in May (blue line), once margin debt had peaked in April (red).  And as I noted back in June:

New highs for margin debt have not been good news for investors in the past.  The astonishing surge in leverage in late 1999 peaked in March 2000, the same month that the S&P 500 hit its all-time daily high…. A similar surge began in 2006, peaking in July 2007, 3 months before the market peak.

So Dalio is therefore quite right to suggest that more QE is needed if stock markets are to move higher.  But this could be a very risky move in a US Presidential election year.  Populist candidates such as Trump and Sanders might well ask what had happened to the $4tn the Fed has already spent on QE since 2009.

MARKET SELL-OFF IS A WARNING SIGN FOR THE AUTUMN
Volatility on last week’s scale is normally a sign that the underlying direction of the market is reversing.  The bulls are trying to take prices higher, but the bears have spotted that their firepower is reducing.  This confirms the insight I was given by one money manager back in December:

“His view was that the lower oil price would help to keep inflation low, and so delay interest rate rises till Q4 2015.  This view means he has to continue investing in the markets, even though he thinks they are all wildly over-valued.  His argument was simple, namely that the Fed and Bank of Japan and others are forcing him to invest in stocks as the money earns nothing sitting in the bank.  He is being effectively held hostage by the central banks.

“His own personal worry, having experienced the 1994 bond crash, is that whilst everyone thinks they can get out ‘before the market turns’, common sense also says everyone will try to stay in until the last possible moment, to maximise returns.  Then everyone will charge for the exits at the same moment, and there could be blood on the street.”

Today, as we enter September, its hard to argue with his forecast.  What happens next is anyone’s guess:

  • History would suggest that the most likely outcome is for a repeat of the 2000 and 2007-8 experience, where margin debt is unwound quite violently as investors rush for the exits in a panic
  • But maybe, ‘this time is different’.  Maybe the Fed will not only abandon hopes of being able to raise interest rates, but also follow Dalio’s advice and go for another multi-$tn QE stimulus package

It could be a fun-packed autumn for those who love horror movies, whilst this battle is fought out in the markets.

WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments: 
Brent crude oil, down 56%
Naphtha Europe, down 57%. “Market fundamentals are weak on signs of softening US summer gasoline demand and cuts in cracker run rates in the key export market of Asia.”
Benzene Europe, down 63%. “Prices hit their lowest point since April 2009 earlier this week amid global downward movement and the wider macroeconomic bearishness stemming from the collapse of Asian stock indices.”
PTA China, down 47%. “Market fundamentals remain weak”
HDPE US export, down 34%. “Domestic export prices continued to drop, as suppliers ran after demand in offshore markets.”
¥:$, down 19%
S&P 500 stock market index, up 2%

Global shipping index hits all-time low

Baltic Dry Feb15aThe world’s major shipping index, the Baltic Dry (BDI), has collapsed by 2/3rds since November, and by 80% since its earlier December 2013 peak, as the chart shows.  It is now at an all-time low of 509, almost half of its initial 1000 level when established in January 1985.

Shipping is the major mode of transport for world trade, so this sudden collapse is potentially very worrying.  Reuters reports 2 shipping companies have already gone bankrupt.  No doubt, more will follow.

The key to the collapse, of course, is China’s move into the New Normal.  Shipping markets were slower to wake up to the implications of this than oil markets, but the BDI’s collapse shows they are now making up for lost time.

As with energy, mining and chemicals, the shipping industry wanted to believe in the myth that China had suddenly become “middle class” by Western standards, and was about to deliver perpetual growth.  So it has vastly over-ordered new capacity, with brokers Clarkson estimating 39% will be added to fleets over the next 3 years.

In the very short-term, of course, the developing port strike on the US West Coast is also a negative influence.

But the core issue is the collapse underway in China’s trade.  January data showed China’s exports were down 3% versus 2014, and its imports down 20%.  Whilst Q4 data showed China suffered its largest capital outflow on record, with $91bn leaving the country.

THIS TIME, THE COLLAPSE MAY BE FOR REAL
Long-term readers will remember we have been here before, only for policymakers to introduce major new stimulus measures:

  • The BDI fell 90% from its May peak by October 2008, but then recovered after the G20 summit in April 2009
  • It fell sharply again in Q1 2010, before China and the US both increased their lending
  • And it fell sharply again in late 2011/2012, before Japan added its Abenomics stimulus to the US Federal Reserve’s Twist programme

So is the BDI’s collapse simply the prelude to another, even larger, stimulus effort?

We cannot rule this out.  But the Fed at the moment is trapped in a web of its own making:

  • It has boasted for months that its policy has proved successful and restored the US economy to health
  • Intensive planning is now underway about the timing of its expected interest rate rise
  • So it seems most unlikely this policy could suddenly be reversed

Instead, it seems more likely that the Fed is repeating its mistake of July 2007, and believing its own propaganda.  Then Chairman Bernanke was insisting the cost of any sub-prime housing problem would only be $100bn at most.

It also seems unlikely that China will change course from its New Normal, with its main policy conference next month.

So this time, the BDI’s fall may not be countered by more stimulus aimed at producing another ‘wealth effect’ in financial markets.  After all, debt has already soared to 3x global GDP as a result of all these stimulus efforts.

Instead, policymakers may begin to realise how difficult it will be to repay all this debt, as deflation causes its value to rise day-by-day.

The great ‘Deflation Shock’ is coming closer

RingofFire Jan15

 

The world is about to be hit by a demand shock equivalent to 1973′s supply shock.  Yet, astonishingly, most commentators remain so focused on central bank activity, that they have completely missed what is happening.  Here’s how it is playing out.

You may remember the ‘The pH Report‘ forecast in early December that:

Oil prices are likely to continue falling to $50/bbl and probably lower in H1 2015, in the absence of OPEC cutbacks or other supply disruption.  Critically, China’s slowdown under President Xi’s New Normal economic policy means its demand growth will be a fraction of that seen in the past.

“This will create a demand shock equivalent to the supply shock seen in 1973 during the Arab oil boycott.  Then the strength of BabyBoomer demand, at a time of weak supply growth, led to a dramatic increase in inflation.  By contrast, today’s ageing Boomers mean that demand is weakening at a time when the world faces an energy supply glut.  This will effectively reverse the 1973 position and lead to the arrival of a deflationary mindset.” 

The reason is that central banks have created a debt-fuelled ‘Ring of Fire’, and as the map shows, major fault lines are now opening up across the world – and creating warning tremors of the earthquakes ahead.

These are unlikely to lead to a repeat of 2008′s financial collapse.  But their effect will be magnified by the fact they are all linked to debt burdens that can probably never be repaid.

THE FAULT LINES LEADING OUT FROM CHINA ARE BECOMING WIDE OPEN
China’s New Normal policies were the starting point for the opening of the fault lines:

  • June saw the first impact as Beijing house prices fell; now property tax revenue is down a third nationally
  • Oil demand then weakened, as the Great Unwinding of China’s stimulus policies continued
  • The US$ also began to strengthen, as the US Federal Reserve tapered its money-printing activity
  • These moves were mutually supportive, as financial players then saw no need to buy oil as a ‘store of value’
  • The first fault lines thus opened between China and Russia/Middle East as oil prices collapsed

Last week, a new set of fault lines opened to Australia and South Africa, as copper prices and mining company shares began to collapse due to major selling in China.

Copper has an importance beyond its own markets.  It is widely seen as Dr Copper – an important indicator for the entire global economy.  Its price decline, along with that of most other commodities, will add to deflationary pressure:

  • China’s slowing economy is exporting deflation around the world – its producer prices fell 3.3% last month
  • The Eurozone went into deflation last month, with consumer prices down 0.2%
  • Japan’s return to deflation is now just a matter of time, despite premier Abe’s money-printing
  • Switzerland’s sudden removal of its currency cap means its deflation will become entrenched
  • And US inflation has already fallen to just 0.8%, making deflation very likely there before too long

Even more significant was that the tremors from Switzerland ‘s revaluation opened the fault lines across the Atlantic to New York.  Currency brokers around the world suffered major losses, as the franc initially soared 40% in 2 minutes versus the euro.

Of course, the same people who missed the start of the Great Unwinding are still arguing that “everything is for the best, in this best of all possible worlds“.

But chemical markets remain the best leading indicator we have for the global economy.  They told us in April that a downturn had begun.  And today I am hearing reports of some major bankruptcies underway in China.  There will be many more globally, as companies find themselves with high-priced inventory whilst demand remains weak.

In 1973, the inflation shock was led by oil, as Boomer demand created massive supply shortages.  Now, 40 years later, oil is taking us into deflation.  The reason is simple – the ageing Boomers no longer need, or can afford, to maintain their previous levels of demand.

 

WEEKLY MARKET ROUND-UP
The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:

Benzene Europe, down 59%. “Weakening oil and energy prices and slow derivative demand are weighing on the market”
Brent crude oil, down 54%
Naphtha Europe, down 52%. “Downstream ethylene volumes are being purchased on a strict hand-to-mouth basis, whilst the propylene market is long”
PTA China, down 45%. ”Sentiment was largely weaker during the week as buyers were trying to maintain low inventories amid an uncertain market outlook”
¥:$, down 15%
HDPE US export, down 19%. “Export prices tumbled across the board in response to lower ethylene and energy market values. But prices still can fall much lower.  Traders reported INEOS auctioned off 8-10 rail-cars at prices 15% below published market prices”
S&P 500 stock market index, up 3%

Polymer markets at risk if China’s ‘collateral trade’ unwinds

Dalian Sept14

Global metal markets are at growing risk from developments in China’s ‘collateral trade’, as yesterday’s post highlighted.  Worryingly, so are products such as polyethylene and ethylene glycol, as it seems likely these have also been used as collateral more recently.  This will be bad news for producers already suffering from slowing demand:

  • China’s economy continues to weaken as the government tackles the housing bubble
  • Major new capacity is starting up within China, reducing the need for imports still further

As the blog noted recently, the background is as follows:

“More recently, it seems large amounts of polyethylene (PE), ethylene glycol (MEG) and probably other chemicals have also started to be used for the trade.  None of this used to matter when the Chinese economy was booming.  Why ask too many questions, when the profits are rising?  But now China’s economy is slowing fast under the new leadership.

“So now people are asking questions about why, for example, polyethylene imports appear to have risen 20% in H1 versus 2013″.

VOLUMES DOUBLED ON THE DALIAN FUTURES MARKET BETWEEN FEBRUARY – JULY
The blog highlighted one of the potential mechanisms in a July post for Beyondbrics in the Financial Times as follows:

“Strange things are happening in China’s polyethylene (PE) market. Despite a slowdown in the economy, demand is surgingOur research suggests that PE, like copper and iron before it, is the latest instrument of China’s ‘collateral trade’, in which spurious imports are helping to drive one of the world’s great credit bubbles….

“The key to success for the PE collateral traders is the availability of a liquid futures market contract for polyethylene at Dalian, where the product can be turned into cash very quickly. As we described in a recent China Compass research note, one common mechanism is as follows:

  • The potential lender buys a PE cargo on normal 180 days credit from an overseas seller
  • He then turns around immediately and sells the cargo on the Dalian futures market
  • Now he has cash to lend into the shadow banking market at interest rates of up to 60%
  • In turn, the property developer now has the cash to finish his building work
  • As the 180 day period ends, the lender can ‘roll over’ the purchase by selling to a Hong Kong-based company
  • By opening a letter of credit, it can then use the proceeds to ‘roll over’ the previous trade

“Naturally, there are risks in this. But China is coming to the end of one of the world’s great credit bubbles. And when this type of bubble is under way, greed is a far more powerful emotion than fear. Who would want to be known as the only business in town that hasn’t done this type of clever deal?

“Of course, it will not end well. The government is unlikely to change its mind about bursting the bubble. And so at some point, all this surplus PE will have to come back onto the market. That will be very bad news for everyone connected to the PE business, be they buyers or sellers.”

The chart above of PE volume traded on China’s Dalian futures market appears to confirm this mechanism.  It shows that volume doubled between February and July from 17 million to 35 million tonnes:

  • Maybe February’s volume was artificially low due to Lunar New Year (but January volume was only 22 million)?
  • Maybe some of the upturn was people taking a punt on higher oil prices, and therefore higher PE prices?
  • But even so, a doubling of volume is still extremely unusual and suggests something else was happening

Today, of course, the opposite is happening.  Volume is weakening and market prices are falling, as oil weakens and demand slows still further.  As ICIS Pricing reported on Friday:

China’s domestic PE prices dropped this week. The market sentiment was weighed down by the plummeting LLDPE futures prices at Dalian after the anticipated economic stimulus policy by the Chinese government failed to materialise. Physical spot traders were seen cutting down their offers to offload cargoes to the market.”

Plus, of course, major new domestic capacity is now starting up in China, as the government aims to achieve self-sufficiency.

None of us can know if the potential Unwinding of the ‘collateral trade’ will indeed take place.  But the risks are rising all the time, especially with official fraud investigations now underway.  As the blog has long feared, polymer producers and consumers may well end up being the innocent victims of circumstances beyond their control.

China’s PE imports jump 26% as credit bubble peaks

China PE Apr14

Strange things are happening in China’s polyethylene (PE) market, as the chart shows:

  • Imports suddenly jumped 26% in Q1 (red column) versus last year (green)
  • This would be an extraordinary amount at any time, but especially now with the economy slowing
  • It comes at a time when China’s own production continued to increase, up 8%
  • As a result, implied demand was up 16% – impossibly high in relation to on-the-ground reports

Luckily, though, we can examine the detailed trade statistics from Global Trade Information Services.  These show that imports began to increase in November last year:

  • October had seen 690KT of imports, but then November saw 870KT and December 908KT
  • Then January jumped to 1.1MT, followed by 741KT in February and 786KT in March
  • Thus Q1 2013 imports totalled 2.6MT, versus 2MT in both 2013 and 2012

So now we know “what” has been happening, its easier to understand “why”.

The answer is very simple – China’s credit squeeze as the new leadership aims to burst the credit bubbles it inherited.  It has to slow credit growth, as described in detail in February’s Research Note.  But the real estate developers have become more and more creative in their search for ways of obtaining cash by the back door.

Thus readers will remember the deals that were being done in China’s auto market in October last year

Everyone’s offering 0% financing now and in some cases buyers end up with their car for free. How? The buyer pays for the car but with the guarantee of the money back in two  years. The seller invests the money in the shadow banking system where he hopes for returns of 60% a year or so before selling up and giving it back. Not bad.”

Metals markets have also been used for the same purpose:

In copper, traders have estimated that up to half of China’s imports have been used as collateral to raise cheap US dollar loans“.

Thus it isn’t rocket science to realise that PE is now being used for the same financing trade.  This can work in a number of different ways, but one common mechanism is as follows:

  • The potential lender buys a PE cargo on normal 180 days credit from an overseas seller
  • He then turns around immediately and sells the cargo on the Dalian futures market
  • Now he has cash to lend into the shadow banking market at interest rates of 60%
  • In turn, the property developer now has the cash to finish his building work

Buyers at last month’s ChinaPlas exhibition were seeing the same picture, as one leading trader told fellow blogger John Richardson:

They were talking about credit shortages, weak downstream demand and PE being used as collateral to buy condos and even luxury sports cars”

Of course, there are risks in this.  But China is coming to the end of one of the world’s great credit bubbles.  And when this type of bubble is underway, greed is a far more powerful emotion than fear.  Would you want to be known as the only person in the office who hasn’t done this type of clever deal?

Of course, it will not end well.  The government is unlikely to change its mind about bursting the bubble.  And of course, at some point, all this surplus PE will have to come back onto the market.  That will be very bad news for everyone connected to the PE business, whether buyers or sellers.