Serious questions need to be asked about the likely level of future demand growth for oil and auto sales in Emerging Markets (EMs), as I describe in my latest post for the Financial Times, published on the BeyondBrics blog Oil market volatility has reached near-record levels in H1 this year, as the first chart shows. It has averaged nearly 10% a week, and over the past quarter-century its three-month average has only been higher during the Gulf War and the subprime crash. Yet there have been no major supply disruptions or financial shocks to justify such a dramatic increase. Instead, July’s report from the International Energy Agency reminds us that:
“OECD commercial inventories built by 13.5 mb in May to end the month at a record 3 074 mb. Preliminary information for June suggests that OECD stocks added a further 0.9 mb while floating storage has continued to build, reaching its highest level since 2009.”
The problem is two-fold:
Financial markets are now reaching the hard part of the Great Unwinding of policymaker stimulus, which began nearly two years ago as we have described in beyondbrics. Their key role of price discovery has been subverted by the tidal waves of central bank liquidity, and today’s elevated levels of volatility suggest it will be a difficult journey back, as markets return to valuations that are instead based on the fundamentals of supply and demand
Life has not stood still over the past few years, and so there will also be plenty of surprises along the way as players are forced to recognise that many of their core assumptions are either untrue or out of date. The excitement of the 2009–2014 stimulus period, for example, seems to have led many investors to ignore the 2012 warning from then Saudi oil minister Ali al-Naimi that “Oil demand will peak way ahead of supply”. Today, they are being forced to play catch-up, as they digest the implications of Saudi Arabia’s new National Transformation Plan. Yet its core objective that “Within 20 years, we will be an economy that doesn’t depend mainly on oil”, is clearly linked to Naimi’s earlier insight.
New data from the US Energy Information Agency (EIA) confirms Saudi Arabia’s need for a change of direction, as the chart shows. The EIA’s reference case scenario out to 2040 suggests that US energy consumption will increasingly be led by natural gas and renewables, and notes that
“Petroleum consumption remains similar to current levels through 2040, as fuel economy improvements and other changes in the transportation sector offset growth in population and travel.”
Nor are these trends confined to the US. As Nick Butler has argued recently in the FT, conventional forecasts of ever-rising energy demand driven by rising populations and rising prosperity in the EMs appear far too simplistic. Instead, as he notes: “Demand has stagnated and in some areas is falling.”
Developments in the transportation sector (the largest source of petroleum demand), confirm that a paradigm shift is now underway along the whole value chain. As Dan Amman, president of GM, highlighted in the FT last year, when discussing the value proposition for city dwellers of buying a new car:
“It’s the last thing you should do because you buy this asset, it depreciates fairly rapidly, you use it 3 per cent of the time, and you pay a vast amount of money to park it for the other 97 per cent of the time.”
China’s slowdown confirms the depth of the challenge to conventional thinking about future auto and oil demand. Many still assume that EMs will account for two thirds of global auto sales by 2020, and underpin future oil demand growth. But the China-induced collapse of commodity export revenues in formerly high-flying economies such as Brazil and Russia means that this rosy scenario is also in need of major revision.
As noted last November, Brazil was temporarily the world’s fourth largest auto market in 2013, whilst Russia was forecast to reach fifth position by 2020. But as the chart of H1 sales in the BRIC countries shows, volumes in both countries have almost halved since then. China’s own sales growth is also slowing, as the government’s need to combat pollution has led it to focus on implementing policies aimed at boosting the role of car sharing and public transport – while its focus on electric vehicles is a further downside for future oil demand.
As we move into H2, it therefore appears that the fundamental assumptions behind the $3tn of energy market debt – $100/bbl oil and double-digit economic growth in China – are looking increasingly implausible. And given oil’s pivotal role in the global economy, today’s near-record levels of oil market volatility may also be trying to warn us that wider problems lie ahead for financial and energy markets.
We are approaching the 2nd anniversary of the Great Unwinding of policymaker stimulus, which began in August 2014:
The initial movement was very sharp, with Brent falling 53% by January and the US$ rising 23% by March
Oil then saw an initial correction – with Brent recovering to being 37% down by May during the “oil rig rally“
After that, Brent again fell away sharply to be 72% down by January this year
Since then we have seen another correction, with the “price freeze rally” taking it to 52% down last month
Meanwhile, the US$ has been stable, trading in the +14% – +23% range set between March – May 2015
The oil price movements highlight how markets will often not move in straight lines:
Some traders will decide to take their profits and sell after a sharp move
This will encourage others to think there is a chance to jump in and profit from at least a temporary bottom or top
And, of course, sentiment will also be impacted by events in the political and economic spheres
The key factor, as I learnt when trading in oil and product markets in Houston, Texas for ICI is that “the trend is your friend“. Traders will delight in short-term volatility, and try to catch the various up and down movements. Genuine investors will ignore these and instead focus on the long-term trend. For them, the Great Unwinding concept has been very helpful in understanding the outlook for oil and the US$ – the 2 key components of the Unwinding.
Another useful guide over the past 2 years has been the concept of “higher lows and lower highs“, which helps to highlight major turning points, as the dotted trend lines illustrate:
Oil prices have never returned to the August 2014 level, and they made new lows once the “oil rig rally” ended
The US$ has essentially been trading within tram lines over the past 18 months – preparing for another breakout
This pattern of “technical trading” is, course, exactly what guided us during the previous oil market rally from 2009 – August 2014. Readers will remember the above chart from 21 August 2014. Its value was that it enabled us to map the battle between the financial players and the fundamentals of supply/demand, as I noted then:
“Thus the oil price is finally starting to fall out of its triangle:
10 years of historically high prices has led to major new investment, which is finally starting to come online – not only in oil, but also in gas and other energy sources
At the same time, central bank lending is finally starting to reduce in China and the US
10 years of high prices have also led to demand destruction via greater efficiency and conservation efforts
“The result, as the IEA note, is that we suddenly find we face a supply glut.
“So the chart is telling us that the financial players are now retreating from the market. In turn, this means physical supply/demand levels will come to drive the process of price discovery once again.”
There was never any real logic behind the story that the US drilling rig decline would lead to lower oil production, or that an OPEC/Russia production freeze would cause markets to rebalance. But in today’s world of high-frequency trading, driven by algorithms, most traders focus on making a quick profit rather than logic. Many senior oil company executives are also happy to talk the market up, hoping this will boost their company’s share price.
But today, we seem to have once again reached the fork in the road, with massive oil surpluses now emerging. As Reuters noted on Friday:
“The levels of diesel, gasoline and heating oil in storage tanks in Europe this week are so high they are causing delivery backlogs and are casting doubt on whether demand for oil to be refined can be sustained….storage tanks for diesel and heating oil are already so full in Germany, Europe’s largest diesel consumer, that barges looking to discharge their oil product cargoes along the Rhine are being delayed, sources told Reuters….
“The sheer volume of gasoline in the system, despite surging demand, has more than halved gasoline refining margins in Europe over the past two weeks to just $5.75 per barrel on Thursday, a fifth of where they stood at the same time last year”
The US$ looks similarly ready to make a move out of its tramlines, as the Eurozone debt crisis re-emerges into public view. The key is the Italian banking system, which appears close to collapse. I will look at this shortly.
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 54%
Naphtha Europe, down 56%. “European gasoline refinery margins have come under increasing downward pressure on an escalation in Atlantic Basin inventory levels.”
Benzene Europe, down 55%. “Other players had a more bearish outlook for oil and energy numbers in the coming weeks, and expect that to pull benzene prices down.”
PTA China, down 39%. “Sentiments were bearish, as a major Chinese PTA producer continued to sell large volumes of Chinese Yuan (CNY)- denominated PTA cargoes this week, with the selling frenzy continuing from last Friday”
HDPE US export, down 33%. “Some Chinese traders opted to stand on the sideline as they hold comfortable inventory levels and an uncertain outlook of the market”
US$ Index, up 18%
S&P 500 stock market index, up 9%
2015 was the year when companies and markets began to feel the impact of the Great Unwinding of stimulus policies.
The blog’s readership has increased significantly as a result, as people began to abandon the consensus wisdom which had so clearly failed – once again – to provide a reliable guide to the outlook.
The key has been China’s change of economic direction. And this is likely to intensify in 2016, as President Xi looks to complete the process of “taking the pain of restructuring the economy” before he comes up for reappointment in 2017. China’s recent Central Economic Work Conference was clear about the priorities:
“In the 1980s, former US president Ronald Reagan and then UK prime minister Margaret Thatcher implemented the policies of supply-side economics and monetarism. Monetarism advocates maintaining money supply according to the GDP growth rate and leaving other problems to the market. According to supply-side economics, the government should reduce taxes to encourage enterprises to foster innovation and boost public consumption…and it added
“China’s economy is in dire need of a makeover. Instead of working on the demand side, attention has turned to stimulating business through tax cuts, entrepreneurship and innovation while phasing out excess capacity resulting from the previous stimulus. Such measures are intended to increase the supply of goods and services, consequently lowering prices and boosting consumption.
“Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.”
Understanding these developments, and their impact on the global economy, will be a key theme in 2016 for my new pH Report subscription service, which has had an encouraging first year. I hope you might consider subscribing.
Thank you also for your continued support for the blog. Its audience continues to grow, as shown in the chart above, with its visits now totalling 380k. Its readership includes 186 countries and over 10k cities. Readers also remain very loyal, with one in two reading it every week, and one in four reading it every day.
It is tempting to blame this on misfiring algorithms at the high-frequency traders. Regulators have been asleep at the wheel, and allowed them to dominate energy markets (and most other major financial markets). They are now responsible for half of all energy trading each day.
But there is a bigger issue underlying this problem, and one that must greatly concern companies as they finalise Budgets for 2016-18. This is the Great Unwinding now underway of the policymaker stimulus that pushed oil and other prices higher after 2008 – and led to China’s property and other bubbles now being unwound by President Xi:
They have given companies a completely false view of underlying demand
It disguised the fact that 1bn people in the world are moving out of the high-earning, high-spending Wealth Creator generation (those aged 25 – 54), into the low-earning, low-spending New Old 55+ generation
As a result, the industry has vastly over-expanded its capacity. It always does this at market peaks, as executives – cheered on by investors – rush to build new plants on the basis that demand growth will continue forever. The post-2008 market cycle has been even worse than normal for 2 key reasons:
Most companies knew very little about China before 2008, and were easily persuaded that it would continue to see double-digit growth. They were also fooled by consensus thinking into believing that 3bn people in the emerging economies were becoming middle class
Companies also put on their rose-tinted glasses when it came to assessing the impact of ageing populations on demand. They wanted to believe that “this time would be different”, and 65-year-olds would suddenly start spending as if they were 20 years younger
Now the Great Unwinding of these policies is underway, and all this excess capacity will force companies to compete fiercely on price and battle for market share. Even worse is the risk that, unlike in the past, demand may never catch up with all this new supply. It will take decades for the supposed ‘middle class’ in emerging economies to actually become middle class – if all goes well. And it would take 25 years for new babies to grow up and become Wealth Creators, even if women suddenly started tomorrow to reverse the decline in fertility rates and have more babies.
And this is where the problem of those ‘flash crashes’ becomes serious. It seems very unlikely that policymakers outside China will suddenly realise the error of their ways, and abandon stimulus. Far more likely, as the European Central Bank suggested last week, that they will do more and more stimulus to try and hide the failure of their policies. So markets will be pushed higher by the lure of unlimited amounts of free money from the central banks, and then brought low by the return of reality in terms of slowing demand and increasing debt levels.
As the map above shows, stimulus has effectively created fault-lines throughout the global economy. hose connected to emerging economies which have lost Chinese markets, have already started to open (thick lines). The developed economies will follow as the impact of China’s slowdown spreads (dotted lines). It will be a bumpy ride for the next few years. And companies should plan for the bumps in the road to be particularly large next year:
China accounted for half of all stimulus in the 2008 – 2012 period before President Xi took office
Since then he has been focused on unwinding the lending bubble he inherited
He has also been redirecting the economy into a services-led New Normal, based on the mobile internet
This means that China’s Old Normal economy will slowly wither away, never to return
2016 is critically important for his policies. He is due to seek re-appointment for a second 5-year term in November 2017. And it would make no sense for him to do this with the job half-done. Political necessity suggests he must try to ‘take the pain’ of adjustment by the end of 2016. Then he can approach the November 2017 Plenum with a platform that can not only claim to have resolved the problems he inherited, but also point to the sunlit uplands ahead – as his major initiatives of the Asian Infrastructure Investment Bank and the ‘One Belt, One Road‘ start to become reality.
So 2016 will see China putting its foot hard on the brakes of the Old Normal economy – whilst Western policymakers compete to ramp up stimulus to compensate. It could easily prove to be as difficult a year as 2008. Companies owe it to themselves to plan ahead for this Scenario. ’Flash crashes’ take place in a flash, not over months. It could prove too late afterwards to regret that you had failed to put the necessary contingency plan in place.
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 54% Naphtha Europe, down 52%. “Petrochemical demand for naphtha softens” Benzene Europe, down 58%. “The key fundamentals in the European market are largely steady” PTA China, down 42%. “Sentiment continued to be depressed by limited buying intentions from end-users and soft Brent crude prices” HDPE US export, down 35%. “Domestic export prices remained stable” ¥:$, down 19% S&P 500 stock market index, up 6%
2009′s ‘Budgeting for a New Normal’ was then more positive than the consensus, suggesting “2010 should be a better year for the chemical industry, as demand grows in line with a recovery in global GDP“
The 2010 Outlook was ‘Budgeting for Uncertainty’. This introduced the concept of Scenario planning, to help deal with “today’s increasingly uncertain New Normal environment.”
2011 was ‘Budgeting for Austerity’. It anticipated weak growth across Europe as a result of the austerity measures being introduced, and disappointing global growth, whilst arguing that major new opportunities were opening up as a result of changing demographic trends
Please click here if you would like to download a free copy of all the Budget Outlooks.
Before publishing the new Outlook each year, I always like to review my previous forecast. Past performance may not be a perfect guide to the future, but it is the best we have.
Last year’s Outlook returned to the Scenario approach, given the potential for further policymaker stimulus. This provides a short-term ‘sugar-high’ for financial markets, which feast on the supply of free cash to push prices higher. There was indeed more stimulus from the Bank of Japan in November and from the European Central Bank in March.
Neither effort has worked however. And thus the Outlook’s main Scenario has indeed come true. All major developed country economies are now back in deflation, as the chart above confirms. As I wrote last year:
“The most likely Scenario focuses on the Great Unwinding of policymaker stimulus now underway. This is taking us into the final stages of the Cycle of Deflation, which has been building since the ‘dot-com bubble’ burst in 2000.
“THE CYCLE OF DEFLATION “The key feature of this Scenario is that the world is now becoming demand-constrained. In the past, advantaged-cost supply was key to success. “If you build it, they will come” was the motto.
“But today, it is becoming widely recognised that we have a supply glut in most key areas – certainly in energy and commodity markets, and also further down most value chains….
“Of course, deflation wouldn’t be a major issue today if markets had been allowed to operate normally after 2000. Most Western countries had moved into budget surplus, and were not burdened with today’s debt levels.
“But we are where we are.”
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 52% Naphtha Europe, down 49%. “Petrochemical demand is starting to soften and this might continue throughout Q4, especially if the price spread between naphtha and propane continues to be as wide as today” Benzene Europe, down 59%. “European benzene spot values continued to move in tandem with crude oil fluctuations as well as developments in the US Gulf market this week” PTA China, down 41%. “Major producers do not expect major increases in demand for PTA cargoes in the near term owing to the bearish outlook for downstream polyester” HDPE US export, down 35%. “Domestic export prices edged up for most grades this week because Texas warehouses are full of material going offshore” ¥:$, down 17% S&P 500 stock market index, up 4%
The global commodity super-bubble is coming to an end, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
It is exactly a year since we forecast that a Great Unwinding of stimulus policies was underway, due to a major slowdown in China. As we warned on beyondbrics:
Oil and commodity prices are falling sharply as supply/demand once again becomes the key driver for prices; the US dollar is strengthening and liquidity is tightening across the world; equity markets risk sharp falls, as investors realise they have overpaid for future growth and rush for the exits; China’s economy is slowing fast as the new leadership implements the World Bank’s ‘China 2030’ plan; interest rates are becoming volatile as some investors seek a ‘safe haven’, while others worry that stimulus policy debt may never be repaid.
Today, it is clear that risks are rising in all these areas. And fewer people now believe that the problems can be magically wished away by a further round of stimulus – even if this was economically and politically possible.
Our view is that markets are beginning to recognise that China fooled the world with its stimulus programme. Contrary to popular belief, China did not suddenly become middle-class by Western standards in 2009. Instead, aided by developed country stimulus, its easy-lending policy created a global commodity super-bubble to rival, and perhaps even exceed, the US dot-com bubble in 2000 and the US subprime bubble in 2008.
China’s new leadership have been busy reversing this policy since coming into power in March 2013, following the strategy set out in the ‘China 2030’ plan. In turn, this has turned the world upside-down for commodity exporters, who had borrowed heavily to boost production in order to meet China’s supposedly ever-increasing demand. This is now creating a debt-fuelled ‘ring of fire’ connecting Latin America, South Africa and South East Asia with Australia, the Middle East and Russia.
It was of course comforting for investors to believe that the start of the downturn in May 2013 was somehow due to a ‘taper tantrum’, caused by a concern that US interest rates might not stay at zero forever. Comforting, but unrealistic. Instead, it was markets starting to recognise that China’s consumption boom was only temporary, and mainly due to government stimulus spending.
Understandably, investors had not wanted to ask too many questions about the underpinnings of China’s boom, as this had stabilised global markets and the economy from 2009. But in reality, it was built on a threefold increase in total social financing through state and shadow banks. Official estimates show lending jumped from $83bn in December 2008 to a peak of $252bn in May 2013 (on a 12-month moving average basis). Since then, lending has fallen by nearly a fifth to average just $202bn in July. Bubbles deflate like balloons when the lending that created them starts to reduce.
The problem with the lending stimulus was simply that it was unsustainable. By the first quarter of 2013, each $1 of credit was adding the equivalent of just 17 cents to Chinese GDP, down from 29 cents the previous year and 83 cents in 2007. And as the FT noted last October, China’s debt service bill is now running at around 17 per cent of 2015 GDP, or $1.7tn, almost equal to India’s total GDP.
Of course, markets and policymakers never move in straight lines. We will almost certainly see further volatility in coming weeks. Many investors have, after all, been taught to ‘buy on the dips’ on the assumption that any downturn will force policymakers to add more stimulus. But the problem with this strategy is that the size of today’s global commodity super-bubble surplus is just too large relative to demand. As the International Energy Agency’s August report noted for oil markets, “global supply continues to grow at a breakneck pace“. As a result, it warned that “2H15 sees supply exceeding demand by 1.4 mb/d, testing storage limits worldwide”.
Thus market developments seem to be confirming our long-held view that oil prices will return to their historical levels around $25/bbl. Our latest pH Report highlights three key implications of this development for investors and companies:
Deflation is looming in the major economies as commodity prices fall and China’s export prices are further reduced by its devaluation.
We fear that the end of the commodities super-bubble will lead to major corporate bankruptcies, as occurred at the end of the dot-com and subprime bubbles.
We worry that protectionism is likely to spread, as governments become concerned to protect employment.
The position is not helped by the high levels of margin debt now existing on the New York Stock Exchange. In real terms, these are higher than at previous margin peaks in 2000 and 2007 – neither of which proved to be good times for buying stocks.
Buying on margin is a very dangerous game, as high levels of margin debt create a vicious circle when prices fall. As we have seen in recent days, this means speculators are forced to sell into weakness to meet margin calls from their brokers. Those who have chased London house prices into the stratosphere may come to learn a similar lesson, as the Chinese buyers who have powered demand for new-build houses in the city centre exit their positions.
Paul Hodges is chairman of International eChem and publisher of The pH Report.