On Monday, I discussed how OPEC abandoned Saudi Oil Minister Naimi’s market share strategy during H2 last year.
Naimi’s strategy had stopped the necessary investment being made to properly exploit the new US shale discoveries. But this changed as the OPEC/non-OPEC countries began to talk prices up to $50/bbl. As CNN reported last week:
“Cash is pouring into the Permian, lured by a unique geology that allows frackers to hit multiple layers of oil as they drill into the ground, making it lucrative to drill in the Permian even in today’s low prices.”
Private equity poured $20bn into the US shale industry in Q1
Major oil companies were also active, with ExxonMobil spending $5.6bn in February
US oil/product inventories have already risen by 54 million barrels since January last year and are, like OECD inventories, at record levels. And yet now, OPEC and Russia have decided to double down on their failing strategy by extending their output quotas to March 2018, in order to try and maintain a $50/bbl floor price. US shale producers couldn’t have hoped for better news. As the chart shows:
US inventories would be even higher if the US wasn’t already exporting nearly 5 million barrels/day of oil products
It is also exporting 500 kb/d of oil since President Obama lifted the ban in December 2015
Nobody seems to pay much attention to this dramatic about-turn as they instead obsess on weekly inventory data
But these exports are now taking the fight to OPEC and Russia in some of their core markets around the world
None of this would have happened if Naimi’s policy had continued. Producers could not have raised the necessary capital with prices below $30/bbl. But now they have spent the capital, cash-flow has become their key metric.
The second chart confirms the turnaround that has taken place across the US shale landscape, as the oil rig count has doubled over the past year. Drilling takes between 6 – 9 months to show results in terms of oil production, and so the real surge is only just now beginning. Equally important, as the Financial Times reports, is that today’s horizontal wells are far more productive:
“This month 662 barrels/d will be produced from new wells in the Permian for every rig that is running there, according to the US government’s Energy Information Administration. That is triple the rate of 217 b/d per rig at the end of 2014.”
Before too long, the oil market will suddenly notice what is happening to US shale production, and prices will start to react. Will they stop at $30/bbl again? Maybe not, given today’s record levels of global inventory.
As the International Energy Agency (IEA) noted last month, OECD stocks actually rose 24.1mb in Q1, despite the OPEC/non-OPEC deal. And, of course, as the IEA has also noted, the medium term outlook for oil demand has also been weakening as China and India focus on boosting the use of Electric Vehicles.
The current OPEC/non-OPEC strategy highlights the fact that whilst the West has begun the process of adapting to lower oil prices, many oil exporting countries have not. As Nick Butler warns in the Financial Times:
“Matching lower revenues to the needs of growing populations who have become dependent on oil wealth will not be easy. It is hard to think of an oil-producing country that does not already have deep social and economic problems. Many are deeply in debt.
“In Nigeria, Venezuela, Russia and even Saudi Arabia itself the latest fall, and the removal of the illusion that prices are about to rise again, could be dangerously disruptive. The effects will be felt well beyond the oil market.”
OPEC and Russia made a massive mistake last November when when they decided to try and establish a $50/bbl floor for world oil prices. And now they have doubled down on their mistake by extending the deal to March 2018. They have ignored 4 absolutely critical facts:
Major US shale oil producers were already reducing production costs below $10/bbl, as the Pioneer chart confirms
The US now has more oil reserves than Saudi Arabia or Russia, with “Texas alone holding more than 60bn barrels”
At $30/bbl, US producers couldn’t raise the capital required to exploit these newly-discovered low-cost reserves
But at $50/bbl, they could
Former Saudi Oil Minister Ali Naimi understood this very well. He also understood that OPEC producers therefore had to focus on market share, not price, as Bloomberg reported:
“Naimi, 79, dominated the debate at OPEC’s November 2014 meeting, according to officials briefed on the closed-door proceedings. He told his OPEC counterparts they should maintain output to protect market share from rising supplies of U.S. shale oil.”
Naimi’s strategy was far-sighted and was working. The key battleground for OPEC was the vast Permian Basin in Texas – its Wolfgang field alone held 20bn barrels of oil, plus gas and NGLs. By January 2016, oil prices had fallen to $30/bbl and the Permian rig count had collapsed, as the second chart confirms:
Naimi had begun his price war in August 2014, and reinforced it at OPEC’s November 2014 meeting
Oil companies immediately began to reduce the number of highly productive horizontal rigs in the Permian basin
The number of rigs peaked at 353 in December 2014 and there were only 116 operating by May 2016
But then Naimi retired a year ago, and with him went his 67 years’ experience of the world’s oil markets. Almost immediately, OPEC and Russian oil producers decided to abandon Naimi’s strategy just as it was delivering its objectives. They thought they could effectively “have their cake and eat it” by ramping up their production to record levels, whilst also taking prices back to $50/bbl via a new alliance with the hedge funds, as Reuters reported:
“OPEC and some of the most important hedge funds active in commodities reached an understanding on oil market rebalancing during informal briefings held in the second half of 2016…. OPEC effectively underwrote the fund managers’ bullish positions by providing the oil market with detail about output levels and public messaging about high levels of compliance”.
This gave the shale producers the window of opportunity they needed. Suddenly, they could hedge their production at a highly profitable $50/bbl – and so they could go to the banks and raise the capital investment that they needed.
As a result, the number of rigs in the Permian Basin has nearly trebled. At 309 last week, the rig count is already very close to the previous peak.
The Permian is an enormous field. Pioneer’s CEO said recently he expects it to rival Ghawar in Saudi Arabia, with the ability to pump 5 million barrels/day. It is also very cheap to operate, once the capital has been invested. And it is now too late for OPEC to do anything to stop its development.
On Thursday, I will look at what will likely happen next to oil prices as the US drilling surge continues.
Mention India to many CEOs and investors, and they will smile broadly at the thought of its “demographic dividend”.
Two-thirds of India’s population are under-35,and are already swelling the numbers of those in the critical Wealth Creator 25 – 54 age group which drives economic growth. As the chart shows:
India’s median age is just 27 years today. It will still be only 31 years by 2030
The Wealth Creator cohort is already 523m, and will reach 652m by 2030, whilst the Under-25 cohort is over 600m
There are only 169m in the New Old 55+ generation. Although life expectancy in India is now 69 years, it was just 37 years as recently as 1950
Helpfully, a major new survey by India’s Centre for the Study of Developing Societies provides new evidence on the hopes and values of this vast younger generation. It aims:
“At understanding the social and psychological wellbeing of young people….because if the expectations of this growing mass of youth are not addressed on time, then the disappointments of this burgeoning population could translate into social unrest and even violence.”
Its key findings are critically important:
One-third of young people are classed as students, up from just 13% during the last survey in 2007. But many are apparently “studying further to delay entry into the workforce or perhaps as a means of ‘timepass’
There is also a clear caste divide in terms of access to education, with “42% of Upper Caste youth reporting themselves as students, compared to 25% of Dalit youth and just 16% of Adivasi.”
“Agriculture is the largest employer of India’s youth” – and 39% of these young people are lowly-paid hired workers
Unsurprisingly, given this background, nearly 1 in 5 young people are worried about jobs and employment, whilst 1 in 10 worry about inequality and corruption
India’s youth also tend to be conservative – 53% oppose dating before marriage, 45% oppose inter-religious marriages and 36% oppose inter-caste marriages. And the survey adds:
“We also ascertained the youth’s opinion on contentious issues which have been at the centre stage of the ongoing debate over liberty and progressive beliefs – banning of movies which hurt religious sentiments, beef consumption and death penalty. We find that 60% supported banning movies which hurt religious sentiments. 46% object to allowing beef consumption and 49% support retaining capital punishment. These figures clearly indicate that most youngsters remain averse to progressive beliefs on political issues.”
As the Financial Times notes in its comments on the survey:
“Religion retains a powerful grip. Nearly half give religion precedence over science when they clash, while just a third would privilege science over religion….more than half of youths believe women should always listen to their husbands. Nearly two-fifths feel it is inappropriate for a woman to work after marriage, while a significant 38% feel women should not wear jeans.”
Similarly, 40% of young Indian women “favoured the idea of an obedient wife”
The survey evidence confirms a critical paradox about India:
Most young Indians have smartphones and are style-conscious
Yet like most poor people, they are very conservative in their social attitudes, with patriarchy deeply-rooted
It is very easy for non-Indians – seeing television news or making an overnight visit en route to/from China – to simply see the smartphones and fashion, and assume India has now become a middle class society by Western standards. Of course, it does have relatively rich people. But fundamentally, as Indians all know, it remains a very poor country with average earnings just INR 272/day ($4.20) – and less than two-thirds of adults are literate.
There are vast opportunities in India, once one accepts these key facts. These are often focused on helping people to build a better life for themselves – one example, as premier Modi has highlighted, is in providing toilets for the 600m who currently lack access to them.
Hindustan Unilever has understood this basic truth for many years, and has become India’s largest consumer products company as a result. Their mission statement is simple and powerful – “doing well by doing good“.
It is hard to be optimistic about the outlook for 2017.
The good news is that policymakers are finally giving up on the idea that stimulus can somehow return us to the growth levels seen when the Baby Boomers were young. As the Bank of England note in a new Report:
”Economic theory suggests that a fall in interest rates should lead to higher household spending, because lower returns on savings decrease the amount of future consumption that can be achieved by sacrificing a given amount of spending today
But as the chart shows, “when asked about how they might respond to a hypothetical further fall in mortgage payments, households reported that paying off debt and saving more were likely to be a more common response than increasing spending”
45% said they would save more, 50% said they would use money saved on mortgage payments to pay down debt and only 10% said they would increase their spending.
Unfortunately, companies and investors will now pay the costs of this failed experiment, as markets return to being based on supply and demand fundamentals, rather than central bank money-printing. Five major risks face the global economy, as my new 2017 Outlook highlights:
□ Global recession: The American Chemistry Council (ACC) index of global capacity utilisation is the best indicator that exists in terms of the outlook for the economy. As I noted last month, it has been falling since December 2015, and its latest reading is close to the all-time low seen in March 2009
□ Populist policies are gaining support: Populists provide simple answers to complex questions, and 2016 saw them gain major success with the Brexit vote for the UK to leave the EU, Donald Trump winning the US Presidency, and Italy’s referendum creating the potential for the country to vote on leaving the euro
□ Protectionism is replacing globalisation: One key result of these changes is that countries are turning inwards. The Doha and Transatlantic Trade and Investment Partnership trade deals are effectively dead, and President-elect Trump has promised to cancel the Trans-Pacific Partnership deal on coming into office
□ Interest rates are rising around the world: Investors have begun to worry about return of capital, rather than just return on capital. Benchmark 10-year interest rates have doubled in the US since the summer. They have also trebled in the UK and doubled in Italy, while negative rates in Germany and Japan have turned positive again.
□ India’s economy is under major strain as a result of the currency reforms, and China’s debt levels remain far too high for comfort. Its housing bubble in the Tier 1 cities has reached price/earnings ratios double those of the US subprime bubble. Its currency is also falling as the economy slows, creating the potential for further trade friction with the new Trump administration
Please click here if you would like to read the full Outlook, and click here to view my 6 minute interview with ICB’s deputy editor, Will Beacham. You can also click here to download a copy of all my New Year forecasts since 2008, when I was warning of a coming financial crash.
2016 saw the Great Reckoning for the failure of stimulus policies begin to impact companies and markets.
The blog’s readership has increased significantly as a a result, as shown in the chart above, with its visits now totaling nearly 500k. Its readership includes 197 countries and over 11k cities. Readers also remain very loyal, with one in two reading it every week, and one in four reading it every day.
The key issue is that consensus wisdom has clearly failed – once again – to provide a reliable guide to the outlook. By contrast, the blog was one of the first to explore the attractions of Populist policies, and to suggest that the UK government would lose the Brexit vote, and that Donald Trump would likely become President.
Even today, however, most “expert commentary” continues to ignore these developments, and the later Italian referendum, and instead believes we will see “business as usual” in 2017. Yet developments in the world’s 2 most important economies, the USA and China, suggest that in reality, this is the least likely option:
In the USA, President-elect Trump continues to focus on the need to reshore jobs from overseas, particularly China, in order to “make America great again”. As Peter Navarro, head of Trump’s new White House National Trade Council, told the New York Times:
“Imposing steep tariffs on China was an essential step to begin to address the American trade deficit with China, which reached $365bn last year. He blamed Chinese trade practices for “destroying entire industries, hollowing out entire communities” and “putting millions out of work.” His colleague, Prof Greg Auty added:
“The Trump camp was dead serious about its threats to impose tariffs on China. The goal is to force manufacturers to come back to the United States as a condition of selling into the American market. A full-on trade war between the world’s two largest economies would cost American jobs in the immediate term, but eventually millions of new ones would be created as the United States again hummed with factory work.
“We moved our supply chain to Asia in about two decades,” he said. “You certainly can do it in the U.S. a whole lot faster. It’s going to take a few years, but it’s going to be a much better America.” (my emphasis)
In China, as Xinhua reports, bursting the property bubble has become the key target of government policy:
“President Xi Jinping highlighted curbing property bubbles at a meeting of the Central Leading Group on Finance and Economic Affairs on Wednesday, the fourth time asset bubbles were mentioned by Chinese leaders in the second half of the year.
“China will take a varied approach to regulating the property market, adopting financial, fiscal, tax, land and regulation measures to build a long-term housing mechanism that provides housing for all people, according to Xi. Thanks to policies introduced by local authorities in October, the property market in big cities continued to stabilize in the last month, gradually retreating from sky-high prices.
“Houses are built for living, not for speculation,” policymakers have agreed.”
In addition, of course, a number of major challenges exist in other parts of the global economy:
The recent Italian referendum means the collapse of the Eurozone has become a real possibility
The future of the European Union itself is also under threat given the Brexit votes and upcoming elections in The Netherlands, France and Germany
Oil markets will likely see further volatility as the inevitable cracks appear in the recent OPEC output cuts deal
India’s currency reforms pose a further threat to the outlook for the world’s 6th largest economy, as premier Modi’s 50-day deadline for resolving all the problems ends today
I will do my best to follow these and other critical developments in 2017. Thank you for your continued support.
Last year it was the oil price fall. This year, there is no doubt that the US dollar has taken centre stage, alongside the major rise underway in benchmark 10-year interest rates. As 2016′s Chart of the Year shows:
The US$ Index (black) has risen 12% since May against other major currencies (euro, yen, pound, Canadian dollar, Swiss franc, Swedish krona), and is now at its highest level since 2003
Benchmark 10-year US interest rates (red) have almost doubled from 1.4% in July to 2.6% today. They are back to 2013-4 levels, when the Fed proposed “tapering” its stimulus policy
Clearly something quite dramatic is now underway.
In currency markets, investors are voting with their feet. It is hard to see much upside in the European, Japanese or Canadian economies in the next 12 – 18 months. Europe is going to be gripped by the unfolding crisis over the future of the euro and the EU itself, as it moves through elections in The Netherlands, France, Germany and probably Italy. By March, the UK will be on the Brexit path, and will leave the EU within 2 years. Japan is equally unattractive following the failure of Abenomics, whilst Canada’s reliance on commodity exports makes it very vulnerable to the downturn underway in the BRICs (Brazil, Russia, India, China).
Investors are also waking up to the uncomfortable fact that much of today’s borrowed money can never be repaid. McKinsey estimated global debt at $199tn and 3x global GDP at the start of 2015, and the total is even higher today.
As I warned a year ago in “World faces wave of epic debt defaults” – central bank veteran), there is no easy route to rescheduling or forgiving all this debt. Importantly, central banks are now starting to lose control of interest rates. They can no longer overcome the fundamentals of supply and demand by printing vast amounts of stimulus money.
This is the Great Reckoning for the failure of stimulus policies in action.
THE RISES WILL CREATE “UNEXPECTED CONSEQUENCES” FOR COMPANIES AND INVESTORS
These moves are critically important in themselves as the dollar is the world’s reserve currency, and US interest rates are its “risk-free” rates. Unsurprisingly, interest rates are already now rising in all the other ‘Top 15′ major economies – China, Japan, Germany, UK, France, India, Italy, Brazil, Canada, S Korea, Russia, Australia, Spain, Mexico. Together, these countries total 80% of the global economy.
The rises are also starting to create unexpected “second order impacts”. For example, many companies in the emerging economies have large US$ loans, which appeared to offer a cheaper interest rate than in their home country. Suddenly, they are finding that the cost of repayment has begun to rise quite rapidly.
This happens in almost every financial crisis:
People become excited by the short-term cost of borrowing – “Its so cheap, just $xxx/month”
They totally forget about the cost of repaying the capital -”I never thought the dollar would get that strong”
There were $9tn of these loans last year, according to the Bank for International Settlements. Many were to weak companies who are likely to default if the dollar keeps rising along with US interest rates.
In turn, these defaults will also have unexpected consequences. Lenders will suffer losses, and will be less able to lend even to stronger companies. Higher borrowing costs will force consumers to cut back their spending. This risks creating a vicious circle as corporate interest costs rise whilst revenues fall.
China is the obvious “canary in the coalmine” signalling that major problems lie ahead.
The Wall Street Journal chart shows 10-year rates have risen despite central bank support
Its total debt is around $27tn, or 2.6x its GDP, due to housing bubble and other speculation
The central bank now has to sell its US Treasury holdings to support the domestic economy
In turn, of course, this pushes US rates higher, as rates move inversely to bond prices
China used to hold around 10% of US debt, and was the largest foreign holder. Japan holds similar amounts, and is also stepping back from purchases due to the growing exchange rate volatility.
Nobody else has the financial firepower to take their place. The only possible replacements – Saudi Arabia and the Gulf countries – have seen their incomes fall with the oil price, whilst their domestic spending has been rising. This means interest rates and the US$ are likely to carry on rising.
Higher rates will further weaken the US economy itself, particularly if President Trump launches his expected trade war. In the important auto market, GM has just announced production cutbacks next month due to falling sales, despite the industry having raised incentives by 21% to nearly $4k/car. GM’s inventories are now 25% higher than normal at 86 days versus 69 days a year ago. Housing starts fell 7% last month, as mortgage rates began to rise.
And then there is India, the world’s 7th largest economy and a leading oil importer. Its rates are now rising as shocked investors suddenly realise recession is a real possibility, if the currency reform problems are not quickly resolved.
These risks are serious enough. But they are very worrying today, due to the steep learning curve that lies ahead of all those who began work after the start of the Boomer-led SuperCycle in 1983.
They assume that “recessions” are rare and last only a few months as central banks always rescue the economy.
Only those who can remember before the SuperCycle know that markets and companies should have long ago taken fright as these risks began to develop
This is why the rise in the US$ Index and US 10-year exchange rates is 2016′s Chart of the Year.