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.
My new analysis for iCIS Chemical Business highlights the paradigm shift now underway in the plastics industry.
A paradigm shift is underway in the plastics industry as public concern mounts over the impact of plastic waste on the oceans and the environment.
For 30 years, plastics producers have primarily focused upstream on securing cost-competitive feedstock supply. Now, almost overnight, they find themselves being forced by consumers, legislators and brand owners to refocus downstream on the sustainability agenda. It is a dramatic shift, and one which is likely to create Winners and Losers over a relatively short space of time.
The pace of change is startling. In January, 11 major brands, including Coca Cola, Unilever, Wal-Mart and Pepsi (and since joined by Nestlé) announced they were committed to working towards using “100% reusable, recyclable or compostable packaging by 2025“. Then in April, a UK government-led initiative saw 42 companies, responsible for over 80% of the plastics packaging sold in UK supermarkets, promise to “transform the plastic packaging system and keep plastic in the economy and out of the ocean”.
Tesco, the UK’s largest retailer, added to the pressure by beginning the move to a “closed loop system”. Clearly seeing the issue as a source of potential competitive advantage, they announced plans to remove all “hard to recycle” plastics – such as polystyrene, PVC and water-soluble bio-plastics – by the end of next year. Then last month, the EU Commission adopted new rules that will mean a minimum of 50% of all plastic packaging waste will be recycled by 2025. In addition, it has proposed drastic action, including bans, to reduce the use of the top 10 single-use plastic items found on EU beaches by 2021.
Understandably, many companies and CEOs have failed to keep up with these developments. Others have simply ignored them on the assumption they will prove to be all talk and no action. But nobody who attended the Circular Economy Forum at the recent ICIS World Polyolefins Conference could have come away believing that “business as usual” was a viable option for the future. As Borealis, Europe’s second largest polyolefin producer, explained, their vision is instead to “establish plastic waste as just another standard feedstock as the new normal” for the industry.
As the second chart shows, major plastics including polyethylene and polypropylene are now under major threat.
More than 50% of PE demand, and nearly a third of PP demand goes into single use packaging. Following the World Economic Forum’s ‘New Plastic Economy’ report in 2016, and Sir David Attenborough’s ‘Blue Planet 2’ series for the BBC, it is clear that this application is under major threat.
PARADIGM SHIFTS CREATE WINNERS AND LOSERS
The third chart highlights how business models are already starting to change. The current model was highly successful during the BabyBoomer-led economic supercycle, when demand grew on a constant basis. Companies could choose to compete via cost leadership or value-added strategies, or via a focus on premium products or service-orientation. But now the middle ground is starting to disappear: as demand growth is slowing and profits will be squeezed as competition intensifies. We are instead going back to the polarised model that existed before the 1980s:
- Upstream-integrated companies can choose to adopt a Feedstock Focus and roll-through their margins to the well-head (in the case of ethane) or refinery (in the case of naphtha) as margins come under pressure
- Those without this ability, however, need to instead adopt a Market Focus, as intensifying competition will squeeze non-integrated companies without the safety net of an upstream margin
- Market Focused companies have the opportunity to respond to brand-owner and legislative pressure by basing their feedstock needs on recycled plastic rather than naphtha, ethane and other virgin feedstocks
- They will need to develop new metrics to measure their progress as they start to build their capability to use recycled feedstocks and create long-term relationships with brand-owners and other stakeholders
Paradigm shifts generally produce winners and losers. In this case, the winners will be those plastics producers who adapt to the new opportunity created by the need to produce recycled plastic. This will clearly require investment in recycling facilities, but the sums involved are small compared to the cost of building new olefin crackers or refinery capacity. And in many countries, producers can even expect to be paid to take the recycled plastic as a feedstock, when the alternative is the cost of sending it to landfill.
The losers, of course, will be existing feedstock suppliers:
- Many oil majors have assumed that rising demand for petrochemicals will help to compensate for demand lost to electrification in the transport sector
- OPEC’s World Oil Outlook 2040 saw petrochemicals as providing “significant growth” for the future
- The International Energy Agency will also need to revisit its assumptions about future demand growth as the impact of the new paradigm becomes more apparent.
As National Geographic has reported, the world has produced around 8.3 billion tonnes of plastic over the past 60 years, and only 9 per cent of this has been recycled. This is a shocking waste of a valuable resource. The paradigm shift now underway is well overdue and should prove very profitable for those companies prepared to seize the opportunities it creates.
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Good business strategies generally create good investments over the longer term. And so Aramco needs to ensure it has the best possible strategies, if it wants to maximise the outcome from its planned $2tn flotation. Unfortunately, the current oil price strategy seems more likely to damage its valuation, by being based on 3 questionable assumptions:
- Oil demand will always grow at levels seen in the past – if transport demand slows, plastics will take over
- Saudi will always be able to control the oil market – Russian/US production growth is irrelevant
- The rise of sustainability concerns, and alternative energy sources such as solar and wind, can be ignored
These are dangerous assumptions to make today, with the BabyBoomer-led SuperCycle fast receding into history.
After all, even in the SuperCycle, OPEC’s attempt in the early 1980s to hold the oil price at around today’s levels (in $2018) was a complete failure. So the odds on the policy working today are not very high, as Crown Prince Mohammed bin Salman (MbS) himself acknowledged 2 years ago, when launching his ambitious ‘Vision 2030:
“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.”
As I noted here at the time, MbS’s bold plan for restructuring the economy included a welcome dose of reality:
“The government’s new Vision statement is based on the assumption of a $30/bbl oil price in 2030 – in line with the long-term historical average. And one key element of this policy is the flotation of 5% of Saudi Aramco, the world’s largest oil company. Estimates suggest it is worth at least $2tn, meaning that 5% will be worth $100bn. And as I suggested to the Wall Street Journal:
“The process of listing will completely change the character of the company and demand a new openness from its senior management“.
MbS is still making good progress with his domestic policy reforms. Women, for example, are finally due to be allowed to drive in June and modern entertainment facilities such as cinemas are now being allowed again after a 35 year ban. But unfortunately, over the past 2 years, Saudi oil policy has gone backwards.
SUSTAINABILITY/RENEWABLES ARE ALREADY REDUCING OIL MARKET DEMAND
Restructuring the Saudi economy away from oil-dependence was always going to be a tough challenge. And the pace of the required change is increasing, as the world’s consumers focus on sustainability and pollution.
It is, of course, easy to miss this trend if your advisers only listen to bonus-hungry investment bankers, or OPEC leaders. But when brand-owners such as Coca-Cola talk, you can’t afford to ignore what they are saying – and doing.
Coke uses 120bn bottles a year and as its CEO noted when introducing their new policy:
“If left unchecked, plastic waste will slowly choke our oceans and waterways. We’re using up our earth as if there’s another one on the shelf just waiting to be opened . . . companies have to do their part by making sure their packaging is actually recyclable.”
Similarly, MbS’s advisers seem to be completely ignoring the likely implications of China’s ‘War on Pollution’ for oil demand – and China is its largest customer for oil/plastics exports.
Already the European Union has set out plans to ensure “All plastic packaging is reusable or recyclable in a cost-effective manner by 2030”.
And in China, the city of Shenzhen has converted all of its 16359 buses to run on electric power, and is now converting its 17000 taxis.
Whilst the city of Jinan is planning a network of “intelligent highways” as the video in this Bloomberg report shows, which will use solar panels to charge the batteries of autonomous vehicles as they drive along.
ALIENATING CONSUMERS IS THE WRONG POLICY TO PURSUE
As the chart at the top confirms, oil’s period of energy dominance was already coming to an end, even before the issues of sustainability and pollution really began to emerge as constraints on demand.
This is why MbS was right to aim to move the Saudi economy away from its dependence on oil within 20 years.
By going back on this strategy, Saudi is storing up major problems for the planned Aramco flotation:
- Of course it is easy to force through price rises in the short-term via production cuts
- But in the medium term, they upset consumers and so hasten the decline in oil demand and Saudi’s market share
- It is much easier to fund the development of new technologies such as solar and wind when oil prices are high
- It is also much easier for rival oil producers, such as US frackers, to fund the growth of new low-cost production
Aramco is making major strides towards becoming a more open company. But when it comes to the flotation, investors are going to look carefully at the real outlook for oil demand in the critical transport sector. And they are rightly going to be nervous over the medium/longer-term prospects.
They are also going to be very sceptical about the idea that plastics can replace lost demand in the transport sector. Already 11 major brands, including Coke, Unilever, Wal-Mart and Pepsi – responsible for 6 million tonnes of plastic packaging – are committed to using “100% reusable, recyclable or compostable packaging by 2025“.
We can be sure that these numbers will grow dramatically over the next few years. Recycled plastic, not virgin product, is set to be the growth product of the future.
ITS NOT TOO LATE FOR A RETURN TO MBS’s ORIGINAL POLICY
Saudi already has a major challenge ahead in transforming its economy away from oil. In the short-term:
- Higher oil prices may allow the Kingdom to continue with generous handouts to the population
- But they will reduce Aramco’s value to investors over the medium and longer-term
- The planned $100bn windfall from the proposed $2tn valuation will become more difficult to achieve
3 years ago, Saudi’s then Oil Minister was very clear about the 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 philosopher George Santayana wisely noted, “Those who cannot remember the past are condemned to repeat it.”
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China is no longer seeking ‘growth at any cost’, with global implications, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
A pedestrian covers up against pollution in Beijing © Bloomberg
China’s President Xi Jinping faced two existential threats to Communist party rule when he took office 5 years ago.
He focused on the first threat, from corruption, by appointing an anti-corruption tsar, Wang Qishan, who toured the country gathering evidence for trials as part of a high-profile national campaign.
More recently, Mr Xi has adopted the same tactic on an even broader scale to tackle the second threat, pollution. Joint inspection teams from the Ministry of Environmental Protection, the party’s anti-graft watchdog and its personnel arm have already punished 18,000 polluting companies with fines of $132m, and disciplined 12,000 officials.
The ICIS maps below confirm the broad nature of the inspections. They will have covered all 31 of China’s provinces by year-end, as well as the so-called “2+26” big cities in the heavily polluted Beijing-Tianjin-Hebei area.
The inspections’ importance was also underlined during October’s five-yearly People’s Congress, which added the words “high quality, more effective, more equitable, more sustainable” to the Party’s Constitution to describe the new direction for the economy, replacing Deng’s focus from 1977 on achieving growth at any cost.
It is hard to underestimate the likely short and longer-term impact of Mr Xi’s new policy. The Ministry has warned that the inspections are only “the first gunshot in the battle for the blue sky”, and will be followed by more severe crackdowns.
In essence, Mr Xi’s anti-pollution drive represents the end for China’s role as the manufacturing capital of the world.
The road-map for this paradigm shift was set out in March 2013 in the landmark China 2030 joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition “from policies that served it so well in the past to ones that address the very different challenges of a very different future”.
The report focused on the need for “improvement of the quality of growth”, based on development of “broader welfare and sustainability goals”.
However, little was achieved on the environmental front in Xi’s first term, as Premier Li Keqiang continued the Populist “growth at any cost” policies of his predecessors. According to the International Energy Agency’s recent report, Energy and Air Pollution, “Average life expectancy in China is reduced by almost 25 months because of poor air quality”.
But as discussed here in June, Mr Xi has now taken charge of economic policy. He is well aware that as incomes have increased, so China is following the west in becoming far more focused on ‘quality of life issues’. Land and water pollution will inevitably take longer to solve. So his immediate target is air pollution, principally the dangerously high levels of particulate matter, PM2.5, caused by China’s rapid industrialisation since joining the World Trade Organization in 2001.
As the state-owned China Daily has reported, the Beijing-Tianjin-Hebei region is the main focus of the new policy. Its high concentration of industrial and vehicle emissions is made worse in the winter by limited air circulation and the burning of coal, as heating requirements ramp up. The region has been told to reduce PM2.5 levels by at least 15% between October 2017 and March 2018. According to Reuters, companies in core sectors including steel, metal smelting, cement and coke have already been told to stagger production and reduce the use of trucks.
The chemicals industry, as always, is providing early insight into the potentially big disruption ahead for historical business and trade patterns:
- Benzene is a classic early indicator of changing economic trends, as we highlighted for FT Data back in 2012. The chart above confirms its importance once again, showing how the reduction in its coal-based production has already led to a doubling of China’s imports in the January to October period versus previous years, with Northeast and Southeast Asian exporters (NEA/SEA) the main beneficiaries
- But there is no “one size fits all” guide to the policy’s impact, as the right-hand panel for polypropylene (PP) confirms. China is now close to achieving self-sufficiency, as its own PP production has risen by a quarter over the same period, reducing imports by 9%. The crucial difference is that PP output is largely focused on modern refining/petrochemical complexes with relatively low levels of pollution
Investors and companies must therefore be prepared for further surprises over the critical winter months as China’s economy responds to the anti-pollution drive. The spring will probably bring more uncertainty, as Mr Xi accelerates China’s transition towards his concept of a more service-led “new normal” economy based on the mobile internet, and away from its historical dependence on heavy industry.This paradigm shift has two potential implications for the global economy.
One is that China will no longer need to maintain its vast stimulus programme, which has served as the engine of global recovery since 2008. Instead, we can expect to see sustainability rising up the global agenda, as Xi ramps up China’s transition away from the “policies that served it so well in the past”.
A second is that, as the chart below shows, China’s producer price index has been a good leading indicator for western inflation since 2008. Its recovery this year under the influence of the shutdowns suggests an “inflation surprise” may also await us in 2018.
Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.
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OECD oil inventories have never been higher. They were 2.9mb at the end of July, and are expected to have risen further since then, according to energy watchdog the International Energy Agency:
- In terms of days of forward cover, they are now at 63 days in the OECD overall
- They are at 68 days in Europe and well above normal in Asia and the US
- China has also been filling its strategic reserve at the rate of 380kb/d all year
And of course, it will not be long before Iran returns to world markets as sanctions are eased. Iran expects to increase its volume by 1.5mb/d by the end of 2016.
Yet media headlines continue to focus on the “noise” around around markets, rather than the bigger picture. This is great for traders, who know they have at least 3 trading opportunities a week to move prices up or down – the weekly US inventory data from the American Petroleum Institute on Tuesday, and from the Energy Information Administration on Wednesday, plus the drilling rig report on Friday.
But it is really irrelevant for everyone else. The inventories are so large that they simply cannot be reduced to normal level within weeks, or even months. And it therefore can’t possibly matter if US production growth is estimated to have risen 100kb/day, or reduced 200kb/d. For a start, these are just estimates – not final figures. And even if they were accurate, the impact on the global market is too small to be noticed.
The problem is that a decade of central bank stimulus means a whole generation of analysts have never had to worry about understanding supply/demand balances. Instead they have made enormous sums of money by using the ‘buy-on-the-dips’ model in oil markets as in other financial markets. In this looking-glass world, bad news is always good news, as it means central banks will keep interest rates low and print more money to invest in oil futures markets.
Nobody can be sure this won’t happen again. This is why we have a $100/bbl oil price Scenario in our Study with ICIS, How to survive and prosper in today’s chaotic petrochemical markets: 5 Critical Questions every company and investor needs to answer. It would be naive not to believe this could happen again, especially as the latest jobless data suggests the recent US recovery is weakening once more.
A Scenario based on a continuation of the $50/bbl price level is clearly also possible – we have, after all, seen prices stay around this level for most of 2015. But my own view is that the current market is fundamentally unstable, due to today’s record inventory levels. It only needs a few people to start selling – perhaps because they need the cash for something else, and prices could quickly spiral downwards to $25/bbl. And this Scenario although seemingly impossible to many, is where prices have been for most of history.
US supply growth may now be plateauing after a period of very rapid growth – US output was up 1.7mb/day last year, for example. But Russian output is at post-Soviet Union peaks, with its revenues supported by the collapse of the rouble, whilst Saudi continues to pump at high levels. And at the same time, demand growth is clearly weakening.
Emerging markets have been responsible for most of the world’s economic growth since 2008 – but they are now seeing major cash outflows – the worst since the 2008 Crisis. And China’s New Normal direction for its economy is sending commodity exporting countries into recession.
It seems wishful thinking to imagine these developments will quickly reverse.
The oil market was the first to feel the impact of the Great Unwinding of policymaker stimulus nearly a year ago. It had completely lost its key role of price discovery due to the liquidity being supplied by the central banks. This had overwhelmed the fundamentals of supply/demand. And we are still living with the consequences today.
Many traders have only ever known a world where central banks aim to dominate the financial markets – and so they jumped on the recent technical rally in the belief that somehow markets would repeat the 2009 rally.
What it is about the world “massively oversupplied” that these traders find so difficult to understand, you might ask?
This, after all, was the phrase used by the International Energy Agency (IEA) last Friday to describe the current state of oil markets. And yet prices actually ended higher on the day, even though the IEA’s monthly report was crystal clear on the outlook:
“It remains that the oil market was massively oversupplied in 2Q15, and remains so today. It is equally clear that the market’s ability to absorb that oversupply is unlikely to last. Onshore storage space is limited. So is the tanker fleet. New refineries do not get built every day. Something has to give.”
Now a further test of oil markets is underway, with today’s historic agreement between Iran and the major global powers on the nuclear issue. As The Guardian reports:
“In terms of Iran’s ability to sell crude, I think that is where we will see the most immediate loosening up of restrictions. Iran has between 40 and 50 million barrels of crude at sea. Expect this crude to come to the market in short order. They will start competing fiercely to regain market share that they have lost to their Persian Gulf neighbors. Unfortunately for Iran the timing couldn’t be worse. Oil prices are depressed and already there is a glut of oil on the market. Adding Iran’s crude will put further downward pressure on oil prices.”
The Guardian thus confirms that Iran already has around 40mb of oil in floating storage, as I noted 2 weeks ago. It will not be long before this oil starts finding its way to market, even if sanctions are still officially in place. And this volume will be appearing as we move into the seasonally weaker Q3 period for demand. Plus the IEA forecasts that Iran could increase production by up to 800kb/day within a few months of sanctions being lifted.
I have forecast for some time that oil prices would return to their historical $30/bbl or lower level, I see no reason to change my mind today.