In my interview for Real Vision earlier this month, (where the world’s most successful investors share their thoughts on the markets and the biggest investment themes), I look at what data from the global chemical industry is telling us about the outlook for the global economy and suggest it could be set for a downturn.
“We look at the world and the world economy through the lens of the chemical industry. Why do we do that? Because the chemical industry is the third largest industry in the world after energy and agriculture. It gets into every corner of the world. Everything in the room which you’ll be watching this interview is going to have chemicals in it. And the great thing is, we have very good, almost real time data on what’s happening.
“Our friends at the American Chemistry Council have data going back on production and capacity utilization since 1987. So 30 years of data, and we get that within 6 to 8 weeks of the end of the month. So whereas, if you look at IMF data, you’re just looking at history, we’re looking at this is what’s actually going on as of today.
“We look, obviously, upstream, as we would call it, at the oil and feedstocks markets, so we understand what’s happening in that area. But we also– because the chemical industry is in the middle of the value chain, you have to be like Janus. You have to look up and down at the same time, otherwise one of these big boys catches you out.
“And so we look downstream. And we particularly look at autos, at housing, and electronics, because those are the big three applications. And of course, they’re pretty big for investors as well. So we see the relative balance between what’s happening upstream, what’s happening downstream, where is demand going, and then we see what’s happening in the middle of that chain, because that’s where we’re getting our data from.
“As the chart shows, our data matches pretty well to IMF data. It shows changes in capacity utilization, which is our core measurement. If if you go back and plot that against history from the IMF, there is very, very good correlation. So what we’re seeing at the moment– and really, we’ve been seeing this since we did the last interview in November— is a pretty continuous downturn.
“One would have hoped, when we talked in November, we were talking about the idea that things have definitely cooled off. Some of that was partly due to the oil price coming down. Some of that was due to end of year destocking. Some of that was due to worries about trade policy. Lots of different things, but you would normally expect the first quarter to be fairly strong.
“The reason for this is that the first quarter– this year, particularly– was completely free of holidays. Easter was late, so there was nothing to interrupt you there. There was the usual Lunar New Year in China, but that always happens, so there’s nothing unusual about that.
And normally what happens is, that in the beginning of the new year, people restock. They’ve got their stock down in December for year end purposes, year end tax purposes, now they restock again. And of course, they build stock because the construction season is coming along in the spring and people tend to buy more cars in that period, and electronics, and so on.
“So everything in the first quarter was very positive. And one wouldn’t normally be surprised to start seeing stock outs in the industry, particularly after a quiet period in the fourth quarter. And unfortunately, we haven’t seen any of that. We’ve seen– and this is worth thinking about for a moment– we’ve seen a 25% rise in the oil price because of the OPEC Russia deal, but until very recently we haven’t seen the normal stock build that goes along with that.”
As we note in this month’s pH Report, however, this picture is now finally changing as concern mounts over oil market developments – where unplanned outages in Venezuela and elsewhere are adding to the existing cutbacks by the OPEC+ countries. Apparent demand is therefore now increasing as buyers build precautionary inventory against the risk of supply disruption and the accompanying threat of higher prices.
In turn, this is helping to support a return of the divergence between developments in the real economy and financial markets, as the rise in apparent demand can easily be mistaken for real demand. The divergence is also being supported by commentary from western central banks. This month’s IMF meeting finally confirmed the slowdown that has been flagged by the chemical industry since October, but also claimed that easier central bank policies were already removing the threat of a recession.
We naturally want to hope that the IMF is right. But history instead suggests that periods of inventory-build are quickly reversed once oil market concerns abate.
Please click here if you would like to see the full interview.
Back in 2015, veteran Saudi Oil Minister Ali Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:
“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.”
As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4. But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand. And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:
“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”
Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.
Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:
- Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
- But its short-term need is to support prices by cutting production, in order to fund its spending priorities
The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past. It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.
The reason is that high oil prices reduce discretionary spending. Consumers have to drive to work and keep their homes warm (and cool in the summer). So if oil prices are high, they have to cut back in other areas, slowing the economy.
CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014
There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.
They were creating tens of $tns of free cash to support consumer spending. But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report. It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:
“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.”
SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS
Oil prices are therefore now on a roller-coaster ride:
- Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
- The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December
Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd). But as always, its “allies” have let it down. So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.
Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:
Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds. As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.
But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.
Companies and investors therefore need to be very cautious. Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.
Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.
*Total cost is number of barrels used multiplied by their cost
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.
Please click here if you would like to download the article.
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Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same. Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.
The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story. So the chart above instead combines 5 “shock, horror” stories, showing quarterly oil production since 2015:
- Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015. OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
- Russia has also been much in the news since joining the OPEC output agreement in November 2016. But in reality, it has done little. Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
- Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
- Venezuela is an OPEC member, but its production decline began long before the OPEC deal. The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
- The USA, along with Iran, has been the big winner over the past 2 years. Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!
But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April. Not much “shock, horror” there over a 3 year period. More a New Normal story of “Winners and Losers”.
So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday? Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble. The answer lies in the second chart from John Kemp at Reuters:
- It shows combined speculative purchases in futures markets by hedge funds since 2013
- These hit a low of around 200mbbls in January 2016 (2 days supply)
- They then more than trebled to around 700mbbls by December 2016 (7 days supply)
- After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)
Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently: “Several of them had little or no experience or even a basic understanding of how the physical market works.”
This critical point is confirmed by Citi analyst Ed Morse: “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.”
Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:
“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).
OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION
The hedge funds have been the real winners from all the “shock, horror” stories. These created the essential changes in “crowd behaviour”, from which they could profit. But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:
- Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
- This level has been linked with a US recession on almost every occasion since 1970
- The only exception was post-2009 when China and the Western central banks ramped up stimulus
- The stimulus simply created a debt-financed bubble
The reason is simple. People only have so much cash to spend. If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy. Chemical markets are already confirming that demand destruction is taking place.:
- Companies have completely failed to pass through today’s high energy costs. For example:
- European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
- They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)
Even worse news may be around the corner. Last week saw President Trump decide to withdraw from the Iran deal. His daughter also opened the new US embassy to Jerusalem. Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.
As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities. Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz. It is just 21 miles wide (34km) at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.
As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”. Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets. We must all learn to form our own judgments about the real risks that might lie ahead.
Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.
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Chemicals are easily the best leading indicator for the global economy. And if the global economy was really in recovery mode, as policymakers believe, then the chemical industry would be the first to know – because of its early position in the value chain. Instead, it has a different message as the chart confirms:
- It shows changes in global production and key sectors, based on American Chemistry Council (ACC) data
- It highlights the rapid inventory build in H2 as oil and commodity prices soared
- But since then, all the major sectors have moved into a slowdown, and agchems into decline
As the ACC note:
“The global chemical industry ended the first quarter on a soft note. Global chemicals production fell 0.3% in March after a 1.0% drop in February, and a 0.6% decline in January. The last gain was 0.3% in December.”
This, of course, is the opposite of consensus thinking at New Year, when most commentators were confident that a “synchronised global recovery” was underway. It is therefore becoming more and more likely, as I warned in January, that policymakers have been fooled once again by the activities of the hedge funds in boosting “apparent demand”:
“For the last 6 months, everyone who buys oil or other commodity-related products has been busy building as much inventory as they could afford. In turn, of course, this has made it appear that demand has suddenly begun to recover. At last, it seems, the “synchronised global recovery” has arrived.
“Except, of course, that it hasn’t. The hedge funds didn’t buy 15 days-worth of oil to use it. They bought it to speculate, with the OPEC-Russia deal providing the essential “story” to support their buying binge.”
This downturn is worrying not only because it contradicts policymakers’ hopes, but also because Q1 volumes should be seasonally strong:
- Western companies should be restocking to meet the surge of spring demand
- Similarly, China and the Asian markets should now be at peak rates after the Lunar New Year
HIGHER OIL AND COMMODITY PRICES ARE CAUSING DEMAND DESTRUCTION
The problem is that most central bankers and economists don’t live in the real world, where purchasing managers and sales people have bonuses to achieve. As one professor told me in January:
“Economists would tend to be skeptical about concepts such as “apparent demand”. Unless this a secret concept (and it doesn’t seem like it is), other investors should also use it, and then the oil price should already reflect it. Thus, there wouldn’t be gains to be made (unless you’re quicker than everyone else or have inside information)…”
But in the real world, H2’s inventory build has now been replaced by destocking – whilst today’s higher oil prices are also causing demand destruction. We have seen this many times before when prices have risen sharply:
- Consumers only have limited amounts of spare cash
- When oil prices jump, they have to cut back in other areas
- But, of course, this is only confirmed afterwards, when the spending data is reported
- Essentially, this means that policymakers today are effectively driving by looking in the rear-view mirror
RISING DEBT LEVELS CREATE FURTHER HEADWINDS FOR GROWTHNew data from the US Federal Reserve Bank of St Louis also highlights the headwinds for demand created by the debt build-up that I discussed last week. As the chart shows:
- US borrowing was very low between 1966-79, and $1 of debt created $4.49 in GDP growth
- Borrowing rose sharply in the Boomer-led SuperCycle, but $1 of debt still created $1.15 in GDP growth
- Since stimulus programmes began in 2000, however, $1 of debt has created just $0.36 of GDP growth
In other words, value destruction has been taking place since 2000. The red shading tells the story very clearly, showing how public debt has risen out of control as the Fed’s stimulus programmes have multiplied – first with sub-prime until 2008, and since then with money-printing.
RISING INTEREST RATES CREATE FURTHER RISKS
Last week saw the yield on the benchmark US 10-year Treasury Bond reach 3%, double its low in June 2016. It has risen sharply since breaking out of its 30-year downtrend in January, and is heading towards my forecast level of 4%.
Higher interest rates will further slow demand, particularly in key sectors such as housing and autos. And in combination with high oil and commodity prices, it will be no surprise if the global economy moves into recession.
Chemicals is providing the vital early warning of the risks ahead. But as usual, it seems policymakers prefer to wear their rose-coloured spectacles. And then, of course, as with subprime, they will all loudly declare “Nobody could have seen this coming”.
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Oil and commodity markets long ago lost contact with the real world of supply and demand. Instead, they have been dominated by financial speculation, fuelled by the vast amounts of liquidity pumped out by the central banks. The chart above from John Kemp at Reuters gives the speculative positioning in the oil complex as published last Monday:
- It shows hedge fund positioning in terms of the ratio of long to short positions across the complex
- The ratio had been at a near-record low of 1.55x back in June last year, before the rally took off
- On 30 January it had risen to a record 11.9x – far above even the 2014 and 2017 peaks
The size of the rally has also been extraordinary, as I noted 2 weeks ago. At its peak, the funds owned 1.5bn barrels of oil and products – equivalent to an astonishing 16 days of global oil demand. They had bought 1.2bn barrels since June, creating the illusion of very strong demand. But, of course, hedge funds don’t actually use oil, they only trade it.
The funds also don’t normally hang around when the selling starts. And so last week, as the second chart shows, they began to sell their positions and take profits. The rally peaked at $71/bbl at the end of January, and then topped out on 2 February at $70/bbl. By last Friday, only a week later, Brent was at $63/bbl, having fallen 11% in just one week.
Of course, nothing had changed in the outlook for supply/demand, or for the global economy, during the week. And this simple fact confirms how the speculative cash has come to dominate real-world markets. The selling was due to nervous traders, who could see prices were challenging a critical “technical” point on the chart:
- Most commodity trading is done in relation to charts, as it is momentum-based
- The 200 day exponential moving average (EMA) is used to chart the trend’s strength
- When the oil price reached the 200-day EMA (red line), many traders got nervous
- And as they began to sell, so others began to follow them as momentum switched
The main sellers were the legal highwaymen, otherwise known as the high-frequency traders. Their algorithm-based machines do more than half of all daily trading, and simply want a trend to follow, milli-second by milli-second. As the Financial Times warned in June:
“The stock market has become a battlefield of algorithms, ranging from the simple – ETFs bought by retirees that may invest in the entire market, an industry, a specific factor or even themes like obesity – to the complex, commanded by multi-billion dollar “quantitative” hedge funds staffed by mathematicians, coders and data scientists.”
JP Morgan even estimates that only 10% of all trading is done by “real investors”:
“Passive and quantitative investors now account for about 60% of the US equity asset management industry, up from under 30% a decade ago, and reckons that only roughly 10% of trading is done by traditional, “discretionary” traders, as opposed to systematic rules-based ones.”
Probably prices will now attempt to stabilise again before resuming their downward movement. But clearly the upward trend, which took prices up by 60% since June, has been broken. Similar collapses have occurred across the commodity complex, with the CRB Index showing a 6% price fall across major commodities:
- Typically, inventory build ahead of price rises can add an extra month of “apparent demand” to real demand
- This inventory will now have to be run down as buyers destock to more normal levels again
- This means we can expect demand to slow along all the major value chains
- Western companies will now see slow demand through Easter: Asia will see slow demand after Lunar New Year
This disappointment will end the myth that the world is in the middle of a synchronised global recovery. In turn, it will cause estimates of oil demand growth to be reduced, further weakening prices. It will also cause markets to re-examine current myths about the costs of US shale oil production:
- As the charts from Pioneer Natural Resources confirm, most shale oil breakeven costs are below $30/bbl
- Pioneer’s own operating costs, typical of most of the major players, are below $10/bbl
- So the belief that shale oil needs a price of $50/bbl to support future production is simply wrong
PREPARE FOR PROFIT WARNINGS AND POTENTIAL BANKRUPTCIES BY THE SUMMER
Over the summer, therefore, many industrial companies will likely need to start issuing profit warnings, as it becomes clear that demand has failed meet expectations. This will put stock markets under major pressure, especially if interest rates keep rising as I discussed last month.
Smart CEOs will now start to prepare contingency plans, in case this should happen. We can all hope the recent downturn in global financial markets is just a blip. But hope is not a strategy. And the risk of profit warnings turning into major bankruptcies is extremely high, given that global debt now totals $233tn, more than 3x global GDP.
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.
Since January, I have also been monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. Today’s forecast for oil prices to fall initially to $50/bbl is therefore now added to those on ethylene/polyethylene and the US 10-year interest rate. I am also increasing the confidence level for the interest rate forecast to 70%, and will continue to update these levels when circumstances change.
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