Oil market weakness suggests recession now more likely than Middle East war

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.

 

 

 

Resilience amidst headwinds is key for H2

Resilience is set to become the key issue as we look forward to H2, as I note in a new analysis for ICIS Chemical Business. None of us have ever seen the combinations of events that are potentially ahead of us. And none of us can be sure which way they will develop. So it seems essential that we start to create contingency plans to build corporate resilience ahead of their possible arrival.

Of course, we can all hope that we are just seeing a series of false alarms, and that business as usual will end up as the outcome. But hope is not a strategy. Even if we optimistically believe it is an 80% probability, the scale of the potential problems under more pessimistic scenarios suggests it would be prudent to decide ahead of time how to tackle them. Everyone will have their own list of possible outcomes. Mine is as follows:

  • Business as usual. Central bank rate cuts avoid recession risk; Presidents Trump and Xi reach stable agreement to roll back tariffs; oil market tensions disappear in the Middle East; Brexit uncertainty is put on hold with another extension period; sustainability concerns over single use plastics are put on back-burner
  • Gathering clouds. China’s vast offshore borrowing creates increasing risk of corporate defaults as growth slows, particularly if the trade war continues; geo-political risks mount in the Middle East; Brexit leads to major friction between the UK and EU27; more major consumer products companies decide to end use of single-use plastics
  • Storm warnings issued. Debt problems morph into major bankruptcies, impacting a range of supply chains around the world; US – Iran tensions mount in the Middle East causing oil prices to rise sharply; regional tensions mount as the world settles into a new Cold War between the USA and China; polymer volumes are hit by a rapid escalation of consumer concerns over single-use plastics

Asia is likely to prove the catalyst for this potential next crisis, if it hits. China has begun to deleverage over the past 2 years, taking $2tn out of its high-risk shadow banking sector. But unfortunately this tightening has driven many of the riskiest businesses into the offshore dollar markets, where naïve western fund managers have rushed to place their bets – driven by their need to achieve higher returns than are available in their domestic bond markets.

If world trade continues to slow as the chart from Reuters shows, and the remnimbi starts to weaken, then some of these borrowers will inevitably default. In turn, this risks a chain reaction across world markets, impacting not only the zombies but also their supply chain partners.

What would your company do in these circumstances? As the American writer Ernest Hemingway noted in ‘The Sun also Rises’, there are two ways to go bankrupt, “gradually, then suddenly”. And the suddenness of the final stage makes it almost impossible for companies to survive if they have not used the gradual stage to create contingency plans. History unfortunately shows that when markets turn, executives suddenly find they have very little time in which to think through how to respond.

Governments will also be in the line of fire, due to their debt levels. And it is unlikely that politicians will know how to respond. They used to be clear about the key issue for the voters, as Bill Clinton famously observed in 1992 – “it’s the economy, stupid”. But today’s politicians instead simply assume that central banks can always print more money to overcome financial and economic crises. They have forgotten the simple mnemonic that many of us learnt at school, namely that “to ASSUME can make an ASS of U and ME”.

Time spent now on building your company’s resilience to potential future challenges may therefore prove time very well spent, if hopes for ‘business as usual’ turn out to have been wishful thinking.

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Recession risk rises as Iran tensions and US-China trade war build

Oil markets are once again uneasily balanced between two completely different outcomes – and one again involves Iran.

Back in the summer of 2008, markets were dominated by the potential for an Israeli attack on Iranian nuclear facilities, as I summarised at the time:

“Nothing is certain in life, except death and taxes. But it is hard to see markets becoming less volatile until either an attack takes place, or a peaceful solution is confirmed. And with oil now around $150/bbl, two quite different outcomes seem possible:

• In the event of an Israeli attack, prices might well rise $50/bbl to reach $200/bbl, at least temporarily

• But if diplomacy works, they could easily fall $50/bbl to $100/bbl”

In the event, an attack was never launched and prices quickly fell back to $100/bbl – and then lower as the financial crisis began.

Today, Brent’s uneasy balance around $70/bbl reflects even more complex fears:

  • One set of worries focuses on potential supply disruption from a war in the Middle East
  • The other agonises over the US-China trade war and the rising risk of recession

It is, of course, possible that both fears could be realised if war did break out in the Gulf and oil prices then rose above $100/bbl.

The issue is highlighted in the Reuters chart on the left, which shows that Brent has moved from a contango of $1/bbl at the beginning of the year into a backwardation of nearly $4/bbl on the 6-month calendar spread. As they note:

“Backwardation is associated with periods of under-supply and falling inventories, while contango is associated with the opposite, so the current backwardation implies stocks are expected to fall sharply.”

But as the second Reuters chart confirms, traders are also aware that forecasts for oil demand are based on optimistic IMF forecasts for global growth. And recent hedge fund positioning confirms that caution may be starting to appear.

Traders are also aware of the key message from the above chart, which shows that periods when oil prices cost 3% of global GDP have almost always led to recession.  The only exception was after the financial crisis when central banks were printing as much money as possible to boost liquidity.

The reason is that consumers only have a certain amount of discretionary income.  If oil prices are low, then they have spare cash to buy the products and services that create economic growth. But if prices are high, their cash is instead spent on transport and heating/cooling costs, and so the economy slows.

“To govern is to choose” and President Trump therefore has some hard choices ahead:

  • His trade war with China currently appeals to many voters, Democrat and Republican.  But will that support continue as the costs bite?  The New York Federal Reserve reported on Friday that the latest round of tariffs will cost the average American household $831/year
  • Similarly, many voters favour taking a hard line with Iran.  But average US gasoline prices are already $2.94/gal as the US driving season starts this weekend, and today’s high prices will particularly impact the President’s core blue collar and rural voters

History doesn’t repeat, but it often rhymes as the famous American writer, Mark Twain, noted. If the President now chooses to fight a trade war with China and a real war with Iran, then he risks losing popularity very quickly as the costs in terms of lives and cash become more apparent.  Yet as we have seen since Lyndon Johnson’s time, this is usually something that politicians only learn after the event.

Investors and companies therefore have little to lose, and potentially much to gain, by accepting that we can only guess at how the two situations may play out.  Developing a scenario approach that plans for all the possible outcomes – as in 2008 – is much the most prudent option.

Stormy weather ahead for chemicals

Four serious challenges are on the horizon for the global petrochemical industry as I describe in my latest analysis for ICIS Chemical Business and in a podcast interview with Will Beacham of ICIS.

The first is the growing risk of recession, with key markets such as autos, electronics and housing all showing signs of major weakness. Central banks are already talking up the potential for further stimulus, less than a year after they had tried to claim victory for their post-Crisis policies.

Second is oil market volatility, where prices raced up in the first half of last year, only to then collapse from $85/bbl to $50/bbl by Christmas, before rallying again this year. The issue is that major structural change is now underway, with US and Russian production increasing at Saudi Arabia’s expense.

Third, there is the unsettling impact of geo-politics and trade wars. The US-China trade war has set alarm bells ringing around the world, whilst the Brexit arguments between the UK and European Union are another sign that the age of globalisation is behind us, with potentially major implications for today’s supply chains.

And then there is the industry’s own, very specific challenge, shown in the chart. Based on innovative trade data analysis by Trade Data Monitor, it highlights the dramatic impact of the new US shale gas-based cracker investments on global trade in petrochemicals.

The idea is to capture the full effect of the new ethylene production across the key derivatives – polyethylene, PVC, styrene, EDC, vinyl acetate, ethyl benzene, ethylene glycol – based on their ethylene content. Even with next year’s planned new US ethylene terminal, the derivatives will still be the cheapest and easiest way to export the new ethylene molecules.

The cracker start-ups were inevitably delayed by the hurricanes in 2017. But if one compares 2018 with 2016 (to avoid the distortions these caused), there was still a net increase of 1.7 million tonnes in US ethylene-equivalent trade flows.

This was more than 40% of the total production increase over the period, as reported by the American Chemistry Council. And 2019 will see further major increases in volume with 4.25 million tonnes of new ethylene capacity due to start-up, alongside full-year output from last year’s start-ups.

The problem is two-fold. As discussed here in 2014 (ICB, US boom is a dangerous game, 24-30 March), it was never likely that central bank stimulus policies could actually return demand growth to the levels seen in the Boomer-led SuperCycle from 1983-2000:

“Shale gas thus provides a high-profile example of how today’s unprecedented demographic changes are creating major changes in business models. Low-cost supply is no longer a guarantee of future profitability.”

This was not a popular message at the time, when oil was still riding high at over $100/bbl and the economic impact of globally ageing populations and collapsing fertility rates were still not widely understood. But it has borne the test of time, and sums up the challenge now facing the industry.

Please click to download the full analysis and my podcast interview with Will Beacham.

CEOs need new business models amid downturn

Many indicators are now pointing towards a global downturn in the economy, along with paradigm shifts in demand patterns. CEOs need to urgently build resilient business models to survive and prosper in this New Normal world, as I discuss in my 2019 Outlook and video interview with ICIS.

Global recession is the obvious risk as we start 2019.  Last year’s hopes for a synchronised global recovery now seem just a distant memory.  Instead, they have been replaced by fears of a synchronised global downturn.

Capacity Utilisation in the global chemical industry is the best leading indicator that we have for the global economy.  And latest data from the American Chemistry Council confirms that the downtrend is now well-established.  It is also clear that key areas for chemical demand and the global economy such as autos, housing and electronics moved into decline during the second half of 2018.

In addition, however, it seems likely that we are now seeing a generational change take place in demand patterns:

  • From the 1980s onwards, the demand surge caused by the arrival of the BabyBoomers into the Wealth Creating 25 – 54 cohort led to the rise of globalisation, as companies focused on creating new sources of supply to meet their needs
  • At the same time the collapse of fertility rates after 1970 led to the emergence of 2-income families for the first time, as women often chose to go back into the workforce after childbirth. In turn, this helped to create a new and highly profitable mid-market for “affordable luxury”
  • Today, however, only the youngest Boomers are still in this critical generation for demand growth. Older Boomers have already moved into the lower-spending, lower-earning 55+ age group, whilst the younger millennials prefer to focus on “experiences” and don’t share their parents’ love of accumulating “stuff”

The real winners over the next few years will therefore be companies who not only survive the coming economic downturn, but also reposition themselves to meet these changing demand patterns.  A more service-based chemical industry is likely to emerge as a result, with sustainability and affordability replacing globalisation and affordable luxury as the key drivers for revenue and profit growth.

Please click here to download the 2019 Outlook (no registration necessary) and click here to view the video interview.

BASF’s second profit warning highlights scale of the downturn now underway

The chemical industry is easily the best leading indicator for the global economy.  And thanks to Kevin Swift and his team at the American Chemistry Council, we already have data showing developments up to October, as the chart shows.

It confirms that consensus hopes for a “synchronised global recovery” at the beginning of the year have again proved wide of the mark.  Instead, just as I warned in April (Chemicals flag rising risk of synchronised global slowdown), the key  indicator – global chemical industry Capacity Utilisation % – has provided fair warning of the dangers ahead.

It peaked at 86.2%, in November 2017, and has fallen steadily since then. October’s data shows it back to June 2014 levels at 83.6%. And even more worryingly, it has now been falling every month since June. The last time we saw a sustained H2 decline was back in 2012, when the Fed felt forced to announce its QE3 stimulus programme in September.  And it can’t do that again this time.

The problem, as I found when warning of subprime risks in 2007-8 (The “Crystal Blog” foresaw the global financial crisis), is that many investors and executives prefer to adopt rose-tinted glasses when the data turns out to be too downbeat for their taste.  Whilst understandable, this is an incredibly dangerous attitude to take as it allows external risks to multiply, when timely action would allow them to be managed and mitigated.

It is thus critical that everyone in the industry, and those dependent on the global economy, take urgent action in response to BASF’s second profit warning, released late on Friday, given its forecast of a “considerable decrease of income” in 2018 of “15% – 20%”, after having previously warned of a “slight decline of up to 10%”.

I have long had enormous respect for BASF and its management. It is therefore deeply worrying that the company has had to issue an Adjustment of outlook for the fiscal year 2018 so late in the year, and less than 3 weeks after holding an upbeat Capital Markets Day at which it announced ambitious targets for improved earnings in the next few years.

The company statement also confirmed that whilst some problems were temporary, most of the issues are structural:

  • The impact of low water on the Rhine has proved greater than could have been earlier expected
  • But the continuing downturn in isocyanate margins has been ongoing for TDI since European contract prices peaked at €3450/t in May — since when they had fallen to €2400/t in October and €2050/t in November according to ICIS, who also reported on Friday that
    “Supply is still lengthy at year end in spite of difficulties at German sellers BASF and Covestro following low Rhine water levels”
  • The decline is therefore a very worrying insight into the state of consumer demand, given that TDI’s main applications are in furniture, bedding and carpet underlay as well as packaging applications.
  • Even more worrying is the statement that:
    “BASF’s business with the automotive industry has continued to decline since the third quarter of 2018; in particular, demand from customers in China slowed significantly. The trade conflict between the United States and China contributed to this slowdown.”

This confirms the warnings that I have been giving here since August when reviewing H1 auto sales (Trump’s auto trade war adds to US demographic and debt headwinds).

I noted then that President Trump’s auto trade tariffs were bad news for the US and global auto industry, given that markets had become dangerously dependent on China for their continued growth:

  • H1 sales in China had risen nearly 4x since 2007 from 3.1m to 11.8m this year
  • Sales in the other 6 major markets were almost unchanged at 23m versus 22.1m in 2007

Next year may well prove even more challenging if the current “truce” over German car exports to the USA breaks down,

INVESTORS HAVE WANTED TO BELIEVE THAT INTEREST RATES CAN DOMINATE DEMOGRAPHICS

The recent storms in financial markets are a clear sign that investors are finally waking up to reality, as Friday night’s chart from the Wall Street Journal confirms:

“In a sign of the breadth of the global selloff in stocks, Germany’s main stock index fell into a bear market Thursday, the latest benchmark to have tumbled 20% or more from its recent peak….Other markets already in bear territory are home to companies exposed to recent trade fights between the U.S. and China.

The problem, as I have argued since publishing ‘Boom, Gloom and the New Normal: how the Ageing Boomers are Changing Demand Patterns, again“, in 2011 with John Richardson, is that the economic SuperCycle created by the dramatic rise in the number of post-War BabyBoomers is now over.

I highlighted the key risks is my annual Budget Outlook in October, Budgeting for the end of “Business as Usual”.  I argued then that 2019 – 2021 Budgets needed to focus on the key risks to the business, and not simply assume that the external environment would continue to be stable.  Since then, others have made the same point, including the president of the Council on Foreign Relations, Richard Haas, who warned on Friday:

“In an instant Europe has gone from being the most stable region in the world to anything but. Paris is burning, the Merkel era is ending, Italy is playing a dangerous game of chicken with the EU, Russia is carving up Ukraine, and the UK is consumed by Brexit. History is resuming.

It is not too late to change course, and focus on the risks that are emerging.  Please at least read my Budget Outlook and consider how it might apply to your business or investments. And please, do it now.

 

You can also click here to download and review a copy of all my Budget Outlooks 2007 – 2018.