The global economy and the US$ – an alternative view

Every New Year starts with optimism about the global economy.  But as Stanley Fischer, then vice chair of the US Federal Reserve, noted back in August 2014:

 “Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back.”

Will 2018 be any different?  Once again, the IMF and other forecasters have been lining up to tell us the long-awaited “synchronised global recovery” is now underway.  But at the same, they say they are puzzled that the US$ is so weak.  As the Financial Times headline asked:

“Has the US dollar stopped making sense?”

If the global economy was really getting stronger, then the US$ would normally be rising, not falling.  So could it be that the economy is not, actually, seeing the promised recovery?

It isn’t hard to discover why the experts have been fooled.  Since June, we have been seeing the usual rise in “apparent demand” that always accompanies major commodity price rises.  Oil, after all, has already risen by 60%.

Contrary to economic theory, companies down the value chains always build inventory in advance of potential price rises.  Typically, this adds about 10% to real demand, equal to an extra month in the year.  Then, when the rally ends, companies destock again and “apparent demand” weakens again.

The two charts above confirm that the rally had nothing to do with a rise in “real demand”:

Their buying has powered the rise in oil prices, based on the free cash being handed out by the central banks, particularly in Europe and Japan, as part of their stimulus programmes.

They weren’t only buying oil, of course.  Most major commodities have also rallied.  Oil was particularly dramatic, however, as the funds had held record short positions till June.  Once they began to bet on a rally instead, prices had nowhere to go but up.  1.4bn barrels represents as astonishing 15 days of global oil demand, after all.

What has this to do with the US$, you might ask?  The answer is simply that hedge funds, as the name implies, like to go long in one market whilst going short on another.  And one of their favourite trades is going long (or short) on oil and commodities, whilst doing the opposite on the US$:

  • Since June, they have been happily going long on commodities
  • And as Reuters reports, they have also been opening major short positions on the dollar

The chart highlights the result, showing how the US$’s fall began just as oil/commodity prices began to rise.

This pattern has been going on for a long time.  But I have met very few economists or central bankers who recognise it.  They instead argue that markets are always efficient, as one professor told me recently:

“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 if you were a purchasing manager in the real world, you wouldn’t be sceptical at all.  You would see prices rising for your key raw materials, and you would ask your CFO for some extra cash to build more inventory.  You would know that a rising oil, or iron, or other commodity price will soon push up the prices for your products.

And your CFO would agree, as would the CFOs of all the companies that you supply down the value chain.

So 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.

What happens next is, of course, the critical issue.  As we suggested in this month’s pH Report:

“This phenomenon of customers buying forward in advance of oil-price rises goes back to the first Arab Oil Crisis in 1973 – 1974. And yet every time it happens, the industry persuades itself “this time is different”, and that consumers are indeed simply buying to fill real demand. With Brent prices having nearly reached our $75/bbl target, we fear reality will dawn once again when prices stop rising.”

Forecasting, as the humorist Mark Twain noted, “is difficult, particularly about the future”.  But hedge funds aren’t known for being long-term players.  And with refinery maintenance season coming up in March, when oil demand takes a seasonal dip, it would be no surprise if they start to sell off some of their 1.4bn barrels.

No doubt many will also go short again, whilst going long the US$, as they did up to June.

In turn, “apparent demand” will then go into a decline as companies destock all down the value chain, and the US$ will rally again.  By Q3, current optimism over the “synchronised global recovery” will have disappeared.  And Stanley Fischer’s insight will have been proved right, once again.

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Chart of the Year: Bitcoin, the logical end for stimulus policies

Last year it was the near-doubling in US 10-year interest rates.  In 2015, it was the oil price fall.  This year, there is really only one candidate for ‘Chart of the Year’ – it has to be Bitcoin:

  • It was trading at around $1000 at the start of 2017 and had reached $5000 by August
  • Then, after a brief correction, it stormed ever-higher, reaching $7000 last month
  • On Friday it was trading around $19000 – fortunes are being made and lost all the time

The beauty of the concept is that nobody really has a clue about what it is all about.  You can read the Wikipedia entry as many times as you like, and still not gain a clear picture of what Bitcoin is, and what it does.  But why would you want to know such boring details?

All anyone has to know is that its price is going higher and higher.  Plus, of course, there is the opportunity to laugh at stories of people who bought Bitcoins, but then lost the code – for an excellent example by a former editor of WIRED (with a happy ending), click here.

But there is another side to the story, as the second chart suggests.  “Mining” Bitcoins now uses more electricity than a number of real countries, like Ireland, for example:

  • On Friday, Bitcoin’s current annual consumption reached 33.73TWh – equivalent to Belarus’ 9 million people
  • Each transaction produces 117.5kg of CO2, as the network is powered by cheap coal-fired power plants in China
  • It also uses thousands of times more energy than a credit card swipe 

And, of course, interest is growing all the time as people rush to get rich.  Today sees the start of Bitcoin futures trading on the CME, a week after they began on the CBOE and CME.  Bloomberg suggests Exchange Traded Funds based on Bitcoin will be next.  In turn, these developments create more and more demand, and push prices ever-higher.

Comparisons have been made with the Dutch tulip mania in 1836-7, when prices peaked at 5200 guilders.  At that time, Rembrandt’s famous Night Watch painting was being sold for 1600 guilders, and at its peak a tulip bulb would have bought 156000lbs of bread.  Bitcoin probably won’t equal this ratio until next year, if its current price climb continues.

Of course, one key difference between tulips and Bitcoin is supposedly that there were always more tulips to buy – whilst there are just 21 million Bitcoins available to be mined.  And apparently, around 80% of these have been mined. Bitcoin enthusiasts therefore suggest Bitcoins will have increasing scarcity value.  But, of course, anyone can create a crypto-currency and many people have – such as Bitcoin Cash and Bitcoin Gold, and the Ethereum family.

Yet already, Bitcoin’s market capitalisation* is getting close to that of the “tech stocks” such as Apple, Alphabet (formerly Google), Microsoft, Amazon and Facebook as the chart from Pension Partners shows:

  • On 7 December, less than 2 weeks ago, its market cap was already higher than major US stocks such as Home Depot and Pfizer
  • On Friday, it hit $323bn, above Wal-Mart and P&G and close to ExxonMobil
  • This also made it worth more than the IMF’s Special Drawing Rights
  • And the total market cap of the 10 largest crypto-currencies has now reached $500bn, equal to Facebook

This is an amazing amount of money to be tied up in an asset which has no intrinsic value.  After all, what is Bitcoin?  It certainly isn’t real, although the media like to picture it as a gold coin:

  • Although it is called a crypto-currency, its volatility makes it unattractive as a currency – major changes in a currency’s value can easily cause businesses (and countries) to go bust, and Bitcoin’s value has moved by 1900% just this year
  • Nor is it a method of settling transactions, as its value is increasing all the time – obviously a good deal for the person who receives the Bitcoin when its price is rising, but why would any sensible person pay with a Bitcoin?
  • So essentially, therefore, Bitcoin is simply a speculative asset, where its value is based on the “greater fool theory”, which says “I know its not really worth anything, but I am clever enough to sell out before it hits the top”

The “story” behind its boom is also powerful because it is linked to the great investment theme of our time, the internet.  We have all seen the fortunes that can be made by investing in companies such as Apple.  Now, Bitcoin supposedly offers us the chance to invest in the Next Big Thing – a new currency, entirely based on the internet.

The Bitcoin mania has many parallels, such as with the South Sea Bubble from 1719 – 1720.  Its power was also based on “the greater fool theory”, and its linkage to the great investment theme of its time – the opening up of foreign trade.  As the chart from Marc Faber shows, one of its early investors was Sir Isaac Newton – one of the most intelligent people ever to live on the planet, who discovered Newton’s laws of motion and invented calculus.  Newton doubled his money very quickly when he first invested, but then re-invested at a higher price – and lost the lot.

Of course, all the dreams associated with Bitcoin and the other crypto-currencies may come true. That is part of their attraction.  Another part of their attraction is for criminals, who can launder money without being traced.  So most likely, prices will continue rising for some time as more and more people around the world see a chance of getting rich very quickly.  We have never seen a global mania before, so nobody can tell how long it will last.

The question for governments, however, is what would happen to the economy if the mania collapsed?  Only China has so far banned Bitcoin trading, as Pan Gongsheng, a deputy governor of the People’s Bank of China, explained:

“If we had not shut down bitcoin exchanges and cracked down on ICOs several months ago, if China still accounted for more than 80% of the world’s bitcoin trading and ICO fundraising, everyone, what would happen today? Thinking of this question makes me scared.”

Having let the mania develop this far, other governments  are in a difficult position – millions of people would complain if they closed down these currencies today.  And most governments are reluctant to intervene as, in reality, crypto-currencies are essentially the creation of central bank stimulus policies, as explained by US Federal Reserve chairman, Ben Bernanke, in November 2010:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” 

But by letting the mania continue, the potential impact from its collapse will increase.  Added together, crypto-currencies already have the same market cap as Facebook – and could soon overtake Apple to become the most valuable “stock” in the world.  Yet unlike Apple, they have no sales, no income and no assets.

Bernanke and the major central banks wanted to stimulate investors’ “animal spirits”, so that they would take on more and more risk.  Crypto-currencies are therefore the logical end result of their post-crisis strategy. The end of the Bitcoin mania, whenever it occurs, will therefore also mark the end of stimulus policies.


*Bitcoin’s market capitalisation is its equity valuation – the current dollar price multiplied by the number of Bitcoins in existence

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Speculators’ tail wags oil market dog as paper trading dominates

WTI futures Jan17aTrading oil markets used to be hard work.

You had to talk to all the major players all the time (not just message them), and learn to judge whether they were telling the truth or inventing a version of it.  You had to watch for breaking economic and political news.  And you needed your own supply/demand balances.  Plus you had to guess how the fabled  ”Belgian or New York dentist” – who traded oil futures to break the tedium of drilling teeth – might be feeling each day.

Today’s trading world is completely different:

   More than half of all trading is done by machines at ultra-high speed.  These are the “legal highwaymen” described in Michael Lewis’ great book Flash Boys. And they don’t care about the real world of oil markets or the economy, as these factors are irrelevant to their business models
   Then you have the hedge funds, and even some pension funds, with quarterly targets for profit.  They can’t afford to spend time developing a detailed analysis, and waiting for the market to catch up.  They have to play the momentum game of finding a story, and jumping on it as quickly as possible
   In addition, of course, there are still producers and consumers, who actually need to buy or sell oil.  They used to set the market prices in the past, but are just an also-ran today as their volume is so small relative to the others.  But in the “real world” outside of financial trading, they are the only people who matter

New data from the CME highlights the change.  It shows paper trading in just WTI futures averaging a record 11 million contracts each day in 2016 (each of 1000 barrels).  Actual physical production, by comparison, is around only 92 million barrels per day.  The speculative tail is indeed wagging the dog.

The chart above shows the current net position of the speculators, which is at a record 371k contracts.  It highlights just how much they love the OPEC production cut story – it is easy to understand, and is easy money for everyone, particularly the momentum traders, as the story seems never-ending.

OPEC Feb17The only problem – for players in the real world – is that the “story” isn’t true.  Today’s headlines may say that OPEC has 82% compliance, but this was only because of Saudi Arabia – which cut 564kb versus the promised 486kb, according to the Reuters data above.  Outside the GCC countries, not much happened.  Venezuela – which led lobbying for an output cut – delivered only 18% of its promise, and Russia only cut 117kb versus its promised 300kb.

“Who cares?”, you might say, if you are one of the highwaymen or a momentum trader.  Talk is cheap, and you can tell the media it is early days, and countries take time to adjust.  They love an easy story, just as you do, and believe their viewers want a quick trading tip – not a boring discussion about rising US inventories for oil (up another 6mb last week) and gasoline inventories (now actually above the upper limit of the normal seasonal range).

You certainly don’t want to dive into the detail of rising US shale production (already back at April’s level), and rising numbers of drilling rigs (back to November 2015 levels). And you certainly won’t discuss the 5300 drilled but uncompleted oil/gas wells, where producers only have to turn the tap to start earning revenue.

Well, not just yet, anyway.  Maybe in a week or two, it might be time to learn a new script.  After all, “what goes up, comes down”.  The dream scenario for the paper traders would be if today’s major rally was followed by a major collapse.  After all, the refinery maintenance season will soon be starting, causing physical demand to drop.

Of course, all this volatility has a price.  The market is a zero-sum game where overall, the consumer and the producer pay the cost of the speculator’s outsize profits.  And in the geo-political world, there is one major loser – Saudi Arabia.

The Saudis know that President Trump doesn’t support the ‘Oil for Defence‘ agreement made 70 years ago, which protected them in 1990/1991 when Iraq invaded Kuwait. So they have to stay close to the other OPEC members, and make the major share of the cuts.  But what will happen in Saudi, if and when prices fall back – say to the $30/bbl level seen a year ago?

Iran talks offer hope on oil prices

Iran Nov13Iran has been at the centre of all the major oil market price spikes in the past few decades:

  • Today’s record prices on an annual basis are partly due to market fears over supply disruptions due to the Iran/Israel nuclear issue
  • Fears over a nuclear showdown also led prices to jump to $150/bbl in July 2008, when the blog then correctly forecasted that “if diplomacy works, they could easily fall $50/bbl to $100/bbl”
  • The ousting of the Shah in 1979 and the Iran hostage issue led to the Second Oil Crisis, when prices jumped from $14/bbl in 1978  to $30/bbl  (equal to $100/bbl in $2013)
  • Iran was also part of the OPEC oil embargo following the Yom Kippur War in 1973 that took prices from $3/bbl to $12/bbl ($50/bbl in $2013)

Now, a new era may be close as Iran seeks to return to world markets.  As the blog told Bloomberg yesterday:

“Lifting petrochemical sanctions will permit $1 billion in exports for Iran, according to U.S. officials close to the talks. Iran may not feel an immediate impact because it’s been able to ship materials such as polyethylene resins to China in violation of sanctions, Paul Hodges, chairman of International eChem, a London-based consulting firm, said in an interview.  Any future increase in Iranian supplies of oil and gas would trickle down to Europe’s chemical industry, creating a potential game changer for energy-intensive industries, including those making PVC, said Hodges.

“You’d have a traditional major producer coming back into the market and desperate to sell,” said Hodges. “This has suddenly the potential to change the whole outlook as there’s someone out there who wants to sell and also needs to sell.  Every single chemical plant in Europe would benefit.   That would be a bonus for companies from German plastics maker Bayer AG and synthetic rubber supplier Lanxess AG to Arkema SA of France and Solvay SA of Belgium, he said.”

As the chart shows, Iran has clear potential to be a major player once more in oil markets:

  • It produced 6mbd in the 1970s (black line) and was 10% of world oil output (green) and 21% of OPEC’s (red)
  • Last year it produced just 3.7mbd, and was just 4% of world output and 10% of OPEC’s
  • Its oil exports have fallen 60% to just 1mbd, compared to 2.5mbd before sanctions
  • So it has a lot of oil that could potentially come to market over time

Oil prices have been boosted since 2009 by fear over potential supply shortages and speculation funded by the central banks.  Now, both influences may be about to disappear, if the Iran dialogue continues to develop and the US Federal Reserve starts to ‘taper’ its spending.

This would be very good news for chemical companies, as it would likely move oil prices back down towards their historical parity with US natural gas prices.  It would also be very good news for Iran’s long-suffering population.

Benzene highlights rising risks in financial markets

FTA v BenThe blog is busy preparing its presentations for its World Aromatics and Derivatives Conference later this month, co-organised as always with ICIS.  As well as looking at the impact of the transition to the New Normal, it will be investigating the current state of benzene markets.  These are always an excellent leading indicator for the global economy, and the current position is particularly significant.

As the chart shows, there is normally little alignment between benzene prices (red) and major financial indices such as the Financial Times All-Share Index (FTA)).  Both should move in line with their own supply/demand balances, and any parallels should be coincidental.

  • There was very little correlation between 1980-2004
  • Both markets did however see major volatility between 1986-90, after the 1985 collapse of oil prices
  • But strong correlation then began to appear in 2004, and has since become a major feature of the landscape

What is behind this change?  10 years is clearly a long enough period to suggest that new drivers have appeared.

The key is perhaps that benzene markets have lost their major sources of on-purpose production. Instead supply now depends on developments in refining and oil markets, and doesn’t adjust with changes in demand levels.  Shortages and surpluses have become more obvious and longer-lasting.

In turn, this development seems to provide a possible answer to the question.  As the blog has discussed in the past, we are now seeing major correlation between oil prices and financial markets for the first time in history, due to the stimulus activities of central banks:

  • In financial markets, they have funded a major buying surge, by providing unlimited and very cheap cash
  • They have also created a panic amongst pension funds, due to their implied policy of weakening the US$
  • As a result, many funds have now invested in oil, believing it has become a new asset class
  • Equally, high-frequency trading in oil markets now dwarfs physical market volumes

Oil markets have thus lost their role of price discovery.  And in turn, this has also impacted benzene markets.  Neither are now trading in line with their own fundamentals of supply and demand.  Instead, they are effectively being manipulated by short-term financial flows.

But these flows cannot continue forever, of course.  What happens next is the question the blog will aim to answer in Brussels.

The weekly comments from ICIS pricing and price changes since January on the benchmark products in the blog’s Downturn Monitor portfolio are below:

Benzene Europe, green, down 21%. ”Spot values have drifted down by up to $100/tonne over the course of October”
PTA China, down 15%. “Large-scale shutdown in the downstream PET sector where average operating rates fell to 55% capacity because of poor demand amid a low season”
Brent crude oil, down 3%
Naphtha Europe, down 2%. “the arbitrage window to Asia has opened wide, prompting high-volume exports to the region and relieving oversupply”
HDPE USA export, up 16%. “Participants expect prices to fall in the next few weeks as producers begin to release more material into the export market”
US$: yen, orange, up 12%
S&P 500 stock market index, purple, up 20%

Oil market hype fails to take prices out of their triangle

Brent Sept13Pity for a moment those poor souls whose income depends on finding ever-more creative ways of justifying today’s record levels of oil prices.  One by one, all their favourite stories have disappeared.  Even the traditional summer warnings of record hurricane disruption have so far failed to deliver.

How different it is from the start of the crisis, when the bonuses were so much easier to earn:

  • The obvious story of a quick V-shaped recovery taking oil prices to $70/bbl was so easy to spread
  • When that began to become doubtful, China and India proved equally successful
  • Naïve pension funds loved the idea that a Commodities SuperCycle was now underway
  • Then, of course, there was the old favourite of war in the Middle East
  • Libya was somehow going to cause shortages at the pumps: Iran was about to nuke Israel
  • Even better was the Arab Spring, which meant breakeven costs would soar as social programmes increased

Think of all those servers installed to carry the message around the world.  All those trees cut down to provide paper copies for senior management briefings.  All in vain.  The promised shortages and disruptions have simply refused to develop as forecast.

But invention is the mother of necessity.  Hats off then to those who managed to forecast shortages due to increasing oil and gas production in the USA.  Crisis!!! Crisis!!! screamed the headlines.  All this new production would swamp the Cushing terminal, and so Brent moved to a premium versus WTI.

Happy days, they were.

What about the problem that higher oil prices were doing their usual job of destroying demand?  No need to worry, thanks to the easy money policies of the central banks.  They would happily lend to anyone whose bank account was large enough to take $1bn or more of the new electronic money they were creating.

It might sound easy being the US Federal Reserve and having the job of quickly increasing your balance sheet from $900bn to $3.5tn.  But how many people are both able and willing to take such wads of cash at short notice, particularly today with global growth slowing?

Thank goodness for the hedge funds, you would say.  The QE3 stimulus might have failed to find enough borrowers if they hadn’t decided to boost their speculative long positions in oil futures to record levels this summer.

Happy days, indeed.

But where are we today?  Syria was supposed to take oil prices to record highs.  But somehow wiser counsels have prevailed.  Equally worrying for the oil price bulls are the new Iranian leadership, who want an end to the nuclear issue, and to increase oil production again.  Even worse, OPEC and Saudi Arabia insist that oil markets are “well supplied“.

Only the Russians remain loyal to the story.  Suddenly Urals blend is at record premia.  But are they really impartial observers?  They are not only major oil exporters, but gas exports are their largest source of revenue – and these are linked to oil prices.

We shouldn’t give up on the imaginative impulses of those whose living depends on spinning stories about oil market shortages.  They may well have another brainwave left.

But as the chart above reminds us, oil markets have traced out an enormous triangle shape.  And such triangles only end in one of two ways.  Either a real shortage appears, and prices sky-rocket.  Or reality finally dawns, and they collapse.

The blog declares an interest in this critical debate.  It now has a number of bets with its investment analyst friends based on prices falling to $50/bbl or less.  And it will be very happy to increase these, if any bullish readers would like to put their own money on the line.  Please just don’t all rush at once.

Latest benchmark price movements since January with ICIS pricing comments this week are below:
Benzene Europe, down 13%. ”Steady-to-weak spot pricing amid several downstream shutdowns, leading to a buildup of length for prompt volumes”
PTA China, down 10%. “Spot availability is abundant mainly because of slower buying activities from India…plus lower-than-expected demand from China and Taiwan amid a traditional peak season”
Naphtha Europe, flat 0%. “Poor margins and maintenance requirements mean refiners have been forced to cut production”
Brent crude oil, flat 0%.
HDPE USA export, up 9%. “Force majeure by LyondellBasell for its biggest plant in North America”
US$: yen, up 13%
S&P 500 stock market index, up 15%