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.
Last week’s summit meeting between US President Donald Trump and China’s President Xi Jinping was initially overshadowed by Friday’s news of US missile strikes on Syria. But from the details since released, it is clear the summit will likely have far-reaching impact on the global economy. As US Commerce Secretary Wilbur Ross revealed afterwards, the 2 leaders agreed to implement:
“A 100-day plan with way-stations of accomplishment. We made very clear that our primary objectives are twofold:
One is to reduce the trade deficit quite noticeably between the United States and China
The second is to increase total trade between the two countries
Ominously, he added, “Words are easy, discussions are easy, endless meetings are easy. What’s hard is tangible results, and if we don’t get some tangible results within the first 100 days, I think we’ll have to re-examine whether it’s worthwhile continuing them.”
Ross has set a tough target to be met with 100 days (18 July), especially given the range of major issues involved.
This is why ICIS and International eChem have combined their expertise to produce a new Report, The War of Words, focused on the implications of any deal – or lack of any deal – on the global petrochemicals industry. The Report highlights how a “business-as-usual scenario” is the least likely outcome for the years ahead. As my co-author, John Richardson of ICIS highlights:
“Our aim is to provide a clear understanding of the tectonic shifts now under way in the world’s two largest economies, and to offer a detailed road map outlining the potential impact of these developments on business and investments.”
The Report provides companies and investors with the insight and analysis needed to prepare for almost inevitable change to today’s business models. It highlights how today’s globalised world – whereby raw materials are routinely shipped half-way around the world, and then returned as finished product – is most unlikely to survive for much longer.
The “War of Words” Report is the first in a quarterly series of “Uncertainty Studies“. It provides a clear understanding of the tectonic shifts now under way in the world’s two largest economies, and a detailed road map highlighting the likely impact of these developments on business and investments. It is essential support for decision-makers.
Please click here for subscription details, or contact me directly at firstname.lastname@example.org
Many commentators were shocked by China’s weak trade data on Monday – with imports falling 12.5% versus July 2015, and January – July imports down 10.5%. But they were no surprise to anyone focused on developments in the chemical industry, which has once again confirmed its status as the most reliable leading indicator for the economy.
The chart shows net trade data in H1 2009 – 2016 for PVC – one of the most traded chemical products, used in construction for doors, windows, cables and other key areas. China’s own production has almost doubled over the period to 8.3 million tonnes, whilst its demand has only increased by around a third. As a result:
□ China has swung from being the world’s largest importer in 2009 to one of the leading exporters in 2016
□ NE Asia has been the main loser, with its exports to China falling by two-thirds to 187kt: NAFTA exports have fallen by more than a third to 130kt
□ China’s own exports have also started to surge, up from just 30kt in 2009 to 575kt this year
The data also confirms that China is now well on the way to reaching its ambitious targets for self-sufficiency (as set out in the current 5-Year Plan to 2020). For ethylene (the raw material for PVC, alongside chlorine) the aim is to reach 62% by 2020, compared to 49% in 2014.
Unfortunately, however, many commentators still remain in denial about these developments. Their shocked reactions to the trade data confirm their continuing failure to appreciate that China’s economic policies have never been based on Western concepts of cost-curves and corporate profitability.
As the chart above suggests, China is instead focused on avoiding social unrest, and preserving the Communist Party’s hold on power. It follows Deng Xiaoping’s policy, which aimed to keep living standards rising in order to maintain the Party’s role in government.
This policy makes perfect sense for China, as it seeks to avoid a return to the chaos of Mao’s ‘Cultural Revolution’:
□ It means that maintaining employment is a key objective, along with steady growth in incomes
□ Western concepts of focusing on corporate profitability and shareholder value are much less important
□ Productivity improvement is therefore critical to economic progress. New data shows, for example, that factory workers now have an average of 10 years schooling, compared to 8 years just a decade ago, helping to enable productivity to double over the same period
The other key change in recent years has been President Xi’s decision to move away from the stimulus policies followed between 2009 – 2013, in response to the financial crisis. China had provided around half of the total stimulus during this period. Inevitably, therefore, this triggered the Great Unwinding of global stimulus.
Unfortunately, as shown by this week’s reaction to China’s trade data, consensus thinking still fails to recognise the impact of these New Normal developments. But this failure also creates a major opportunity for those individuals, companies and investors who prefer to trust their own judgement on the outlook for China and the global economy .