Boom, Gloom and the New Normal

An excellent new report from Citi’s commodities team suggests the US supply/demand balance for crude oil is undergoing fundamental change.

Importantly, they also argue that the concept of ‘peak oil is being buried’, and add:

“The belief that global oil production has peaked, or is on the cusp of doing so, has underpinned much of crude oil’s decade-long rally”.

US OIL MARKETS
As Citi note, the arrival of shale oil in the USA and the associated liquids from shale gas, is now “leading the US to be the fastest growing oil producer in the world“.

The Citi chart above provides dramatic evidence for the first assertion. It shows that the US has become a net exporter of refined oil products (gasoline, diesel, jet fuel etc) for the first time in 60 years. The scale of the turnaround is also important. The US imported 2.5mbd in 2005, but exported 360kpd in H2 2011.

Citi argue there is little reason to expect this trend to change. Not only is more oil being produced all the time, but US demand is also declining:

• On production, the key is developments in states like N Dakota, where companies are applying shale gas drilling techniques to shale oil deposits
• On demand, Citi share the blog’s view that higher prices reduce the ratio of oil demand growth to global GDP growth. Higher auto fuel standards, the attractiveness of shale gas, and increasing use of ethanol will also reduce oil demand

Citi thus expect the US “to achieve energy independence this decade”. This has been long-delayed since the goal was announced by then President Nixon in reaction to the 1973 oil crisis. But not only are the tools to achieve it now available, but also the political will.

PEAK OIL DOUBTS
The concept of ‘peak oil’ was originally invented in 1956 by a Shell geologist, M King Hubbert, and gained credibility from its accurate forecast that US oil production would peak between 1965-70. However, as the blog noted last year, Hubbert’s other forecasts were less successful. The USA produced 7.5mbd in 2011, rather than just the 1.5mbd he expected.

The major influence of the peak oil story has been in commodity markets.

As we noted in chapter 3 of ‘Boom, Gloom and the New Normal’, pension funds and others have been sold the idea that oil and other commodities represent a ‘store of value’ whose prices will always keep rising. Thus they have continued to buy, even though demand is falling and inventories are comfortable.

The major impact of the Citi argument is initially on US markets. They therefore expect the recent disconnect between WTI and global markets to continue.

Yet now the ‘peak oil’ theory is being challenged, the door is also opening for other countries to exploit the large deposits of shale gas and shale oil that exist outside the USA.

January was not a great month for auto sales in the 3 major markets of the USA, EU and China. These amount to over 50% of global auto sales, and are a key indicator of underlying consumer demand.

As the chart shows, sales were just 3m (red square), down from 3.2m (green line) in 2011:

• China’s volumes were down 17% to 1.2m from 1.4m
• EU fell from 1.04m to 0.97k
• Only the USA saw a rise to 0.9m from 0.8m

Of course, China’s sales were much slower than last year due to the Lunar New Year taking place earlier than in 2011, and combining with the Spring Festival. But even so, China’s auto industry is only forecasting 8% growth this year – in line with the 6% seen in 2011. This is well down on the 33% and 49% increases seen during the stimulus period.

It is also difficult to be optimistic about EU sales, with auto companies forecasting sales declines of 6% or more this year. Whilst sales growth forecasts in the USA will be tested by today’s high gasoline prices.

This time last year, the petchem industry stood on the edge of an unseen precipice. Life seemed good. Prices were racing ahead and demand appeared buoyant. But in reality the buyers were only buying forward to protect margins, whilst end-user demand was slowing fast.

This year, the blog fears, we may be about to take one step forward.

As last year, the evidence comes from ICIS market reports. The highly experienced Linda Naylor last week reported buyers commenting as follows in European polyethylene and polypropylene markets:

“‘We expect an increase for ethylene in March, so we are buying our full contracted volumes in February, and also in January, even though our demand is poorer than we expected. That way, we won’t have to buy so much in March.”

“‘Our demand is below what we expected but we are taking our full contracted volumes to be able to have a buffer next month.”

Similar warning signs are reported by Becky Zhang in China’s ethylene glycol markets, and Helen Yan in Asian butadiene:

“‘The market is full of offers and this [has worsened the] bearish sentiment’, a major regional trader said. China’s port inventory reached a historic high of over 750KT, with increased import volumes arriving from all over the world. This is almost exceeding China’s maximum storage capacity of around 800KT.”

“‘BD prices are higher than BR and this is not sustainable,’ another synthetic rubber producer said.”

The chart shows how prices for the benchmark products have seen 3 major rallies since 2009. These followed the 3 major stimulus packages.

Today’s rally began with Q4′s US Federal Reserve’s $400bn Operation Twist programme. It is clearly much weaker than those which followed the March 2009 and August 2010 quantitative easing programmes.

Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 11%. “Offers for re-exports from China were heard at lower prices than offers from the US Gulf”
PTA China (red), down 11%. “The current supply and demand balance as well as volatile external markets did not support a solid upturn”
Naphtha Europe (brown dash), down 7%. “Vitol continued its naphtha buying spree, taking 5 cargoes after it bought eight cargoes last week”
Brent crude oil (blue dash), down 5%
Benzene NWE (green), down 4%. “Continued buoyancy on crude and energy numbers counterbalanced by lower demand.”
S&P 500 Index (pink dot), no change

Last April, China’s polyester market provided an early warning signal that the current downturn was about to start. Now, it is flagging an important change in relative positions within the value chain.

9 months ago, the divergence between crude oil prices and those for the C8 chain highlighted slowing end-user demand. The chart above updates the picture since then:

• Brent (purple line) is ~150% above its January 2009 level
• PTA (red) peaked at ~130%, but is now only ~75% above this level
• PET (blue) peaked at ~110%, but is also now ~75% above this level
• PX (green) has been relatively stronger, and is 100% above this level

This, of course, is very bad news for those who have invested in PTA and PET. They are suffering value leakage in relation to paraxylene (PX) prices, rather than adding value.

The reasons are probably three-fold:

• Slow end-user demand means products close to the oil barrel have greater pricing power than those downstream
• Lower Western refinery operating rates are reducing mixed xylene production, and increasing the differential necessary to justify extraction
• A massive jump in Asian PTA capacity (primarily in China) is not being accompanied by a similar increase in PX supply

The jump in Asian capacity repeats the pattern seen in the early 2000s, when China first boosted PTA production. Fellow-blogger Malini Hariharan noted last month that nearly 11.5MT of new capacity is expected in Asia this year, whilst only 1.4MT of new PX supply is scheduled.

Major shortages, and considerable market disruption, could therefore occur if the new plants all bid for the same few available feedstock parcels. This wouldn’t happen in the West, where issues of profitability would take priority. Producers would instead optimise margins by selling PX and covering their PTA commitments by purchases.

But China’s philosophy is not so profit-oriented. Instead, due to the often close linkages between companies and government, the need to maximise employment can have priority. This is especially true in a year when major politburo elections are underway, and the need for social stability is strong.

Shipping markets are usually a good leading indicator of future economic activity.

They have their own supply/demand balances, of course. Not every uptrend or downtrend can be taken too seriously.

But the Baltic Dry Index of ocean freight costs has done a good job for the blog in the past.

So one cannot simply dismiss its message today.

It is an excellent proxy for world trade and activity in China, as it covers the heavy bulk products (iron ore, grains, coal). It was strong through 2007/8, before collapsing. Last March, it was the first indicator to signal the start of China’s slowdown.

As the chart shows, it has now been falling steadily for over a month. Day by day, every day. So far, it has fallen for 28 days in a row. This is quite remarkable behaviour for any market.

It is now back at the levels seen in December 2008.

Optimists who believe that China is about to see a renewed boom will continue to ignore the Index. They will argue its decline simply reflects the fact that too many ships were ordered at the height of the boom.

But this seems too simplistic a response. The recent price weakness is far too dramatic to be simply reflecting this already widely known fact. The blog suspects that the Index is also reflecting a serious slowdown in world trade. It is yet another sign that a new recession is probably underway.

UPDATE. The Index today fell 2.6% today, and is now at a 25 year low.

‘Would you buy, or would you sell?’ is always an interesting question in any market. Petchems provide a particularly balanced answer today.

• Buy arguments include – China’s buyers will return from holiday, and will need to restock; gasoline markets are tightening after the Petroplus bankruptcy; bad weather is causing some disruption
• Sell arguments include – US GDP data disappointed with inventories showing a big rise; a blockage of the Strait of Hormuz seems less likely in the short-term; European demand remains slow for the time of year

The ‘safe’ answer to the question would therefore be to buy. And this is what has been happening, especially as consumers need to build inventory ahead of proposed price increases. They cannot pass these on downstream, so their profitability depends on buying forward.

The second question, of course, is ‘would you therefore go long?’ And today the ‘safe’ answer would be to simply maintain prudent inventory levels. Markets have been driven by supply-side constraints for many months now, not by strong levels of demand.

The ‘sell’ arguments above create justifiable concern that one day, perhaps not too far away, fundamentals of demand will come back into play. Going ‘long’ would require either a strong belief that demand is returning, or confidence that supply will remain disrupted.

The blog suspects that crude oil market moves may prove decisive in the end. The bankruptcy of European refiner Petroplus is yet another warning sign about the impact of demand destruction at today’s record prices. But equally, oil is still trading in its ‘triangle’ pattern, so it would be premature to anticipate its future direction.

The chart shows market developments over the past year. Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 16%. “Trading was thin, with the Chinese New Year holiday keeping Asian markets at a standstill”.
PTA China (red), down 13%. Markets were closed for Lunar New Year
Brent crude oil (blue dash), down 11%
Naphtha Europe (brown dash), down 11%. “Restocking, delays in the Mediterranean, and higher propane prices which have finally encouraged buyers back to naphtha”.
S&P 500 Index (pink dot), down 4%
Benzene NWE (green), down 3%. “Some key European producers have been aggressively purchasing benzene instead of pygas”.

Latest data from the IMF shows that the EU remains the world’s largest economic unit. Its GDP in 2010 was $16.2tn, 26% of the global economy. The USA was next with $14.5tn, and China 3rd with GDP of $5.9tn.

So what happens in Europe matters greatly to the global economy.

Equally, petchems are one of the best leading indicators that we have for monitoring the health of the broader economy. So the chart above of ethylene production in the EU 15 (plus Norway), based on APPE data, provides good insight into what lies ahead:

• Q4′s 4.4MT output (red line) was the lowest since 1995, excluding 2008
• Total 2011 output of 19.6MT was the lowest since 2000, excluding 2009
• Q4 operating rate was just 72%, and H2 only 77%

This is not good news, by any standard.

Another way of interpreting the data is to average 2010-2011 volumes. This takes account of 2010′s stock-build as crude oil prices rose, and then 2011′s destocking. It gives an average volume for the 2 years of 19.9MT. This would be the lowest volume since 2001, excluding 2009.

The conclusion is obvious. Demand destruction is underway in the world’s largest economic region. It also seems unlikely that things will improve short-term with oil prices at a sustained record level, and with EU governments committed to an austerity approach.

Producers and consumers have done a superb job over the past few months in reducing output in line with demand. In the short-term, they should hope for a reward in terms of a bounce in orders. H1 should be the seasonally strongest part of the year.

But only an extreme optimist will regard this as a sign that the economy itself is turning the corner. And policymakers’ continuing inability to finalise Greece’s inevitable default is a reminder, if one were needed, of the banana skins that now litter the world’s economic outlook.

The blog’s argument that there is no shortage of crude oil seems finally to be going mainstream.

Equally, its concern over the impact of today’s high prices, especially by comparison with natural gas, is also now starting to be highlighted.

Thus the Wall Street Journal notes:

“Oil inventories in the Western world are now high.

“In Europe, at the sharper end of the (potential Iran) embargo, International Energy Agency data show a less benign, but hardly alarming picture. On a 12-month rolling average to take account of seasonal swings, stocks covered roughly 140 days of net imports in October. That is 10 days less than in mid 2010, but in-line with the average of the past five years.”Meanwhile the New York Times reports:

“Nationwide, the average household using oil spent $2,298 on heat last year, compared with $724 spent by gas users and $957 spent by electricity users, according to the Energy Department. This year, heating oil users are expected to spend 3.7% more than last year, while natural gas customers are expected to spend 7.3% less and electricity users will spend 2.4% less.”

Cars are now the largest single market for chemical sales, as housing markets have slowed globally. Each new US car is worth $3297, for example, according to the American Chemistry Council (ACC), making the US market worth $42bn in 2011.

2011 auto sales were ~59m, up 4% from 2010. The West (EU, USA, Japan) still dominates, with 50% of demand. Developing countries showed rapid growth until recently, but the BRICs (Brazil, Russia, India, China) are still only 35%.

The chart above shows performance in the 3 largest markets since 2007:

• China (blue column) remained in top spot at 14m. But its growth rate collapsed with the ending of stimulus spending – from 49% in 2009, and 30% in 2010, to just 5% in 2011. Q4 growth was only 1%, as the last subsidies were removed in September
• The EU (red) was 2nd at 13m, continuing its recent decline. Sales have now fallen for 4 successive years. Without Germany, whose sales rose 9% to 3.1m in 2011, the picture would be even worse
• The USA (green) remained 3rd with sales up 11% to 13m, hopefully having now bottomed, as the blog noted recently. But they are a long way from the 15 – 17m range enjoyed during the 1995-2007 boom years

• Japan was the next largest market at 4.2m, hit by 2011′s tsunami disaster. The other main markets are small by comparison – Brazil at 2.7m, Russia at 2.6m, India at 2m

Overall, growth in the 3 major markets weakened significantly last year.

2009 had equalled 2008 performance, as China’s massive stimulus balanced the US/EU slowdown. Then co-ordinated G20 stimulus led to 10% growth in 2010. But last year saw growth decline to 4%. Q4 growth was only 2%, versus 10% in Q4 2010.

The blog does not rule out a panic reaction by policymakers, as it becomes more apparent that the world has re-entered recession. Co-ordinated stimulus would work for a period, as it did in 2009/10. But the debt overhang afterwards would be even worse than today’s.

In the absence of further stimulus, it is hard to see much growth in 2012, particularly with oil prices at today’s record level:

• Germany’s economy is slowing fast, so EU volumes are likely to continue their decline
• China’s growth will remain slow, as its primary focus is now on controlling food price inflation, rather than boosting demand
• The USA will probably also see only slow growth, even with further stimulus ahead of the presidential election

It is not all bad news, however, as moves to reduce auto weight will boost chemical and polymer demand. The ACC estimates, for example, that 378lbs (172kg) of plastics and composites were used in the average light vehicle in 2010, up from 286lbs in 2000 and just 20lbs in 1960.

But clearly the days of steady SuperCycle growth are now behind us, as the Western BabyBoomers enter the New Old 55+ generation. With 29% of the Western population already in this cohort, their mobility needs now represent a new and potentially very attractive market opportunity.

We highlight these in more detail in Chapter 8 of ‘Boom, Gloom and the New Normal’, to be published next week.