Oil prices vulnerable to China property market fall

US oil stocksApr14

Oil futures markets are a wonderful thing, in theory.  They are supposed to enable price discovery, whilst their liquidity is meant to enable companies to reduce inventory levels.  Instead of tying up working capital, they can simply go to the market and buy what they need, when they need it.

But the chart above, of US oil and product inventory since 1983, suggests they are currently failing to do their job:

  • 30 years ago, average inventories were ~75 days of demand (blue column), and oil prices were ~$30/bbl
  • Inventories then reduced very steadily till they were ~45 days in 2003, with prices still ~$30/bbl
  • Clearly over this period, markets were performing the role for which they were intended

But then things began to change around 10 years ago, from 2004 onwards.

First of all, prices began to rise under the influence of the US Federal Reserve’s refusal to increase interest rates.  Instead it kept them low to support consumer spending and the subprime housing market.  As the blog identified at the time, this artificially-created demand meant the margin of spare supply became dangerously low globally.

This also encouraged hedge funds to think of commodities as a new asset class, separate from stocks and bonds.  This is, of course, nonsense, as commodities only have a value in respect of their overall role in the economy.  They cannot be separated from their end-use, and the interest rate environment.

The period since 2009 shows how damaging these changes have been:

  • Prices collapsed in 2008 with the subprime bubble
  • Oil and financial markets should then have been allowed to stabilise at a sustainable level
  • But of course policymakers couldn’t leave well alone, and instead embarked on $33tn worth of stimulus
  • As a result, oil prices leapt back to all-time record annual levels above $100/bbl
  • And at the same time, inventories rose to average ~60 days as these high prices encouraged a supply surplus

As we also know, regulators also encouraged the growth of high-frequency trading, in the belief that high prices in financial markets would in turn stimulate consumer demand and restore economic growth.   Even today, they still fail to understand their objective is impossible, due to the world’s earlier demographic dividend now turning to demographic deficit.   But the end result has been, as Michael Lewis discusses in his new book ‘Fast Boys’:

The United States stock market, the most iconic market in global capitalism, is rigged.  If it wasn’t complicated, it wouldn’t be allowed to happen. The complexity disguises what is happening. If it’s so complicated you can’t understand it, then you can’t question it.”

We all know that it is very dangerous to bet against the Federal Reserve.  We also know that the Brent oil price is a badly-broken marker, which anyone with deep pockets could easily manipulate.  So it is not difficult to understand how this combination of forces has led to today’s position, where no single market now knows what it is pricing.

But suppose, just for a moment, that China’s new leadership is totally committed to its current policy of allowing the country’s property bubble to burst, as discussed last week?  As the Wall Street Journal warns, the alternative does not bear thinking about:

Without stronger oversight of China’s lending practices, the country risks a financial crisis that could send the economy into a nosedive. And that could wreak havoc on global growth, weighing particularly on other emerging markets that rely on demand from the world’s second-largest economy”

After all, a year ago the leading property developer, China Vanke, was able to borrow $800m for 5 years at an interest rate of just 2.6% – less than the rate paid by most governments.  Brazil, then riding high in investor ratings, paid 4.6% in the same month.

The major central banks and governments have now been manipulating markets for a decade.  Companies need to realise that this, and this alone, is the foundation for the consensus view that oil prices will remain above $100/bbl.

If China is serious about its new economic direction, as the blog suspects, then this cosy cartel could well break up.  And the new leadership certainly appears to be serious.  As official news agency Xinhua wrote Monday:

Any talk about an incoming stimulus package is misleading and those anticipating the kind of stimulus China unleashed following the 2008 global financial crisis are likely to be disappointed.  The sweeping measures did help China’s economy recover rapidly but also led to overcapacity, skyrocketing house prices and a credit boom, all of which the authorities are now trying to rein in.”

Believing that President Xi and Premier Li will change course could well prove to be a bigger mistake than betting against the Fed.

WEDNESDAY EVENING UPDATE: Data released by the US Energy Information Agency showed crude oil inventory in the Houston region is now at record levels, and expected to continue growing.  Bank of America forecast this will soon be selling at a $13/bbl discount to Brent.

About Paul Hodges

Paul Hodges is Chairman of International eChem, trusted commercial advisers to the global chemical industry. The aim of this blog is to share ideas about the influences that may shape the chemical industry over the next 12 – 18 months. It will try to look behind today’s headlines, to understand what may happen next in important issues such oil prices, economic growth and the environment. We may also have some fun, investigating a few of the more offbeat events that take place from time to time. Please do join me and share your thoughts. Between us, we will hopefully develop useful insights into the key factors that will drive the industry's future performance.

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