By John Richardson
THE REAL crude-oil supply story is becoming more commonly understood – hence, the recent declines in pricing. As I discussed in early March, before oil prices started heading south again, supply has been long for a substantial length of time. It is just that speculators chose to view the data in a different way as they piled into a record-high number of long positions.
Fellow blogger Paul Hodges yesterday described how these speculators are now heading for a very crowded exit. He also gave important new details on the scale of today’s oversupply. The next shoe to drop will be weaker-than-expected demand. We could thus see oil prices halving from today’s levels.
The negatives for demand will largely centre on China and signs that the Chinese government is tackling last year’s damaging re-inflation of the credit bubble.
The first evidence of this came with important changes to Chinese lending patterns in January and February. Overall lending was down, but more importantly, the composition of lending changed as the shadow banking sector was reined-in and mortgage lending declined.
Next came measures to control the housing-market bubble, which was one of the factors behind a 6% fall in iron-ore prices. Commodities are all connected, of course, as China is the main driver of global demand growth for iron ore, copper, aluminium and crude etc. What has already happened in iron ore could thus be soon mirrored in oil.
As Beijing gets more serious about economic reforms, there is also evidence that it is once again stepping up the pace of its “whack-a-mole” game against commodity speculators.
In February, the Chinese government announced that it was investigating speculation in commodities that was threatening a sharp rise in inflation. And this week I heard that letters of credit have been made harder to secure for importing chemicals and other commodities. Recent inventory overhangs in polyolefins and in other chemicals and polymers– as well as today’s very-high levels of iron-ore stocks – might be behind this decision.
What could be the next sign confirming my view that China will moderately slow down this year – not collapse, but just moderately slow down? I believe it may be a decline in the country’s private (Caixin/Markit) manufacturing purchasing managers’ index (PMI).
This particular PMI mirrors China’s credit cycles. The chart above shows how the index responded to the tighter lending conditions that resulted from the reform programme announced during China’s pivotal 3rd Plenum meeting in November 2013. As Bloomberg writes:
China entered a manufacturing recession in December 2014 that lasted until June 2016. This isn’t reflected in the gross domestic product reports or in the official purchasing managers’ index data.
Instead, it can be seen in a private survey of purchasing managers at small- to medium-sized manufacturers known as the Caixin report released by Markit Economics. It is the PMI to watch for China, and it showed monthly contractions in all but one month between December 2014 and June 2016.
But the PMI bounced back in 2016 as credit growth took off again, with the improvement carrying on into February of this year. The March Caixin/Markit PMI could thus be an important milestone. Or perhaps the excess credit still coursing through China’s economy may keep manufacturing strong until April.
Oil markets will eventually start to factor-in the slowdown in China, which, as I said, should only be moderate – provided today’s “War of the Words” over trade with the US doesn’t become a full-blown trade war.
This links to another important aspect of demand for oil in 2017: Markets have already priced-in a positive impact on US economic growth from Donald Trump’s plans for tax cuts and infrastructure spending.
As yesterday’s postponement of the vote on healthcare reform indicates, President Trump is going to struggle to implement his agenda during the rest of this year. Once this becomes better understood, this will also exert further downward pressure on oil prices.