By John Richardson
HOW you view any set of data depends on where you are standing. A hedge fund manager who has gone long on crude oil might, for example, have been encouraged by this report in the FT last week about shrinking US oil inventories:
US crude stockpiles fell by 7.2m barrels in the week ending July 21, according to the US Energy Information. That’s steeper than the 3.1m barrel draw expected by analysts surveyed by Bloomberg, and well above the 4.7m drop registered last week.
But she or he could well have overlooked the next line in the same FT story which said that, despite the decline crude stocks, inventories were still in the upper half of the average range for that time of year.
For me, this is a crucial qualification. Yes, stocks for the week ending 21 July were lower than most analysts had expected, but over a longer-term time frame they remain high. As this Seeking Alpha article writes:
OECD petroleum stocks (both products and crude) are approximately 250m barrels higher than the 5-year average. Much of this is attributable to the US. Total stocks in the US are 175m higher than the 5-year average.
The article concludes that whilst the last few month have seen drawdowns in OECD and US inventories, year-to-date inventory growth is still flat – and so inventories are still higher than long term averages.
Be careful of what you also believe about US shale oil production. Another reason for last week’s rally in oil prices was reports that shale producers were cutting back on capital spending. There also appeared to be a slowdown in US shale production growth.
What the dollar says about US growth
But as this OilPrice.com article points out: It is important to note that last week’s week-on-week production decline was entirely driven by Alaskan output while lower 48 production expanded for the 24th time in 28 weeks this year.
Last week also see the Baker Hughes count of active US oil rigs climb by two to 766. This was the third weekly increase in July.
Hedge funds and other speculators may well have increased their crude futures buying activity in response not just to their reading of the oil market fundamentals, but also because of a weaker US dollar. When the dollar weakens, oil and other commodities tend to rise in price.
The weaker dollar is another reason to be cautious on the sustainability of today’s rally in oil prices, as the greenback has fallen on weak US economic data and the political chaos in Washington. Weak economic data, especially wages growth, of course suggests weaker consumption growth in the US for crude and all the things made from oil.
And the political chaos in Washington – and I think it is fair to describe events as such – indicates the likelihood that the “Trump bounce” will not happen. Chances of major tax reform and infrastructure spending continue to diminish a long with, as a result, the prospects of improved GDP growth.
US crude inventories down on higher product exports
You also have to ask the question of why US crude inventories were so sharply down last week, and whether this decline is sustainable.
This seems to have been largely the result of increased exports of refined products. As Reuters reports in this article, US refineries are producing more fuel than ever before, but this is to serve overseas rather than domestic demand.
Last year, the US became the world’s top net exporter of fuel, and net exports are set to hit another record-high this year.
One reason for the surge in exports of US refined products is the US shale-oil revolution. Crude costs for refiners have slumped, thanks to falling shale-oil production costs and the shale supply glut.
This has reached the point where, as Reuters again reports, US refiners are able to undercut local refiners in the Brazilian fuels market.
Meanwhile, some overseas refiners are struggling to meet demand in their home markets because of production problems. Take Mexico as an example, which is already the US’s biggest export market for gasoline and diesel. A fire at a local refinery could drive US shipments to Mexico even higher levels.
This raises the question of whether US refiners can maintain their strong export performance in Latin America, and also in Asia and Europe. As Reuters again reports, June diesel exports to Europe rose to their highest level in two years.
The answer to this question inevitably comes back to China and its impact on the global economy, and thus the global demand for refined products.
The Chinese economy will undergo a moderate slowdown in H2 2017 and/or 2018 as a result of reduced lending growth.
This will not be a big deal for China itself. As I keep stressing, China will be fine, but it is instead the rest of the world you have to worry about because of the importance of China to global growth.
As William Sterling, chief investment officer at Trilogy Global Advisors, wrote in this FT Beyondrics blog post:
China’s impact on the world economy is significant. Over the past five years its nominal GDP has expanded by $3.7tn, an amount that exceeds the GDP of Germany. In contrast, the entire global economy has expanded its nominal GDP by only $2.2tn.
Real story behind rising Chinese crude imports
A return to mild global reflation is thus set to turn to deflation as China continues to tackle its credit bubble. Destocking would happen up and down all the global manufacturing chains if my forecast of a return to deflation happens.
This would hurt demand for US refinery exports – and would, of course, have much broader ramifications.
“But even if China’s economy is slowing down, its demand growth for oil remains incredibly strong,” you might well say.
“Just look at, for example, the growth in China’s imports of crude during the first half this year. They were up by 14.5% year on year to 8.6m barrels a day, from 7.51 million barrels a day in H2 2016,” you might then add.
“This points to the booming Chinese middle class, who have rising disposable incomes to spend on oil and all the things made from crude.”
True, this year’s strength in imports has taken my colleagues at ICIS China by surprise, as they had expected a slowdown in the growth of crude imports.
We believe, though, that the rise in imports doesn’t reflect booming local gasoline and diesel markets – in fact gasoline demand growth in China is this year slowing down on greater fuel efficiency and on regulations restricting new-car sales.
China’s diesel market has seen negative growth for the last few years on a slowdown of investment in heavy industries. And in order to reduce air pollution, diesel trucks are being replaced by LNG and other lower-emissions means of transporting goods.
The boom in crude imports is instead partly the result of lower Chinese oil production. But a bigger factor is booming gasoline and diesel re-exports. Bloomberg writes:
Diesel shipments jumped almost 21% in the first six months [of this year] compared to the same period a year ago, averaging about 328,500 barrels a day, according to Bloomberg calculations based on data posted Sunday on the website of the General Administration of Customs. Gasoline exports rose 8.1%, averaging nearly 222,000 barrels a day.
China’s state-run fuel makers have sent more fuel overseas to draw down stockpiles that have swollen thanks to a refining capacity glut.
This tells us that if the global economy does hit the buffers on a slower China, US refiners might find themselves increasingly competing with Chinese refiners for weaker growth in global refined-products markets.
A gasoline and diesel etc. price war could be the end-result. True, the US refiners would be in a strong position to withstand such a war because of cheap supplies shale oil.
But so would the Chinese refiners because of their cheap, state-directed financing. Chinese refiners are likely to run harder in a lower price environment rather than shutdown because of the need to preserve jobs.
Global deflationary pressures are set to take hold again on a Chinese economic slowdown. Why? Take away the exceptional growth we saw in China during 2016, which was the result of the reflation of its credit bubble, and most of the rest of the global economy looks very weak.
Take the US as an example. Demographics are destiny and its largely unrecognised challenge remains an ageing population. Until or unless this challenge is recognised, its middle classes will continue to face low income growth. There is also a significant chance that the Trump White House’s policies will make America’s problems worse.
Nothing has therefore essentially changed in oil market over the last week except the mood music. Crude prices might thus soon start heading down again – towards $35 a barrel.