Economic growth in China is starting to show signs of weakness right as the world begins to react
to renewed Delta virus concerns. Does this signal further headwinds for global growth with negative
effects on global asset prices, or is this yet another wall of worry for markets to climb?
If you have any questions about topics discussed in today's episode or any questions you like
answered in future episodes, please put them in the comments below. After being one of the most
aggressive actors on covid during the first wave, China was one of the first countries to return to
normal, and they saw one of the fastest and most robust economic recoveries of any country. Now,
as the variance spreads across the globe. China is once again one of the first countries to
reimplement strict controls. This may already be showing up in economic data, as many of the key
numbers for July missed expectations. With this weakness showing up across the board,
retail sales help give a better picture of the strength of the Chinese consumer and coming in
at eight point five percent year on year growth versus a ten point nine percent expectation.
We aren't seeing negative activity yet, but a trend worth monitoring.
Industrial production was not rosy either, coming in at six point four percent year on year growth
versus an estimate of seven point nine percent. Also, in the period from January to July, fixed
asset investment slowed to ten point three percent versus an estimate of eleven point three percent.
Manufacturing also took a hit with the most recent Caixin manufacturing PMI coming in just
barely positive at fifty point three for its third consecutive decline and second consecutive miss.
All these numbers are still positive, but focus now shifts to the upcoming August data. Due to
the lag in collecting and measuring economic activity, China could serve as a good barometer
for their future effects on economic activity in other countries should they implement any
new restrictions. One sector that is likely to acutely feel any slowdowns in activity
is the energy sector. In China, the largest oil refiner, OPEC, is said to cut run rates
by five to 10 percent in August as compared to the prior month. While other companies are reporting
unspecified levels of production, one of the largest sources of demand for that refined product
comes from travel, which is taking a major hit in the country. International travel is one of
the key points of China's new covid restrictions, this is already playing out in flight data. In a
recent week in August, China's top 20 airports showed traffic at just 40 percent of peak
twenty nineteen levels. The same is true on the roads as congestion was also significantly off.
The exact impact on fuel demand can't yet be measured, but some experts are estimating that
between late July and early August, demand was down as much as 30 percent from prior periods.
The effect of these restrictions on Chinese economic data may be a good measure for
what we could expect in other regions should lockdown's move around the globe.
But Chinese asset prices may not be. It's hard to tell how big of an effect the slowdown is having
on asset prices in China as the markets begin to show signs of weakness from their tech crackdown
long before many of the stricter lockdown measures were implemented. No matter how you slice it,
though, Chinese shares have taken a major hit. The iShares MSCI China ETF peaked in February and
has fallen over twenty five percent since then. Tech names bearing the brunt of the scrutiny from
Beijing fared even worse, with Krein shares China Internet ETF down over fifty five percent in the
same period. This equity weakness has not made it to the U.S. quite yet. After a brief scare in US
tech, likely due to forced liquidations and margin calls as investors Chinese positions took hits,
U.S. equity indices have continued to show incredible resilience
in the face of economic uncertainty. With the exception of the Russell Two Thousand Index,
every major US benchmark has made new all time highs in the last few weeks. These rallies have
largely been driven by the highest quality large cap stocks like the Fang M complex.
While more speculative names have struggled since peaking out earlier this year,
this can largely be seen by the performance of meem, stocks and spaatz.
Although there is not a well-defined benchmark yet for Speck's ETFs like S.P.C.A., which aim
to track a broad basket of these new issues, is down over 30 percent since February 17th.
Interestingly, just one day off of China's tech peak individual meme, stocks like GameStop and
AMC have not languished for nearly as long as icepacks or even returned to the levels seen
before. Speculative interest sent them soaring higher. But over the last few months, those stocks
have come down significantly from their peaks. If there's one thing investors learned in twenty
twenty is that the market is not the economy, and especially with policy support, asset prices can
remain strong in the face of economic uncertainty and even flat out weakness. So far, this seems to
once again be the case. One of the first signs of economic slowdown in the US was weakening
consumer sentiment, as measured by the University of Michigan survey. This survey badly last week,
with households reporting lower than expected consumer confidence coming in a reading of
seventy point two after expectations of eighty one point two. This reading was even lower than
the April twenty twenty reading. At the peak of the pandemic, the weakness of the US consumer was
confirmed once again this week with another bad miss. U.S. retail sales fell one point one percent
month over month, missing expectations of a small decline of just point three percent.
This metric is historically finicky, flip flopping from positive to negative quite frequently.
But the US consumer is the foremost driver of the US economy, and with resurging fears around covid,
investors need to be paying attention for any sort of downward trend here. On the positive side, the
month over month change in industrial production came in above expectations at point nine percent
growth compared to the expectation of zero point five percent. The year over year numbers were also
positive at six point fifty five percent growth, but continued a three month trend of declining
increases. The industrial production numbers are holding up well for now, but should be paid close
attention to as supply chain issues continue. These supply chain issues can be seen by the
current levels of the Baltic Dry Index, which tracks the cost of moving raw materials by sea.
The index is seeing ten year highs and reflecting the massive rise in cost to
get goods from point A to point B. Should this continue, we may see industrial production slip
as producers struggle to get the supplies they need at affordable prices. We mentioned
earlier how investors are often finding themselves squaring worsening economic realities with rising
asset prices as these forward looking markets can price an optimism around future growth.
But some markets have a much harder time looking forward. Commodity markets and more specifically,
energy markets are one of the most real time sectors, as daily and weekly fluctuations in
supply and demand can have huge effects on commodity prices and their related equities.
Last year, we saw oil prices go negative as the world locked down. Now, this was partially
driven by a price war between Russia and the Saudis who have since come into alignment. But
questions remain on how demand destruction could impact this highly sensitive market
as well. With consumers already hurting, rising gas prices have become a political issue
in the US. President Biden has asked for and been denied increased production from OPEC plus for an
administration already dealing with trouble. The Middle East squabbles with OPEC plus and rising
gas prices are one problem they really don't need. That's why this week in the Chatter segment,
I spoke with Jim Mitchell, head of Refinitiv America's oil analysts, to discuss how significant
this plea from the Biden administration is, how to quantify the potential demand shocks due to Delta
and this new reality that demand and not supply may be the key factor driving oil prices.
All right, Jim, thank you so much for joining us for the chatter section here on the big
conversation. We're going to be talking about oil today. Why don't we just start out with a
broad question. Where are we in the oil markets right now with the Biden administration asking for
more oil, even as OPEC plus has agreed to start raising production?
Yeah, that's a great question and very topical.
The optics look really really bad for the president's administration. I don't necessarily
think, though, that the statement made by Jake Sullivan, the national security adviser, I don't
think it's necessarily incongruous with his plan. As I understood the Biden administration's plan
there, they've always been about cheap energy for Americans. Now, the question then becomes
what kind of cheap energy? And that's where the difference between
the green segment, the Green Movement, which really helped get President Biden elected,
and the more traditional oil and gas sector, who has been a little bit on their heels in terms of
where the market goes forward. So how does this all play together?
I think it's about timing. So the oil industry has always been a long game. There's very little that
happens. And there are some things, but very little that happens that immediately impacts
the oil industry. Obviously, covid was was one thing that immediately impacted. But in terms
of investment, in terms of production, all this stuff is stretched out over years, if not decades.
What President Biden was asking for is, I think, more politically related than oil related.
Gasoline prices are really high. I saw some six dollars at the pump, Prince in California, which
may be a little bit extreme. So I saw more of them around the four fifty dollar a gallon area.
I really think this has to do more with the upcoming election cycle,
which should start in about three or four months here.
So we've lost about, I think, six million barrels since covid from OPEC plus and then
about two million barrels from shale. Some of that you would think shale is something
that the US controls, something that we can go. Why is he going to OPEC versus maybe trying to
work within our own backyard to incentivize some of that production to come back online?
Yeah, yeah. Another great question. The US at its peak produced a little over 13 million barrels a
day. Now we're about eleven point two, eleven point three, eleven point four. We kind of sit
in that area and that's the question why didn't President Biden address other American companies?
Why can't we do it? We're, as I mentioned, probably a million, eight short of where we were.
Why can't we get back there? There's some pretty powerful market forces going on. And obviously
the president and his administration know this, there's a shortage of crude, literally workers.
There's issues with permitting, right?
There's issues with capital expenditure from oil companies. Do they want to increase
production? There's some of the wells that are in the non core area that are marginal producers,
which is to say they have a higher cost of production and don't produce quite as much.
Those are the wells mostly that are off bringing those back. It certainly could be at seventy
dollars a barrel for WTI. You would have thought those would have come back because most of that
break evens around 60 to maybe fifty five ish. But they're not and they're not coming back for
some of the market reasons that I just mentioned. Another one that I did mention this
that we saw in the earnings releases was there are some massive hedge losses in this industry,
by my count, somewhere around 12 billion dollars. So that's a straight extract of cash as these
companies have to put a margin relative to that oil, which is future revenue still in the ground.
Yeah, and you talked about how it actually is a much longer term sector than most people think,
given the big spikes we've seen in the past few months. But I think part of the reason
shale isn't coming back on is because of people being burned in this last cycle. And
many of the lenders, a lot of this is funded by by debt capital, they require hedging in
the market and so we have a backward dated curve right now. And so, yes, we might have
spot prices up around 70 dollars a barrel. But the shale producers,
they have to hedge out that risk and this backward dated curb, we're much closer to that breakeven
price than we are with the seven spot. How much does curved shape affect the market?
The forward curve is definitely something that does come into account. But again, for producers,
you know, they're looking at they want to be producing oil for 10 or 20 years,
not three months. So does it come into play? Sure it does. Does it affect their hedging? Yes sort of
but most of that is determined by their banks or whoever is financing them. And one of the thing
that I saw that was pretty interesting, I thought that some of the bigger companies that can hit the
capital markets have and they have in a big way, I think somewhere in the 40 billion dollar range,
some of the bond covenants that I'm hearing about is that they cannot use this new
money directly for drilling. The new money is intended to shore up the balance sheet,
which could be a play. Obviously, they don't release that kind of stuff to me,
but that could be something that's coming into play here.
OK, and I think the final question I want to ask is about Delta variant. And then some of the shock
with oil has been from the increased production coming out of OPEC plus. But a little bit of it
because we have seen that steady rally sort of bubble a little bit over the last few months. How
much of it is because of these concerns around the returns to lock down? You saw Australia, I think,
today and not announcing a return to total lockdown when you factor in what the demand,
potential demand destruction could be for what looks like would probably be if we did
get lockdown's would not be a true global lock down like we saw before, something much more
intermittent on a countrywide basis or country by country basis. How do you think about that,
that potential for demand destruction and how it could be relative to last time?
Yeah, and I think that the basis of this question is the really, really important thing.
In years past, it was all about supply. Now we are much more in a demand driven market. So we see an
outsized impact of what we saw with covid a year ago, a year and a half ago. And we're going to
see that outsized impact continue because we're in a demand driven market. To answer your question,
the big demand centers are really going to drive this. So the covid outbreaks in China is
affecting demand and it's maybe not affecting demand as much right now as we talk about it.
But the expectation that if the Delta variant goes crazy in China, it's going to affect demand. Now,
with that said, China overproduced in the last probably two or three months. They have a lot of
inventory and the cracks, the difference between crude in and products out, the cracks got beat
up pretty hard in Asia. The US is a little bit different story. So US is the single biggest
demand market. And if you bring in the Americas, as the US continues to export gasoline and diesel
to Mexico and Brazil and other Latin American countries, as covid impacts these various areas in
different ways and circumstances, it affects that demand in a big, big way.
And there's also regional variations. California is different from Texas, which is different from
Chicago. There is refining in each of these areas. Obviously, Texas has about a third of
the country's refining. So as far as Texas goes, so does the excess of gasoline and diesel that
Texas produces to go elsewhere. California and the West Coast prior to covid a lot more balanced,
which means then when covid hits the West Coast. There's a lot extra gasoline and diesel
around, and if China continues to put product into the Atlantic, that creates a big excess
as China has curtailed exports and the demand in California, for example, is going crazy.
That's why they're getting the gasoline prices that they are. They're short supply.
Well, so, you know, I'd like to wrap this up here. We've talked about a lot of things. You
really highlighted the importance of this being a demand driven market. When you think about the
indicators that everybody focus on the oil market should be watching moving forward,
where should we all be looking?
Well, I think it's really a demand supply thing. So coming into 2021, our research at Refinitiv
suggested that we were about a million and a half, a million seven barrels a day
short. Right. So that means demand over supply. As we were coming into Q3 starting in July,
we expected that to come way closer to balanced, to maybe even slightly over a little bit supply.
One of the things that I think has changed is OPEC and specifically Saudi Arabia's
reluctance to increase oil production. So by our analysis, we look to be a million and a half
barrels ish short pretty much through the end of the year unless something changes.
OK, well, Jim, thank you so much for coming on the chatter segment today
and looking forward to having you back again soon.
Thanks. I appreciate you having me.
Once again, we'd like to remind you that if you have any questions about
topics covered in this episode or topics you'd like covered in future episodes,
please post them in the comments below. Thank you for watching.