Primary Vision Insights – May 26th, 2020

By Mark Rossano

Sections

Introduction Overview of Frac Spread Activity in the U.S. A Quick Run Down of Builds Throughout the U.S. Complex Implied Demand will Struggle as Spending Patterns/ Exports/ Travel Change European Flows Struggle as Imports from the U.S. Lag and Trapped Cargoes Linger on the East Coast and in Africa Physical Crude Prices Have Surged Impacting Refinery Demand as Margins are Compressed Three Key Storage Locations Show the Pace has Slowed, But Builds Continue to Mount May/June Loading Trends are Supportive of Near-Term Pricing India Recovery will be Slow- Limiting Crude Coming Off the Water There is no spoon OPEC Countries Struggle Under the Weight of Weak Oil Prices and Low Volumes Global Debt and Weak Export/Shipping Debt Will Be a Huge Headwind Debt Levels Mount as Countries Announce New Stimulus Packages Geo-political Issues are Starting to Resurface as Countries Come Out of Lockdown

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Introduction

It is important to keep the weakening economic backdrop in your mind as you read throughout the rest of the report. We have written over the last 2 months the struggles faced on a global level. In January, we wrote a big report on China, and the struggles they face trying to stimulate the economy as many levers have been pulled and leverage is maxed across their system. China has been the largest issuance of debt over the last few years, and is set to rise again- followed closely by the rest of the world! Every country is trying some form of stimulus all financed through debt, which will keep global debt levels hitting new all-time highs throughout the year. Central banks are pushing for negative rates or other forms of quantitative easing to keep the circus going, and until we have a meaningful failed Sovereign Auction or partial default- the game will continue. The fact so many emerging markets are already supporting their currencies, leveraging loans from the IMF, and facing steep losses due to weak exports/local demand will prove to be the tidal wave to end the party.

Human psychology comes into play as we look to normalize life in the midst of an unseen enemy with no proven means of curing or vaccinating against. This is all happening in a backdrop of surging unemployment while the Fed looks to support (re-inflate) asset prices by driving inflation. The below chart of continuing unemployment claims highlights the devastation that has rolled through the U.S. economy, and to be clear- we aren’t the only country experiencing this type of surge. Countries have issued their own form of stimulus in order to soften the blow of the huge rise in unemployment. The bigger issue will be- “when do these people go back to work” and “will it be in the same industry or job they left?” The view is that about 50% of these individuals will have to shift jobs and/or industries in order to find work, which takes time and training. The size of the unemployment number will also force people to accept a lower wage in order to work, and with the Fed driving inflation- the real wage/ discretionary spending will decline across the board. This will cause long term implications across the economy that is not fully appreciated or understood as spending patterns shift. The long term implications of the adjustments will create an overhang through not only the U.S. economy but also the global market.

U.S. Continuing Jobless Claims

Overview of Frac Spread Activity in the U.S.

The pace of declines has slowed as the market finds a bottom for frac activity across the U.S. Appalachia is starting to attract new fleets as the decline in oil production causes a drop in associated gas, which has incentivized gas E&Ps to start reactivating equipment. Activity has started to reverse in the Northeast and Oklahoma dry gas, while oil spreads are starting to flatten out across the complex. The Permian will stabilize closer to 23 spreads while most places settle in around 2-3 frac crews. Overall, the national frac spread count will touch about 37, but find support as companies look to manage decline curves. In terms of areas that will see the most support, Midland/ Delaware/ Eagle Ford/ Williston given the location, take away, realized prices, and end users. The Midwest refining complex is going to struggle as builds increase across refined products limiting crude intake. The DJ/ SCOOP-STACK will find it difficult to compete in the current environment versus other basins competing for capital.

E&Ps will look to offset decline curves by managing a combination of new completions, chokes, shut-ins, workovers, and re-fracs. An E&P company does not have the luxury of just letting the decline curve take over, because the loss of production would be insurmountable without a huge outspend to close the gap. For example, if a company has a natural decline curve of 25%- the goal would be to offset some of that lose to be closer to 10%-15% in order to close the gap once the market adjusts higher. Shut-ins lasting for 30-45 days are relatively common when you do offsetting fracs, so we know there will be no lasting damage. Wells are regularly shut to build pressure/offset, but as the time is extended some unknowns will come into play. The below supply adjustment puts U.S. crude production closer to our number of about 10.6M and not the reported 11.5M barrels a day. Some producers have announced that if crude prices can hold over $30, they would be reversing some of the shut-ins and bringing them back online. I think we have seen the peak of shut-ins, and some wells will start to be reversed as we head into June. This will dampen some of the expected crude draws that normally occur throughout the U.S. complex. Wells that have been shut-in are a sunk cost with all drilling and completion activity being realized, and with MVCs (minimum volume commitments), lease hold obligations, other contractual obligations, and just general need for some cash flow will push guys to adjust shut-ins to choke backs (limited flowing volume). The Alyeska pipeline is also in the process of increasing flow to get back to 100% of flow after cutting volumes by 10%.

U.S. DOE Crude Oil Supply Adjustment

A Quick Run Down of Builds Throughout the U.S. Complex

The problem with a quick turn around of wells is the glut that persists throughout the globe. Crude stocks have started to turn away from Cushing, which has helped avoid negative pricing while not breaching everyone’s favorite term “tank tops.” Instead, crude is flowing into PADD 3 given the refining capacity and export channels. The SPR (strategic petroleum reserve) received more crude with “About 35% of 23m barrels of storage capacity in Strategic Petroleum Reserve rented out to producers has been delivered, according to Energy Dept. Assistant Secretary for Fossil Energy Steven Winberg.” The allotment will be delivered through the end of June with another auction potentially coming in June/July.

DOE Cushing Oklahoma Crude Oil Total Stocks Data- Largest Draw on Record and Avoids Hitting 2017/2016 highs

DOE Crude Oil Inventory- PADD 3 at All Time Highs

PADD 3 has the most refining capacity in the country, but the area is facing a problem with exports as oil/refined product demand struggles. Magellan East Houston (MEH) and Louisiana Light Sweet (LLS) has priced itself out of the refining stack as it yields negative margins (-$6+). The spot prices rose and once a potential buyer factors in shipping/ total transportation cost/ storage- it makes more sense to purchase other grades that will yield a better margin. This is already reverberating in the system and will send crude exports lower over the coming weeks. The lack of crude exports and refinery runs (chart below) hovering around 70% will cause more builds around the Gulf of Mexico. This also doesn’t include the crude waiting to offload in the Gulf, which will keep the area saturated with oil and limit new purchases over the next few weeks. China received their first shipment of U.S. crude this year with another already in transit, but they remain well off the pace outlined in the Trade Deal signed on Jan 15 th - more on that later.

Imports of oil slowed as timing delays will limit the speed at which crude is able to come off the water. Saudi vessels have begun to arrive with 5 already in the Gulf and another two following closely behind. About 50M barrels will end up in the Gulf to be processed or be put into storage over the next several weeks. Crude runs will increase to about 72%, but will remains about 20% off of seasonal norms as headwinds persist in crack spreads. Hurricane Harvey is the last time we really saw this kind of drop in refinery utilization rate, but the adjustment was relatively quick as assets tried to normalize from a structural impact. The current slow down is being driven by a demand problem and given the overhang of oversupplied refined product and crack spreads- depressed runs will linger throughout 2020.

DOE Percent Utilization Refinery Rates- Will Remain at All Time Lows (or Harvey Lows)- Problem is- the Recovery will be Much Slower

Implied Demand will Struggle as Spending Patterns/ Exports/ Travel Change

Implied demand remains a big focus as product demand remains well off normal as the U.S. struggles to normalize. Jet Fuel demand will remain at all time lows even as some recovery is realized. Gasoline will stabilize around 7.5M to 8M barrels a day over the next few weeks, but that will be a ceiling throughout the summer. The comps will get harder as we progress through the summer as it is peak driving season, but extensive work from home programs, unemployment, limited travel, and other COVID19 mitigating factors will hinder a stronger response.

DOE Gasoline Total Products Supplied- Will Normalize at Around 7.5M-8M barrels a day

Distillate remains a big overhang over the coming weeks as demand normalizes near all-time lows but falling mid-west demand will start to roil the disty market and cause storage to fill up quickly.

DOE Distillate Products Supplied (Demand)- Another Bounce off the Lows but Will Hold at All-Time Lows

Exports of products will face serious headwinds as Lat Am faces a surge of COVID19 cases- especially Brazil. Brazil is one of our top importers of distillate, and between their reversal of production cuts, maintaining runs at about 80%, and terrible local demand- product imports will face long term issues. Ecuador and Mexico have already cancelled/ deferred a huge chunk of shipments that will weigh on gasoline/disty/ jet fuel exports. Crude exports will continue their decent, and touch about 2.5M barrels a day over the coming weeks as the market struggles to absorb the current glut. The lack of demand globally and glut of product will trap a huge chunk of it on the U.S. coast. The other problem remains the saturated U.S. markets limiting areas PADD 3 refiners are able to send the spare product.

DOE U.S. Distillate Fuel Exports- Will Shift Lower over the Next 2 Weeks

European Flows Struggle as Imports from the U.S. Lag and Trapped Cargoes Linger on the East Coast and in Africa

Another key market is Europe, but with large shipments from Asia/Middle East and large storage builds- the flows haven’t made sense. The same will persist over the coming weeks acting as another key headwind. China continues to operation facilities at about 70% utilization rates and pushing more product into the market. Local European refiners are also starting to come back online which will also promote limited imports from the U.S. Imports from Europe to the U.S. have picked up: “European oil product exports to the Americas have gained momentum with a steady increase in flows from Europe’s ARA hub, fixture reports and vessel-tracking data compiled by Bloomberg show. Some tankers bound for the U.S. Atlantic Coast have deviated to other destinations.” The ships will start towards PADD 1 and 3 but will deviate at times as better buyers appear and storage in the U.S. remains an overhang. For example: “Two tankers initially bound for New York-New Jersey Harbor have been diverted away from the region Separately, the LR1 STI Westminster left Estonia in early April and then floated off Virgin Islands for about 3 weeks after having been diverted away from New York. It is now sailing toward the U.S. Gulf Coast

NOTE: Gasoline inventories on the U.S. Atlantic Coast rose w/w and are at the highest level for this time of year since at least 1990, latest EIA data show”

Gasoline builds returned across the board as areas prepared for the increase in driving for Memorial Day and to backfill the system after a few weeks of draws. The pace of draws will slow down and more surprise builds are likely as refiners increase throughput, exports slow, and domestic demand disappoints.

Something to watch is the growing glut in distillate as the U.S. faces mounting pressure in storage. PADD 2 is an area that has seen a huge surge in disty storage: “Lower Midwest diesel dropped to a 4-month low with farmers nearing the end of spring planting. Prompt ULSD on the Magellan Pipeline at Tulsa, Okla., fell 2.25c to Nymex June ULSD -10.75c/gal at 3:13pm ET, lowest since Jan. 16, data compiled by Bloomberg show. “Diesel also loses support on swelling stockpiles Midwest diesel inventories up 6 straight weeks through May 15: EIA data 80% of corn planted week ending May 17: USDA data.”

DOE Distillate Fuel Oil Inventory PADD 2 Reaching Highs from 2016 and will Quickly Take Out the Highs

Distillate remains a key focus for me as it represents the fuel that drives the economy, and prices/cracks remain under significant pressure pointing to a very slow global recovery.

Physical Crude Prices Have Surged Impacting Refinery Demand as Margins are Compressed

Physical crude prices have seen a quick rally across the board, but the speed of the move is pressuring refiners as product gluts have weighed down crack spreads. There has been a shift in the market with gasoline margins flipping positive, jet fuel off the lows, but disty falling 15% or so across the board. This has kept a lid on refinery profitability and will pressure new oil purchases and refinery throughput. China has been an active buyer as they backfill their system due to the restrictions on the supply chain with provinces shutdown. This will cause gasoline exports to fall this month, but as the system is recharged- exports will surge again- especially if China maintains the current refinery utilization rates. Here are just two examples of pricing structures: “Russia’s ESPO crude, which is shipped mostly to Asian buyers from the country’s Far East, traded at premiums as high as $3.50 a barrel to its Dubai-crude benchmark this week. By contrast, June-loading cargoes changed hands at discounts of as much as $4.80 a barrel to Dubai last month. Iraq’s Basrah Light and Heavy crudes for June loading were sold to a buyer in China at a premium of between $4.50 and $4.80 a barrel to official selling prices, according to traders who asked not to be identified. That’s up from $2.50 and $3.50 a barrel in May.” The below is a list of Official Selling Prices across the Middle East with many of them trading $1-$2 tighter. The change in the market is driven by mostly Asia as India starts to re-activate and China backfills their order book. In March, China cancelled several shipments in April and delayed all May purchases, so they are now going out into the market and buying up “deals” in the market. India is also in the process of restarting assets back to 20%-40% across various assets, and are looking to make purchases.

The speed to market and limitations of exports has led to a resurgence of pricing- and moved floating storage from Africa into Europe and Asia. There have been limits to oil hitting the water out of KSA, Russia, and some other GCC nations. The Neutral Zone (a shared field between KSA and Kuwait) was up to about 80k barrels a day but will be shut starting June 1st for 30 days. While cuts have been talked about from Iraq and Nigeria, they have been slow to show up at the coast. The resurgence of crude buying won’t help U.S. exports the same way given the availability of competing crudes that are priced “cheaper” than U.S. LLS and MEH once shipping and transportation costs are factored in- cracks using U.S. crudes are averaging between -$3 to -$6.5 a barrel: “The bleakest spot for a price recovery remains the U.S. Gulf Coast, where a flood of exports from Saudi Arabia has exacerbated a surplus, adding to pressure on competing offshore grades like Mars Blend. Onshore, West Texas Sour crude has dropped to a discount of 35 cents a barrel below WTI futures, down from a premium of $3.50 as recently as May 11. WTI in Midland, Texas -- the heart of the state’s shale region -- has also slumped.” U.S. crude will remain at a disadvantage driven by the quality/ geography/ refiner margins. Many of these countries cutting oil exports are increasing refined product exports, which is a way to get around some of the limitations from the OPEC+ agreement. Local demand remains weak for refined product, so it enables more to be placed on the water, which is showing up in global storage centers and imports into Europe/Africa.

Even as less crude is exported into the market, there is still a steep glut floating on the water. Some declines have occurred in floating storage as Africa has moved some cargoes to new homes.

Global Crude Oil Floating Storage- It has Started to Decline but the Pace Will be Slow

While India starts to raise run rates as lockdowns are eased, it will be a slow grind higher as movements slowly normalize. “Indian Oil Corp. raised crude throughput to 60% at its nine refineries with the restart of several process units that were suspended due to the lockdown measures, company officials said.” India is moving into the third phase of opening up, and the refiners plan to slowly work up from 60%: "We plan to raise crude throughput at our refineries to 80% levels by the end of May due to an improvement in retail demand for fuels amid a gradual relaxation of the lockdown," a company official said.” While some assets will increase or have run at near normal rates, it isn’t uniform across India’s complex. Facilities are talking about keeping run rates close to 30%-35% until the lockdown is over due to the loss of local demand. [1] For the most part, refiners/petchem will average run rates at about 60%, which will start pulling more crude off the water as India has maxed out onshore/offshore storage capacity. While India starts to come back, South Korea, Japan, and Singapore have seen their storage levels rise across the board. South Korea has maxed out their storage capacity causing people to scramble to find alternatives: “The country, the world’s fifth-largest oil importer, is fast running out of commercial storage space, leaving some of Asia’s biggest refiners scrambling for alternatives as the coronavirus pandemic batters energy demand and feeds a glut in global supply. “We are in an unprecedented crisis,” said Kim Woo-kyung, at the country’s largest refiner, SK Energy. South Korea has the fourth-largest commercial storage capacity in Asia, and is a popular spot to store crude and fuels thanks to its proximity to the region’s big oil buyers, including China and Japan. SK Energy has filled 95 per cent of its 12m-barrel onshore crude oil storage capacity, and storage on vessels — such as the 2m-barrel carrier it is using off Jeju — is running perilously low.” [2] While the market focuses on China/ India, gluts still persist across the region.

Asia Crude Oil Floating Storage

The below helps highlight the storage situation in Japan, which is also running refiners at multi-year lows given the limitations on local demand.

Outside of Asia- Europe has seen another rise in floating storage. There was some reduction as Norway/ North Sea was able to sell some cargoes, and Germany started pulling more into the system through the Rhine River. The storage will start to decline again as the UK and Italy start ramping activity, but it will be a very slow process as demand struggles remain throughout the region.

Europe Crude Oil Floating Storage

Three Key Storage Locations Show the Pace has Slowed, But Builds Continue to Mount

Just to put into context the size of the oversupply in the market-below looks as the USA/ Japan/ Fujairah as a way to see crude and distillates together. The pace is slowing, but it is still progressing in the wrong direction as more builds amass at key ports/storage centers. The slow pace of global recovery and distillate being a dumping ground for jet fuel (kerosene) has kept these increases relatively sticky across the region.

As the price of crude has quickly risen, it has put pressure on crack spreads that haven’t had a chance to catch-up. Global crack spreads remain either negative or slightly positive driven by several factors:

Gasoline margins have finally flipped positive in Asia The rise in gasoline margins has been muted as gasoil/disty cracks have worsen offsetting some of the rallies. Due to the poor margins, refiners won’t be increasing run rates- instead they will opt to pull/sell product from storage This will be an overhang for a real recovery in crude demand as refiners remain well off seasonally normal runs The reduced run rates will help pull more refined product out of storage, and clear one glut- but it will leave more crude in storage and cap the price increase.

Below are some examples of refiner cracks that have recovered but remain well off seasonal norms:

Bloomberg Fair value- Northwest Europe Jet- Ice Gasoil Spread Month 1: It Looks at the Spread Between Jet Fuel and Gasoil. It is still Negative but has rallied off the lows as jet fuel demand has started to recover a bit.

U.S. Gulf Coast WTI Cushing 321 Crack Spread- The Spread still remains under significant weight as oil prices have rallied

ICE Gasoil Futures Minus ICE Brent Futures Month 1- Gasoil Remains Under Pressure due to an Oversupply onshore as well as new Shipments Arrive

Asia Gasoline 92 RON FOB Singapore Cargo vs ICE Brent Crack Month 1- Has Just Flipped Back to Positive for the First Time Since the Beginning of March

The pressure will remain across the crude curve as refined product demand provides an overhang for a ramp in purchases. There is a global glut of product, floating storage, and onshore storage to contend with as crack spreads remain negative across large parts of the world. The fundamentals point to WTI shifting back to $27 but based on current front month prices fundamentals are being ignored and technical are driving some of the price appreciation. The crude curve has flattened as producer hedges start to rise, and expectations grow that U.S. producers will ramp as well as OPEC+ as production cuts are reassessed in June. This has weighed on the curve- allowing the front months to rally, but putting pressure on the middle of the curve seen below.

WTI Cushing Curve- Current Levels Have Flattened

The tightness of WTI Cushing to Brent is tough to maintain at $2.33 as it doesn’t even cover shipping costs, which will trap more oil at the coast. The shift in the market will likely push Brent higher instead of sending WTI back into the $20 realm. There will need to be another negative EIA report on Thursday to shift some of the views in the market, but if investors believe gasoline demand will recovery rapidly- it will be difficult to fight the trend. The quick move higher will also bring more crude shut-ins back online, as producers look to lock in a higher price. This doesn’t mean we will get new completions, but instead a recovery in shuttered flow and a stabilizing spread count. Crude quality is going to matter more and more as refiners try to optimize runs to reduce some outputs. Vasconia and Lula fall within the “Goldilocks” blend of medium sweet, which also includes many West African Blends. The medium sweet provides optionality for many different refiners, and will remain a desired crude into China as refiners look to find deals. About 60% of Brazilian crude heads to China with most of Angola sending their cargoes that way as well. There will be a growing disconnect between OSPs and physical prices as crudes see more demand as the refined product market remains saturated. Each barrel yields different refined products, and limiting gasoline will be key here.

Some other key storage areas that are seeing a rise across the board are Singapore and Europe (ARA). Builds were realized in Residual fuel stocks with just small declines in Light and Middle Distillate as more product was sent into Europe. Due to the new flows into Europe, the ARA reports small declines as more refined product was moved inland as some travel restrictions are lifted and to make room for new imports. Europe also increased some exports into the U.S., but with storage capacity being reached and backlogs at the coast- shipments will be diverted into other regions.

Singapore Oil Products Stock Data Remains at All-Time Highs

All of these components sit at or near all-time highs, which will remain in place as European demand struggles. Many people are adjusting vacations and plans to minimize travel and remain “in-country” due to safety or forced restrictions due to lockdowns

May/June Loading Trends are Supportive of Near-Term Pricing

Russia has been shifting some of the flows higher during the month across oil/ gasoline/ diesel- so things can change quickly.

May loadings have seen some adjustments over the last few weeks with June showing some additional reductions out of Angola. Russia is expected to reduce additional volumes in June- but not all loadings have been reported at this point. “Russia’s average daily oil exports in the first 20 days of May slumped 25% m/m to 428k tons (3.14 million b/d), Interfax reports citing industry data.” Seaborne exports have fallen about 33% m/m while pipelines have seen a slowing of about 13%. Some of this is offset with an adjustment in Urals loadings from the Baltics that has increased to 4.8M tons from 4.3M tons. Similar adjustments will happen in June- especially as prices have recovered and local demand continues to remain weak. The expectations are for additional cargoes to be left off in June, but with the increase in prices recently for Urals and ESPO- they might decide to add back some cargoes. Several companies are seeking government assistance in Russia, which could push some additional barrels into the market. The other issue within Russia is the rampant spread of COVID-19 throughout the country, which is limiting demand for local refined products. This has put more diesel into the export market, so even though the country has announced reduced refiner runs (to 2015 levels) they have increased diesel runs by 15%. It is a mixture of different crude slates, but also the limited local demand sending more into the open market. Norway has increased runs a bit while flows remain relatively stable out of Nigeria and Angola.

Canada has reduced total flow by about 1M barrels coming in just above 3.5M barrels a day. These levels will be maintained due to the difficulty of adjusting production quickly and the limited amount of storage available in the area.

Total Canadian Oil Production Seasonally Adjusted

All of the focus has shifted to China, and the recovery of refinery runs back to about 13M barrels a day driven by run rates remaining at about 70% across parts of the system. Teapots are being shifted closer to 65% (or at least the government has been trying) in order to help support operations of State-Owned facilities. There will be a drop in May in Chinese refined product exports as the system is being backfilled with gasoline. Both diesel and gasoline set new export records, but both will see some near-term pressure in May. If the current throughputs and local demand remains in place, China will return to record high exports in June.

Crude Storage at Independent Refiners Have Started to Decline

China Exports of Gasoline and Diesel Hit a New Record After the CCP Increases Export Allocations Higher

Crude storage at independent refiners came down again this past week as more crude was moved through the system, but exports remain elevated across all refined products. Something that should be considered- is China storing up on crude and food because there is currently a second wave of COVID-19 hitting? We know that in the Northern Provinces of Jilin and Heilongjiang there are a little over 100M people facing some form of lockdown. There is also a new testing surge in Wuhan after a resurgence of cases. Doctors have also said that they are finding patients that are asymptomatic longer and test positive for an extended period. It is also more impactful on the lungs and overall respiratory system vs previous strains that also caused other organ issues. “In an abrupt reversal of the re-opening taking place across the nation, cities in Jilin province have cut off trains and buses, shut schools and quarantined tens of thousands of people. The strict measures have dismayed many residents who had thought the worst of the nation’s epidemic was over.” [3] [4] The issues are mounting across the globe as South Korea/ China/ Japan/ Singapore faced their own varying forms of resurgence and had to pause/ delay/ or renew lockdowns in order to slow the spread of the virus. The weak economic footing the world entered 2020 on mixed with COVID headwinds leads me to believe demand won’t just surge back to normal.

The limitations spoken about makes the ability to close this gap HIGHLY unlikely- especially recovering all gasoline demand by end of Summer or as OPEC expects only a 3M barrel a day loss in 4Q’2020. Airlines along make up 8M barrels a day of demand that alone can remain off by 50% throughout the year and would already break the expectations between 2019 and Q4’2020.

India Recovery will be Slow- Limiting Crude Coming Off the Water

With all the focus on China- India will be slow to recover: “The country consumed about 4.6 million barrels a day in May last year, which means demand probably stands at about 2.8 million barrels a day now, according to data compiled by Bloomberg, based on estimates by the executives. Gasoline demand is still about 47% below the same time last year, while diesel consumption is about 35% lower, they said. Jet fuel was still a massive 85% weaker, they said.” It is tough to normalize fuel demand back to previous COVID-19 levels as India faces monsoon season (biggest in 2 decades currently hitting), and the lockdown has been extended in specific some areas. The problem will be getting migrant workers back to cities, and all of these adjustments take time. The other overarching problem is the lack of wages earned during the lockdown, which will limit the amount of travel/fuel that is consumed. India is another place diesel is a the key focus because the economy was slowing in 2019, and was facing headwinds coming into 2020. “Sales of diesel, mainly used in transport and industries and accounting for 40% of India’s total oil demand, jumped 75% in the first half of May compared with the same period in April. The executives are also expecting gasoline consumption to accelerate quickly as people returning to work choose their own cars or taxis over public transport.”

The extensive slowdown in the economy will add to the slow grind higher as their market normalizes. This is also assuming trade partners recover, and there isn’t any resurgence of infections. “Trucking, which accounts for the majority of diesel consumption in India, is still facing logistical and financial constraints. About 70% of the transport sector remains frozen, according to All India Motors Transport Congress, the largest body of transporters in India representing almost 10 million truckers. “It is highly unlikely that the economy will return to normal any sooner than 8-10 months,” said Naveen Kumar Gupta, secretary general of the congress. “Poor demand will result in poor production and industrial output, which will further impede utilization of truck fleet. There is extreme financial pressure on the small operators who are highly fragmented and unorganized. If urgent relief measures are not taken, the day is not far away when the transport sector will not be able to function.”

There is no spoon

The market continues to shift away from reality as economic data highlights the struggle the global market will face on a path to recovery. I hear/read constantly that the “market” isn’t the “economy”, which is accurate and has been the reality (unfortunately) for about the last decade. The stock market has been a means of injecting liquidity into the market as central banks have run out of options, so by driving negative rates and bond yields below inflation- investors are pushed into stocks. The stock market has always been forward looking, but the question is- “how far should the market really be looking out?” Economic data was typically an indicator on how well earnings would be over the next few quarters, but on an increasing level- I keep hearing: “Don’t worry about 2020 because it is all about 2021.” I should clarify- in 2019 everyone said the same thing about focusing on 2020. Now we have terrible economic data and very little guidance on company outlooks, which is sending market multiples to all-time highs. Many companies have removed their yearly guidance due to the uncertainties globally, but yet investors at an increasing clip feel confident everything will recover quickly- even though things were slowing across the board in 2019. Market participants and news outlets try to place headlines to explain movements, when Monday’s rally was purely a reaction to the Powell news of QE infinite.

We do believe some of the economic data has bottomed, but expert a more tempered and grind higher in key metrics that will drive crude/refined product demand. The major overhang will be the growing unemployment levels that will weigh on purchasing power going forward. A person without a job in a market with so many unemployed around them will accept a lower wage, but because Powell and the Fed continues to inflate all assets- real wages (discretionary spending) comes under pressure across the country. This limits spending on non-essential goods/ vacations and just general purchasing power. Households will turn to more debt to close the gap, but as the U.S. consumer already has record debt at $14.7T- it is hard to see how much more we can go. Additional debt is also hard to obtain as more credit card and mortgages are delinquent. “Lenders in April had nearly 15 million credit cards in “financial hardship” programs, such as deferral programs that let borrowers temporarily stop making payments, according to estimates by credit-reporting firm TransUnion. That accounts for about 3% of the credit-card accounts the company tracks, TransUnion said Wednesday. Nearly three million auto loans were in these hardship programs, accounting for about 3.5% of those tracked.” [5] The below chart helps highlight how spending patterns have adjusted and expenses being incurred at the household level. Many of these items won’t see a huge resurgence as job security comes into question and government benefits run out.

OPEC Countries Struggle Under the Weight of Weak Oil Prices and Low Volumes

Some of these OPEC+ countries are facing more stress on their balance sheets causing subsidies to be cut ranging from fuel subsidies to monthly checks- which is driving countries to find ways to raise capital. The impacts of COVID are being felt around the world- Kuwait (one of the richest countries in the world) is facing a rising deficit that rivals the 1991 Gulf War: “National Bank of Kuwait SAK, the country’s biggest lender, already predicts the shortfall will reach 40% of gross domestic product in the fiscal year that started April 1, or double what Fitch Ratings forecast a month ago. That would be the most since the 1991 Gulf War and its aftermath. No country is expected to run a deficit in excess of 30% this calendar year, according to the International Monetary Fund.” “According to a new survey by Bensirri, a Kuwait-based independent communications consultancy firm, 45% of companies polled in the country have shut down operations, 22% are experiencing difficulty getting financing and 80% won’t be able to cover more than six months of fixed costs.” The problem is about 90% of the government’s income is derived from oil, so the current pricing in the market and reduced volumes is increasing the severity of the deficit. There is a very good chance the below fiscal stimuluses will grow in order to offset the extensive declines in the local economies. Saudi Arabia has increased VAT taxes to 15% and taken austerity measures to shrink the deficit to about $9B.

If the rich oil countries are struggling, we all know places like Nigeria, Iraq, Kurdistan, and others are facing pain. Nigeria has already received approval for another IMF loan of $3.4B (talked about two weeks ago) and a deferral of interest payments to China. “The Kurdistan region of northern Iraq is now struggling to repay a $500 million loan from commodity giant Glencore Plc, according to documents reviewed by Bloomberg News. Glencore and rival trader Trafigura Group Ltd. are also in talks to restructure oil-for-cash loans of about $1.5 billion with the Republic of Congo, according to people familiar with the matter. And Chad, one of the poorest countries in the world, is using a clause in its oil-for-cash contract worth more than $1 billion to reduce payments.” “Chad told the International Monetary Fund that it plans to repay an oil loan of more than $1 billion from a Glencore-led syndicate more slowly than anticipated, using a clause in the contract that allows it to reduce payments when prices drop below $42 a barrel. Brent crude is trading at around $35.”

Global Debt and Weak Export/Shipping Debt Will Be a Huge Headwind

Global debt levels have surged, which complicates the push to stimulate struggling economies. As debt grows to stimulate the economy, we can see the weakness across the board really started in 2019 by reviewing exports across the transportation complex. Many of these bellwethers were weak throughout 2019, and even with weak Q/Q and Y/Y comps failed to show growth. The below charts drive home the weak stance we are trying to rally from- and the pressure across the world. The CASS Indexes do a great job of outlining global benchmarks to identify growth areas and slowdowns. The below chart shows that April shipments have dropped straight down to 2009 lows. The problem is China/ South Korea/ German/ Japanese don’t show that reversing quickly as exports struggle across all of their data points. So far- South Korean export data continues to track poorly for May.

The chart highlights the impacts on leading indicators that are impacting the market and the movement (or lack thereof) around the world. Korean exports remain about 25% below normal, and these comps are starting to merge with the impacts from the recent Korea/Japan trade war. The trade war (started over comfort women- again) hurt South Korean exports, but the issues have been shelved as countries look past some political hurdles to unite against COVID-19 and a potential common enemy China.

Container ships and port data show the slowdowns haven’t reversed outside of clearing some backlog left in the system. “A.P. Moeller-Maersk A/S expects container volumes to fall up to 25% this quarter and plans to cancel dozens of sailings as the Danish shipping giant copes with sliding demand in consumer and industrial markets from the coronavirus pandemic lockdowns.” The company moves about 17% of the world’s containers, and this helps drive home the overhang that will last in the system for diesel and economic recovery. “With the U.S. and European countries stepping carefully toward reopening their economies, Chief Executive Soren Skou said he expects no meaningful recovery until the end of the year, and added that container volumes are expected to fall 20% to 25% in the second quarter from a year ago.” [6] “Maersk and other container shipping lines have canceled hundreds of sailings on major trade lanes and idled ships to cut costs and maintain freight rates amid the declining demand. Maersk said its average container freight rates were up 5.7% in the first quarter from a year ago. The carrier canceled more than 90 sailings in the first quarter and expects another 140 to be dropped in the second quarter.” Airfreight data has tightened a bit as commercial jets typically reserve space in the belly of the plane to carry freight. With the loss of flights, the available cargo planes are finding support across pricing and volume- especially as companies struggle to source key components quickly.

The issues persist across all forms of travel and transport including Truckloads and Rail. Truckloads have falling to financial crisis levels as costs surged and companies focused on only moving essential goods. Trains and trucks all burn diesel, and will just be another huge overhang on refined product demand.

Rail traffic was coming off a weak 2019 following increased competition from trucking companies due to overcapacity, but the chart below helps drive home how sever the drop has been. Many engines have been sidelined which limits diesel consumption, but the depth of the collapse also highlights how long it will take to recover. 2019 was weak, but even the first few months of the year were down 5%-8% across the board… so this slowdown will be sticky.

Debt Levels Mount as Countries Announce New Stimulus Packages

Debt levels have surged throughout the world driving more pressure on balance sheets with some simple graphics below to drive home the issues. We have discussed this extensively two weeks ago, so we will wait for the updated data before we harp on the struggles again. As debt loads rise above GDP, the leverage becomes even more onerous as any slowdown creates a much bigger problem for every % point drop. More countries are talking about negative rates, and other quantitative easing measures to push liquidity into the market. The decline in real yield (factoring in inflation) is pushing more people into equities and riskier assets in order to avoid “losing” money investing in bonds or keeping cash in savings.

Total U.S. Debt- Reached a New All Time High and Will Easily Reach over $25T in the Next Few Weeks

Debt Loads in Europe are Mounting with Germany Now Agreeing to Joint Issuance

Geo-political Issues are Starting to Resurface as Countries Come Out of Lockdown

Several key geo-political issues to focus on this week are the growing tensions between the U.S and China, which are manifesting in different corners of the world and local economies. It is extending to others as China has lashed out now against Europe/ Australia, but the issues will now center on the Trade War. The rhetoric is growing around the failure of China to address COVID-19 early on and hid the true impacts the virus was having across the country. China will fail to meet the levels agreed upon in the trade deal signed on Jan 15, 2020. The dollar values will be impossible to hit, and quantities challenged due to current market conditions. Negotiations will have to start again as language was in place to cover pandemics (I know shocking). The below chart shows the trade deficit in 2019 the U.S. had with China totaling $329B, with the gap expected to be closed through energy, agriculture, and other large purchases. The first two crude purchases were just made in May with MANY more needed to meet even the lowest level of the agreement. The deficit shrunk through January to $24.106B, but things adjusted quickly as imports have fallen exponentially throughout China. Local demand remains very weak, with little chance of improving over the next few months- making the trade deal number impossible to hit.

The trade issues are made worse by the aggressive actions China is taking against others in the region. China has sunk another Vietnamese fishing vessel, harassed a Malaysian Seismic Ship, several Rosneft vessels, and provoking Taiwan (causing the country to scramble Naval vessels and aircraft). China has also been clashing with India in two key regions Sikkim as well as in the eastern Ladakh region.

Sikkim/Doklam Plateau (in Bhutan) is the easiest way to get heavy machinery through the Himalayas, and both sides have been constructing military and transportation assets in the region. The area is a choke point for India that would enable China to connect to Bangladesh, and the ports China owns in the country through the Belt and Road loans.

Not even two weeks later- another skirmish arose between India and China in a contested part of Kashmir, which is an area Pakistan, China, and India converge. China and Pakistan have come together to form the PAK-China Economic Corridor, which would link Gwadar with Western China.

https://timesofindia.indiatimes.com/india/india-china-deploy-additional-troops-fortify-more-ladakh-areas/articleshow/75816007.cms?utm_source=twitter.com&utm_medium=social&utm_campaign""""""""""""""" =TOIDesktop

Kashmir has been a battle ground since 1949, but over the last several years the militaries have increasingly gotten involved. Artillery and sorties are being run in the area with India killing the newest leader of the local militia. The problems in the area have been mounting over the last several years with about 100 Kashmir militants killed along with 20 Indian soldiers. China provoking India is just adding more fuel to an already raging fire.

Based on the chart above, China is looking to connect Gwadar and Kolkata, but India stands in the way North of Bangladesh and in Kashmir. The food issue within China is pushing them to act more aggressively as food inflation has risen above 14% in China as food hoarding and locust swarms intensify.

The new Hong Kong laws being passed in China will be a huge blow to the “One Country Two Systems” mantra that has been the cornerstone of the assimilation. Protests died down during the COVID-19 outbreak, but have find a resurgence as things normalized a bit and anger grows over the CCP tightening control. [7] The U.S. has responded with human right violation legislation that is manifesting in the form of restricting and making disclosures more comprehensive to list on a U.S. exchange. The problems are only beginning with China as the trade ware takes center stage. The “Cold War” never really ended with China- the trade deal was a weak attempt to pacify both sides as the CCP knew a potential pandemic was brewing in their backyard. The issues going forward will be does the CCP implement anything or will China call for a renegotiation.

The CCP and SOE (State Owned Enterprises) typically avoid calling attention to contracts they aren’t adhering too- so any type of new deal will have to originate from the U.S. side. Tensions have risen over the handling of COVID-19 and now the new Hong Kong laws. China also made aggressive maneuvers throughout the South China Sea while the USS Roosevelt was dealing with a COVID outbreak. In order to get elected in this country, it will require taking a “tough” stance on China- especially through trade. As a new COVID outbreak takes hold with slightly different characteristics, the problems will mount across the global market- as Brazil and China experience a COVID virus that is proving to be asymptomatic longer and impacting the respiratory system more vs other organs.

Overall, the issues are mounting with economic data consistently coming in weak and showing we are far away from a recovery. We have highlighted that we have come off a bottom, and will not likely retest the extremes in terms of oil demand destruction or broad shutdowns. There will be rolling shutdowns as states/ countries experience spikes in COVID activity. We believe that oil demand will remain under pressure and see depressed demand as refiners struggle to reactivate with weak spreads.

[1] https://www.spglobal.com/platts/en/market-insights/latest-news/oil/051520-refinery-news-roundup-refineries-in-india-start-raising-run-rates [2] https://www.ft.com/content/2a873b63-8160-4ffc-9dfc-36197d550f0e [3] https://www.bloomberg.com/news/articles/2020-05-20/china-sees-signs-new-cluster-carries-virus-longer-than-in-wuhan [4] https://www.bloomberg.com/news/articles/2020-05-18/over-100-million-in-china-s-northeast-thrown-back-under-lockdown [5] https://www.wsj.com/articles/millions-of-americans-skip-credit-card-and-car-payments-11589985381 [6] https://www.wsj.com/articles/maersk-expects-container-shipping-volumes-to-fall-up-to-25-11589388695?mod=e2twlx [7] https://www.bbc.com/news/world-asia-china-52759578?at_custom3=%40BBCBreaking&at_custom4=4BA77F50-9B6A-11EA-9A75-CEAEC28169F1&at_campaign=64&at_medium=custom7&at_custom2=twitter&at_custom1=%5Bpost+type%5D