Primary Vision Insights – August 3rd, 2020

By Mark Rossano

Summary

U.S. Frac Spread Update Saudi Faces a Mounting Deficit Floating Storage Levels Remain Elevated Heading into Shoulder Season The Glut Grows as COVID Cases Rise Based on the Above Consumer/Activity Weakness: Economic Data Will Remain Weak China Data Faces Headwinds Through Q3 Three Gorge Dam Update as Flood Warning Level is Reduced Libya Update Brief Iran Recap

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U.S. Frac Spread Update

The frac spread count has been trending higher driven by activity picking up in the Permian. The Appalachia basin has remained relatively stable as Dec’20 to Feb’21 has been holding between $2.90-$3 even as the front month has come under pressure. There have been some 1 offs in fringe acreage driven by spot contracts, which will account for some areas seeing 1 or 2 spreads activate for a few weeks at a time. We have seen a pick-up in some private companies taking advantage of reduced stage pricing, as well as trying to manage decline curves across the portfolio. Natural gas areas will plateau here as pricing remains problematic, and we will see some activity fall off in Appalachia- shifting back to 13. Based on our data gathering, the Permian will keep climbing through at least the first two weeks of August as new crews are activated in the region. The Bakken will remain relatively flat staying around the 4-week rolling average of about 5 crews. The remainder of Texas will also hold around the 4-week rolling average as refiner activity remains elevated (relatively speaking) through the first half of August. Exports will be supported through the next several weeks as pricing had been favorable over the last month, but pressure is rising as Urals, Basrah Light, and several West African blends start trading at discounts. The expectation for Saudi pricing (OSPs-Official Selling Prices) is a cut of about $.48 into Asia for Arab Light. The previous premiums in the market supported U.S. crude sales, which will be filled over the next few weeks- but the widening discounts in the crudes listed above will weigh on future U.S. exports. The physical market operates about 6-8 weeks out, so crude being exported today was purchased when Urals and other competing blends were trading at much higher premiums.

The shift in exports will weigh on future activity, which is why we believe that completion crews will remain in a relatively tight range with a peak at around 85- but with a 4-week rolling average hanging in at around 75. On a seasonal basis, August typically slows down with a pickup in the 2/3 rd week of Sept that leads to an increase of activity that doesn’t adjust lower until Thanksgiving thru Christmas. COVID has shifted that normal seasonality, and we expect to see some more activity throughout the Permian in August.

As we go through Q2 earnings, there will be more information on hedging structures across the hydrocarbon chain. Based on Q1 earnings, there was a total increase in hedging across all producer sizes driven by concerns around COIVD/ OPEC+. The protection derived from hedges can offer a net cash benefit to the company (if unwound) or a way to keep producing product making a physical delivery at a contractual agreed upon price instead of the spot price.

These little nuances allow for companies across all sizes to keep production elevated. Hedging structures can range across put spreads, three way/ two way collars, outright puts, swaps, basis/differential hedges, or other structures. Each one has their cost/benefit breakdown, but I have been asked many times- how the U.S. can keep producing at 10.9M-11M barrels a day even though WTI Cushing is sitting at about $41.

The answer is complex, but it begins with the overall hedge book that can ensure the price you see on the screen isn’t the one the company is receiving. The below chart gives a breakdown on total volumes, and the structure used to provide financial protection. Last year, hedges were a bit light, but as the fear surrounding OPEC+ and COVID rose- so did the need/desire to protect cash flow. The banks that provide your revolver can also dictate how much cash flow has to be locked in to maintain access to capital, and I am sure as prices dropped management teams were receiving phone calls. Natural gas and oil are easier to hedge further out due to the liquidity in the market, but NGLs (natural gas liquids/ condensate) is typically limited to a maximum of 6 months due to the thin market. These protections enabled some operators to keep working even as the prices crashed around them.

The end user or consumer of the product is also a big consideration for realized prices at the E&P/ midstream level. Refiners need a steady stream of oil to run through the system 24 hours a day, and the crude slate is a pivotal component to the process. These specific end users- refiners/petrochemical facilities- will pay a premium to keep the crude flowing and will do so by working out a deal with the E&P directly to ensure a steady flow of product comes through the gate. Another obvious beneficial end point is the coast or specific exporting capacity. The international markets provide a variety of opportunities to sell oil at a price that isn’t really reflected on the screens. It can always work in both directions, but the optionality provides a natural benefit to the E&P. Outside of the benefits brought on with downstream clients, it can also prove disastrous if the firm transport contracts become onerous on the E&P with out a means to adjust pricing. Firm transport or FT is purchased on a specific pipeline, and the E&P must product the volumes committed or go out and replace the flow. If the E&P fails to comply with the contract, the midstream or end user will start charging penalties that add up to a costly impact. MVCs or minimum volume commitments can cause an E&P to continue drilling because it is deemed “cheaper” to lose money completing a well to meet the volume instead of just paying the penalties. There are many nuances behind these contracts that will keep getting ironed out in bankruptcy courts as restructuring starts to accelerate across the energy space.

There are also ways to try to defer costs over a period of several quarters by spending capital on drilling but wait until you have enough wells to complete to maximize the efficiency of the frac crew. Drilled but Uncompleted Wells (DUCs) have risen in key areas, such as the Bakken, Eagle Ford, and Permian that help to offset some of the costs when they are finally completed and brought online. The biggest spend remains completions vs drilling, but it is a way to optimize costs by spreading them out. There is always a natural DUC count to keep operations moving smoothly, but the excessive build up allows for some running room without the need for additional rigs. The problem is- “what is the real number of DUCs?” I can conservatively say- any well drilled before mid-2016- will never be completed; out of the remaining wells- 30%-50% are too far out of the money based on hydrocarbon mix and location to be even remotely close to economic, and the rest either fell out of zone or were part of a drilling program that failed to meet expectations. Even though we see huge DUC numbers, there is still significant limitations to what is actually viable to drill at this current price deck.

Drilled but Uncompleted Wells in the Bakken/ Eagle Ford/ Permian

The pricing pressure across the U.S. resulted in a quick reaction to reduce all completion activity throughout the U.S. Now that we have seen stabilizing prices (lower vs what people would want), the energy sector is preparing for the “new normal” over the next several quarters with significant unknowns still sitting in the market. This will make them more willing to hedge (and incentivize banks that provide revolver capacity to insist) to lock in cashflow and provide a working drilling plan. These factors will get completed wells back off the lows, as we have seen crew activations over the course of July- which means June will be the low for completed wells. We don’t expect a huge surge in completions, but something between May/June activity (based on the chart below) as pricing is a bit more stable with some additional exports/ refinery throughputs. There will also be a steady increase in completions through August, but it won’t be driven by a surge of new completion crews- instead it will be achieved by utilizing crews on a 24/7 basis and utilizing zipper fracs or dual fracking (frack two offsetting wells at the same time).

Completed Wells in the Bakken/ Eagle Ford/ Permian

As the rolling average of the frac spread count has increased from end of June into July- we can expect to see more completions and “stable” activity at 75 on a 4 week average. It will be difficult to see any sustainable move above 85 given the current crude fundamentals. The growing discounts on spot/contract cargoes out of Russia, Iraq, and West Africa will push WTI prices lower as U.S. grades price at a discount to compete in the global market.

The last key contribution I will touch on is the underlying infrastructure that is owned or operated by the upstream company. If an E&P owns their own upgrading facilities, pipelines, or downstream assets, the company can manage costs a bit better or at least has more levers across different points of the supply chain. It also creates natural vertical integration efficiencies that reduce the total costs per barrel- especially when you also process/ run third party product. Another key efficiency is the sheer size and contiguous nature of the acreage- this is your typical large-scale example of spreading the cost across a large volume and maximizing the infrastructure usage. These key economies of scale allow for cost savings that can come through and make realized prices come in better than the spot market.

Spot Oil Pricing in the U.S.

The above points provide meaningful economic drivers that can help insulate companies from debilitating losses and allow them to weather some price volatility. The other side is- the E&P really has no choice. Many companies are facing a tough market, but due to poor capital management, over levered balance sheets, and falling acreage values (among other asset write-offs) E&Ps are maintaining activity in order to generate some cash to cover costs. At the current strip, there is only so much running room provided these companies as the cash burn overwhelms available cash on the balance sheet. As core locations are completed, companies are struggling with ways to not only manage decline curves, but to produce enough cash just to breakeven. The pain being felt isn’t limited to just U.S. companies, but span the globe on a corporate and country level. Vertical integration provides some insulation because as crude prices fall it becomes cheaper to produce refined products, but with the demand problems globally remaining through at least year end- many companies are struggling on all ends of the business. Private companies have a bit more flexibility based on: Who is the backer? Are they stripper wells or low cost assets? When you don’t have to report to investors/ backers, you can pick up a bit more flexibility on activity.

As shut-ins are now almost completely reversed and completions pick back up off the lows, we should see a stable 10.9M barrels a day. The problem will come down to the glut that remains in the global market on not only a crude level but also refined products. We continue to believe that WTI crude pricing will fall closer to $33 over the next few weeks with mounting economic and fundamental pressure. The discounts developing in the international markets will cause Brent vs LLS to widen out back to a $1.50-$2 as U.S. crude blends have to trade at a steeper discount to find a home in Europe. The discounts in competing barrels abroad will drive U.S. blends lower to compete but will limit purchases from Asia as shipping costs make it mostly prohibitive.

Saudi Faces a Mounting Deficit

Saudi Arabia has been experiencing significant economic pain as pricing has failed to cover the fiscal balance sheet. “Oil revenue was down 45% in the second quarter from the same period last year to 95.7 billion riyals ($25.5 billion), according to budget data released by the Finance Ministry on Tuesday. Non-oil revenue drawn from sources like taxes and fees declined by 55%. The deficit more than tripled from the first quarter to 109.2 billion riyals even though authorities cut spending by 17% compared with a year earlier.” KSA and other countries have an additional layer of problems to deal with including social programs- which means a country’s break-even is much more complex. Many oil countries (especially within OPEC) provide subsidies through various programs to help “spread” the wealth across citizens. KSA has cut many programs totaling about 17%, but still faces a rising fiscal shortfall, which means additional cuts will be coming or KSA will be looking to issue more debt to cover the shortfalls.

Saudi Arabia has been slowly increasing production as the OPEC+ cuts adjust starting Aug 1 st with reductions moving from 9.7M to 7.7M. KSA and the GCC also carried out additional cuts of about 1.2M (KSA contributed about 1M to that number) that are also being reversed. Not all this crude will be coming to the international market, as additional crude is consumed internally for power generation. The levels of consumption can vary based on weather, but KSA has also been increasing their use of natural gas for electricity- which will put some of the production reversals into the market. “Saudi Arabian Oil Co. informed at least nine customers in Asia that it will give them all of the crude oil supplies they had sought for cargoes loading next month, according to refinery officials who received the notice from the producer.” The shift in the OPEC+ agreement is coming at a time when renewed lockdowns and/or slowed reopening are happening on a global level- especially in key demand countries. “Saudi Arabia may have little choice but to reduce the price of its oil as OPEC and allied producers start to ease output curbs amid weakening demand that’s crashed the value of physical supplies. The price of spot crude cargoes from Russia to Angola to Brazil has plummeted this month after a pull-back in purchases from top importers including China. Refining margins are still well below five-year lows on a seasonally adjusted basis in the Asian oil hub of Singapore, weighing on the ability of processors in the region to turn a profit and pay more for crude.” We have been talking about softness creeping into prices for 6 weeks now as the physical market has cooled across key blend benchmarks. The below benchmark started to soften at the middle of June, and has only accelerated to the downside with the reversal of OPEC cuts and shoulder season coming up quickly. Historically, crude pricing softens through August as purchases slow down as refiners prepare for shoulder season.

Dubai Aug/Sept Swaps Move Back into Contango (Below Zero Contango/ Above Backwardation

Floating Storage Levels Remain Elevated Heading into Shoulder Season

We have been highlighting that crude builds in floating storage were not dropping at the rate the market was anticipating as economic activity slowed considerably- especially with China slowing purchases. “China’s oil buying has slowed in recent weeks after rapidly rebounding from a virus-driven lockdown, which led to a cluster of tankers waiting off ports to unload their crude cargoes. Processing rates at the nation’s independent refiners started to ease from record levels in mid-June, while massive floods across the country are expected to crimp consumption.” Floating storage is persisting across the market with additional builds increasing in West Africa/ Middle East as production cuts are being reversed. “The amount of crude oil held around the world on tankers that have been stationary for at least 7 days fell to 174.73m bbl as of July 24, Vortexa data show.”

That’s down 4.8% from 183.47m bbl on July 17 Asia Pacific down 9.1% w/w to 126.92m bbl Middle East down 1.6% w/w to 13.68m bbl U.S. Gulf Coast up 85% w/w to 8.08m bbl West Africa up 54% w/w to 7.03m bbl; highest since September Europe down 10% w/w to 4.94m bbl; lowest since April

The most concerning increase outside of Asia is the build in West Africa because it is an indicator of slowing demand for crude that typically moves quickly. The medium-sweet characteristics make it easier to refine and typically allows it to sell quickly and at a premium. One of the biggest customers for Angola and other West African grades is China. We have been talking about slow downs in Congo, Angolan, and Nigerian purchases even as Angola increases September loadings. Just a quick example of reduced demand: “Singapore is expected to import 580,000 bpd in July, down from 870,000 bpd in June, which was already down on the more normal level of 910,000 bpd in April.” Nigeria normally sells crude into Europe and other markets that remain well off of seasonal norms when it comes to refinery runs. This is leaving more oil right off the coast and is starting to result in steepening discounts.

West Africa Floating Storage

While crude storage grows, Angola also added about 200k barrels a day for their Sept schedule, and Russia will be adding about 1M (only 500k or so is reflected). These increases are being reflected in the soft spot market, and the growing discounts in the physical market. The growing discounts to move physical barrels will weigh on realized prices globally as competition heats up with the uncertainty of COVID limiting activity during winter.

Crude Loadings (Exports) for Angola/ Russia/ Nigeria

The Middle East has also seen their floating storage shift higher, and while it still remains within a normal range- it is right at the top of the range. Based on the underlying ship movements- we expect storage to remain near the top of the range over the next few weeks. The below is another example why it is likely Saudi will cut OSPs to clear some of the glut that has been building as new production comes back online.

Middle East Floating Storage

The crude in these key regions- Middle East and West Africa- are being impacted by the slow downs in the Asian markets. We are seeing some of the floating storage clear, but it remans on a very slow pace which is worsening with renewed limitations in India, Japan, and China. China is experiencing bottlenecks at ports as testing ramps for COVID as products come through port. We are also seeing slowdowns in economic activity across the country, which is limiting total refined product demand and causing refiners to slow runs (more on that later).

Asia Floating Storage

The Glut Grows as COVID Cases Rise

The inability to clear the crude/ refined products glut ahead of turn around (shoulder season) will prolong the oversupply in the energy markets sitting on a record amounts of total products. “For clues about how glutted the global diesel market remains, just look at the bizarre voyages being undertaken by tankers hauling the fuel. One cargo of diesel got hauled all the way to Singapore from the Persian Gulf -- only to be loaded onto a much bigger ship and taken back to the Middle East. Another tanker hauling the fuel to Europe from India abruptly changed course over the weekend and is now heading south toward the Cape of Good Hope and signaling West Africa. Over the past few months, a tanker hauling diesel west from Asia even did a double U-turn when it was part-way across the Indian Ocean, ultimately sailing thousands of miles to the Bahamas where it reportedly started to discharge onto another vessel. Two others that loaded in India made it almost all the way to the U.S., only to turn back across the Atlantic Ocean for Europe.” The movements of ships (both gasoline and distillate) point to a huge oversupply in the market with limited space for onshore storage. Typically, Europe is a big importer of the diesel- but with maxed out storage and reduced demand globally (and in Europe) there is a plethora of supply and just not enough demand to go around.

The reopening or normalizing of the markets remains an unknown as COVID cases globally are maintaining an upward trend as we head into flu/cold season. The uncertainty of COVID will limit the amount people are willing to travel or resume normal activities. A conversation that has popped up over the last few weeks addresses a question: If you start getting cold symptoms- are you supposed to run to the Dr for testing? If the average adult gets 2-3 colds a year and child event more- does that require a test and quarantine? These are some interesting questions to consider as we try to model out what oil (gasoline + diesel) demand will look like as we head into year end. As someone who has 3 children- 5/3/1- during the winter school year it seems like they are sick every other week. The way COVID presents in children can be vastly different vs adults- so will each one require testing and quarantine from school?

We are at peak driving/ vacation season, but we have seen activity plateau and start to rollover weighing on total movements around the world. In the U.S. alone, we have been targeting 8.5M barrels a day of gasoline demand for peak summer. As we progress out of summer and into fall/winter, we believe the demand levels decline along seasonal norms- but remain at historic lows. This means that the trend will follow the normal seasonal movements, but at a record low level as people reduce exposure during peak illness months. The fear/uncertainty described above will keep people cautious, which will translate directly to limited travel. There has been an improvement in daily cases/ hospitalizations as daily deaths tick higher. Just based on inherent lag s from infection to hospitalization to death can account for the spike over the last several weeks. The “benefit” with the current data points are the slowdown in total deaths due to major adjustments in treatment protocols for those sick. While the numbers have improved, we are still experiencing a loss of life well above normal trends which remains concerning as we head into fall/winter.

This brings new questions to the forefront as we see total cases/ deaths rise on a global level. The rise in new cases is being seen on multiple continents driven by Germany and Spain/ Japan/ Australia/ China while we see new spikes in India/Brazil deaths. The rising cases have caused some regions to put limitations back in place or delayed openings in order to limit the total spread to specific provinces/cities.

The rise in deaths is coming with a new surge in cases across Latin America, U.S., and India. Latin America is now accounting for a large percentage of the deaths as fatalities have been reduced across Europe and the U.S. It is unlikely given current treatment protocols to see a similar surge in deaths in Europe and the U.S unless we see a new strain appear. Regardless, many areas still have some form of social distancing, masks, or policy in place to limit contact and reduce the spread of COVID.

The Oxford Stringency Index highlights how much countries have enforced lockdowns, and as you get closer to 100 indicates a full shut down. Here you can see Sweden showing the least amount and Italy the most in terms of government mandated policy adjustments. Countries have begun opening back up but given fear of spread and as we prepare for seasonal changes- it will be difficult seeing activity getting back to Feb levels. The goal now is to “maintain” current openings while reducing the spread of the virus to minimize net economic impacts.

The activity levels remain well off normal, and some of the countries that have achieved the most “normalcy” and increased activity- such as Japan, are facing renewed spikes in COVID cases and are rolling out some new restrictions. “Tokyo will ask bars, restaurants and karaoke stores to shorten their business hours as officials race to stop a resurgent spread of the coronavirus in the Japanese capital, with Governor Yuriko Koike threatening to declare a state of emergency if the situation doesn’t improve. Shops will be asked to shut at 10 p.m. from August 3 until the end of the month, the first such restrictions since the capital lifted all limits in June. Tokyo reported 367 cases on Thursday, one higher than the previous record.” We expect to see this limitation come and go throughout the fall/winter months with a focus growing on the rate of transmission. Some states (NY being one of them) are looking at this rate to gauge reopening status because if the rate of transmission increases to quickly it could lead to infrastructure (hospitals and other) being constrained. While deaths have declined, COVID still requires significant medical care/intervention that averages about a 12-day hospital stay. These requirements can stress the system if precautions aren’t taken and if hospitals aren’t prepared for the influx of cases while also maintaining normal operation.

The increase in cases have shown up in the below google mobility data with Japan seeing a quick drop off following the spike in cases. India is another one that remains well off highs achieved in June with more deaths and cases being reported. It is interesting to see the rapid response from announced spike to decline in mobility. These are key reasons why we remain bearish product and oil demand through the remainder of the year. Even as some of the COVID rates have normalized in countries, people are still reducing their total activity (as seen below). Outside of just COVID fears, there is a real monetary impact as personal balance sheets are stressed to the breaking point with record high unemployment and a growing lack of job security. This is pushing people to reduce spending across their daily lives.

The below breakdown between emerging markets and developed nations really drives home the overwhelming issues between EM and developed. Emerging markets are already sitting on a record amount of debt as their local populace struggle under rising inflation and one of the weakest global markets on record. The EM countries are struggling to normalize following COVID cases, but also their key trade partners are struggling as well. The ability for EMs to stimulate their economies is severely limited due to overleveraged balance sheets and the inability to increase trade as trade partners are experiencing the same problems. For example- Japan vehicle production was down 61.1% in May- that means fewer natural resources, parts, and equipment. The breakdown of industrial production reverberates throughout the supply chain, and due to leverage, strikes emerging markets the hardest. The global movement of products remains well off norms based on shipping data: “Global Port Tracker, published monthly by the US National Retail Federation (NRF) and Hackett Associates, predicts a 13.3% drop in imports for August, followed by contractions of 12.3% and 9.9% for September and October. For November, it envisages a decline of 0.6%.” “Statistics published by the Intermodal Association of North America (IANA) show further declines across the board in June, with total intermodal shipments for the month down 4.9% from June 2019. International containers showed the steepest drop – falling 13.2% – and on the domestic front, containers were down 6.8% and trailers slipped 4.6%.” “The Dubai state-owned company, which also operates logistics facilities, handled 16.7 million shipping containers in the second quarter, down from 18.3 million a year earlier. It recorded its biggest quarterly decline in the Asia Pacific and Indian subcontinent region, where volumes fell 12.2% to 7.2 million containers.”

These are just some examples of slow downs we have been tracking in the shipping market. We also look towards Japan, Germany, South Korea, and China for key indicators for import-exports and total trade volume. The activity charts help to highlight the limitations across each region, and now we have England issuing a renewed lockdown: “New restrictions barring different households from meeting indoors in homes, pubs and restaurants are being introduced in Greater Manchester, West Yorkshire and east Lancashire following increased rates of coronavirus transmission in the areas. The restrictions, which come into effect from midnight tonight, cover all of Greater Manchester as well as the local authority areas of Blackburn with Darwen, Burnley, Hyndburn, Pendle, Rossendale, Bradford, Calderdale and Kirklees. The same restrictions will apply to the City of Leicester.” [1]

Based on the Above Consumer/Activity Weakness: Economic Data Will Remain Weak

The GDP data across Europe and the U.S. for Q2 started to roll through, and not surprising printed record lows. The U.S. printed an annualized decline of 32.9% with Germany printing a decline of -10.1%. The problem remains the data remains a key headwind as we see below with the NY Fed Weekly Economic Index.

U.S. Second Quarter GDP

German GDP Growth QoQ

Eurozone Second Quarter GDP

The above charts are looking backwards and just highlighting how deep the contraction was across the second quarter. As we look at the trend from 2018 into 2019, GDP was slowing across the globe and put us on a weak footing coming into 2020. As we look to project forward, our target is to evaluate leading and current indicators to distinguish how much the underlying economy is recovering. The below chart hows how economic activity has started to turn lower again, and the spending at discount stores is heading back to the lows achieved at peak COVID lockdowns. This is something to watch as unemployment becomes a bigger problem with uncertainty around benefits. According to the White House, President Trump supports an extension of the $600 payment to bridge the gap in the short term waiting for a deal between the GOP and dems. The GOP want to cut additional unemployment to $200 from the current $600 where the dems want to keep it at $600.

The growth from June into July for some has been expansionary based recent PMI data and industrial production data. July has been a bit more challenging with rising cases in some key U.S. states and provinces abroad leading to some renewed lockdowns and economic headwinds. Consumer spending and corporate investment has remained weak with consumer spending recovering about half the drop while corporate investment remains down with little sign of a real recovery. Companies have announced additional layoffs, and the job losses are increasing in the top 20%. The issues aren’t going away any time soon as Initial claims remain over 1M individuals (1.4M) and continuing claims shifted back above 17M. It is hard for companies to invest new capital when they are focusing purely on survival. Additional layoffs have already been announced and as many countries struggle to get back on their feet- corporate investments will remain weak. It is also made worse due to the amount of debt/leverage sitting on balance sheets hindering investment and resulting in more cost cutting initiatives- layoffs and furloughs.

Some of the spending recovery came across home improvements, appliances, and furnishing but we have seen searches for the items drop off as people have made the purchases delayed due to COVID. Now that lockdowns are starting to increase again, and more jobs are at risk- it is unlikely to see the spending trend remain stable.

The next real test for spending will come with “back to school” shopping but based on the trends happening in the market right now it is unlikely to fulfill the hopes and dreams of the retail sector. The search for virtual classrooms and home schooling have skyrocketed as people search for alternatives to in person education. A common thread has been the growth of “pods” where friends will arrange for an accredited teacher to lead classes of small groups where the families are comfortable with precautions everyone is taking. These are simple adjustments that will not only reduce net consumption but will also lead to a reduction in gasoline/diesel usage.

China Data Faces Headwinds Through Q3

China has been experiencing significant flooding (more on that later) as well as new increases in COVID cases. “Mainland China reported 127 new cases of coronavirus for Jul 30, the highest daily number since Mar 5, said the national health commission. Of the new infections, 112 were in Xinjiang, 11 in Liaoning and the other 4 were imported cases.” Many of the components driving the Q2 GDP beat were many one off components: industrial inventory builds (that we have discussed throughout previous reports), construction restarts of building projects, and filling delayed shipments. We wrote a full report in Jan how it is impossible for China to properly stimulate the economy much further. “But prospects for more stimulus are poor: credit growth now appears to be plateauing and local governments are running through their special bond quotas.

There are few signs that consumer spending can pick up the slack after a dire first-half. Households are reporting stagnant income, and this economic uncertainty is encouraging them to save more. Discretionary purchases are likely to remain weak for the foreseeable future, epidemic or no epidemic.

Business has struggled to return to normal in China with slowdowns across their industrial/business segments:

The above helps to highlight how China saw a peak in the end of June, but activity has slowed down across the board- failing to get over 87%. The ceiling on activity is something that isn’t unique to China as many other countries are experiencing the same stress. As we showed in our last report, trade flow remains weak globally for China specifically- driven by economic headwinds (thanks COVID) and rising political disagreements – resulting in military action in some instances.

The retail/consumer has struggled to get back to normal as sales have struggled to materialize back over the dip experienced in Q1.

The only real bright spot was construction but based on provinces complaining about a severely limited amount of remaining projects- it is difficult to see how the growth is sustainable. There is always a limit to the amount of ghost cities that can be built.

Rounding out the surge that we have talked about is the growth in inventories that have built up as trade partners face massive headwinds (described above) in terms of imports/ consumer activity. The local Chinese consumer is not making up for the shortfall in the international market- so now that inventories are normalized it is hard to see another surge.

The head winds we have been tracking based on the drop in refinery runs, buildup of onshore/offshore crude storage, rising product builds, and stagnate exports will be a problem as we head through Q3. Activity in key trade partners remains weak as well as rising political and military headwinds.

The headwinds highlighted above makes these types of numbers difficult to believe:

China July Manufacturing PMI at 51.1; Est. 50.8 National Bureau of Statistics and China Federation of Logistics and Purchasing release figures today.

July manufacturing PMI forecast range 50.5-51.5 from 34 economists: June 50.9 July non-manufacturing PMI falls to 54.2 from 54.4 in June; est. 54.5 (17 economists) July composite PMI falls to 54.1 from 54.2 in June

The Belt and Road Initiative has always been a focal point for me due to its vast size and scope around the world. The focus of the BRI was to increase the Yuan economy/trade and procure a huge amount of natural resources and various assets. The structure of the deals can only be described as debt traps, with the initial investment being at teaser interest rates- but the rates would rise as the project progressed. The other key problem- all equipment, materials, and labor had to be procured from China- which just cycled cash back into the country. It did little to enrich the local economy- but instead invited a foreign entity to reap the potential rewards. The banks funding the projects have an estimated $8T that is being spread over these countries. The problem now- many of these emerging markets are struggling to survive- let alone pay off debt to China. This is only going to stress the Chinese balance sheet further as many projects are at a standstill and bad debt expense is rising. The BRI once considered to be a huge asset to the growing Chinese economy is now shifting into a huge liability. China has already taken ownership of some assets from countries/companies that have defaulted on the debt. Debt diplomacy at its finest!

Countries that have Signed BRI Cooperation Documents with China

Three Gorge Dam Update as Flood Warning Level is Reduced

As we go through China economic progress, the discussion has to shift to the Three Gorges Dam and the flooding that has been ravaging the whole area. (We will leave the India/China border alone for this week). The below chart helps to highlight the flood plane of the Yangtze river down stream from the Three Gorges Dam. Rain has been ravaging not only upstream but also downstream from the TGD (Three Gorges Dam), which has caused flooding displacing millions, destroying homes/businesses, and decimating crops. China has already purposely blown up 2 dams in order to relieve some of the pressure on the TGD and trying to manage the banks of the river.

Elevation (Flood Plain) of the Yangtze River

The problem is the ports along the route handle millions of cargoes every year, and it is a pivotal point of trade within the Belt and Road Initiative. It is a crucial point of trade over land (The Silk Road) and sea (Maritime Silk Road). The land route provides a significantly shorter distance to markets, and has seen a significant increase in cargoes over the last 10 years. In 2018, the route carried over $550B in trade- making the route pivotal for not only China- but Europe. The massive floods/ COVID has put a huge damper on total trade-limiting movements. A breach of the dam (unlikely but possible) would cause a wall of water to devastate the whole flood plain outlined above.

The movement of goods on the river is also important to reach rail and road assets to move products into South East Asia as outlined below. Limitations remain in place due to COVID and flooding, as well as trade tensions that have escalated with the South China Sea and the Nine-Dash Line.

Rail/ Road Routes from China into South East Asia

Now to put on a tinfoil hat for a minute- let’s consider Chinese infrastructure and build quality. The TGD has critics both inside and outside China that were concerned about the engineering and construction of the dam. Some scientists/ engineers disappeared within China after speaking negatively against the project due to concerns over improper measurements and considerations. The three biggest factors were: structural depth- it was believed that the concrete should have gone further down into bedrock to handle the stress of the expected silt pressure. The belief was that the current design wouldn’t be able to withstand an unlikely event (now playing out) with all of the flood gates wide open. The second issues was the poor interpretation of the changing river currents and tributaries that all funnel behind the dam. There was concern that the new currents would begin to erode around the dam and cause silt to build up much faster vs expectations. The last was the total construction material- including rebar- quality. There was a concern that to save on cost corners were cut and sub-par material was used to secure the dam.

Some of these concerns are starting to be realized with the dam shifting based on recent satellite imagery. Now- a structure has the ability to “shift” without causing terminal damage based on the engineering specifics. The tensile strength of the concrete/rebar can move within a margin and still remain fully intact. So based on the current calculations- the recent moves are within the margin of safety. But- in true CCP fashion- there are rumors that 38M people downstream have been evacuated or told to be on high alert to escape a wall of water. This could very well be a precaution- but the true colors of the CCP have truly been on display in 2020- what some of us have known for years.

Libya Update

It is important to due a quick recap of the issues facing Libya. The GNA (Government of National Accord) and the LNA (Libya National Army- led by General Haftar) have been engaged in a battle for control even before the last ISIS strong hold was eliminated as the GNA was formed in 2015. The GNA is recognized by the UN as the rightful government supported by Turkey, Italy (questionable), and Qatar. The LNA backers are Egypt, France, UAE, and Russia- with the last one providing on the ground military personnel and equipment. The UAE has flown sorties on behalf of the LNA, and Russian mercenaries have also pushed into strategic assets and locations. Turkey has provided a significant amount of equipment and personal on the ground in support of the GNA. Egypt has started to get more involved for two key reasons:

They share a border with Libya that is controlled by General Haftar, and they believe is a viable fighting force to protect against terrorist cells. Egypt and the LNA have some agreements on conducting oil and gas exploration activities Egypt vehemently rejects the deal signed between the GNA and Turkey

Turkey’s interests center around the agreement made with the GNA that opens up exploration opportunities in the Mediterranean, but it also crosses directly into Greece and Egypt’s coastal Exclusive Economic Zone (EEZ). It also “technically” gave Turkey grounds to block the build out of natural gas pipelines expected to connect between Greece/ Cyprus/ Eastern Med with the rest of Europe. These economic interests have put NATO allies and others in a tough spot as Turkey is part of NATO but Egypt is strategically important. The issues go deep, and I would be happy to provide more depth- but we will just hit the high level points here.

The rhetoric has gotten much worse following the lifting of the force majeure and the quick replacement of it. Libya was producing about 1.2M barrels a day before the LNA and GNA negotiations broke down, and General Haftar went out to capture key oil producing assets and the surrounding infrastructure. Throughout the process, equipment and infrastructure has been damaged that will take time and capital to fix- but any real settlement of difference could bring back about 350k barrels quickly. The additional barrels would take months to several years depending on the extent of the damage in the region. Libya is sitting on a huge reserve of oil, which is why so many countries (Russia/ Italy/ France/ Turkey/ Egpyt) are so interested in the area. The UAE (and GCC) also see the opportunity, but they have been paying Haftar to not pump oil in order to help remove the glut in the market. As the OPEC+ meeting was getting closer, there were rumors the FM being lifted was a negotiating tactic to keep money flowing from cash strapped oil producers within the GCC. Several attempts at negotiations between the GNA/LNA have been attempted in various parts of Europe, Russia, and Egypt.

GNA and Turkey Agreement

At the moment, the fighting will remain regional and Russia/Turkey are looking to avoid an escalation between each other- especially given the current backdrop of Syria. Egypt/Turkey on the other hand could be a flash point depending on how long the stalemate lasts. Sirte (as seen in the map below) is a very important strategic assets based on coastal assets, crossroads, and pipeline infrastructure. This is the flashpoint to watch for a potential escalation- the other key areas will be some of the oil facilities where Russian personnel are placed. Many of these areas will be avoided to keep from escalating, but if one is engaged that would quickly ratchet things up a notch.

Areas of Control and Oil Fields/Infrastructure Within Libya

Brief Iran Recap

The last geopolitical update I will leave you with is the increase in Israeli air strikes within Syria striking at Iran/Hezbollah positions and strategic targets at the Lebanese border following a failed attempt at infiltrating. Israel has moved advanced equipment into the region and put soldiers on high alert in the region following more destabilization in Lebanon and an increase of Hezbollah activity. Israel has been striking targets at will within Syria destroying equipment and infrastructure related to Iran, Hezbollah, and supporting proxies (Syrian Army assets included). In retaliation, rocket attacks and skirmishes at the border have increased as well as rocket attacks in Iraq targeting coalition forces and bases as well as Iraqi infrastructure and equipment.

Iran continues to be weakened by the economic sanctions, and now with OPEC cheaters “forced” to rectify for overproduction- Iran has lost a very important outlet for their oil. Iran and China have been working towards an agreement, but the local populace will never support a long-term agreement with China. The government is trying everything to maintain control and bring in fresh capital as crude piles up in onshore and offshore storage. Iran is attempting to use their proxies to project strength and unity, but things are degrading quickly.

The chance of a bigger escalation is limited, and any conflict will most likely occur at the Israeli border. Impacts to crude in the short term will be limited, but a long-term shift remains in the works that will unlock Iranian crude. We are move closer to a regime change in Iran.