Primary Vision Insights – October 13th, 2021

By Mark Rossano

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SUMMARY

• U.S. Completions and Refining Activity • Global Inflation Levels and Activity • Global Energy Crisis and Response

• U.S. Completions and Refining Activity

The U.S. completions market will continue its slow grind higher as prices support activity, and rigs are brought back at an elevated rate to build out new DUCs for next year’s activity. The NGL market remains tight and supportive of prices as we head into the winter months. This is the lowest level of propane we have had in storage for this time of year as demand remains robust internally and internationally. The OSP cuts in the energy markets have expanded providing a bump to refinery margins, which have also been helped by the bid in the distillate market.

The rally in cracks hasn’t been beneficial for everyone ranging from the consumer to some refiners based on input costs.

Lotos is just one example- which is a company that makes 65% diesel- so it will be interesting to watch if they get any uplift from the OSP cuts. Libya/ Russia/ ME are all increasing competition into the European market.

Even factoring in elevated natural gas and hydrogen prices- these types of spreads will keep refiners pushing middle distillate production. We talk more about storage levels and underlying flows later on, but this will keep refiners focused on middle/heavy disty. When you create diesel- you inherently make gasoline as well which will make the light disty/gasoline levels elevated and provide an overhang on pricing. But given the depth of OSP cuts and elevated middle cut products- they can easily absorb the weaker gasoline spread.

• Global Inflation Levels and Activity

Global inflation keeps shifting higher as pressure grows on the underlying consumer. As we predicted last month, China had a bounce in the service sector while the underlying manufacturing industry remains lackluster and weakening. The whole Asian region is still struggling with more headwinds as prices for EVERYTHING continue their relentless bid higher.

In the U.S. alone, we have natural gas prices at $5.66, gasoline at $3.22, and diesel at $3.47- before we even get into the record high for food prices (chart lower) among essentially everything in our daily lives. We have reached well past the point of demand destruction- the question will be the speed in which we see it in the market.

China for example had a good PMI service (which we have been talking about in Sept), but we also said things softened into the end of Sept and continue to be weak into Oct. The pain is spreading again in China as prices shift higher and pressure grows on the export orders (more on that below). In Caixin services PMI, sub-indexes of new business, prices charged and employment all returned to expansionary territory, although new export business shrank again, hitting the lowest in 7 months. Input prices rose for 15th straight month and grew at a faster pace. The biggest issue remains the slow down in new export orders expanding as input prices rose again for the 15th straight month… this will get passed on to the customer, which is the U.S.

Latin American is also feeling the squeeze on inflation, which makes the next few moves in rates only moving in one direction. On a global level, we are moving firmly into a rate hiking cycle with a Fed tapering very likely as we head into Nov.

The inflation shift is becoming a much bigger problem- especially for EMs. The ability for their populace to absorb these increases are minimal as their trade weakens and pressure mounts. The U.S. being the largest buyer in the world will have impacts on a broad scale- especially as economic data continues to slow. The jobs data came in much worse than expected (and well below my expectations). I was expecting a bump in Sept, but instead we got a very lackluster backdrop. We are heading into an interesting period as the Fed tapers just as U.S. economic (and really global) data gets much worse across the board. The U.S. still won’t be raising rates, but the expansion of tapering will reverberate through the system and drive other countries to adjust rates faster.

This will just send the number of central banks tightening back to the highs and put more pressure on buying and borrowing.

Liquidity in the market has been getting pulled out as China tightens along with the rest of the Emerging Market world. The sheer size of China is one of the biggest reasons we have seen such a huge reversal, because we know the Fed hasn’t made any adjustments yet as a record number of USD head to the RRP.

We are still well above pre-pandemic levels, but that will keep eroding as we head through Nov and the U.S. (hopefully) joins the tapering party as expected. The slow down in job growth shouldn’t be enough to deter Powell- but we have seen crazier things happen in this market. The underlying food crisis is a growing issue that will keep prices pinned to the highs as fertilizer prices move higher.

The issues in China are expanding with more slowdowns on an economic level and pressure from the real estate sector hitting other companies.

• Moody's lowered Chinese property developer Fantasia Holdings' long-term issuer rating to "SD" (Selective Default) from "CCC" and also lower the company's senior unsecured bills that matured on Oct 4, 2021, to "D" from "CCC". • Fantasia missed a $205.7M bond that was due Monday and Country Garden Services (a sub of Fantasia) didn’t repay a 700M yuan loan that also came due on Monday… the plot thickens! • China saw 515 mln tourist trips in National Day holiday (Oct 1 - 7), down 1.5% y/y and recovering to 70.1% of pre-pandemic level, said Ministry and Culture and Tourism. Domestic tourism revenue in the holiday fell 4.7% y/y to 389.1 bn yuan, about 59.9% of pre-pandemic level. • Chinese #property developers have defaulted on 39 #bonds this year as of Sept 27, vs 29 in the same period last year, and their failed payment totaled 46.75 bn yuan in the period, jumping 159% from a year ago, according to China Real Estate Information Corporation (CRIC). • Shenzhen saw 2nd-hand #home sales tumble 80% y/y to 1,765 units in Sept, down 13.6% m/m, falling below 2,000 units mark for the first time in 12 years, according to local official data. Home sales by floor space slid 78% y/y to about 169,300 sqm, down 13.4% m/m.

• Global Energy Crisis and Response

The energy crisis has taken center stage around the world as electricity prices surge, and countries evaluate the costs of alternative power generation. There is already a fairly broad installed base on “oil” (diesel, fuel oil, gasoil) power generation available in Europe, but the carbon taxes make many of these means very expensive even with the elevated pricing. This is restricting some spare capacity being brought online or some facilities from increasing current power generation levels. Even when German electricity prices spiked to over 300 a MWh- bringing on additional coal was still barely breaking even due to the underlying costs. Natural gas storage is the biggest overhang heading into winter, which is driving up prices of LNG in the market as Asia/ Europe compete for spare cargoes.

The ability to flex the coal and oil side of the power burn will be driven based on pricing and policy. The policy side could just be a “pause” in enforcement to allow for pricing to abate. The power customer is left shouldering a huge amount of the burden as Europe heads into winter in a very concerning spot. The growing concern is the shortage of natural gas in storage ahead of winter.

Europe storage shortfalls are being driven by a handful of nations, but the fear of a cold winter and shortage of natural gas from Russia is causing some severe price swings.

The shortfalls aren’t just in the Europe where coal stockpiles are running tight in India and China causing a broad increase in the price of LNG. Spot liquefied natural gas in northeast Asia soared to a fresh record, posting the biggest-ever daily move amid a fierce competition for cargoes with Europe. The regional spot LNG benchmark, Japan-Korea Marker, surged $16.655 per million British thermal units higher in just one day to reach $56.326 per MMBtu on Wednesday, according to S&P Global Platts. The push in Europe to replace Russian flow is driving up LNG competition and sending prices to records.

The tightness in the coal market is also creating more pricing pressures with China and India volumes running at very low levels. China just had another problem with the pause of activity at 27 coal mines due to flooding in the region. China has also resumed purchasing coal from Australia “quietly” to try to address some of the shortfall- “China has started unloading a small number of Australian coal shipments despite an unofficial import ban, analysts said, in a move underscoring the intensity of the power crunch facing the world’s second-largest economy.” “Coal shipped from Indonesia — China’s biggest supplier — jumped sharply last week. Medium quality Indonesian coal was changing hands at a record high of $166.5 a tonne, the highest level since Argus started assessing Indonesia coal in 2004. While China’s biggest coal miners have pledged to increase production and go all out to help beat the power crisis, analysts are skeptical they can respond quickly enough to make a difference this winter.” [1] China has increased the purchasing from Indonesia, but Australia shipped 35M tons to China in 2020 and about 50M in ’81-’19. This is not a small amount to make up as stockpiles remain tight heading into winter.

The issues within China have been a point of contention for local politicians: “In a sign of how worried Chinese officials are, Premier Li Keqiang has vowed that every effort will be taken to maintain economic growth. China will ensure the needs of basic livelihoods are met and will keep industrial and supply chains stable, Li was cited as saying by China National radio during a meeting with foreign diplomats Thursday. But what was meant by Li’s comments? He gave a speech in front of a shuttered coal mine that was stopped due to safety issues. At the beginning of the year, a wave of mines was closed due to dangerous conditions. So, when he gave the speech of “at all costs” – it has to be put in context. He was referring more to political pressure (Australia) and the underlying danger in mining. China also sees a big boost in electrical power in September as companies run hard ahead of Golden Week to get goods on the water that will be sent around the world for the Holiday Season. This is why Oct/Nov is typically a slower power burn season as demand wanes along a seasonal level.

Russia is the biggest provider of coal for China and Europe- so even if you don’t take their natural gas or LNG- countries are also taking their coal shipments.

The rising cost of power in Europe hits household disposable income and their ability to spend. It will be in the best interest of the EU to alleviate the cost to consumers to help support a very young economic recovery that is still trying to get off the ground and being supported by the ECB and fiscal stimulus. The cost of power and heating is going to hit incomes and spending hard unless they are addressed.

In the U.S. alone, we have natural gas prices at $5.75, diesel at $3.47, gasoline at $3.22 and food prices at 60-year highs factoring in inflation, but leaving things constant- back to the highest prices in a decade.

The pain mentioned above is compounded by a record price across the commodity space. This is driving input prices to new record highs as companies try to pass on as much cost as possible.

China is front and center on some of these commodity shifts as power rationing has been rolled out in the country.

The NDRC has rolled out some new policies to help alleviate the situation by tying prices closer to the cost of coal for industrial users. This will help reduce some of the heavy consumers while also providing some relief to utility companies that will be incentivized to increase power output. NDRC’s power play (National Development and Reform Commission)

• Finally, China’s macro planner (NDRC) has responded to the ongoing power shortages.

On Wednesday, the NDRC issued a statement explaining the agency’s policy tools to address the issue.

Some context: The country has been suffering very disruptive power shortages for weeks now.

The NDRC pledged to increase the supply of coal, which is the primary source of China’s power, by (NDRC):

• Expanding domestic coal production • Increasing coal imports • The aim is is to ensure power generators have enough coal stock before the main heating season. • The NDRC vowed there won’t be cuts to residential power use. • That leaves businesses in the lurch. The positive news is that the NDRC pledged no complete power cut-offs. • But electricity rationing stays. • And projects that consume a lot of energy, and emit lots of carbon, will continue to be prime targets for power rationing. • That’s bad news for sectors like chemicals, steel, and nonferrous metals. And industrial companies will likely see costs increase. • The NDRC will let provincial power prices rise • Get smart: There’s no sign China will resume thermal coal imports from Australia. • Why that's a problem: No other import sources can make up that gap in the near term. • Glass half-full theory? More expensive power is better than no power at all.

On Monday, Hunan economic planners announced thermal power plants are allowed to charge more for producing electricity to address recent power shortages.

Some context:

• The shortages have multiple, complex contributing factors, but boil down to insufficient and expensive coal supplies that can’t meet excessive electricity demand. • High fuel prices have forced some thermal power generators to operate at such a loss that many have suspended or reduced production. • The problem is worsened by the mechanism for determining the price at which they can sell their electricity to power grids. • Taking effect in 2020, that mechanism only allows downward floating based on locally-mandated benchmark prices. • In recent days, some provinces started allowing on-grid prices for market-traded, coal-fired power to rise 10% over the government benchmark price, based on market dynamics.

They include:

• Western Inner Mongolia • Ningxia • Shanghai • Shandong • Guangdong • Hunan went further, tying coal-fired power’s on-grid price directly to coal prices: • After coal prices rise to a certain point, for every additional RMB 50/ton increase, regulators will allow the benchmark power price to increase by RMB 0.015/kWh. • Get smart: Higher on-grid prices will give coal-fired plants new incentives to crank up power, but won’t address the fundamental problem of coal supply shortages.

Get smarter: This market-based solution is long overdue, and its effect on alleviating power shortages (or not) should be closely watched.

The power throughput will see some reduction as we normally due in Oct/Nov. The reason Sept saw the last big push was driven by a late heat wave and the push we described above to meet some orders.

We are already seeing a big drop off in steel production, which is being caused more by a reduction in demand vs mandated reductions. The total amount of orders have been slipping according to “new export orders” and the import of raw materials. The slow down in the region is a broad problem that will have broader implications on the global economy as well as where power demand will be over the next few months.

The slowdown on the industrial level is hitting multiple places and will result in a much bigger issue when we consider growth.

But first, it is important to look at how much distillate is available in the market as we prepare for an uncertainty winter. Middle/ Heavy distillate and residual fuel levels will be very important over the next few weeks to see if refiners crank up the production of these products ahead of winter. It is important to understand what levels we are starting at for storage as crack spreads incentivize additional disty runs.

China teapot and state owned refiners are sitting on a very large amount of fuel oil, which will likely be kept local in order to provide a buffer for potential power shortfalls.

India has increased their export of diesel as the country struggles with a glut. Refiners have cut runs a bit while shifting refiners to make more gasoline and less distillate over the next few weeks. Now this might pivot or at least stop the shift given the premiums that have come into the floating market. India has been unloading a lot of product into Europe (Atlantic Basin) and into storage based on the last delivery into Singapore.

Combined exports of diesel and jet fuel from Asia to Europe surged to a 17-month high in September, with the bulk of supply flowing from India, Serena Huang, an analyst at Vortexa Ltd. said by email.

• Shipments were at ~457k b/d last month, 16% higher m/m • More than 50% of exports were from India • Flows could remain robust through 4Q, although increased supply from the U.S. and Russia could limit Asia’s exports to the region • Jet/kerosene shipments to Europe may also ease as refiners in South Korea shift yields to produce more kerosene to meet heating demand from Japan during winter • Meanwhile, overall exports last month from Asia to the U.S. and Africa dropped 24% and 21% m/m, respectively; flows to the U.S. were at ~181k b/d, while those to Africa were at ~246k b/d

European imports of clean petroleum product from India are set to rise m/m in October, according to ship-tracking data, tanker fixtures and port reports compiled by Bloomberg.

• Six ships hauling about 460k tons of CPP between them are currently signaling European ports and October arrival dates • More CPP-laden tankers are currently sailing toward the Suez Canal, though are not currently signaling a European port or arrival date

Singapore has seen a bounce in storage as some cargoes that are leaving India are heading into the area. This is the seasonal weak period for Asia, which normally kicks off about mid-sept as we saw in Pakistan and Bangladesh. The spike in refinery margins driven by recent OSP cuts and distillate cracks will help push additional activity for the shoulder season, which is why storage will be key heading into last week of Nov/Dec. Gasoline (light distillate) will be an issue though because when you make diesel you inherently make gasoline. This will have to be addressed with either petchem shipments or broader discounts to try to manage the top of the stack.

Europe is running short on gasoil while still very long fuel oil, which is attracting more product from Asia and the Middle East. As we highlighted above- the level of imports has hit a 17-month high with more sitting behind it. Europe will look to build up stock in front of an uncertain winter, but it is also something they normally do because oil burn remains a common power generation backdrop for some countries. This will keep a healthy bid in the distillate market moving flows from Asia into the Atlantic Basin.

There have been additional cuts to industrial capacity in Europe with the most recent being Aldel Aluminum- Aldel to lower production in Delfzijl, Netherlands from Sunday by 60% to 70%, NOS reported Thursday, quoting CFO Eric Wildschut.

• Wildschut cites high gas prices which make normal production unprofitable • Energy cost/ton aluminum recently EU4,500 with selling price EU2,500 • Doesn’t exclude layoffs

The industrial complex in Europe and Asia have been reducing throughput as margins are pushed firmly negative driven by elevated power and raw material pricing. Input costs were already elevated, but once that was mixed with natural gas and electricity prices- facilities had no choice but to either slash runs or shutter all together.

The growing competition in Europe for LNG is driving up global prices further and hitting their industries and underlying inflation. India is expanding their curbs to pricing after raising NG and petrol prices. They have asked phosphate fertilizer firms to absorb the higher costs as input costs hit a new record.

“India won’t increase subsidies on phosphorus-based fertilizers and has directed producers to refrain from raising prices, according to people with knowledge of the matter, threatening the firms’ margins as global costs of the raw material surge.

Chemicals and Fertilizers Minister Mansukh Mandaviya instructed the companies, the people said, asking not to be identified as the details aren’t public. A spokesperson of the fertilizer ministry declined to comment. Prices of phosphoric acid and ammonia, used to make the soil nutrient, have soared in the world market due to tight supplies, putting pressure on Indian producers as they import a majority of their requirements. Some global ammonia makers have cut output or are seriously considering that option due to high natural gas prices.”

The problem is- India’s rural economy is struggling causing more stress across the system making it near impossible for the farmers to take the hit AND for the fertilizer firms to eat the additional cost.

With input costs rising and food price inflation declining, the terms of trade have turned against the agricultural sector in recent months.

• Input price inflation for the agriculture sector rose to 8.5% year on year in August from 8.1% in July and a trough of -1.8% in September last year. • Wholesale food prices deflated by 1.3% in August and have been on a downtrend since April when inflation peaked at 4.6%. • The double squeeze of rising costs and falling prices is hurting agricultural incomes. Farmers have started cutting back on tractor purchases, with sales contracting 17% year on year in August -- the deepest drop since the nationwide lockdown-induced slump in April 2020. • While the summer crop sowing has recovered to last year’s level, we expect rising input costs to put pressure on farmer incomes in the year ahead.

The U.S. also saw a big spike in fertilizer prices head back above 2008 peak levels as the underlying cost for everything reaches a fever pitch. This is coming at a time when jobs are slow to fill, and wages are stagnate or falling in every level except the lowest. The pain is spreading into all nooks and crannies of the market as inflation hits every day life to the max.

The pressure in the market is also creating more saber rattling out of China as they increase the level of sorties being run into Taiwan and move across the de-militarized zone with India. Interesting to note the new China border incident with India sits roughly 70 Kilometers from a newly constructed, operational PLA garrison in the region.

Given the recent statement by the COAS India, a revisit to the Aksai Chin conflict zone throws light on a significant increase in construction, repair & upgrade activity by China, roads, camps & allied infrastructure all seem to be focused on, improving logistics & connectivity. This is all happening ahead of winter, so we don’t expect to see any big “fireworks” in the region. Instead- we will see China wrap up building and staging centers for the winter.

This will increase the activity in the South China Sea: “CHINESE FOREIGN MINISTRY SAYS CHINA WILL TAKE ALL NECESSARY MEASURES TO RESOLUTELY CRUSH ANY TAIWAN INDEPENDENCE PLOTS

The PLA ran a total of 96 sorties into Taiwain’s airspace as the U.S. ran drills in the Philippines. Xi and Biden are set to have a broader meeting about issues between the countries as the U.S. keeps the trade deal in place and will keep tariffs in place. I expect the South China Sea to heat up this winter… stay tuned!

[1] https://www.ft.com/content/eae7454f-60de-4b76-a2b5-b61a2b63ee47

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Primary Vision Insights – October 13th, 2021

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CONTACT

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