Primary Vision Insights – Enterprise Subscribers

Breakdown of the Report

U.S Completion Activity

Asian Flows and Physical Crude Markets

OPEC Update on Production, OSPs, and Cuts

Emerging Market Pressure Grows

Emerging Market Debt and Flows of USD

Chinese Data Shows More Problems Ahead and a “Soft” Reopening

Petrochemical Demand Will Fall Further

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U.S Completion Activity

U.S. activity has slowed down along seasonal lines, which will continue as we head into Christmas/ New Years. The pace of the slowdown won’t be as “extreme” as previous years driven by activity topping out at 300 spreads. The question now turns to- What happens next year? We expect 2022 to bottom out at about 265 spreads, and we will see a rapid move back to 285 as we progress through January. The additional 15 will be more weather based on how quickly they return to action. In the very near term, there is another warning about a severe cold snap dipping down into Texas, which is something that needs to be watched closely. During Winter Storm Uri, there was an “all-stop” of activity across the South. We could get a similar setup if the ice and power situation play out the same way, which is a current possibility.

There is some new equipment coming to market in 2023, but nothing that is going to take us back to 400 spreads. We may get to a total of 350 spreads depending on delivery timelines, but that only puts the potential of active spreads close to 325-330. We do expect to see more dual frac or simulfrac, which will help streamline operations at the well head level. The broader adoption of the process absorbs more horsepower, but also brings on more production faster. We expect to see broad inflation remain in the oil patch across steel and labor, while some prices improve. The below chart puts into perspective just how high steel pipe prices are and even a large correction would still not put us near the average.

North America Steel OCTG P110 Pipe 5.5-inch Diameter Spot FOB

We expect to see “stickiness” in oilfield service inflation, but we also expect to see support across the hydrocarbon arena. U.S. production will have an exit rate of about 12.7M barrels a day next year, but a large part of it will be driven by liquids production. U.S. production is inherently getting “lighter”, but the market needs more NGLs- especially as the Middle East reduces their exports and consumes more internally. Russia is also a big provider of NGLs and condensate to the market, which will come under pressure as their production is limited by supply chain bottlenecks. They will try to maximize production, but without engineers and equipment coming from the U.S. and Europe- it will be near impossible.

Asian Flows and Physical Crude Markets

The volume of oil stored in tankers off Singapore, Malaysia and China has halved from a year earlier to around 30 million barrels, according to data and analytics firm Kpler. There’s been a significant decline of Iranian crude in floating storage since late September, with a large portion put into onshore tanks in China, said Emma Li, an analyst at Vortexa Ltd. The oil industry in Iran has been supporting the current protests, which is limiting production and taking some of the crude off the water. We have highlighted in the past how we think the protests will continue to spread, and the regime is currently in a “terminal decline.” The assassination of Soleimani took away a key mastermind of IRGC control, which is allowing the protests to expand. It is near impossible to nail down when a pivot will happen, but as we wrote in Feb 2021- the tide was turning. In the near term, this will create disruptions to flow, but over the longer term it will actually be a positive for production and a reversion back to the original relationship with the West. Will this be 2023/ 2025/ 2027- I have no idea- but the shift is real, and it will occur in this decade.

Asian volumes of crude have fallen in floating storage, but we will see another rise as cargoes make their way into the region from Russia and West Africa. There is still a near record amount of crude in transit, and a large part of it is targeting the Asian markets, which will put more crude in floating storage.

Russia is flagging more of their cargoes as “unknown” in order to get crudes into the market. It’s also a way to hide their final destination to get around restrictions that have cropped up since December 5 th .

When we look at the two grades coming from Russia, there is a bifurcation in terms of spreads. ESPO is only trading about $17 below Brent, which is above the price cap creating some hesitancy from shipping insurance companies. Since Urals trade well below the cap level, there has been no disruption to the flow of crude originating from Ural ports.

“Since the cap began, ESPO, which stands for the initials of a pipeline that takes the oil from east Siberia to the Pacific, has seen loadings halve from a month earlier, tanker tracking compiled by Bloomberg show. By contrast Urals, a much larger grade exported from western Russia, is flowing freely to customers in Asia — aided by the fact it fell far below the $60 threshold a few weeks before it was introduced.

Tankers appear to be shying away from the Asian grade, though. In the 10 days since the measures began, 4.4 million barrels have been loaded onto tankers at Kozmino, the tanker tracking compiled by Bloomberg shows. In the same period a month earlier, there were 8.8 million barrels loaded.

People involved in trading ESPO said it’s too soon to be confident that the observed drop in flows reflects something structural. However, weather conditions haven’t been particularly bad and there doesn’t appear to be many candidate ships in place to collect cargoes in the coming few weeks. Tanker tracking data is always volatile, depending on the timings of loadings, and the comings and goings of individual tankers.”

It will take time for companies to come up with alternative means, and in the meantime, it will push down the price of ESPO and pull up the price of Urals. This drop in ESPO is also tied to the saturation in the Asian markets, and the slowing demand within Asia. We will talk later on in the report about the issues surrounding Emerging Market demand- especially as manufacturing and economic activity slows in the region.

They will also have to compete with West African crude grades that have been slashing their OSPs.

West African cargoes are struggling to clear in a big way. Angolan crude differentials have fallen to the lowest levels since May 2020, and there still remains cargoes to sell.

PLATTS:

Chevron offered 1m bbl Nigeria’s Usan crude for Jan. 13-14 loading at $3.70 less than Dated Brent: person monitoring window Declined from -$2.95/bbl on Dec. 6, -$2.80 on Dec. 5, -$2.30 on Nov. 30

Vitol offered 430k bbl of Gabon’s Rabi Light for Dec. 20-25 arrival to NW Europe on CFR Rotterdam basis at $6 per barrel less than Dated Brent; vessel is Nissos Nikouria: person monitoring window Deeper discount than -$5.25/bbl for a similar cargo on Nov. 29; Grade has been progressively offered since lower mid-Nov.

SONANGOL SPOT OFFER:

950k bbl of Dalia for Jan. 23-24 loading listed at $2.25/bbl less than Dated Reduced from -$1.75/bbl on Dec. 8, down from -$1.20 on Dec. 1

650k bbl of Saxi for Jan. 23-24 loading offered for $2.50/bbl less than Dated Cut from -$2 on Dec. 8, -$1.50 on Dec. 1

950k bbl of Mostarda for Jan. 23-24 loading pegged at $4.25 less than Dated Lowered from -$3.75 on Dec. 8

Another 950k bbl shipment of Mostarda for Jan. 30-31 also priced at -$4.25

As the market struggles to clear WAF crude, Nigeria increased production to about 1.41M barrels a day, which will make the storage situation more complicated and result in additional floating storage. We had some cargoes move into the market, but the drop will be quickly reversed as buying slows again.

West Africa Crude Oil Floating Storage

Nigeria, Angola, and Norway have seen their production and loadings grow over the last few months as demand has worsened.

The below chart shows the bounce (especially in Norway) as we see growth in loadings. “Equinor ASA, Norway’s biggest oil and gas producer, said the second phase of its giant Johan Sverdrup field in the North Sea is now on stream. Production began Thursday, the company said in a statement. This second phase will lift the volume of crude oil coming from the field to 720,000 barrels of oil a day, with a goal to reach 755,000. That’s enough to meet as much as 7% of Europe’s daily oil demand.” Crude oil from the field comes at a time when European refineries are phasing out Russian supplies. Johan Sverdrup, which produced 587,000 barrels a day in November, is regarded as a good replacement for the Russia’s flagship Urals grade, mainly due to a similarity in quality.

CPC flows remain elevated with a new near-term record following the continuation of flows coming from the terminal. As the third mooring comes online, we will see CPC move back to a record level, and feed into Europe keeping ME flows into the region to a trickle.

There were a lot of delays crossing the Turkish Straits, but we are now seeing some of the crude move through the bottleneck. There was an issue with insurance (proof and ownership) as well as inclement weather impacting passage. “Tankers able to haul in excess of 15 million barrels of crude have navigated either the Bosphorus or Dardanelles shipping straits since Saturday, according to tanker tracking data compiled by Bloomberg. Those flows were somewhat impeded by poor weather at the weekend, but conditions were more favorable on Monday morning, according to information from local port agents.”

“The government in Ankara demanded letters proving that each individual shipment was covered for transit, something insurers initially resisted. The US and UK pressed Turkey to revise its approach. But on Saturday, Turkey distributed a sample letter to insurers that it would find acceptable as proof of cover, according to the shipping official and a port-agent report. The letter was similar to versions that had already been submitted to Turkish authorities, creating optimism that a solution had been found, the person said.”

Europe will be able to function off of CPC, Libya, and U.S. imports with a sprinkle of whatever country tempts to buy Urals.

Russia is still sending a ton of crude into Asia, but the demand is slowing (especially from China and India) so we will see a big increase in floating storage in the region. Russia is to sent additional cargoes to the Asian theatre as a “preemptive” move to shorten some shipping times by having the cargoes ready to go as they are bought. This is a key reason for the “unknown” cargoes, which will likely become “Malaysian”.

As the “Russian Cap” pushes prices higher- we should actually see revenue from export duties actually increase. I see more support in their revenue generation even as the cap is implemented and crude.

The markets in general will see a bit of a bounce after every rally getting sold hard. Brent and WTI are going to remain fairly range bound over the next week in the paper markets. Brent bounced hard off the $75 level, but there is a growing resistance as we get closer to $80. The physical market continues to point to weakness, so a move back of $80 won’t be sustain unless we get a much bigger pivot. WTI showed something very similar with a strong bounce off of $71, but as we move back to $75 there is a lot of pressure keeping us stuck in a tight range. The market will wait to hear from the Fed and US CPI data coming out tomorrow. We will continue to see a slow down in the “rate of change” of inflation, but there isn’t anything that will reverse the move higher in the near term. The market is “buying ahead of the print,” which is setting up for a “sell the news” event. The crude futures market has had perpetual sellers in the front months, while we move into contango across the front end of the curve. There is nothing in the market to show this changing as purchases slow from Asia and countries “Wrap-up” as we head into the holiday season. Most of those cargoes have already been secured so we move further into Jan-March for signals of buying. We don’t think things will go well in Jan.

Quick update on TC Energy- they have started to move crude through some key parts of the system, but we should get more information on Dec 20th. This will keep some of the pressure on Cushing/ Canadian flows in the near term. “TC Energy Keystone pipeline segment to Patoka, Illinois, is running at about half its ~600k b/d capacity after restarting Wednesday, according to people citing Genscape monitoring data.”

Segment to Cushing, Oklahoma, oil hub remains down after oil spill in Kansas last week

OPEC Update on Production, OSPs, and Cuts

OPEC+ announced “no cut” at their most recent meeting, which came as a bit of a surprise to the market (and me). I was expecting a cut of about 250k barrels a day, which would “actually” equate to a cut closer to 150k that would be carried by Saudi Arabia. Instead, they decided to stay the course. We discussed previously how the UAE and Iraq already told KSA they would NOT participate in the pervious 2M barrel a day cut, and they reiterated those views to KSA when it came to this meeting. Saudi probably figured they would save the political capital for next year, and instead cut OSPs (Official Selling Prices).

OPEC released their most recent estimates for demand and not surprising to see them taking down expectations. We have been very clear about our views on demand, and how many entities in the market are “overestimating” demand. We believe the write-downs will continue on demand especially as the economic data gets much worse throughout the end of this year and Q1’23 next year. Things will likely shake out below 100M barrels a day as we head into next year.

Production dropped off this past month as floating storage rose, and crude purchases slowed. Many of these reductions were driven more by economic backdrops and increases on internal refining. The Middle East (especially Kuwait and KSA) are bringing online new refining capacity so even as exports/production slow- we are seeing an increase in refined product exports. There will be a stabilizing in production over the next few months, but we do expect OPEC+ to announce a cut early next year. Based on the below production, it won’t have a “real” impact as there has already been a reduction. The official cut will be driven by Middle East floating storage, and demand indicators from term buyers. I think it’s likely that we get a cut in OSPs and a smaller than expected cut on the production side.

“Europe is bringing in diesel cargoes from around the world at close to a record pace ahead of the coming ban on shipments from its biggest external supplier. In the first 10 days of this month, the UK and European Union imported more than 16 million barrels of diesel-type fuel via ship — a rate that, if continued, would make December’s total the second highest since at least the start of 2016, according to data provided by Vortexa Ltd. and compiled by Bloomberg. Europe is structurally short of diesel and has long relied on others for imports. With much of December’s arrivals coming from Asia and the Middle East, the shipments provide a glimpse into how the region might get by after EU sanctions banning seaborne deliveries from Russia take hold in February.”

Russia is going to keep dumping refined product into the market ahead of the February cap. We expect to see more Russian product imported into the Middle East as they utilize the region as a “stopping ground” before being moved into the Atlantic Basin. There are two options: 1) the ME imports Russian product and uses it internally in order to export more of their own domestically created 2) import Russian product and “co-mingle” it in tank for exports into the Atlantic Basin.

In the meantime, we will see a rise in Russian refined product exports as the supply chain and shipping lanes adjust. The Middle East and Asia (mostly India) are exporting more into the Atlantic Basin as Russian product backfills the “normal flows.”

The Middle East crude glut still remains extensive against the historical backdrop. The fact KSA didn’t cut OSPs into the U.S. and isn’t competitive into Europe will keep their drawdown of storage muted.

Chinese imports of crude already moved higher as Shandong refiners increased runs to about 66%. We expect them to get to about 69%-70% over the next few weeks, but we have also expected state run refiners to underwhelm. Based on the recent data, we believe this will remain consistent into next year.

Run rates +0.28 ppt w/w to 66.17% as of Dec. 15, the industry consultant said in a note

Rates for state-run refiners nationwide unchanged at 74.49%

Rates private for refiners countrywide +0.35% ppt w/w to 64.58%

Commercial diesel inventories rose to 14.1m tons, +0.09% w/w Gasoline stockpiles -2.4% w/w to 15.62m tons

Theoretical profit margins for teapots +20% w/w to 811 yuan/ton, while margins for state refiners -104% w/w to a loss of 2.3 yuan/ton

We don’t believe that China will increase imports above current levels, but they could reduce their exports of refined products. The question becomes- will the reduction of product during China’s reopening be met with falling demand from the economic pressures of Asia? We think they will match up closely, and we also believe that China’s reopening will be VERY underwhelming when it comes to economic activity as well as crude/refined product demand.

Saudi Aramco rolled out OSP (official selling price) cuts, but not the degree necessary to clear the glut in the floating market. They also cut prices for Europe but left everything unchanged heading into the U.S. markets. Europe isn’t a buyer of Middle East crude at these prices given flows from Libya, CPC, and the U.S.- all of which also remain more competitive vs Saudi. KSA’s announced cuts were more aggressive heading into Asia, but the buying in the region has slowed limiting the ability to clear the builds in the floating markets.

Floating storage has started to clear, but is moving along normal seasonal lines when you consider the “rate of change.” As economic activity slows further in Asia, it will limit the number of new buyers and create more problems as we head into January. West African crude grades keep reducing their offer prices, which will also hinder the ability of the Middle East to push more product into the market. The European price cuts aren’t enough, and the lack of a cut into the U.S. will keep America a buyer of Latin American and WAF cargoes.

Middle East Crude Oil Floating Storage

Even as prices fall, it’s important to put into context where it is in relation to historics. The premium to Oman/Dubai is back to levels from 2013/2019, but still at the top of the range. You can see that small blue dot on the left hand side, where things have gotten “closer” to normal but still priced at a premium.

Middle East Arab Light Crude Saudi to Asia OSP Spread vs Average Oman/Dubai FOB

When we look at the heavier side, the price is now back to $1.25 BELOW Oman/Dubai, which is much closer to the historical average looking back over the last 20 years. This should provide some relief for refiners in Asia trying to protect crack spreads as they soften across gasoline and diesel. The chart below has the little orange dot on the left-hand side, but you can see it is MUCH closer to the “normal” discounts from previous years. It’s just off the 20 year average, and this is margin that can be passed down to the refiner.

Middle East Arab Heavy Crude Saudi to Asia OSP Spread vs Average Oman/Dubai FOB

Floating storage and refinery crack spreads (specifically in Asia) will be a good bellwether to see how demand is holding up with some of these broader discounts.

The U.S. is still exporting 3.8-3.9M barrels a day so the need of Extra light/light is minimal, but it would have been beneficial to see a cut to the Medium and Heavy side of the barrel. These barrels will likely move into Asia instead, and put even more pressure on the West African market flowing into Asia.

Europe saw some minor cuts, but nothing that would meaningfully change the flow of crude into their markets. CPC is loading at a 2 year high, Libya is putting out about 1M barrels a day, and U.S. crude is still priced well to take out any broader Middle East Demand. “CPC Blend loadings for December revised higher to 1.53m b/d, the most in more than two years.”

CPC FINAL PROGRAM:

CPC crude loadings for this month were revised up to 5.996m tons from the terminal near Russia’s Black Sea port of Novorossiysk

Equates to 1.53m b/d, the most since March 2020, compared with 1.43m b/d for November

The preliminary plan released on Nov. 11 had shown 5.876m tons, or 1.5m b/d for December

We also saw Libya slash it’s own OSP to the lowest since May 2020, which will help them retain all of their demand and keep Middle East flow at bay. “Libya set its Es Sider OSP for December at a discount of $2.85/bbl to Dated Brent, according to a price list seen by Bloomberg.”

This is the lowest since May 2020, compared with +15c for November

Sharara OSP was set at Dated -$1.70/bbl, vs +$1.30 for November

CPC flows were facing struggles in the near term as insurance rules for cargoes going through the Turkish straits with about 26 tankers carrying about 23M barrels of Caspian CPC are unable to pass. The tankers have to prove insurance, port of loading, and type of crude in order to move through the Bosphorus Straits. “A backlog of tankers waiting to haul oil through Turkey’s vital shipping straits is clearing, offering evidence that authorities in Ankara have resolved a spat with the insurance industry that arose following sanctions on Russia. Tankers able to haul in excess of 15 million barrels of crude have navigated either the Bosphorus or Dardanelles shipping straits since Saturday, according to tanker tracking data compiled by Bloomberg. Those flows were somewhat impeded by poor weather at the weekend, but conditions were more favorable on Monday morning, according to information from local port agents.”

The U.S. has maintained something around 3.8-3.9M barrels a day of flows into Europe, which will remain elevated as we head into year end. Saudi Arabia kept all prices into America the same, which makes sense for light because we are exporting so much of it. On the other hand, reducing the OSPs for medium and heavy into the U.S. would be a big benefit for increasing flows. I think this was a mistake that will limit flows from the Middle East, and still keep cargoes stuck in the floating market without much of a home through January.

It's important to point out that the pivot started back in 2014 (and likely a bit before) was for the GCC nations (Gulf Cooperation Council) countries to expand their refining and petrochemical capacity. Kuwait is the most recent to bring on additional capacity. “Kuwait has invested tens of billions of dollars upgrading and building new refineries in recent years. That will enable it to boost exports of diesel and jet fuel to Europe in 2023, Sheikh Nawaf said. Those shipments will go a small way toward replacing flows of refined oil from Russia, which the European Union is set to ban from February as part of measures to punish Moscow for its invasion of Ukraine. Kuwait exported its first jet fuel from the new Al-Zour refinery last month. The facility is designed to be able to process 615,000 barrels a day, making it one of the biggest refineries in the world. It is meant to be finished early next year, taking Kuwait’s total refining capacity to about 1.5 million barrels a day. “It’s not going to be so much crude as product” when it comes to sales to Europe, the CEO said. An increase in Middle Eastern exports of diesel and other products to Europe is likely to be “permanent,” he said, with Russia forced to focus more on Asian markets.”

When we look at the updated market

Saudi Arabia and UAE have also taken a similar path with more coming over the course of this decade.

Saudi Arabia Sharpens Petrochemicals Focus in Energy Transition

Kingdom intends to use 4m b/d oil for chemical-making by 2030

Energy transition will drive demand for petrochemicals: Aramco

“Saudi Arabia plans to allocate more than a third of its current oil output to chemical production by 2030 in a bid to squeeze more value from its barrels as the world shifts toward a low-carbon economy. The biggest crude exporter aims to convert 4 million barrels a day into higher-value products such as plastics and fertilizers by the end of the decade, Aramco Chief Executive Officer Amin Nasser said at an event in Riyadh Tuesday. It’s a shift that will require huge investment in its petrochemicals facilities. The kingdom also wants to ensure there’s demand for oil even if crude-buying nations reduce consumption in favor of less-polluting alternatives to reduce their greenhouse gas emissions. “Under a net-zero scenario, petrochemicals could still account for more than half of total global oil demand by 2050,” Nasser said. Eventually, Saudi Arabia wants to sell all of its crude output as oil products or petrochemicals, energy minister Abdulaziz bin Salman said at the same event.”

The shift is going to continue to pull crude off the water and increase the amount of product that is being moved throughout the world. This was the pivot that was set in motion years ago, which is shifting the way product moves around the world.

On an operational update, Canadian heavy crude’s discount to WTI widens $1 to $15/bbl at US trading hub of Cushing, Oklahoma, market participants said.

Discount widens as TC Energy plans restart of one leg of shuttered Keystone oil pipeline beginning Dec. 10, according to people familiar with the matter

NOTE: Co. declared force majeure on shipments on 600k b/d line on Thursday after 14k bbl of crude spilled in Kansas, prompting shutdown

Saudi Arabia and China met in KSA, and came out with commentary that was supported by many in the Middle eastern world- here are some quotes from Trivium.

Xi began by hailing Sino-Arab ties (MoFA):

“As strategic partners, China and Arab states should carry forward the spirit of China-Arab friendship, strengthen solidarity and cooperation.”

“China supports Arab states in independently exploring development paths suited to their national conditions.”

“The two sides should jointly uphold the principle of non-interference in other countries’ internal affairs, practice true multilateralism, and defend the legitimate rights and interests of developing countries.”

And he weighed in on one of the region’s most intractable conflicts:

“The Palestinian issue bears on peace and stability in the Middle East.”

“The international community should stay firm in its commitment to the two-state solution and the principle of ‘land for peace’

He then suggested several areas for them to do just that, including:

Development support

Food security

Public health

Green innovation

Energy security

Security and stability

The most important comment is the last one- essentially discussing the “end to the petrodollar.” I have heard since at least 2006 how the US Dollar was going to be replaced. As long as the U.S. Navy sails the seas and patriot missiles protect KSA assets, the US dollar isn’t going anywhere. The Yuan and Chinese economy are in a terrible place with more weakness to come- especially on the debt and currency side. I am by no means saying the US Dollar doesn’t have its problems- but jumping from USD to Yuan only leads to more problems… not less. I think people continue to overestimate the Chinese economy, and the issues of massive spending, wasteful building, and huge debt loads (with little collateral) keeps the likelihood of a broad adoption unlikely. Let alone the strength, size, and influence of the U.S Navy- so everyone can talk a great game- but the US Dollar survives this round.

"China will continue to firmly support the GCC countries in maintaining their own security... and build a collective security framework for the Gulf," Xi said on Friday at the start of the China-GCC summit.

"China will continue to import large quantities of crude oil from GCC countries on an ongoing basis," he said, also vowing to expand other areas of energy cooperation including liquefied natural gas imports.

Additionally, Xi said China would make full use of a Shanghai-based platform "to carry out RMB [yuan] settlement of oil and gas trade" -- a move that, if Gulf countries participate, could weaken the global dominance of the US dollar.

I do believe that the next Bretton Woods will see the USD lose some influence with currencies backed more by “hard assets and commodities” gaining some relevance. But a weakening of the USD hold as the reserve currency is by NO MEANS a replacement… more to come on this fun topic.

Emerging Market Pressure Grows

The global economy is showing more cracks as manufacturing moved further into negative territory, and now the recent Indian data is showing an acceleration to the downside. “India’s lower-than-expected industrial production in October follows September’s one-off growth spurt that was driven by spending in the festive season. This slowdown supports our view that pent-up demand is now fading and the near-term outlook faces increased headwinds from geopolitical conflicts, tightening financial conditions at home and abroad and slower export orders.”

The ASEAN region is still showing “Expansion”, but it’s slowing considerable, and we expect a negative print in Dec that only worsens as we progress into Q1’23. We will cover this more in the weekly insights coming out this Friday. The global economy is showing more cracks as manufacturing moved further into negative territory. When we look at the broad economy, manufacturing has had a huge reversal to the downside, and we are just starting to see this hit the emerging markets. The November Global Manufacturing PMI fell lower by .6 to 48.5, which is still below the “50 threshold” for the third month. The only region that saw “expansion was in the EM-Asia Ex-China region.

It's important to put the ASEAN “growth” in context as we see a steep drop from the highs, and as demand slows further from the OECD nations- the data will likely turn negative in December. All of the leading indicators- new export orders, new orders, imports, inventory, expected orders- all moved into contraction 2/3 months ago, which is now hitting the “headline” numbers.

India was the one of the strongest entities out there posting a strong bounce in September, but we called this out as pent-up demand. Our expectations were for a steep drop in October data, and the recent Indian data is showing an acceleration to the downside. “India’s lower-than-expected industrial production in October follows September’s one-off growth spurt that was driven by spending in the festive season. This slowdown supports our view that pent-up demand is now fading and the near-term outlook faces increased headwinds from geopolitical conflicts, tightening financial conditions at home and abroad and slower export orders.”

Industrial output contracted by 4% y/y in October- reversing Sept growth of 3.1%- all of which was much worse than expected.

The contraction was mainly driven by demand in manufactured good with the most prominent being in consumer goods.

The deeper fall in consumer goods output suggests the economy is starting to take a hit from slowing export orders.

We see this continuing through the remainder of 2022, which will weigh on the data set and setup for a broad global recession in 2023.

Even though the ASEAN region is still showing “Expansion”, it’s slowing considerable, and we expect a negative print in Dec that only worsens as we progress into Q1’23. When we factor in varying “real” components- we have already crossed the threshold of a slowdown in global activity. “Falling manufacturing PMI is due to both a decrease in activity components (-0.9pt to 46.7) and a more significant decline in price pressures components (-1.7pt to 53.7).”

A very important leading indicator is new orders to inventories, which has already turned negative and is approaching levels not seen since the early 2000’s.

When we look at “OECD Leading Indicators,” we are already in contracting territory for October, but when we cycle in announced November data and leading indicators- we have only slowed further with PMIs disappointing to the downside across the OECD nations.

The U.S. posted something well below 0 and one of the worst numbers since the “Financial Crisis.”

The OECD markets are huge consumers of goods- especially derived from the Emerging Market world. This can come by way of intermediate goods or raw materials that go into the supply chain. Many goods/raw materials will pass between Emerging Markets before it goes into finally assembly (normally in China, India, Japan, or South Korea) before it finally heads to the end destination. When we look at general trade data, Japan, South Korea, and China have all turned much lower (some of them negative) as India slows further. This has pulled global manufacturing firmly negative with more downside on the horizon.

When we compare that to manufacturing production and the “output index” (an important leading indicator), you can see there is even more downside to economic growth in these key areas.

The Composite Output Index is also a crucial leading indicator for the direction of GDP growth. When you look at it compared on the chart below, the move into global GDP contraction (recession) is swift once the COI has turned negative.

The huge disconnect in delivery times and supply chains resulted in a huge surge in orders. This has been described as a “bullwhip effect” – “The bullwhip effect is a supply chain phenomenon describing how small fluctuations in demand at the retail level can cause progressively larger fluctuations in demand at the wholesale, distributor, manufacturer and raw material supplier levels. [1] ” This resulted in a massive surge in orders that are now sitting in inventory, and severely hindering new orders across the supply chain. It takes time for this to reach the beginning of the supply chain (in this case Emerging Markets), but the impacts have finally shown up on their shores. This is becoming more apparent as delivery times have now shortened for seven months in a row- driven by both fewer bottlenecks but also a slowdown in demand. This has resulted in developed markets returning to pre-crisis levels for wait times.

We are also seeing global productivity levels getting much worse, which is showing how slack in the output side.

These indicators help to indicate direction and severity of the slowdown, which is accelerating into year end with more downside coming in 2023. When we look at the export levels, we can see a big shift in export levels as the composite index has turned negative.

The only thing keeping us positive on the “real export” side is the support from Emerging Market flows, but we are starting to see these flows come to an end. When we turn to recent leading indicators for trade data, we are seeing negative flows with imports leading the way down. For exporting nations, a big pick up in imports is a positive signal because it means manufacturing will ramp internally, and those imports become exports for the global market. Based on commentary from Maersk, FedEx, Amazon, Walmart (to name a few), we are seeing a hard pivot lower. When we look at the U.S., we are moving to new seasonal lows given 2019 was NOT a good year. “November 2022 had the greatest October-to-November decline since 2016 at 12% as volumes trend back to 2019 levels.”

Demand in the U.S. has weakened further when we consider PMI new orders, and what is waiting at the ports. The above container chart shows the strong drop off as inventories have already normalized in the U.S. Forward buying has already dropped off, and the U.S. is the only one that is showing the big drop. Global manufacturing PMI new orders project a steep drop in EPS growth over the next 12 months, which is going to exacerbate the issues at the Emerging Market level.

The slowdown in trade is already being forecasted, but the depth is likely to remain much lower for longer given the rising rates volume globally. The below chart shows a bit of a “normalized” buying world as we head into 2024, and I think we are going to see something very underwhelming given the backdrop of debt and other pricing pressures.

Central banks have been forced to raise rates to get in front of inflation and pull back on liquidity. It has sent the “World Yield Curve” to be inverted, which is the first time since at least 2000. We are seeing something relatively “unprecedented” when it comes to the pressure on the yield front. This is happening during a time when there is a RECORD amount of global debt in the market, and a large portion of it is priced in US Dollars.

Central banks have raised rates and actively stepped into the market to protect their currencies from devaluing further. This results in a big drop in foreign reserves because the CB is selling USD or EUR to “buy” their local currency. In order to refill the coffers, central banks have been liquidating their treasury holdings to “pull forward” USD to replenish the drop in FX reserves.

Emerging Market Debt and Flows of USD

We have to consider how an Emerging Market “naturally” brings in USD through trade using a widget moving from Vietnam to the US.

A U.S. company agrees to buy a widget from Vietnam, and since over 80% of international transaction take place in USD- it makes the transaction easier. The Vietnamese company expanded operations and issued USD denominated debt for the expansion While they have to pay interest in USD, they also have to import the raw materials priced in USD while they pay their labor in Dong.

In a normal year, the US companies and other exports pay the Vietnamese company in USD and they are able to cover interest expense as well as raw materials.

As trade slows, the company is no longer taking in USD at the same rate- but they have already ordered raw materials and still have to pay interest expense in USD.

Now the Dong is weakening against the USD, and it’s becoming more expensive to manager their interest expense.

The Vietnamese company is forced to convert Dong into USD in order to cover their imports and interest expense. As other companies face the same struggle- they are actually making the FX exchange worse.

The Vietnamese Central Bank steps in to try to mitigate the cascading monetary issues, and they are forced to liquidate t-bills in order to manage the outflows.

As trade slows, it cascades in emerging markets from the simple company up to the government and central bank. During COVID, every government issued a significant amount of fiscal support along side central bank monetary easing. This has created a ton of slack in the market, which is making the above example much worse.

We can also look at it slightly differently by using a sale of Argentina soybeans to China as an example.

An Argentina farmer agrees to sell soybeans to China

Over 80% of all transactions occur in USD, and the farmer ends up buying fertilizer and seed from the import markets in USD. This means that the Argentine farmer will want USD for the transaction.

The farmer receives his USD, but the price of seed and fertilizer has gone up putting pressure on margins and driving up the cost of his farm.

The farmer borrows money to cover the cost of seed and fertilizer, which causes him to also raise the price of soybeans to customers.

Global governments try to subsidize the rise in food costs but have limitations on the amount they can protect prices.

Local governments get concerned about food availability, and put up “gates” on exports keeping more product in the country

But what happens to the farmer that just bought seed/ fertz in USD at much higher prices, but isn’t allowed to recoup cost in the international markets. He also is subsidized for his cost.

The farmer is also not bringing USD into the country, which helps also support the local economy and banking system.

When we look at the amount of reserves sitting on balance sheets (outside of China and Japan), you can see a huge drown draft that is only going to get pressured further!

Global governments and central banks are dealing with these problems in real time as trade slows and “natural” accumulation of USD dries up. By actively going into the market- they are driving up the price of the dollar as investors bet against their markets and yields drive higher. This limits their ability to borrow and drives up the cost because interest rates surge. This is why you see a massive downshift in “new borrowing” as countries/companies can’t afford to borrow. The adjustment complicates their ability to finance normal operations and roll debt. As companies can no longer “roll debt”, they have to cut CAPEX and labor to afford the principal repayment. This stops the expansion in the country, and puts a huge pivot in economic expansion.

Food inflation is a real problem for large parts of the world, especially the emerging markets where over .80c of every dollar is spent on food.

Even as prices move lower, they are still at historic highs with a lot of staying power given the cost of fertilizer, energy, diesel, and other important input costs. Food and Agriculture World Food Price index increased by just 0.3% year/year (orange) in November, slowest since August 2020 and well off peak of 41% in May 2021.

The affordability index for fertilizer also remains very low as more issues crop up along the availability of product and yield. Farmers have been facing a worsening backdrop as their yields fall, and while this has driven up prices- they are unable to bring in the same level of value.

Global yields have been heading in the wrong direction for years, and we are BELOW the levels that sparked the “Arab Spring”, “Peasant Uprising”, and “Wheat Wars.” The pressure is growing at multiple levels, and this hits Emerging Markets the HARDEST!

The issues expand into water and food issues as major concerns grow across all of them. Water isn’t just an Emerging Market problem BUT the developed world that is facing the water crisis are also key growing regions. As the droughts increase, the yield at the farm level drop off and impact the “available” amount of food that can flow into the market. All of this drives up prices of food (mostly priced in USD) and hits the emerging market community.

Chinese Data Shows More Problems Ahead and a “Soft” Reopening

We also have to talk about the “elephant in the room”- China. There is a ton of hopium cycling around the reopening of China, but when you look at all the data the issues have been building for years. Even when China was “open”, they weren’t able to see a meaningful bump in local activity. This was also when the world was still massively short, but any increase was short lived and met with a quick reversal. Even when you look at 2019 (pre-COVID), the cracks were already forming in the Chinese juggernaut.

Employment has been a huge issue for China as those working has dropped hard, and it’s been in contraction well before COVID.

We also have the “new” advent of near-shoring and on-shoring, which is pulling additional manufacturing out of China. Apple is the most recent:

“On Saturday, the WSJ reported that Apple is accelerating its plan to move production out of China, citing unnamed sources.

The reason: Apple is sick of supply chain disruptions in China.

ICYMI: In the past few months, Foxconn’s Zhengzhou factory – which manufactured about 85% of the iPhone Pro series at its peak – has been nothing short of chaos , largely caused by zero-COVID policy.

Phone production is facing serious delays .

That’s got Apple looking for alternatives:

“[Apple] is telling suppliers to plan more actively for assembling Apple products elsewhere in Asia, particularly India and Vietnam.”

Employment has been a going concern- especially for the youngest cohort. You can see how Europe and the US became worse during COVID, but the issues have been growing for China (white line) since 2019 and has only progressively gotten worse through 21-’22.

Between lockdowns and the real estate crisis, All 31 of China’s provinces ran deficits in their general budgets in 1H, with some 23 provinces recording deficits that were bigger than their full-year shortfalls in 2021, when measured as a percent of GDP. The longer strict containment measures stay in place, the worse the situation will become. This is already on the back of massive deficit spending that China embarked on over the last two years. The sheer leverage backdrop makes any move down exponentially worse.

Unemployment, uncertain economic outlooks, slowing trade, reduced manufacturing- is all resulting in people saving more and reducing their spending. “Income gains have suffered. Increases in real household income slowed to 3.2% year on year over the first three quarters of 2022, less than half the average pace of 6.7% in the five years before the pandemic. Meanwhile, savings rates are climbing again this year -- a sign of economic anxiety that depresses consumer spending and growth.”

A key leading indicator out of China “New Orders” is already showing a pivot lower, and if you look throughout 2019- problems were already cropping up. COVID bottlenecks and stimulus were able to “cover” some of the issues, but as the market returns to a “normal” state- the problems are coming back with vengeance.

It’s hitting all sides of the economy from the manufacturing and the non-manufacturing (service) side of the business.

All of these key pieces are showing a very steady down move in Chinese exports, which we believe is already negative and just going to get worse.

Just rounding out the MAJOR issues in China is the lack of credit growth. Whenever exports have slowed, the PBoC and CCP have driven more debt and “Stimulus” through the infrastructure world. The problem is- the world of spending has been erased by saturated markets. Even though the supply of debt is available- THERE IS NO DEMAND! Many companies and consumers are saddled with massive leverage and falling asset prices. Banks have been directed to lend, but their collateral is falling aggressively in value making their balance sheet weaker. We have been saying from the beginning that the old Chinese playbook for stimulus was going to fall flat- and the below chart is a perfect example of its failure.

“ China Nov credit growth slowed further. No evidence of more relaxed policies on the property market as mortgages weakened further.

Credit impulse remains little impacted, navigating slightly below its neutral level, yet sending a better signal than manufacturing surveys

Even as China tries to pump in more credit- there is no demand for it. The PBoC and CCP are trying to increase stimulus by pushing additional spending through infrastructure and other formats but try as they might- there is no end user demand keeping the money on the sidelines.

The uncertainty around “Zero-Covid Policy” and slowing demand is going to keep companies from investing, borrowing, or hiring. These are huge headwinds for the 2 nd largest economy in the world that already has a leverage ratio of over 350% to GDP.

Investors and “talking heads” will try to tell you that the reopening will change everything, but the issues have been compounding for over a decade. How many ghost cities can be built? How much debt can you layer into the system?

The CCP has been playing the same card since 2006, and now the house of cards is being blown down.

Real estate, manufacturing, and exports are the core drivers of the Chinese economy and each one is failing. The endless cycle of stimulus and infrastructure spending is collapsing, and we don’t see this reversing anytime soon.

Key bellwethers for trade weakened again and remain on a soft path- being led by China and now India. It has reverberated back into key growth regions.

Petrochemical Demand Will Fall Further

As we see a drop in global manufacturing, the demand for plastics and other chemical products inherently drops. We are on the brink of a global recession (many parts of the world are already in one), which will send demand for these key products even lower. When you evaluate a petrochemical company, it’s important to understand their “crack spread” or realistically how they make money and what kind of margin they can achieve. The spread is simple:

The petrochemical facility needs a feedstock to break down and convert into something else

A cracker (the part of a facility that breaks down the hydrocarbon) takes in a mix of products: ethane, propane, butane, iso-butane, light naphtha, heavy naphtha, or gasoil. It “cracks” the hydrocarbon down into other materials that can be converted

The cracking process requires multiple ingredients- feedstock, natural gas, and electricity to create the next step. The cost of these key pieces is very important because as costs rise at the front end- the company needs the price of the end stock to also rise!

We have seen natural gas and electricity prices soar, which should increase the price of the final product.

For example, they produce LDPE (low density polyethylene, which is just a plastic container or squeeze bottle or other molded plastic. They also produce PVC (polyvinyl chloride), which is just the tubes used in the house to run water, electricity, or outline doors/windows.

During COVID, shortages appeared everywhere, and housing took off sending the price of LDPE and PVC skyrocketing. Even as electricity, natural gas, and feedstocks also soared, the chemical companies were able to pass through the additional price and add a significant premium.

Now that supply chains have caught up, manufacturing is falling, and housing is collapsing- the cost of feedstocks are still high but there is NO DEMAND for the end product.

This has caused margins to collapse, and severely impact the ability for the companies to actually generate revenue

We have seen a slew of economic run cuts, which just means that a facility is reducing its operation because it can’t make money. The facilities have to run at a minimum level (usually around 60% utilization) to maintain pressure gradients. Typically, it’s cheaper to have it run at a minimum to cover fixed costs while the company loses money on their variable costs. The shutdown and restart of these facilities is a massive undertaking (and very costly) which is why they just reduce runs instead of “mothballing” them.

On the other side, we have had new facilities come online over the last year that have been under construction for the last 3-5 years. After spending billions, companies are incentivized to “turn them on” even if the market is oversupplied to cover fixed costs.

This is all leading to a market that is saturated with product as the market is just at the beginning of tipping into a recession. Plastic demand is dropping in response as the housing market is getting hit hard around the world shrinking new starts and a key end market for petrochemical companies.

The below charts are just some examples of how deep the margins have fallen.

PVC Proxy

Integrated LDPE proxy

Integrated LLDPE proxy

When you layer in all the crack spreads against the stock price, you can see a massive move higher in stock price that is NOT supported by margins. Instead, margins have dropped off significantly while price has remained very elevated. We expect to see a swift reversal especially as the global economy worsens and housing data continues to disappoint to the downside.

The two best ways to play this is by buying puts on WLK and LYB. Their earnings and guidance were absolutely terrible, and you can see how the street has been taking down estimates while the stock price has moved higher. Westlake is more U.S. based with the largest exposure to housing, while Lyondell has exposure in both the U.S and Europe with exposure to the broad plastics market. LYB’s exposure to Europe and the ongoing natural gas and electricity crisis means the stock price didn’t rally has high as Westlake. But it doesn’t mean that they both won’t collapse- just one has “further to fall” vs the other.

When we look at “oxy-fuels”, which is a key component to combustion- LYB was the beneficiary of a HUGE surge in pricing. As the world slows, the demand is dropping back to the normal range- which creates a tough comp while cutting a cash cow that helped insulate them from a falling plastics market and weak economics in Europe.

When we look at new home sales compared to previous Fed tightening cycles, there is more pain that will last for an extended period of time. We have a historic spread between homes under construction vs completion- which is a problem for petrochemical companies. All of the homes under construction have already put in orders and likely taken delivery of the product they need. The slow down in demand and housing is going to keep those homes on the market and drive down new starts going forward.

Homebuyer demand is collapsing, and it’s reached the lowest level since the start of the 2008 housing crash. We are still in the early innings when it comes to the drop in housing data.

We have expected single family sales dropping like a rock:

The affordability indexes have also gotten hit, which means people won’t be in any hurry to purchase a new home:

When we summarize all the data and look at key metrics for Westlake- things are only getting worse.

We have already covered in great detail the continuing slow down on PMI, global manufacturing and trade, and consumer activity. All of these core pieces are moving in the wrong direction. China has “saved us” in the past, but they are experiencing a real estate crisis that rivals 2008 (and likely worse) which has absolutely destroyed demand in Asia. They have also brought on their own petrochemical capacity that is no longer being consumed in a meaningful way within their borders. Not only is the economy slowing BUT now you have to compete against insanely discounted Chinese product.

“China activity indicators for Nov came in much weaker than expected on Covid-linked restrictions and protests . Too early for easing property measures to have an impact: floor space started remained at 13-year lows and residential demand is back to new cyclical lows.”

“Overall construction activity was unchanged at cyclical lows and 24% below pre-pandemic trend while bottoming out on a y/y basis (-9.3% y/y vs -14.2% in Aug).”

We have industrial production around the world dropping and retail sales- so can we really see a big pick up in plastic demand? Can housing really save us? The last point of strength in manufacturing has been Asia-Ex China, which has moved into contraction in December.

As central banks keep pushing rates higher, world manufacturing is only going to slow further as investments pause and companies struggle to manage balance sheet leverage.

Given the level of debt in the world- central banks can’t afford to slow down their rate hikes to attempt to pull liquidity from the system and manage inflation.

We have also never had a coordinated increase in global rates to this level any time in our history. We are going to see way more pain across the board impacting plastic and housing demand.