U.S. completion activity continues to trend higher as smaller basins start seeing some seasonally normal increases in activity. There is normally a pick-up in activity as we get to the back-half of June. We usually see a bit of a slowdown as companies move spreads into position to make the summer push. There were also some weather issues when you look at significant heatwaves limiting the running time of spreads. The southern heat also pulls in a bit more horsepower as companies try to balance activity so as not to overwhelm the equipment. Normally, we see a pick-up in the smaller basins until we get to the end of July with another increase at the end of Sept into October. On a seasonal basis, it’s also normal to see the Williston pick-up some activity in the summer months before we get a steady drop as we head into November.
There was another drop in the rig count, but this will be the cycle low on the horizontal rig front. We could get some additional reductions on vertical rigs in the near term, but we should start to see HZ rigs moving back into the market. Directional rigs have also seen a bit more activity, which could be because costs have fallen and it’s easier to use them as “Vertical” rigs. This is likely a precursor to seeing a small pick-up in horizontal activity. We don’t expect a big surge in rig activity, but we are much closer to the bottom as more activity picks up into the summer months.
We see crude remaining range bound with Brent’s low being between $72-$73 with the upward bound $77-$78. The goal for OPEC+ remains the $75-$76 target, which is likely as pressure remains on global economics and key growth markets.
Driving demand remains lackluster in Asia even with the Eid holiday. North America had a small bump following the Juneteenth holiday, but we have now moved into a “lull point” ahead of the 4th of July week. There should be a bit more of a drift lower as people slow activity, but we will get a nice seasonal jump in two weeks that will market the core of driving season. It’s typically July 4th weekend through August 15th that will market the peak. We expect total demand to underperform by about 8%-10% against historical norms. So far, the data has continued to confirm our underlying views of the broader market.
China is benefiting from a bump driven by the Dragon Boat festival that kicked off this Thursday. We expect the driving levels to fall back to 2022 levels and hold in those areas as we head into the summer months.
We have started to see a slowdown in Chinese physical crude purchases, which is what normally happens at the end of June. Typically, the slowest period of Chinese physical buying is end of June through end of July. While this is occurring, it is happening from a VERY elevated level as China takes advantage of discounted Russian and Iranian barrels.
“Flows into stockpiles are the largely ignored but potentially vital cog in #China’s #crude market. May was significant, with 1.77 million bpd added to inventories, the most in almost 3 years. Inventory builds exceed import gains so far in 2023.”
We are seeing a large amount of crude heading into storage as refiner run rates hold well below seasonal norms. This is pushing more products into the global markets and will result in additional builds across Asia and the Middle East.
Here is a fun chart showing the increase of Chinese imports from Malaysia… I mean Iran- HA. China loves to classify Iranian crude as “Malaysian.”
As run rates for Chinese refiners stay low, we will see a balancing of product vs crude play out.
This will keep exports elevated for diesel (1st chart) and gasoline (2nd). We expect the gasoline exports to continue to outperform diesel at this point in time.
This is all happening as a record amount of crude is on the water with a 2023 high for crude oil in transit. Floating storage is also setting seasonal records (only 2016 was higher) as more crude is pushed into the global market. Russia is trying to maintain underlying flows while Iran increases their volumes.
Global Crude Oil on Water
We have also started to see some slowdowns in physical crude pricing- especially from Nigeria. “A glut of unsold Nigerian oil has built up again with as much as half of output due to be loaded next month still searching for buyers after the nation’s tax clawback dented market confidence.” “The surplus is a sign that global reductions in oil supply from leading producer nations is yet to tighten every market. There are between 20 and 22 cargoes that remain unsold for July, about half the total, according to the traders of West African crude.” While there is some political risk with Nigeria, if the market was tight- this would be overcome. The lack of urgency and growing contango is going to keep people on the sidelines.
PLATTS:
- Vitol offered 950k bbl of Nigeria’s Escravos for July 1-10 arrival at Dated Brent +$4.25/bbl, CFR Rotterdam/Augusta
- Cargo to be unloaded from Suezmax Seaways Montauk
- Declined from +$4.55/bbl on June 20
This is a sizeable drop with pricing starting at $4.60, and the pace of the reduced price has accelerated.
The general speed of physical sales isn’t showing a tight market, but there is still some pricing strength in medium/heavy vs light sweet. We don’t see that adjusting in the near term.
In this week’s econ show, we discussed why the Fed will likely raise rates another one or two times and put us between 5.25%-5.5% on the Fed funds rates. We have been saying (for years now) that the pace of disinflation was going to be MUCH slower than expected given the amount of liquidity sloshing around in the world (let alone just the U.S.). I think the below chart does a great job putting into context the issues we have seen with estimates, and the failures of economists and the Fed to predict the stickiness in the market. We were very consistent in saying the spike across the inflation spectrum was way more than just supply side issues.
It’s also important to note that this is by no means something unique to the U.S. On a global basis (especially in the developed world), core inflation remains elevated and is actually turning higher on average in the G7. This is going to keep central banks- and yes the Fed- pushing rates higher and keep rates elevated for much longer than the market expects. At this point, I think it’s a fair assessment to say that a bigger surprise to the market will be rates staying higher for longer vs another one or two rate hikes.
I think it’s funny when you look at the Fed balance sheet and remember that we were supposed to reduce the balance sheet. If you remember, Bernanke had a 2010 target of under $1Trillion… do we call that chart a “small” swing and a miss?
The biggest question mark is always- when does the consumer give way? When you look at all the data- credit cards, shopping numbers, retail sales, travel… we continue to see momentum loss and underlying reductions. When you finally layer in bank loans to consumers, you can see the anchor is in place and will pull us lower over the next few months. We made the call that the consumer peaked in March, and so far, we have seen data that only confirms that trajectory.
The U.S. posted more negative leading indicators when we evaluate some key data samples. “May marked 14 consecutive monthly contractions for Leading Economic Index (LEI) from Conference Board … a streak only seen in recessions that started in 1973 and 2007.”
It’s also important to look at leading indicators relative to coincident indicators. Historically, ratio has given reliable signals for peaks and troughs in cycles; and as of now, leaders continue to lag at significant pace.
We had some more negative flash PMI data with softness creeping further into services and manufacturing moved deeper into contraction. “June SPGlobal U.S. Manufacturing PMI fell to 46.3 vs. 48.5 est. & 48.4 prior; Services PMI down to 54.1 vs. 54 est. & 54.9 prior … Composite (chart) down to 53 vs. 53.5 est. & 54.3 prior.”
This was all capped with additional slowdowns in the existing one family home sales that have moved further into contraction. As we highlighted in the Econ show, we expect that to move down further as pressure grows on single-family homes and multi-family units come to market. This will bring rents down further and push people to rent instead of buying.
The below chart puts into perspective the amount of 5 units or more buildings under construction. We took out the 1973 highs.
As these units come online, it will help pull down rents further and pull people away from buying homes as mortgage rates hold over 6% and rents drift further down. The costs of building have fallen, but they are still well above average. The reduction has enabled some construction to commence, but many of them are on the multi-unit side. As they come online, we expect to see the rents fall faster.
A large part of homeowners also have very favorable mortgages- so why move if you will sell a home at a reduced price while still “overpaying” with a mortgage rate that will likely double. This will keep homeowners locked into their current residence and maintain a low level of inventory in the market. Data from Redfin show roughly 4 in 5 homeowners with mortgages have an interest rate below 5%; nearly 1 in 5 have rate below 3% … 80% of likely home sellers say they would feel more urgency to sell if rates were to drop to 3% or lower.”
The market is consistently overestimating Chinese growth, and we have started to see banks reducing their estimates for GDP growth.
- Bank of America downgraded GDP forecast from 6.3% to 5.7%
- JPM cut from 5.9% to 5%
- UBS reduced from 5.7% to 5.2%
- Standard Chartered slashed from 7% to 5.8%
- Nomura 5.5% to 5.1%
- Citi cut from 6.1% to 5.5%
We have consistently said that China will grow between 3%-3.5% based on the current trajectory in the underlying data. Our view was that the bounce from the end of Zero Covid Policy would quickly evaporate and give way to a much broader slowdown as the global economic slowdown bites hard. China is the largest manufacturer in the world and relies heavily on the international market. Within China, the local economy was already struggling under the massive debt load and underlying pressure from a broken housing/ real estate market.
It was always interesting to hear economists and “China Watchers” talk about the strength of the Chinese economy, yet in the same breath talk about stimulus from the CCP and PBoC. Why would you look to stimulate a strong economy? We have said that the Chinese economy won’t respond well to any form of stimulus because of the law of diminishing returns. The CCP has been cutting taxes for over a decade, and the PBoC has been consistently cutting rates along the same time frame. Without any “tightening”, the ability to stimulate using the same tools diminishes to zero. A quick definition of the Law of Diminishing Returns- benefits gained from stimulus will represent a proportionally smaller gain as more money is invested in it. Said another way- a “new dollar” will have a smaller impact “util” and will require a large amount of money to have the same impact over time. This occurs until every new dollar actually has a negative util- or a negative impact on the economy. This can come by way of inflation, debt loads, underlying leverage- there are many ways this can begin to have detrimental impacts.
One of the ways China tried to bump GDP was to push money into infrastructure projects by way of LGFVs (Local Government Finance Vehicles). The amount of debt sitting at the local government is now MASSIVE with a growing interest expense burden that is getting squeezed further with diminished tax revenue and faltering land sales. Another big concern for the PBoC and CCP is the large amount of this debt that sits “off balance sheet.” There were a significant number of loopholes that exist allowing the governments to issue this debt without having to recognize it on their balance sheets. “There are more than 3,000 individual administrative units in China, with 31 provinces, 333 cities and almost 3,000 counties. Many of them use companies called ‘local government financing vehicles’ to borrow money to pay for infrastructure and other services that can’t be paid for from their official budgets. The companies are controlled by the local authorities but are not officially part of the government, so their debts don’t appear on official balance sheets, making local finances appear to be in better shape than they really are.”
The CCP has launched an audit program across all the provinces in an attempt to calculate the “real” debt burden. The “official” debt to GDP ratio for China hit about 280%. We have said for a VERY long time it is well above this reported number, and the LGFV and SPB (Special Purpose Bonds) are the fundamental reasons on why. “The central government officially denies that government is responsible for these debts, but investors and banks lend to the LGFVs at low interest rates because it is assumed that local authorities will not let any of them fail but will eventually repay their debts.”
China is a communist country and in theory the CCP will be responsible for the debt. But, being a communist country they could easily just say NOPE and let the debt default. The problem is the sheer size, and the contagion risk it creates to banks, consumers, and international markets. The sheer number has exploded over the last few years as the CCP supported writing this debt to prop up economic growth.
Outside of just the interest expense, there is a large number of LGFVs that are maturing with the principal being returned to the lender. This means that the government will either have to pay back the debt or find a way to refinance what is expiring. Many of these loans are written against projects as the collateral- so as activity dwindles- do they “create” projects to borrow against? Does the CCP or Provincial government step in and assume the debt? The chart below helps to put in perspective the problems local governments have in regard to revenue. We don’t see the land/real estate market improving anytime soon, and with the CCP talking about MORE tax cuts and rebates- there will be additional pressure on tax revenue.
Outside of just the tax cuts, the Chinese economy has been shrinking with rising unemployment and companies leaving or at least reducing investment. This is another hit to the underlying flow of money to government entities.
The below chart puts into perspective just how underwater some of this debt is when it comes to cash flow. The initial infrastructure projects from around 2011-2017/2018 were good projects that were required and generated sufficient revenue. As the CCP and local governments kept going back to the same playbook- the project quality faltered. Our view has been that the multiplier effect was now well below 1 and something closer to .86-.88. This just means that for every $1 invested it only yields $.86 in growth, which doesn’t cover interest- let alone principal.
Here is a great summary from Bloomberg on the situation. It gives you an idea of how long this has been happening, and why this was a MASSIVE issue before we even knew how to spell the term “COVID.” It’s important to remember that these are also just estimates, so the actual numbers are likely larger than what is being expected.
“Ministry of Finance data showed governments across China had 37 trillion yuan ($5.1 trillion) in on-book debt outstanding at the end of April, but there is no official total for how much hidden debt there is and who owes it.
The International Monetary Fund estimated in February that nationwide there was 66 trillion yuan of LGFV hidden debt at the end of 2022, up from 40 trillion yuan in 2019, with that quick increase underscoring how local governments ramped up off-book borrowing and spending during the pandemic to support their local economies.
China has already conducted several audits of local debt over the past decade. After a 2013 audit, Beijing banned local authorities from borrowing except through the sale of official bonds, and then in 2015 launched a campaign to swap local governments’ off-balance-sheet debt for bonds.
The Ministry of Finance more recently allowed some regions to issue bonds to repay LGFV borrowings in an attempt to eliminate the remaining hidden debt, after another round of checks in 2018. Guangdong province became the first to claim it had successfully done so in 2021. Other LGFVs have been allowed to renegotiate their loans, including one in Guizhou province agreeing with its banks in December last year to extend its loans for two decades.
This new audit of local government debt risks comes just as China’s economic recovery is losing momentum. The real estate sector shows no sign of rebounding, global demand for Chinese goods and domestic consumption are both weakening, and local authorities’ ability to spur growth with infrastructure spending has been limited by their massive debt stockpile and falling income.”
China is claiming they will make available MORE debt to companies, but they said the same thing the last few years and corporations aren’t taking any additional. The debt loads have already been climbing in the small business realm. Some investors think this number “isn’t meaningful”, but the SOEs don’t employee all the country.
SOE’s employee anywhere between 55-57M people in a country with a population of about 1.4B. Anyone who thinks private businesses don’t matter in China isn’t very good at math. These organizations don’t have the capacity to keep borrowing based on their current leverage ratios and rising delinquencies.
The PBoC has begun cutting rates- but this has been a consistent theme going back to 2018.
“China is ramping up policy stimulus to boost its faltering economy, although soaring debt levels and concerns about financial stability mean the measures are likely to be limited compared with support packages in previous downturns. The People’s Bank of China unexpectedly cut a series of different policy interest rates on Tuesday, paving the way to lower the key lending rate which will be announced on Thursday. After reducing a key short term interest rate that heavily influences interbank liquidity early on Tuesday, the central bank then cut the higher rates which are seen as the ceiling of the corridor, adding to expectations of more easing. In addition to these monetary policy actions, officials are considering a broad package of stimulus proposals, which include support for areas such as real estate and domestic demand, according to people familiar with the matter.”
The problem on “additional monetary policy actions” comes down to the Law of Diminishing returns. How much additional stimulus can the market bear and at what size is needed to make a meaningful impact? Have we reached a point of diminishing returns? I think the PBoC is just trying to keep things from getting worse rather than trying to actually drive growth. The PBoC is also fighting a rising tide when you look at global rates and a slowing global economy. “PBOC Governor Yi Gang last week hinted at more policy flexibility, vowing to step up “counter-cyclical adjustments” — a shift in language that some analysts said signaled more easing. He also pledged to “make all efforts to support the real economy” as the recovery in demand has lagged that of supply. The timing of the central bank’s rate cuts may have also been motivated by the US Federal Reserve’s policy decision this week. The Fed is likely to pause its rate hikes, which would help ease pressure on the yuan. The Chinese currency has weakened 3.6% against the dollar this year, making it one of the worst performing Asian currencies.”
The PBoC will try to keep renminbi values lower to help push more exports and compete with South Korea and Japan. They are seeing a broader slowdown in bond/loan demand and will try to manage it. We have discussed the PBoC trying to manage credit impulses and trying to maintain the 12-month just below or right at zero. “China’s credit growth has dropped back sharply following the initial re-opening boost, with the three-month credit impulse turning deeply negative again in May (data are seasonally adjusted but volatile nonetheless).”
When we look at some of the varying data points, you can see that loans and social financing hasn’t really recovered from the COVID drop.
The slowing bond market growth helps to drive home the difference between the government and public sectors. The SOEs have the flexibility to take new loans and roll the debt due to their favored stance with the federal government.
When we look at the aggregate of the borrowing data, you can see how no matter how you look at it- demand for new debt is diminishing. Just because it’s offered- doesn’t mean that people will take it.
We expect to see the cumulative financing weaken as demand for new debt slows. The New Loans is showing the underwhelming levels that we see being consistent over the next few months.
A significant amount of pivotal GDP growth pieces is slowing at a much quicker pace. Chinese exports have slipped further with additional pressure likely based on other bellwethers in the region.
An important point of interest will be the current foreign exchange reserves. A number that is important for the market is $3T, which has been looked at as a very important line in the sand.
Another important and politically sensitive point is the rising youth unemployment. China claims that total unemployment is only 5%, but we believe it’s likely trending a bit higher given recent (non-government surveys).
So, we have employment lackluster and the “key” driver of previous LGFV and SPBs is faltering.
It’s important to look at the pace of the slowdown from April into May, because we don’t see a meaningful pivot higher from this point. “Chinese activity data for May confirm April’s loss of momentum, driven by construction activity The supply of residential space fell further to its lowest level since Nov 2008, while rising residential demand, barely visible on the chart, remains at its cyclical low.” The below highlights how the issues haven’t improved much in the building market. It has bottomed, but we don’t see much momentum higher- at least in 2023- given the losses many consumers took over the last 2.5 years.
“Property investment in China fell at a faster pace in Jan-May 2023, dropping 7.2% from the same period a year earlier. New construction starts measured by floor area fell 22.6% and property sales by floor area declined 0.9% vs. 0.4% fall in the first 4mo.”
Our view has been that Chinese retail sales were going to just move sides once we had the final “bounce” following the end of the COVID zero policy. “After a strong rebound in Q1 (>40% q/q ann), retail sales remained unchanged over 2 months and more than 10% below trend. The slight rebound in May (+0.2% m/m) came from a recovery in car sales (>6% m/m).” We don’t expect much recovery in the retail sales space, which is a cause for concern. Xi has spent years trying to drive home the importance of the “Dual Circulation Strategy” and “Common Prosperity”. They have all failed to materialize in a meaningful way to help adjust the heavy reliance of international players. This can come by way of FDI, exports, and other foreign influence. Xi has wanted to increase the purchasing of “Made in China” products and drive-up local consumption. It’s why we look so closely at retail sales because the increases have come with SIGNIFICANT federal support.
Fixed assets investments lost 2.1% on the month, falling further below its long-term trend and driven by all its main components, notably manufacturing.
This is an issue when you factor in the broad slowdown on FDI.
While manufacturing and sales are showing a bigger move lower- especially when you factor in sales growth and other leading indicators.
The side of the economy that was holding in some strength was the service sector, which is a similar story around the world. Unfortunately, these areas are also showing a general break lower with additional momentum to the downside.
This is why the move for China to “go back to” the infrastructure spending is going to be really hard to drive growth. It was used so aggressively for years. The benefits have already dwindled to the point that every new dollar into the market is showing a negative multiplier. On the otherside, “real estate, which recorded its sharpest contraction (-21.4% y/y) since the inception of the series, and infrastructure, whose spending growth continues to shrink in the absence of an expansive fiscal policy.”
When you piece all of these together, you see a real miss in the underlying strength of GDP growth. As we have been saying, it’s not that growth collapses- but rather just stays much lower vs expectations. “The combination of retail sales and fixed investment (proxy for private demand) for April and May points to a first GDP growth figure for Q2 at 2.8% q/q ann, still not a catastrophe but a sharp drop in momentum compared to Q1 (>10%).”
China’s property market is in a bad shape: residential demand is back at the bottom of the cycle and households are no longer applying for mortgages. However, we may not be far from a cycle trough when we look at the main determinants of household mortgage demand. We may very well be at the cycle lows, but it doesn’t mean we need to see a strong bounce. We believe that China will bounce around at the cyclical lows as consumers struggle and structural issues remain on the deb and leverage ratios. We don’t believe a drop in mortgage rates will drive things much higher as demand continues to weaken from a consumer perspective especially without any government support. There is no easy way out of this mess…
