Primary Vision Insights – July 20th, 2020

By Mark Rossano

Summary

U.S. Fracking/ Production/ Refining Round-Up Crude Demand Estimates Coming Down OPEC+ Meeting Wrap-up Export and Floating Storage Summary Quick Review of Russian Flow Summary of Saudi Arabia Refined Product Demand Overview Review of Exports/Imports Our Favorite Topic China Global Economic Data Review of Some U.S. Statistics Geo-Political Summary Quick Talk on Food Inflation

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U.S. Fracking/ Production/ Refining Round-Up

The U.S frac spread count remains range bound with a rolling 4-week average sitting at about 72. The 4-week average will start to shift higher as we head into Aug and reach a normalized number closer to 75 as we activity comes back into Texas and remains relatively flat at these levels in natural gas basins. The national count will likely average between 65-85 over the remainder of July and well into August. The Permian will start to see an increase this week as the decline in activity has finally bottomed and marketed- working spreads have started to rise in the region. There will be slow additions through July, but August should see a sustainable increase in Permian completion crews. The natural gas areas have seen some decline in activity, and given the current pricing environment and growth in natural gas production from associated gas, it will be difficult to see additional activity coming from areas such as Appalachia, Haynesville, and Oklahoma dry gas.

With realized crude prices firmly in the $40-$42 range, E&Ps will start to ramp some activity in areas to capture the best pricing as reflected below- which doesn’t always necessarily correlate directly to the spot prices. It is a huge component, but there are other inputs that also matter, such as takeaway, hydrocarbon mix, and end user (refiner or export). This will help not only ensure consistent demand, but also support pricing metrics. E&Ps are also facing the daunting task of arresting the shale decline curve. After several months of limited new completions and shut-ins, companies will have to start finding ways to bridge some of the decline or 2021 will be a very difficult year. I am not discussing production growth, just ways to minimize the declines as we head into the second half of the year. In order to achieve U.S. production growth, it would require something closer to +/- 150 active spreads. This is not something achievable in the current environment, so getting back to about 80-85 completion crews will be enough to stem the declines for 2020- but at these levels decline curves accelerate in 2021. This is going to be a focal point for us over the coming month to really tighten up the figures to understand- “where do we achieve flat growth (cover the decline curve) and at what point do we start to see production growth.” I believe the 13.1M or so barrels a day isn’t something attainable in the next few years- but given the fact the world is oversupplied light/sweet crude- there is no need for this level of U.S. production. The new refiners coming online in the ME/ Asia all have coking capacity and other processes that require a net heavier blend to properly function. Many of these facilities were started in 2014-2016 when heavy-sour was still trading at a steep discount, and now as facilities start to become operational- they will require a heavier mix- similar to our GoM (PADD 3 refiners). PADD 3 runs typically average 33-34.5 API and the new facilities are something similar. Now the facilities are investing in new processes to adjust this figure lower- but that takes time and capital- and in a COVID world that work has slowed considerably.

U.S. production currently sits at about 10.8M barrels a day, and by the end of Aug will have reached about 11M barrels. This will be driven by shut-ins close to fully reversed, and some new production coming online across Texas. North Dakota (Bakken) should see relatively stable production, but growth will be difficult-especially with the unknown outcome of the Dakota Access Pipeline (DAPL). One judge initially mandated the pipeline had to seize operation by Aug 5 th , but another judge overruled the mandate and will allow it to operate while it lives in the court system. Once we factor in shut-ins and lack of new completions, there is enough pipe and rail capacity to meet current demands- it may not be the most efficient (will cost more to transport causing the differential to widen) but product will be able to move.

Crude prices will remain range bound with WTI Cushing having a ceiling of about $41 and a floor of $39. OPEC has come out and announced they will begin raising production- but in Aug/Sept most of the new production in the Middle East will be consumed for local demand (Summer burn). With COVID weighing in the region, does this reduce industrial demand and put a bit more vs seasonal norm on the water- most likely. But in my opinion, it will not be a huge additional quantity- though it will allow them to keep exports flat instead of seeing an Aug decline. We believe that the LLS and Brent spread will remain within a $1 over the next 2 weeks, and the futures market will continue to ignore the physical market weakening fundamentals. Offshore storage builds, weak refining demand, and rising supply are coming at a time when crude demand is plateauing or rolling over in key oil demand regions. With that being said, the stable export market from the U.S. driven by competitive pricing due to elevated OSPs, will keep Texas crude flowing and support additional fracking activity.

Crude Demand Estimates Coming Down

Angola was supposed to cut their flow through Sept, but they have now announced an INCREASE from Aug to Sept of about 200k barrels a day. The U.S. was given a gift with KSA and others increasing OSPs (Official Selling Prices), which help support our exports into the market- especially Europe. Crude demand remains about 10-15% below normal, and when we factor in the terrible crack spreads around the world- refinery runs aren’t going to be increasing any time soon. We have already seen countries/companies reactivate post lockdown, which has driven the bounce off the lows (expected)- but closing the remaining gap will be near impossible as COVID cases rise and industrial production/exports remain well off seasonal norms. Estimates for Q3 have finally started to come down for crude demand, which is driven by the large amount of refined product in storage, sticky non-OPEC production (Brazil reached a milestone of 680K barrels a day from a platform and remain near all time highs), KSA/Russia keep refined product exports flowing, and refined product demand faces more hurdles.

Based on the chart above- driving demand just isn’t returning to the levels people assume- we have been consistent that the U.S. would average about 8.5M barrels a day of gasoline demand through the summer. This is well below peak driving season norms, and this puts us in a precarious position as we head into shoulder season. Here are some rough estimates on global refining crack spreads:

We can show you FCC/ hydrocracking/ hydro skimming/ Vacuum/ thermal Cracking/ topping- all of the margins are either negative or slightly positive but below $1. Refiners are struggling to just breakeven, and the rise in oil prices is doing NOTHING to help the situation as feedstock costs remain elevated given where the fundamental market sits for refined products. The South Korea margins also come at a time when: “Average run rates so far in July are ~85-90% of capacity, compared with 80-85% in June, said two of the traders; the other two traders declined to give estimates but said runs had increased slightly.” The rise in activity will help work off some of the floating storage in Asia, especially as they buy some spare cargoes from China- “Some Korean companies bought some of the re-sold cargoes floating off China, while two Korean refiners purchased Oman crude from INE’s depots in China on separate occasions.” These are all positive data points, but as we exit summer demand- the market faces a very oversupplied refined product market heading into shoulder season.

The reason we keep talking about “shoulder season”- which is a period of reduced demand as heating hasn’t started yet and driving demand slows- is driven by the fact oil demand normally drops during this period. Refiners typically go into their turnaround season, which is a problem because they purchase less crude. The way the physical market works- crude is sold 6- 8 weeks in advance- so refiners around the world have already purchased their oil needs for the remainder of summer. So the increases in OPEC+ production in Aug (keeping exports stable as the increase in oil is consumed locally and exports can be flat to slightly up) will not be absorbed fully in the market and lead to an overhang and not the desired shortfalls the market is predicting.

China has remained a big buyer through June and part of July- which we knew, but they are also slow steaming the oil to reduce some of the bottlenecks at the coast. I will go into more detail on this later, but China is testing imports aggressively for COVID- which has created a substantial bottleneck at the coast. So the crude currently in transit will be deemed “floating storage” when it shows up and will keep Asian floating storage at record breaking highs.

OPEC+ Meeting Wrap-up

The OPEC+ meeting is now behind us, and we got exactly what was telegraphed to the market- a roll back of cuts from 9.7M to 7.7M barrels a day. In order to soften the blow, OPEC+ agreed to “penalize” the cheaters by making them maintain cuts longer through Aug and Sept. This includes Nigeria, Iraq, Angola, and Kazakhstan. The total expected cut for Aug is 8.1M barrels a day- so about 400k barrels that will carry over from July. There is supposed to be about 842k barrels a day that has to be made up in cheating with Iraq cutting 174k barrels a day and Nigeria about 68k barrels a day in Aug. Angola was “supposed” to also cut, but they have now increased their Sept runs by about 200k barrels a day to 1.31M barrels.

Angola Loading Schedule Through August

The total cuts for August should be about 326k barrels a day by the cheating parties. July, August, and Sept are also periods when Saudi (and other ME nations) consume more oil locally as electricity demand spikes for the heat of summer. If we look back through seasonal flows, this is normally a period that KSA oil exports dip as more crude is consumed within the Kingdom. This will limit some of the additional exports into the market as additional crude is preserved for domestic burn. Exports will remain around the seasonal trend as Aug is usually a slower month, but we have seen Saudi maintain relatively stable flow outside of the spike at the beginning of the year. The unknown will be how far below normal burns will we see driven by COVID slowdowns within the Kingdom. At the moment, we believe it will be nominal- but something to track over the next few months. We have already seen an increase in floating storage, which has moved back to seasonal averages and if that begins to rise would be a great indication of reduced demand within the kingdom as it becomes slated for sale. The below chart shows the typical seasonal adjustments for oil exports, and in a normal world Saudi raises production during this time to cover their personal consumption. So the timing of the increase is seasonally expected, and it enables them to maintain consistent exports- which will move back closer to seasonal norms in July/Aug.

Export and Floating Storage Summary

It is hard to say for sure how the cheaters will handle the additional cuts, because based on loading schedules- Nigeria and Angola has already indicator higher (as shown above). When considering how each country handles the reduction, we need to consider exports and not just production and given the deferrals/ storage- there can be a cut and either flat to slightly down exports. The Middle East floating storage picture is back to 2020 highs but holding around the 5-year average- once you back out the 2016 surge. The trend will be something to watch over the next several weeks as Asian/U.S buying slows down as refiners prepare for shoulder season. Iraq so far has seen a decline in July: “Total exports dipped to 3.22m b/d during the first 15 days of July, compared with a revised average of 3.27m during the whole month of June, according to tanker-tracking and port-agent data compiled by Bloomberg.” The target level from May-July production was 3.592M barrels a day, and the country only achieved cut to 4.21M in May and 3.91 in June. In theory, this will be made up through July (which so far is happening) and Aug/Sept- I remain skeptical. It is important to separate production vs exports, and even as promises of commitments to a production cut through Sept is approved- exports can still remain flat if domestic demand falls or if term buyers opt to not take allotted flow. Iraq cut allotments to several buyers, and funny enough someone didn’t even want it: “Of the three refiners which had their term supplies cut, one didn’t request any cargoes; another did request some shipments but failed to get any allocations.”

Middle East Floating Storage

The demand levels in the market vary wildly, and it is getting worse with inconsistencies across crude grades available in the market. Heavy Sour and in general heavy crudes are harder to come by, which is leading to premiums across some blends. It comes down to- what type of refiner is looking to ramp up (what process is available), what kind of product is the target, and what kind of crude/refined product do they have in storage. The cuts from OPEC+ have created an odd mix in the physical market with premiums shifting and given the pervasive issue- it won’t be fixed/arbitraged away. This leads us to Nigeria and general west Africa storage. Nigeria is also supposed to cut production but given the current market for the region- those cuts appear to be needed regardless of the OPEC+ agreement. Demand for West African crude has fallen- driven by limited demand in North America and a slowing of Chinese purchases. “Two West African grades -- Angola’s Cabinda, and the Republic of the Congo’s Djeno -- were both offered at lower premiums than recent weeks amid what traders said has been an apparent slowdown in Chinese buying. Indian Oil Corp. bought two cargoes from Vitol.” These specific blends typically flow into China, and with China sitting on a record amount of oil and refined product in storage- demand has slowed considerably as refinery runs pull back. VLCCs signaling China remain elevated (as talked about above), but this is crude that was already purchased and slow steaming into the area. Current, crude offerings have been slow to fill, and this will lead to more deferrals in the market, but with floating storage pushing towards new highs- production will have to be walked back. These competing issues will keep Nigeria and Angola in check per the agreement, but it is really market forces making them “compliant.” So as Angola does an about face and increases Sept by 200k barrels- we will have to see how OPEC+ responds.

West Africa Floating Storage

Quick Review of Russian Flow

The Chinese market remains flooded with crude and new purchases are already falling across all blends. Urals were flowing at a healthy clip into the Asian markets, but has fallen off a cliff so far through July. China is having bottleneck issues at the dock (which we will discuss further later) that is also hindering the offloading of crude from offshore storage. The issues in China are reverberating through West Africa as well, and the limitations in the physical market have yet to show up in the futures world. Refiners in the region are rolling back runs due to limited storage space and already crowded offshore space.

Russia has already stated they will increase output by 400k barrels a day in Aug, and based on the export data, the country has been doing a relatively strong job of maintaining compliance. We have discussed numerous times the loading schedules, and here is another look from Kpler on the total amounts falling significantly over the last 3 months.

While some of this was offset with refined product exports, the drop in production was meaningful, and based on current loadings and commentary- Russia will be back to about 3.1M barrels a day in exports for Aug. The below chart doesn’t reflect all of Aug- so it will keep moving higher as more allotments are sold and reported. We can expect to be above July by about 400k+ barrels even as some of their refiners come back online. Refining in some areas have also been relying on more semi-refined oil so help improve some margin while also adjusting the targeted product. The other problem remains with overall refining margins as Urals continue to yield a steeply negative margin:

The issues above have limited the term buying of Urals in the European market, and Russia has responded by reducing some flow into that region. This will put more crude on the water heading to Asia as well as filling up local refiners that are slowly coming back to life. Russia has started to increase their refinery runs, but they remain off seasonal norms- even as refined product exports stay at seasonally adjusted all time highs. “

Rosstat in Moscow reports Russia gasoline production in week through July 12 rises 2.6% w/w versus 1.5% w/w a week earlier.

Russia produced 807.9 thousand tonnes of gasoline in week through July 12 Production of diesel was 1456 thousand tonnes, which is -2.2% w/w”

Russia Crude Loadings

Summary of Saudi Arabia

Saudi Arabia increased OSPs (Official Selling Prices) across regions/ crude grades, but the views in the market were a bit mixed as they increased below expectations. The rise puts it just above the 20-year average but given the remaining weakness in refined product demand refining margins will stay weak. “In addition to the strengthening of prices for Dubai and Oman crude, the weighted average of Singapore hydrocracker refining margins (based on Oman crude), strengthened by $3.63/bbl from May to an average of negative $1.71/bbl in June. Singapore refining margins serve as a benchmark for the broader Asia-Pacific region.” The comments are just interesting given that most refiners are still losing money for every barrel turned into product, and while they are now losing “less” money- it is still at a net loss. This also comes at a time when we are now past peak summer driving/travel season, and now seasonality will impact demand structures. Coastal storage is already rising in key buyer markets, which is showing a slowdown in key markets.

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

Saudi has also remained active in keeping petroleum products flowing into the market:

Even during the cuts, Saudi was able to keep (and increase) the flow of clean products into the market. This is another key aspect that has been an overhang in the market, the amount of refined products that are sitting in onshore/offshore storage. Offshore products have fallen about 40% on average (depending on product varies), but it is still elevated in monitored locations. Japan and Fujairah have seen steady declines while the U.S/ Europe/ Singapore have been a mixed bag. Today- Singapore had a small draw, but is still sitting at seasonally adjusted all time highs.

Total Singapore Refined Product Storage

Europe Storage (net small draw)

Refined Product Demand Overview Review of Exports/Imports

The oversupply in the refined product market is a huge overhang on pricing and will act as a hurdle for price appreciation in the market. Exports have recovered in China with more being sent into the floating market as Asia remains awash with product. The bright spot is the reduction in flow into Europe as India has come back from the COVID lockdown. Demand won’t get back to pre-COVID levels, but we are seeing a steady increase in demand across all products- especially diesel. So even as China increases exports- it is being absorbed (for now) in the Asian arena. This provides an opportunity for U.S. distillate to move into the European markets as we see some demand recovery in France and Germany.

We have been talking about a rising amount of Gulf of Mexico storage as shipments transition from being deemed “oil in transit” to “floating storage.” Many of these cargoes were taking the long way to the gulf and slow steaming to minimize the time in storage. The Gulf is now only 135k barrels below the peak seen when the Saudi armada reached our coast. The transition from offshore to onshore storage will hinder draws that should be elevated through the remainder of the summer. The rise in COVID cases across high mileage areas will limit demand and keep refining activity depressed across the U.S.

The slowdown in trade and intermodal remains a problem for distillate as shipping/rail demand remains well off y/y rates. Rail freight remains about 15.8% below 2019 on a cumulative basis, with key industrial bellwethers remaining well off an already challenged 2019. The Port of Long Beach on Friday reported that 602,180 TEU was moved across its docks in June, making for an 11.1% decline compared to June 2019. Imports shrank 9.3% to 300,714 TEUs, exports dropped 12.2% to 117,538 TEUs, and empty containers shipped overseas to Asia were down 13.1% to 183,928 TEUs. [1] The movement of tonnage through the ports remains well off 2019 as issues from COVID and the global slowdown remains an overhang. U.S. imports/exports remain well below 2019 (especially exports) as the global market stays in contraction. Rail movements struggle across the U.S. as intermodal levels are depressed due to the supply chain still relying heavily on trucking. Trucking capacity in the market will be elevated driven by competitive pricing and shipment sizing small enough to make road transport preferable or at least economically viable. The reduced tonnage of movements also points to the limited demand at the industrial (raw material) and consumer level (finished good).

https://www.aar.org/wp-content/uploads/2020/07/2020-07-08-railtraffic.pdf

The only area seeing some expansion is in the trucking region with more product being moved on roads. Trucking was taking market share from rail last year due to overcapacity that resulted in aggressive pricing. Trucking offers mobility options that are obvious, but limits on total tonnage is key when moving large quantities of goods. It can also help move goods throughout a system with significant bottlenecks, such as COVID. As COVID took hold in the U.S., there was a big spike in activity as supply chains paid up to get product into their stores and attempt to backfill the supply chain. As rolling shutdowns continue across the U.S., it will keep intermodal shipments on rail depressed while trucks relatively busy. The slow down in port activity will also be an overhang for rail, but as the supply chain is restocked- there will be a slow down in trucking demand as well.

The total movement of products on and off the U.S. coast remains at depressed levels vs historics. Imports have seen a rebound but are still pacing below 2019. On the other hand, exports have been hit very hard and fallen well below seasonal norms as our trade partners struggle. The limitations of exports are also hindering the needs for rail capacity to ports as well as coming into the U.S. Total flows will remain a headwind for diesel demand as rail and shipping flows stay weak.

U.S. Imports by HS2 Commodity Name

U.S. Exports by HS2 Commodity Name

The above data points on U.S. exports/imports is an example of pressure on both sides of the coastline and is showing up in other areas. CAICT said phone manufacturers shipped 27.7 million units in June, down from 32.7 million in the same month last year. June's disappointing decline follows -10% in May, from 36.4 million in May 2019 to 32.6 million in May 2020. Chinese-branded smartphone shipments declined 17% y/y in June at 26.6mn (vs down 10% in May at 30.2mn, up 15% at 37.3mn in April, down 26% at 18.2mn in March) in part due to a seasonally slower period in demand. 5G shipments were steady and ticked up to 17.5mn (vs ~16mn in April and May). Apple is obviously not participating in the 5G market growth just yet. - Nomura [2] .” Slowdowns in tech will also show up in key areas of Japanese/ South Korea data points, which remain well below seasonal norms. Exports and Imports remain well below normal, which is only a continuation from weak 2019 numbers. The varying data points throughout Asia show some improvement but remain at all-time lows with additional COVID cases sparking renewed lockdowns. Hong Kong, Japan, India, and South Korea are facing varying degrees of resurgence that will limit total activity. This will impact July data as well when considering imports/ industrial production in each area. Based on the charts below, any slow down locally or at key trading partners will act as just another headwind against an already weak 2019. The fact to remember- many of these charts are y/y, and South Korea-Japan were in their own trade war that impacted trade and production data. So anything y/y should (in theory) have easy comps- so COVID and economic headwinds are even more problematic as indicated by the depth and slope of the recovery.

South Korea Exports- Total Preliminary

Japan Indices of Industrial Production MoM (The only bigger dip was in 2011 with Fukashima)

Japan Merchandise Trade Exports YoY (only lower period was 2009)

Our Favorite Topic China

Outside of Japan/South Korea- China is the other (obvious) bellwether but the data lacks clarity/consistency especially when measured against trading partners (imports at the receiving end) and other Asian/Europe exporting nations. Exports have recovered back to positive but remain down 3% y/y (measured from Jan-June)- which isn’t surprising given the impact to their trade partners and stagnate recovery within China. Exports to the U.S. still remain well off the 5-year average, and as the rhetoric gets worse between the two countries (especially with Hong Kong) the numbers will fall further and trend closer to low end of the chart.

China Exports USD (Y/Y) Jun: +0.5% (est -2.0%; prev -3.3%) China Imports USD (Y/Y) Jun: +2.7% (est -9.0%; prev -16.7%) China Jan-June yuan-denominated exports -3% Y/Y China H1 Total Trade With US At 1.64T Yuan -6.6% Y/Y

China Export Trade USD YoY

The issues are compounding within China as industrial activity/retail sales remain stagnate even though they have been attempting to stimulate the economy. This also comes at a time when China has already tapped out the stimulus allocated for this year.

“Word is out, the Ministry of Finance (MoF) just approved another RMB 1.26 trillion in local government special purpose bonds (SPBs) and has already distributed them to provincial governments. This means that the entire RMB 3.75 trillion SPB quota for 2020 has now been allocated. Some context: RMB 2.29 trillion of the quota had already been allocated by the end of May. More context : MoF is still holding on to RMB 200 billion of the total quota, which was decided last week will be used for recapitalizing some of the country's small banks.”

We wrote back in January- how China was running out of ways to stimulate the economy due to a saturation in fiscal/monetary stimulus. Many provinces have already said infrastructure projects that have now been completed can’t pay for themselves and must be funded with tax revenue. So now the Ministry of Finance has pushed more Special Purpose Bonds to the provincial governments, but the ability to effectively invest that cash has already hit a wall. The other problem with tax revenue- last year China cut taxes, which already limited the inflow of capital- now with reduced industrial production, exports, tourism, and elevated unemployment- the ability to fund investments will be at a huge expense. “China's debt across all sectors is on track to hit 335% of GDP, after rising to 318% in Q1 from 302%, the largest quarterly surge on record, said the Institute for International Finance. About 60% of the debt build-up was due to non-financial corporates, it said.”

CHINA'S FIXED-ASSET INVESTMENT FELL 3.1% Y/Y IN THE FIRST SIX MONTHS, VS EXPECTED 3.5% DROP, 6.3% FALL FOR THE FIRST FIVE MONTHS

CHINA'S RETAIL SALES FELL 1.8% Y/Y IN JUNE, VS 2.8% DROP IN MAY.

CHINA'S INDUSTRIAL OUTPUT ROSE 4.8% Y/Y IN JUNE, VS EXPECTED 4.5%, PREVIOUS 4.4%.

The above charts just highlight the absurdity in the recent China GDP announcement of 3.2% y/y growth. We have been highlighting how the retail consumer (imports and consumer spending) has been struggling for months yet things normalized? Business activity peaked at 87% or so and have seen some reduction as demand just isn’t there for products both internally and externally. Consumer spending saw its 8 th consecutive month of y/y contractions, which is also reflected in the lack of gasoline demand and record high storage.

Consumer purchases contracted throughout the quarter (see next entry). The services sector struggled throughout out most of Q2 – with the majority of restaurants reporting contraction in revenues and foot traffic through April and May and the Ministry of Transportation’s passenger traffic data showing ~50% y/y contraction through the end of May. Businesses were only operating at about 85-90% of typical output throughout April and May. Value-added of industry grew 4.8% y/y – up from 4.4% in May, and not far off the 5% average growth seen in Q3 2019, or the 5.9% growth seen in Q4 2019. Retails sales contracted by 1.8% y/y – improved from the 2.8% contraction in May, but bringing the overall H1 average contraction to 9.7%. Overall fixed asset investment grew by 8.5% y/y – up from 8.1% in May and the highest level since June 2017. [3]

Many components of the GDP calculations were firmly negative last quarter even after the government attempted to stimulate the economy with added fiscal support. China travel data also shows movements are still down about 50% (using TomTom) as people are traveling less on their spare time. Travel agencies were just allowed to fully reopen with caveats to maintain social distancing and capacity constraints.

As we have been stressing for several weeks, China crude purchasing will remain weak over the next few months. “While the world’s biggest importer took delivery of record amounts of crude in June, traders from Geneva to Houston to Singapore report that the country’s buying interest has cooled notably in recent weeks, taking away a key support for a strengthening global market for crude.” The problem remains the amount of crude sitting offshore, and the surge in refined product in storage as local demand remains weak. “China's crude runs increased to a record high in June, despite slowing motor fuel demand, government data show. Stronger petrochemical demand and additions to China's swelling storage capacity absorbed the increase in refinery output.” Refiners increased run rates despite weaker demand for gasoline and diesel in June. More products instead went into inventories and to meet petrochemical demand, according to state-owned oil firm CNPC's research arm ETRI.” [4]

The issues will persist with independent refiners (teapots) also sitting with a record amount of crude both onshore and offshore.

China Independent Refiner Storage

China Shandong Gasoline Stock Storage

China is also facing a huge supply chain problem at the port as they are testing everything coming in for COVID. This has created bottlenecks with congestion at all ports. Local demand remains weak for refined products, which also points to problems internally and is showing up at the refiner. Refining margins have just moved to be “less bad”, but still negative in many major locations driven by rising feedstock costs (crude pricing), record level product supply, and weak pricing driven by soft demand. “Independent refiners in Shandong province may cut crude runs to 1.9-2.0m b/d range in July and August from a record high of 2.3m b/d in May amid narrowing margins, industry consultant FGE said in a note. The drop driven by sharp rebound in crude, although swift product inventories builds due to run hikes since mid-March also contributed. Gasoil cracks may weaken as manufacturing and construction activity ease seasonally and the domestic surplus of the fuel may increase as more refiners push more jet fuel into the gasoil pool. Given the teapots’ heavy reliance on gasoil, margins may come under further pressure in 3Q and could even turn negative. Higher spot premiums for grades such as ESPO and Lula that are favored by teapots could further erode margins.” The headwinds in margins, rising storage, and maxed out exports (per export allotments) will keep crude demand capped and falling as run cuts are pushed through the system. The Asian floating storage will remain elevated through the rest of the year at least.

Asia Crude Oil Floating Storage

Global Economic Data

The economic data that has come out over the last few months have shown modest recovery off of lows, but we are now seeing plateaus and economic reductions, which will continue through the remainder of the summer (at least). The problem remains activity across the consumer and industrial sector as COVID resurgence pressures markets around the world. Layoffs, unemployment, and debt levels are a huge headwind on all levels of spending. “China's debt across all sectors is on track to hit 335% of GDP, after rising to 318% in Q1 from 302%, the largest quarterly surge on record, said the Institute for International Finance. About 60% of the debt build-up was due to non-financial corporates, it said.” “Global debt rose by $1.2 trillion to $258 trillion in q1, hitting record of over 331% of GDP vs 320% in q4 2019 -IIF.” Something we have continuously stressed is that the issues around the global economy are not unique to 2020, but really have roots in 2019. Central Banks/ Governments were already attempting (failing) to stimulate economies throughout 2019 and earlier. The lingering effects of the financial crash, European crisis, and 2016 slowdown (saved by China) were all paved over with liquidity and stimulus but did little to generate sustainable economic growth.

The below chart on daily activity shows a breakdown with some countries, such as France, Italy, and Germany posting some normalizing characteristics around economic recovery- which have also begun to plateau as the slope flattens out of many of these curves. The rest of the countries are either plateauing or starting to head back in the wrong direction. This will inherently weaken and slow the recovery of the 3 leading European nations based on the below daily activity index. Even with the recovery- it hasn’t translated into refined product consumption.

Just an example of Italian fuel sales:

Many countries- even though activity is getting close to pre-COVID levels, we are still seeing 15%-20% demand loss in refined products. This will remain as unemployment headwinds persist across all markets- some faring better than others- but still seeing persistent unemployment figures. The three European regions also have a healthy tourism sector that won’t be coming back anytime soon as shown through not only the jet fuel figure, but also the lack of spare income and growing political divide for travel driven by sanctions and temporary lockdowns. Even as some industries return, the countries still face headwinds on industrial production. The data has gotten a little bit better through June, but the additional growth will pause as industrial output faces hurdles. The issues remain consistent across many countries with limited purchasing powers of locals and struggling exports as trade partners face a resurgence of COVID and weak demand. Just an example- last year Germany exported $127.5B worth of goods to the US, $115.8B to France, and $105.1B to China. These are figures that will be difficult to achieve- especially given the slowdown that was already happening in 2019. So even against “easier” comp numbers of 2019- flow will be down y/y/ acting as a headwind across industrial recover.

GDP estimates will keep adjusting throughout the year as new information becomes available as well as COVID and general business cycle impacts (or what is left of them). The contraction will be steep across the globe, but the bounce back will be difficult as we see the trend from 2017 (peak growth) as Europe slowed and was entering 2020 already on a weak footing.

Outside of just advanced economies, Emerging Markets have hit a ceiling on daily activity- especially as regions experience a new increase in COVID. The other key problem is the lack of buying goods/raw materials from the emerging market world. The over levered and at times- commodity weighted economies- are struggling to stimulate their local economies while trying to minimize the spread of COVID. Many of them are also facing a growing food crisis that is made worse with the local inflation and lost wages many are facing. Even China- first in and first out of the COVID lockdowns is seeing their activity turn lower. There are new outbreaks looming in some of their key trade partners as well as locally (Hong Kong and Mainland) that will keep pressure on getting back to not just pre-COVID levels but the “highs” achieved in June. As we discussed above, many of the data points seem a bit inflated, but none the less they are better vs many others given their early entry into a full country lockdown.

When we break it down further, many of the countries have hit a ceiling trying to get past the 75% mark of total activity levels. The key drivers in this metric are Indian and China, but each country will struggle given the headwinds persisting in their end markets. Mexico and Brazil are pivotal for U.S. refined product exports, and the problems that are pervasive in their countries (and worsening) will be a huge overhang through the remainder of the year. The overhang has been lessened slightly (as described in previous writings and the podcast) as ME/Asian refined product isn’t flooding into Europe/Lat Am at the same rate. This helps to open up some traditional exports from the U.S.- but it won’t be in enough meaningful quantities and will sit below the 5-year average.

There isn’t a clean fix-all given the backdrop of weakening or flattening activity that is a huge overhang for the market at every level. The lack of industrial activity at the advanced economy level limits the amount of raw materials that are purchased at the Emerging Market level- and the cycle repeats without any real way to get off the merry-go-round. Central banks have tried to spur monetary policy to generate economic stimulus, but after years of trying the laws of diminishing returns are kicking in and we aren’t generating meaningful growth. The debt levels globally have reached new records, and we don’t have much to show for it- especially given the amount of borrowing that was done in 2019 to result in more industrial slowdowns.

Review of Some U.S. Statistics

As we turn inwards to the U.S., we see hours worked through the HomeBase data shifting lower on a rolling basis. We previously discussed how the July 4 th holiday would make sense to be a big drop, but as COVID spiked in key regions- some jobs were going to be furloughed again. Based on the data, and renewed lockdowns/rolled back phases, the data will keep shifting lower. Initial jobless claims rose again by 1.3M (topping estimates of 1.25M) while continuing claims dipped to 17.338M below estimates of 17.5M. Claims remain elevated, and will likely rise over the coming weeks as PPP money runs out and other backstops are exhausted causing another round of job losses.

Retail traffic has declined over a similar time frame, but as retail traffic fell retail sales kept their upward trajectory. The spending has been driven with more online sales, but there has been a nice bounce off the lows. June was expected to be a bit stronger given the re-opening of specific states and cities, but the spending will start to slow as subsidies and extended benefits begin to roll off.

The sharp response in retail sales is a positive overall, but as we head through July and into August, we will get data showing back to school sales, elevated continuing jobless claims, and exhausted federal stimulus measures. This will be a better gauge of recovery, and the preliminary data is a bit mixed but the renewed cases in U.S. states will be a headwind.

Another interesting data point is the shift in job seeking as it relates to larger cities as measured in the chart below: a metro area population greater than 500k. Typically during a downturn, especially one with record levels of unemployment, the search for jobs and recruiting will shift higher as employers look to take advantage of the growing job pool and the unemployed look for work. This is more of a unique time as employers aren’t quick to higher back furloughed employees or job cuts are permanent- meaning the position all together was terminated. The loss of the actual positions now means there are less jobs available, but it also points to the shift away from cities. Based on the recent housing data, the move away from cities has only accelerated.

Just a chart to put in perspective the amount of jobs lost in the U.S.

Some of the recent industrial data has come in positive, which even if it misses estimates allows for an expansionary backdrop. The Philly Business Outlook. Empire Manufacturing, Industrial Production, and other key metrics have been either positive or at least trending in the right direction. The problem remains we don’t see any real growth year over year. There would be an expectation goods would be moving through the system, but based on the shipping/TEU container data discussed earlier- there is more “stuff” moving around bit it hasn’t been consistent. There remains excess capacity in the system so pricing hasn’t shifted higher, which is also aided by weak diesel pricing. Once you normalize for diesel pricing, demand for transportation is rising but still lagging. The other issue facing the industry- just as things are starting to normalize COVID is hitting supply chains and intermodal movements again.

One of the key metrics discussed was the West Coast and how flows are still well below 2019 figures, which also hinders the “Trade Deal” as China still isn’t purchasing what was initially promised:

China Imports of HS2 Commodity Names into California- Remain well off Normal Flow

China Exports of HS2 Commodity Names From California- Remain Under Pressure

It is worth reminding everyone that the base year set for China exports was 2017 in the Phase 1 Trade Deal- so the purchasing is supposed to be above those levels. There could be a view of saying- well the above are purely from California- but when we look at any state- we still fall well short of the mark. As tensions between the U.S . and China rise, the potential to close the gap (already nearly mathematically impossible) will be a thing of the past.

China import of HS2 Commodity Names from the U.S.- Remain Under Pressure

Geo-Political Summary

China remains front and center given the growing political escalation with the U.S. We have been talking about how the China situation was going to unfold with the rhetoric only getting worse. When China passed the Hong Kong laws, it was a clear signal that they were no longer going to even pretend to care how the international world views their policies. The shift has been swift with every day a new movement in a direction that will drive a growing divide. The U.S. has responded to the HK law and other human right violations with a slow escalation:

Send two aircraft carrier groups into the South China Sea (one is now in the Indian Ocean) The U.S. has never accepted the 9-dah line, but when asked directly on the matter- the standard answer was- we support the ruling of the U.N under the UNCLOS (UN Convention on the Law of the Sea) against the validity of the 9-dash line. The U.S. now explicitly stands behind the Philippines claim and the Arbitration Court over the Scarborough Shoal. The U.S. now rejects the 9-dash line without question (including the Spratlys) None of this is theoretically “new”, but it does remove any question or doubt as to the views of the U.S. We have always operated freedom of navigation under the view that the 9-dash line is not an accepted maritime zone- but the State Department just made it final South Korea and the U.S. will have live fire training exercises B-2 bombers have been flying through the Strait of Taiwan Intelligence gathering aircraft have been flying close to the Chinese shore to monitor troop movement- especially in the Guangdong province Legislation has been proposed (or passed) to limit the movement of CCP officials and their families Legislation has been enacted to target China for human rights violations in Xinjiang (Uighurs)

The list can keep going, but many of these things have come to pass over the last 30+ days at a growing frequency that requires constant attention. China is losing more support within the region, which will help the U.S. find allies and support in the region.

The issues have not gone away with India either with conflicting reports of troop and equipment movements along the LAC. China has apparently not retreated from the Pangong Fingers, which were outlined in the agreement of de-escalation. Other areas have so far seen a de-escalation, but the strategic importance of the Pangong fingers will keep this place a powder keg. Both sides have moved some assets back to support positions but are still in close proximity/striking distance. India has also found additional support from Japan (had joint naval exercise) and additional support from Australia. The allegiances are being made and lines in the sand are being drawn. I have said from day 1- we would let Hong Kong fall, but Taiwan will be our line in the sand. It will take a lot for the U.S. to get involved with the India conflict- especially if it escalates- but Taiwan would be what drives us to arms.

China and Iran have been trying to work out a deal that would put several thousand Chinese soldiers within the country, billions in investments, crude purchases at steep discounts (rumors as high as 25%), among other terms. The bigger push would be getting Iran further within the Belt and Road Initiative through debt entrapment forms of financing. China would also help out two ports, but in return India can no longer be involved with the Chabahar Port and the railway projects connecting into the area. India and Iran have been allies/ trade partners for over a thousand years, and trust isn’t something that develops overnight. This will not sit well with the local populace or other interested parties (Russia/U.S.) in the region.

Outside of purely geo-politics, China is facing record breaking rain fall and flooding throughout large parts of the country. This is putting extensive strain on many of their dams (one already broke), but the big one is the Three Gorges Dam. The dam was criticized internally and externally by scientists and engineers saying it failed to factor in current changes, erosion driven by shifts in currents, among other factors. Several detractors in China “disappeared” and the dam was completed. Now keep in mind the rebar requirements in China weren’t created until 4-5 years AFTER the dam was finished- this doesn’t mean they didn’t purchase the strongest rebar available- but it is something to keep in mind. They have now opened all spillways and flood gates, which has caused “controlled” flooding down stream in order to remove some of the pressure from behind the dam. The Three Gorges was tested in 2017 when extensive rainfall struck and here it still stands- but the scientists/engineers have said- the dam wasn’t built to handle the extensive strain with rainfall at these levels for this prolonged period of time. This is important because if the dam fails- 400M people will be impacted/ many nuclear facilities/ industrial production/ and crops. The flooding has already impacted millions of lives and destroyed crops, which is why China has aggressively been buying grains in the open market. This is a key piece of infrastructure that should be watched closely.

Iran has been experiencing random explosions and destruction on low level infrastructure- but the game was stepped up with the destruction of the centrifuge facility and now 7 boats set on fire in port. The local populace (about 85% or more) are no longer tolerating the current regime. I have listed in previous writings including the random killings of innocent protestors to the downing of a commercial jet, but COVID adds a new wrinkle to the China/Iran relationship. The majority of the people within Iran blame the regime for covering up the severity of the disease and its spread- as well as being one of, if not the last, country to close off flights from China. The recent increase in infrastructure blowing up could easily be a group of locals that are fed up with the current establishment, but just need the equipment to carry out disruptive behaviors. This may seem like nothing- but IRGC guards have been deployed to several major cities and missiles defense systems put on high alert. There is something more happening beneath the surface, and while it is near impossible to call regime change- we are closer to one vs further away.

Iran is also sitting on a huge chunk of crude in onshore and offshore storage that would provide a huge cash boost if it was released into the open market. It currently is stuck behind a wall of sanctions that limits the ease of selling and the true value as it has to be sold at a steep discount. If there were to be a regime change, actions could be swiftly taken to help fund the new government by unlocking these stores of oil. “Total onshore crude stocks surged to 54 million barrels in April from 15 million barrels in January, and swelled further to 63 million barrels in June, according to FGE Energy. Market intelligence firm Kpler estimated Iranian average onshore crude storage for June to be around 66 million barrels. That is around 85% of available onshore storage capacity.” Iran’s floating storage is also filling up. Shipping sources said Iran was estimated to be using in the region of 30 tankers to store oil – most of them supertankers, each of which can carry a maximum of 2 million barrels of oil. This would equate to over 50 million barrels of oil being stored, which has been static for some months. This is likely to be a combination of crude and condensate, a very light grade of crude, the sources said. Refinitiv data showed a maximum of 56.4 million barrels were being held in floating storage by July 3. Iran’s fleet of crude oil tankers numbers 54 vessels, data from valuations specialist VesselsValue showed.” [5]

The economy is also struggling due to sanctions, which has generated a black-market exchange rate that is devastating due to the massive inflation it is causing for the average person. The below chart could be the final straw for a populace that has experienced a significant amount of turmoil going back to the ’79 revolution.

Quick Talk on Food Inflation

After talking about China food purchases, it is important to remember how the world is hurting from the effects of COVID and just general economic slowdowns. The amount of undernourished people is set to rise over the coming years as droughts hit key regions and climates continue to shift. COVID is just exacerbating an already growing problem driven by nationalism (hoarding), lack of migrant workers to till the land, damns/climate change reducing waterflow, and a growing population. For example, Ethiopia has completed the dam it started building in 2011 and it will take 7 years to fill- starving water from areas such as Sudan and Egypt. Again- many people don’t want to go to war- but if you take food/water from someone’s family- I can assure you they won’t shrug and say “ok- no problem.” We have already seen food inflation in the U.S. and we are a developed nation with a massive amount of farmland. I know it is way more complex but this document is already 40+ pages and I will address this in way more detail in future writings. But in the U.S. the average amount of money per paycheck going towards food continues to rise (we estimate $.20) while around the world it is moving to over $.80. On just a general economic level that removes discretionary cash to purchase “stuff”, which reverberates around the world. We were already on a tough trajectory, but COVID now puts a spot light on these issues around the world. China’s moves in the 9-dash line and BRI (Belt and Road Initiative) also have a goal of securing food, but typically at the price of the local nation.

https://www.bloomberg.com/news/articles/2020-07-13/global-hunger-and-obesity-are-getting-worse-due-to-virus-fallout?sref=q8seIhDd

[1] https://gcaptain.com/port-of-long-beach-cargo-volumes-decline-in-june/ [2] https://www.zerohedge.com/markets/smartphone-shipments-china-slump-june-casting-doubts-economic-revival [3] https://mailchi.mp/f2a35521a321/calling-bs-china-markets-dispatch-july-16-2020?e=21cdcdff2c [4] https://www.argusmedia.com/en/news/2123687-chinas-crude-runs-top-14mn-bd-in-june?backToResults=true [5] https://www.reuters.com/article/us-iran-oil-storage/irans-oil-storage-almost-full-as-sanctions-and-pandemic-weigh-idUSKBN2481M3