[ihc-hide-content ihc_mb_type="show" ihc_mb_who="10,13,14,16,18,19" ihc_mb_template="1"] By Mark Rossano In today’s report, we will spend a lot of time looking at the new policies within China and how it impacts the world and US policy going forward. We have spent a lot of time highlighting the expansion of refining and petrochemicals within China, as trade routes change forever. China has been importing a growing amount of oil, but also increasing their exports of refined products. So while one side is bullish- more crude being consumed- the growth of refined product in the market is forcing other facilities to either cut runs or shut down completely. The shifting paradigm is real and is a key reason we follow flows of not only crude, but also all the products oil is turned into. This paints a clear picture of the changing tides and shifting supply chains that we face going forward. The report will have two parts: US Crude Fundamentals and the Changing World of China. Energy and most commodities were able to get a strong bid following the Pfizer news last Monday, which just carried over to strong results from Moderna. We can go through the data collection process and the logistics of getting vaccines around the world, but regardless- crude is now right back into its same trading range. The market has been held in a tight range with a few potential breakouts and breakdowns along the way, while everyone waits for some specific catalyst. Refinery utilizations remain depressed as economic run cuts limit the normal ramp in activity seen at this time of year. Unless we get a surprise from OPEC+, there is little in the way of new data saying we will break in any direction with any type of conviction. I remain on the bearish side once I factor in my views of the global economy, COVID cases rising, and underlying weak demand. As we head into an OPEC+ announcement, here are our assumptions for the outcomes: Base Case: OPEC+ agree to delay the increase to cuts for 3-6 months. The group was supposed to increase production by 2M barrels starting Jan 1st. Bear Case: OPEC+ agree to only increase production by 1M barrels a day and allow Libya to fill the other million barrels as they return to pre-blockade production levels. Bull Case: OPEC+ cut production further by 1M barrels to offset Libya and try to limit cut more supply as OECD and general levels remain well above 5-year averages. There are always some sort of variations with some putting their base cases with a cut of 500k barrels a day, but I think any cut would be viewed as bullish- even if it isn’t enough to offset the rise of Libyan barrels. We will have a report coming out that week to discuss the meeting, and what it means for the next few months of crude supply in the world. We remain more bearish on the demand side, which has proven correct so far as the EIA/ IEA/ OPEC all bring their demand numbers closer to our estimates. The UAE has started talking about their displeasure with the current splits, but this doesn’t signify a huge fracture just a negotiations tactic as we head into what will be a pivotal and likely contentious meeting. KSA is also sitting on a huge slug of debt that only grows, which will be important to monitor when considering FX reserves and US Dollar holdings. WTI CUSHING CRUDE PRICES While WTI prices and realized prices are important, E&Ps are focusing on decline curves and trying to bridge the gap into Q3’2021. The view is that a vaccine will be readily available by the summer (latest by end of summer), and the OPEC+ cuts will have taken a significant amount of spare crude out of the market and tightening spreads. As we have been saying, decline curves are the enemy and limiting losses to between 10%-15% provides a runway to stabilize growth in 2021 if the perfect storm arises and capture growth. In the last write up, we went in-depth on the natural gas side- so in this report we will dig a bit deeper on the crude side. We expect to see additions across the Permian and Eagle Ford through the remainder of November with the Williston holding between 8-10 spreads. Typically, there is a shift in activity to warmer weather, but any type of frost or cold can delay work- as we saw a reduction of 5 spreads in the Permian driven by a cold spell. Overall, the national average will remain between 127-135 with adjustments coming in some of the fringe/ non-core basins with sustainable growth for the next few weeks being delivered in Texas. The work in Ardmore, Arkoma, Cherokee, Fort Worth, and Green River will start to roll off through Dec. Denver is interesting because 3 will likely be the “top”, but there is enough to keep at least 1-2 crews busy for the next few weeks. Uinta-Piceance and Anadarko have been holding firm at about 4 and 5 respectively with little to change that direction. The Western Gulf, TX- LA-Salt, and Permian will see growth to offset the declines in the other basins. Seasonal slowdowns normally start next Friday (Thanksgiving) and decline through Christmas/New Years to pick back up in January. Due to the shut-ins and sharp drop off in work, we will likely buck that trend and stay stable with some incremental growth over the next two weeks. There will likely be a short-term decline next Friday, but it will quickly get picked back up the following week as companies make a final push into year end. When we look at the 4-week rolling average in the National Spread at 127 and Permian at 58, we will see the National Spread rolling average push up to 130 while the Permian count moves to 60. The activity will be driven more about decline curves and less about actual pricing in the interim. That isn’t to say that companies will actively attempt to lose money with many laser focused on reduced costs and acreage providing the “best” returns given the underlying circumstances. Pressure will persist through year-end across pricing, because even in our “bull” OPEC+ case- we aren’t going to see prices move much past $45. Many companies will struggle to break-even, let alone make money, at a strip sitting at $45. PERMAIN FRAC SPREAD COUNT SEASONALLY ADJUSTED Realized prices remain depressed across the U.S., and have limited exports over the last few weeks. Purchases have started to increase for late Dec, Jan, and Feb delivery as we have had pricing open up a bit vs Brent and due to a push for cargoes ahead of China’s Lunar New Year. At the moment, Brent is at $44.20 put the spread with LLS at $1.16 and MEH at $1.61. While we have seen some price recovery, lockdowns in Europe and rolling restrictions in the U.S. will limit total activity and cap any real refined product demand in the near term. Cushing is already sitting at levels we saw at the beginning of the year, which will keep pressure on general WTI pricing. Cushing is currently sitting on 61.613M barrels of crude, which is really close to pressure we saw in April/ May where the levels reached the follow: April 24th- 63.378M…. May 1st- 65.446M and May 8th – 62.444M Commercial storage is getting crowded, and even though pricing has improved to the coast we still have production at about 10.9-11.1M barrels a day, which is outpacing the demands for U.S. refining. U.S. storage levels were aided by hurricane forced shut-ins across the Gulf of Mexico, but with hurricane season ending- production will remain stable coming in off the water. This will accelerate builds in PADD 3 as we have some additional vessels also coming into the market, which will keep oil trapped in Cushing. Spreads will need to open up a bit more to incentivize more crude to move through the system. DOE CUSHING OIL STORAGE LEVELS We will get a little bit of help as refinery utilization starts to move higher reaching about 80% by the end of November. Even at 80% utilization rates, we will be well off of seasonal norms with a peak of throughput at around 14.1M-14.3M barrels a day of throughput. The demand factors will keep things relatively capped throughout the U.S. as more European products come into PADD 1. The other problem with widespread European lockdowns is the limited need for U.S. oil exports into the country as well as pressure on refined products (specifically distillate) that flows into the area. This will limit the total exports leaving from the U.S. into Europe and Latin America. DOE U.S. Refinery Utilization Rates The big problem as we head into a key driving period is just how low miles driven remains- we always show high frequency and weekly data, but this is DOT information that comes out on a lag confirming the problems. The problems will persist as cases rise and consumers adjust their underlying behavior, which we have seen time and time again across the world. A quick backdrop as we head into a quiet week with Thanksgiving right around the corner. There has been a lot of talk about Chinese and Indian demand, but when we look at it objectively- the improvement has been muted. We can’t deny the draw down from floating storage, but onshore storage remains elevated in China as refiners cut runs in Nov and Dec. There were additional purchases as refiners prepared to ramp up activity, but the actual growth has been along seasonal norms. Typically, spot buying accelerates at this time of year with as China prepares for Lunar New Year. India had their festival season from the middle of Oct into the middle of Nov, which is always a big pick up in total demand. Now that festival season ended, we are seeing demand cool off in the region. The below helps demonstrate where India currently sits vs previous years. They are still down about 500k barrels a day y/y, but have closed some of that gap with the recent improvement in COVID cases and activity normalizing a bit. Sale of diesel, India’s most widely-used fuel, slumped on a y/y basis in first-half November after staging a strong rebound in October. 1H Nov. diesel sales -5.1% to 2.86 million tons, data from India’s three biggest fuel retailers showed1H Nov. diesel sales +7.7% from 1H Oct.For 1H Nov., India’s gasoline sales were little changed y/y at 1.03m tons, or +4.7% m/mJet fuel sales -53% y/y to 157.2k tons, +1.3% m/m Liquefied petroleum gas sales -2.2% y/y to 1.08m tons, -7.6% m/m This will be something to watch as refiners have increased operations, which is supported by the export market. The international market remains awash in diesel and jet fuel hurting total margins and limiting a natural outlet for excess capacity. The builds can be seen with the spike in places like Fujairah and Singapore. India Gasoline Exports India Diesel Exports Light distillates such as gasoline and naphtha surged 17% to 6.307 million barrels, the highest since Sept. 28 and middle distillates such as jet fuel and diesel expanded 11% to 5.963 million barrels, close to the record high of 5.997 million barrels on June 1. International Enterprise Singapore Oil Products Singapore Stock Data International Enterprise Singapore Middle Distillates Singapore Stock Data PJK International ARA Gas Oil Inventory K Tonnes While Europe has some draws in gasoil- but very much along seasonal norms even as refinery run rates across the region are slashed. The demand for oil has dwindled as we see builds in floating storage mounting in the region. The below chart helps drive home why the arb opened up so quickly to bring European gasoline into the US again. The builds have been massive as driving remains depressed even as activity stabilizes in the region. PJK International ARA Gasoline Inventory K Tonnes Floating storage has risen throughout Europe and the North Sea, and with limited demand in the market it will continue to grow. West African grades have found some home in Asia, but even with China buying an additional 15M barrels of WAF- Nigeria spreads tightened $.50, which just points to how long the market remains on the physical side. Oil in transit has started to increase as more shipments hit the water from West Africa and Libya. We are expecting Libya to export a little over 1M barrels through the end of the year with production at about 1.2M, which is about 9 months ahead of our expectations for production growth. North Sea Crude Oil Floating Storage Europe Crude Oil Floating Storage There were some drawdowns that continued in Asia even as the levels remain well above normal. Asia Floating Storage The overarching problem remains China onshore is well stocked with crude and refined products with demand sitting well below average, which is why the Dual Circulation System is an interesting pivot or expansion of Chinese policy. China refineries cut their average run rate to around 78.9% in October, third consecutive monthly drop from a six-month high of 83.1% in July. As we head into the OPEC+ meeting, we have many countries maintaining elevated levels of exports and production. All the while- floating storage has stopped going down and OECD levels remain well above the 5 year average. Iraq Exports- Still Pacing Well Ahead of OPEC+ Targets According to JODI data, Saudi Arabia production has been sitting very close to the 2019 levels we have seen, and as demand weakens- even though Oct levels will remain stable vs Sept- we have seen a pick-up in Norway, Iraq, Nigeria, and Libya flow which more than offsets the drop in Oct according to the chart. September in 2019 there was an attack on KSA capacity, and we can see how quickly it was recovered by other areas and crude was pulled out of storage to backfill the system. OECD Oil Inventories in Millions of Barrels including Preliminary Estimates for October (IEA) “OECD industry stocks fell for the second consecutive month by 19.7 mb (0.66 mb/d) in September to 3.192 mb and were 225 mb above their five-year average. – IEA. Weak historical data and the resurgence of Covid-19 in Europe and the United States led us to revise down our near-term global demand outlook by 0.4 mb/d in 3Q20, 1.2 mb/d in 4Q20 and 0.7 mb/d in 1Q21. – IEA” These organizations continue to adjust their demand estimates to move closer to our levels given the headwinds across the macroeconomic landscape. There has been some recovery in activity in the emerging markets, but the level of debt it has taken to generate that growth will be a massive overhang over future growth. This also comes as developed markets worsen with new spikes of COVID cases being announced in Japan and the US with Europe slowly containing the current outbreak. Global trade continues to disappoint with US imports down y/y, and export-import data missing estimates in key regions heading into year-end. The big issue now will be stimulus in the U.S. as many programs are set to expire that have propped up the U.S. consumer. The “recovery” will be uneven and slow as we head into 2021, where estimates remain well above where they should be given the level of debt, COVID, slowing economic activity, permanent job losses, and other headwinds that don’t magically disappear. Global trade will always be a good bellwether for activity, and the US (the largest importer in the world) remains depressed with a peak back in 2018. High frequency data shows a deepening drop in trade. The volume of goods arriving at U.S. ports in the four weeks through November 5 is down 10.5% from January levels. China recently had their fifth plenum of China’s Communist Party to lay out the economic and policy goals for the next five years. There were many consistencies that carry over from the last meeting, but they are now increasing the focus on key areas. One of the big areas that many of the adjustments fall under is the Dual Circulation Strategy or DCS. “Han took the opportunity to expand a bit further on the dual circulation strategy (DCS). Han said DCS is a way for China to become more like the US (Sina):“A common feature of the big economies is that they are dominated by domestic demand and domestic [economic] circulation.” “[The US] has a dependence on foreign trade of 26.4%, which is 9 percentage points lower than that of our country. But this does not prevent the US from being a major global trading country, and a major power utilizing foreign investment and conducting outbound investment.”China must control critical technologies and ensure the security of supply chains.China must improve efficiency of logistics and lower costs.Han said that the Party will “resolutely prevent income polarization” by optimizing the structure of income distribution.China must protect consumers’ rights and build an environment conducive to consumption.”[1] Many of the DCS adjustments are can be broken into four different buckets: China must control critical technologies and ensure the security of supply chains.China must improve efficiency of logistics and lower costs.Han said that the Party will “resolutely prevent income polarization” by optimizing the structure of income distribution.China must protect consumers’ rights and build an environment conducive to consumption. [2] China has historically had weak local consumption, and the goal of the recent update is to reinvigorate the strategy of cutting dependence on international markets and technology. The renewed vigor is in no small part attributed to the rise in global sanctions against China, Huawei, and other Chinese corporations and officials. The best way to summarize the strategy: production, distribution, and consumption to cultivate a stronger local market. The Belt and Road Initiative was created to vertically integrate supply chains by investing in raw material mines, rail systems, ports, and other infrastructure to transport goods and export the Chinese economy. “Made in China 2025” was created to further develop the manufacturing and deploy investments across complex infrastructure, such as refining/petrochemical in order to become more self-sufficient across key semi-finished products and fuels. The next layer of the plan was to expand high-tech industries including next-generation technology/ telecommunications, advanced robotics, and artificial intelligence. The end goal was for a complete integration of the “fourth industrial revolution”- referring to the integration of big data, cloud computing, and other emerging tech into the global manufacturing supply chain.[3] The next progression of these initiative (not that they are ending) is to generate a robust domestic market that creates a self-contained/ self-sufficient entity breaking further away from international markets. China has now signed the Regional Comprehensive Economic Partnership (RCEP), which provides an opening of markets within Asia: the Association of Southeast Asian Nations (Asean 10): Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam as well as Australian, Japan, New Zealand, and South Korea. I will go through that in more detail, but it is worth discussing the major updates in the 5-year plan and what the DCS means for investments. We will dig deeper into the RCEP later on in the report. The biggest driver behind Chinese policy is to increase their independence regarding technology. The below chart provides a breakdown of where key semiconductors are manufactured, but another important side of the equation is where they are tested. Testing new chips is a highly sensitive business due to their integration into top secret equipment and other high value assets, which is why it is closely guarded. The U.S. has secure sites that test for functionality and monitoring the ability to meet specific goals on processing. These are highly secure sites, and something to consider when factoring in the full process of developing new technology. The below diagrams breaking out the supply chain to create chips help to drive home the complexity of becoming a technological powerhouse. There are many steps that go into not only the development of technology, but also the manufacturing and more importantly (as described above) the testing and assembly. The research and development side takes many different components including time, money, and personnel. For those that have been following our work, we have highlighted the importance of China retaining top talent- especially those that go abroad for college and advanced degrees. A big piece of the puzzle was creating an environment where Chinese students wanted to return home because a person with a PhD from MIT/ Stanford has transferrable skills- so why am I going to return to China? A part of Chinese policies over the last decade was to attract and retain top talent with a current study showing in 2016 56.95% returned, an improvement from 37.61% in 2011. The below heat map outlines where air pollution is the worst, which reduces quality of life and keeps well educated people from returning. China has aggressively attacked the rise in pollution with more natural gas and LNG throughout key regions reducing overall pollution. There is a direct link between economic growth and particulates in the air driven by respiratory illness, asthma, cancer, and other ailments that increase health care costs, shorten life spans, and increase illness. These all have impacts limiting economic impacts, especially attracting new talent. At one point over the last 10 years, China had 10/10 of the most polluted cities in the world- they now only have 2 in the top 20 with India claiming the top 12 spots. Another key aspect of attracting talent is the protection of intellectual property and compensation for innovation. These are key aspects that have been on the agenda of the CCP over the last decade, and the recent Plenum was no different. China used the BRI and Made in China 2025 to help attract people to drive R&D on the design side and finding ways to protect intellectual properly. The IDM or Integrated Device Manufacturers keep everything in-house, which takes a significant amount of capital and manpower to achieve. The manufacturing side is a highly complex process that requires facilities costing billions of dollars to build and operate. It takes about 6-8 weeks for the entire manufacturing process to build a chip because there are many advance logic processes that occur with about 1k steps impacting them. As chips get more complex, the fab or foundry to build them will also get more costly- a building now costs about $3-$4 billion with a recent one built in Taiwan costing $9.3B. There have been estimates a future fab facility will reach $20B as the complexity only intensifies. It takes several years to build a foundry, which is why China can’t just flip a switch to replace the chips they are importing and have increased imports to buffer sanctions being placed on companies such as Huawei. There are clearly logistical issues across the design and manufacturing stage but testing and assembly is also a large part of the process. The testing is by no means as expensive, but it is a core function to ensure it hits all necessary requirements in order to achieve the intend purpose. The chips are sent to their final destination to be installed into the final product or a semi-finished good that is sent on to the final assembly. Each part of the process is paramount to the security of the supply chain and advancement of technology. This is why China has been focused on creating a more insulated process, which has been the long-standing goal of creating a home-grown technological sector. Over the last decade, China has taken drastic steps to secure their technological expansion, but they are still importing many chips that leave them susceptible to disruptions and sanctions. A key component to that expansion is a domestic market that can help drive a local market. Han Wenxiu, Deputy Director of the Office of the Central Financial and Economic Affairs Commission reiterated that innovation and control of key technologies is a must for China- especially in regards to semiconductors. He argued that innovation and control of key technologies is a must for China to minimize vulnerability to foreign countries (Sina): “Reality has shown us that key core technologies cannot be bought [from foreign countries].""Even if they sell it to you they may ask for a high price, or once they are in a bad mood they will cut off the supply and put you in shock.”“In 2019, China imported USD 305.5 billion worth of chips. It can be said that many multinational companies, such as Qualcomm, Intel, etc., could not have grown to their present size without cultivating the demand of the Chinese market.”“Now the US cut off supply, but our market demand still exists. This provides a rare opportunity for our domestic chip companies.” Get smart: In key sectors, China is determined to replace foreign suppliers with domestic alternatives.[4] The drive to create a more robust consumer market also has history in the past- every time the government has attempted to limit stimulus or financial support the economy slowed and it was quicky reversed or replaced with something different. Stimulus has taken many forms in China over the years, and now there is a renewed focus on consumer spending- especially in rural areas. China is now in its 8th month of “Recovery”, and still hasn’t been able to climb out of the 2014 slowdown (will explain more on why 2014 in a minute). I have highlighted countless times how the struggle is real within China, and every time the country attempts to “reduce lending” or “clean up the financial sector” or “cut stimulus” the CCP yields and pumps more into the market. It has come with extreme debt that has stretched collateral or FX reserves to the limit that is now barely propping it up. They have to change the structure to be more “internal” because they are out of bullets after a decade of ghost cities, infrastructure building to nowhere, and tapping the consumer. Premier Li Keqiang was supposed to deleverage the system, which was to be done by getting rid of shadow banking and adjust the financing metrics. Instead anytime they tried to adjust the financial backdrop economic growth stalled and they provided a big bump to the system. President Xi now needs the system to work but with law of diminishing returns crushing everyone outside of China... it has now come home to kill China as well. They are tapped out and have no means of gunning the system as law of diminishing returns has finally shattered the dreams of Xi. So now they are looking to create a dual circulation system or DCS to create a self-contained structure where they can start printing without issue of inflation fears but they rely too much on the USD or FX reserves to maintain collateral against the plethora of debt sitting in their market without a cash generator or asset behind it. Or as I have called it... the can is light, and the foot is strong until you are trying to kick it against a wall. China was able to bail out the world in 2014 and again in 2016, but the problems are much different today vs the previous few years. “To begin with, the Chinese shutdown happened in January and February, meaning that October was the eighth month of reopening in that place. Back in those first two months of the year, IP had plunged 13.5% year-over-year. Rather than recover like a “V”, China’s vast industrial sector has meandered back toward growth rates that for years have clearly pointed toward nothing good. Worse, October’s 6.9% was actually the second 6.9% in a row (same as September, no acceleration).”[5] The narrative shift continues with a move to bridge gaps in the system as more companies, especially state owned enterprises, start missing bond payments. “A worsening liquidity crunch is sweeping through some of the biggest Chinese conglomerates like Citic Guoan, underscoring concerns that the funding pain is far from over despite bouts of stimulus measures. Bonds from at least 44 companies totaling $42.9 billion face repayment pressure, a 23 percent jump from the tally at end-March, data compiled by Bloomberg show.”[6] China has opened its debt market to the world, but all this is doing is transferring risk into foreign hands as leverage levels remain at record levels. The below backdrop on industrial production, fixed investment, and retail sales, help to paint a picture that shows the recovery has been on the production side with little recovery on the consumption side with most being indirect. The retail sales just announced also include golden week, which provided a small bump that still disappointed estimates. China has also been playing with 2019 figures to help show a bump in 2020 data by revising 2019 lower. China has blended previous months in previous years to boost y/y numbers, which undermines the true accuracy of the data itself. In August, China had reported its first positive retail sales growth of 2020 on the basis of a similar adjustment, which depressed year-ago figures by 50 billion yuan.[7] China continues to cherry pick data in order to drive a narrative that is unraveling at the seams, which is why the increase in global trade is interesting given the depressed imports of key trade partners. Even with the “adjusted” y/y figures China is experiencing a slowdown in activity, and President Xi is looking for a way to change the narrative and link together all previous policies. The Dual Circulation System helps to give support to the systems that have created a massive amount of debt across the Chinese system. “Total Chinese debt across household, government, financial and non-financial corporate sectors rose from over 300% of GDP to nearly 318% in the first quarter, according to estimates published in July by the Institute of International Finance. The trade group expected that ratio to reach 335% of GDP in the following months.”[8] The bad debt expense that we have spoken about in previous reports is also rising, which is why China is looking to pull forward US Dollars. “China’s holdings of U.S. government debt fell for a fourth-straight month to the lowest level since February 2017, according to the latest figures from the Treasury Department.” The total for China -- the second-largest holder of U.S. government debt -- dropped by $6.3 billion in September to $1.062 trillionJapan’s holdings declined $2.2 billion in September to $1.276 trillion, while remaining the largest holder of U.S. debt The pressure is mounting because many of the loans/ bonds that have been issued over the last four years are either being financed with tax revenue or are underperforming with limited cash flow being generated by the assets. Volumes Arriving at US Ports The problem remains the struggling import markets for China’s core trade partners across the globe. The U.S. has seen a big shift lower on import activity across the board as inventories have normalized across large parts of the supply chain. As we have been highlighting, the struggles started well before 2020 on total trade into the U.S. High frequency data shows a deepening drop in trade. The volume of goods arriving at U.S. ports in the four weeks through November 5 is down 10.5% from January levels. The problem is this started in 2019 and has only accelerated lower with the recent spike in May/June being driven by additional flow to backfill inventories. China has been reducing their reliance on global trade as a driver for GDP growth. China’s trade balance has remained fairly stable over the years as the country has grown, and the share of GDP growth derived from it shrinks to about 15%-17%. Imports have slowed after the spike of technology was imported to build up stockpiles ahead of sanctions. Exports have stayed strong, but with key trade partners struggling- they are likely to slow even as China has picked up a bigger percentage of global exports. All of China’s trade partners (outside of Vietnam) are facing a large contraction in activity within their borders and general region. The below data for Q2’2020 provides a backdrop of just sheer size regarding trade and the international partners. The U.S. is the largest partner, but when we go through the rest of the top 15 countries- six of those that signed the RCEP. China is going to struggle going forward generating the same type of GDP growth achieved in years past, and with a soft target set at 5%- they plan on building a stronger consumer through local consumption. By focusing on the Dual Circulation System, China is hoping to promote more corporate investment within the country while also incentivizing the consumer to purchase more locally. The CCP wants to be able to create a more succinct local market to rely less on the global markets, and the US dollar as the Yuan/ Renminbi pick up a bigger piece of the total trade. While this all sounds exciting- the consumer remains stressed and is receiving additional support in their purchases- specifically now in rural areas. “Chinese top policymakers said the country will make more efforts to stimulate consumption, including boosting automobile and home appliance sales in the rural areas, to strengthen the economic recovery in the wake of the coronavirus crisis.”[9] The debt levels within China have now pushed over 300% of GDP and will approach 325% of GDP by year end, which will be a huge weight on growth. The signing of the RCEP trade deal (Regional Comprehensive Economic Partnership) is broken down across the countries outlined in the chart. A total of 15 nations signed the free trade agreement, which doesn’t include the US or India. “RCEP, often labelled inaccurately as “China-led,” is a triumph of ASEAN’s middle-power diplomacy. The value of a large, East Asian trade agreement has long been recognized, but neither China nor Japan, the region’s largest economies, were politically acceptable as architects for the project. The stalemate was resolved in 2012 by an ASEAN-brokered deal that included India, Australia, and New Zealand as members, and put ASEAN in charge of negotiating the agreement. Without such “ASEAN centrality,” RCEP might never have been launched.” [10] The deal will help streamline trade, while simplifying the regulations across local source requirements and other hinderances to trade. China’s sheer size will help it dictate more of the terms, but it also opens up the Asean 10 countries into broader markets. The U.S. and India already have some form of agreements with each country, and there are several paths forward for both countries to get involved in the region. There are many concerns in the surrounding areas regarding Chinese activity in the South China Sea (9-dash line), and aggressive trade tactics that have occurred with Australia and India. Chin and India are already in a border dispute along the Line of Actual Control in the Himalayas with China/Australia in a trade war that is intensifying. China ratcheted up issues with Australia by listing 14 grievances against Australia (list below the Trade Agreement Participants Chart). Many of them are fairly open ended with limited proof, and others highlight the tensions growing in the South China Sea and sanctions placed against Huawei and ZTE. Right after Australia and Japan signed the RCEP- they also signed a mutual defense pact to increase military ties. [11] “Australia and Japan say they have reached broad agreement on a defence pact that will allow their forces to train in each other’s territory, as both countries seek to navigate tensions with an increasingly assertive China. Once it is finalised and then approved by Japan’s parliament, the agreement will mark the first time in 60 years that Tokyo has approved a deal permitting foreign troops to operate on its soil.” Japan, Australia, U.S., and India have increased military activity throughout the region as China challenges freedom of navigation and ramps activity around Taiwan. The benefits of a trade deal is vast especially for countries like Australia and Japan that can now trade more openly with other Southeast Asian nations. The US and India can still use the RCEP deal to strike their own open agreements by utilizing the FOIP (Free and Open Indo-Pacific) version to link multilateral trade relation. Vietnam has gotten much closer with both the US and India as China has encroached on their fishing spots and EEZ zones. The RCEP has been in the works for over 8 years, and is still in its infancy when it comes to ratifying and implementing the changes outlined. Another option is to bring back the CPTPP (Comprehensive and Progressive Agreement for Trans-Pacific Partnership) and expand it to include other countries such as- Indonesia, Philippines, South Korea, Thailand, and the UK. There are many options that the U.S. can take as relations have improved over the last decade, and the renewed fears of China in the region have increased. The below chart of the members of the RCCEP vs CPTPP helps to highlight the opportunity presented in the current structure. As we said before, it will take time to implement the changes under the RCEP, and the framework (or at least some of it) can be adopted into the CPTPP. The U.S. Navy and cooperation in the area plays a pivotal role regarding freedom of navigation and military assets in the region. For example, Vietnam is exploring a closer relationship with the U.S. in military cooperation after an embargo on US military sales was lifted back in 2016. India gave a submarine to Myanmar as part of the military outreach in the region, which remains an important bid to counter Chinese influence in the region. The below grievances reinforce the problems that are pervasive in the region- even after the signing of the RCEP. Australia addressed the concerns with the comment “Australia will not bow to pressure from China, Prime Minister Scott Morrison insisted on Thursday after Beijing released a laundry list of complaints about the country.” "We won't be compromising on the fact that we will set what our foreign investment laws are or how we build our 5G telecommunications networks or how we run our systems of protecting against interference Australia's way we run our country," he told Channel Nine.” Australia and China have been in a heated trade war that remains an overarching problem. It will be the first real test for Biden as to how he addresses a long time ally vs China. China's '14 grievances' 1. 'Incessant wanton interference in China's Xinjiang, Hong Kong and Taiwan affairs' 2. 'Siding with the US' anti-China campaign and spreading misinformation' 3. 'Thinly veiled allegations against China on cyber attacks without any evidence' 4. 'An unfriendly or antagonistic report on China by media' 5. Providing funding to 'anti-China think tank for spreading untrue reports' 6. 'Foreign interference legislation' 7. 'Foreign investment decisions' 8. 'Banning Huawei technologies and ZTE from the 5G network' 9. 'Politicisation and stigmatisation of the normal exchanges and coorperation between China and Australia' 10. Making statements 'on the South China Sea to the United Nations' 11. 'Outrageous condemnation of the governing party of China by MPs and racist attacks against Chinese or Asian people' 12. 'The early drawn search and reckless seizure of Chinese journalists' homes and properties' 13. Calls for an independent inquiry into Covid-19 14. 'Legislation to scrutinise agreements with a foreign government' [12] President Xi didn’t waste any time connecting the Asia-Pacific Economic Cooperation keynote speech back to the Dual Circulation System: He said DCS will: “[E]xpand domestic demand…and ensure smooth flow of economic activity.”“[M]ake scientific and technological innovations to foster new growth drivers.”“[C]ontinue to deepen reforms and energize the market.” These reforms will enable China to: “[F]ully unlock its market potential and create greater demand for other countries.”“[O]pen up wider and share more opportunities for mutual development.” “[C]ontinue deepening international cooperation for shared benefits.”[13] President Xi is attempting to make a broader connection to the rest of the region by explaining how a bigger domestic market with local reform will provide outsized benefits for foreign businesses and investors. This soft tone comes immediately after providing Australia with the list above, which is meant as a warning to potential critics. It may silence some, but it will likely galvanize more anti-China sentiment not only in the region but on the global stage. It is interesting that China launches this “soft” threat while trying to move other trade deals in place- China-Japan-South Korea FTA and The EU-China Comprehensive Agreement on Investment. Premier Li Keqiang also pushed the DCS doctrine after talking about how the recovery has been lopsided due to constraints in consumption and trying to explore ways to spur domestic demand. We should expect to hear WAYYYY more about how domestic consumption will be paramount to the further growth of the Chinese economy. This will be worked into most speeches and written commentary for the foreseeable future. China is also preparing for a change in rhetoric from the US- it may be more veiled, but the threat will be real: “What Happened The Republicans on the U.S. Senate Foreign Relations Committee released a strategy document on Nov. 18 that calls on the United States to adopt a more multilateral approach to deal with China. Why It Matters: The document aligns with the strategy that U.S. President-elect Joe Biden’s administration is expected to take against China upon taking office in January. This indicates that despite the polarized U.S. political environment, Congress and the White House will likely work in a more bipartisan fashion against Beijing under Biden, as opposed to his predecessor’s reliance on executive action. The next four years could thus see more U.S. policy changes on China written into law.”[14] While the commentary is welcomed, the below charts help to drive home just how engrained the China-US are in all things- especially trade. The impacts we can see below are broad, and show the issues from the US-China trade war and the slow down in general activity. Imports have slowed from China, and just in general as the U.S. inventory reaches more normal levels. Chinese imports of US goods are well below the target laid out in the trade deal, which we have been highlighting for over a year now. Biden will need to address the trade concerns very quickly in his China comments, which aren’t expected to come out until January. As we have described throughout this report, there are many issues outside of just trade that will need to be addressed and established over the next decade. China is important and will be a key point to watch, but the U.S. still has a very robust relationship with India. With India and the US not involved in the RCEP deal, there are other opportunities to increase our trading frameworks. The U.S has seen a steady increase of imports from India with a similar increase in exports. As the trade war with China intensified, the U.S. relied more on Indian goods, which is something that won’t change in a new Biden administration. Obama laid out a solid framework that was picked up and carried forward by President Trump. Based on the Obama administration and Trump success with India, it is highly unlikely that Biden would deviate from the current trajectory with India. If anything, I would expect a renewed push of the CPTPP and expanding it to incorporate more countries across the Asean. The plan remains consistent based on the “key messages” delivered by the Plenum discussion regarding- investment/ domestic demand/ high quality but we are getting more discussion around National Defense and Security as pressure mounts with surrounding countries. We have already highlighted the problems with the US/ India/ Australia and other Southeast Asian Nations, but Taiwan is another thorn in Xi’s side as the US has a trip force positioned there with over $1B dollars’ worth of harpoon missiles (anti-vessel) being sold. China has reduced treasury holdings in order to pull forward USD and limit exposure to potential sanctions, but based on the current trade relationships and reliance- the US/China relationship isn’t ending soon. China needs to foster more internal creation of products- especially high value technology and R&D. Many pieces of the puzzle are falling into place, but it will take time to create the self-reliance desired. In the meantime, China will have to rely on foreign products to backfill the needs across the board. The integrated circuits is the big one that China is actively trying to replicate within their own borders given the importance across all current and future technology. As security and national defense becomes more important- it will be pivotal to have highly sensitive tech staying within their borders. Even as China relay on imports, they remain a key area for assembling finished products, which we can see with the global share in high-tech exports. They still don’t have the ability to create their own at desired levels, but many US companies assemble products in China to be shipped into other regions or back into the US. This keeps their share of high tech exports high versus their closest competition. While it is great to be part of the process, in order to drive real change within the country- it is important to create your own chips and software. The US may not manufacturer a large amount of their chips within the country, but the key components that drive innovation- such as chip design, intellectual property, and ship design software are mostly deployed in the US. This helps to ensure a certain amount of security around potentially sensitive data and IP. Keeping some pf these key factors within the US borders helps to protect general integrity of the information and data that can be classified depending on its usage. A large part of the chip manufacturing and testing takes place with allies and close trade partners, which is pivotal given the sensitive nature of these chip sets and inherent information. By keeping as much IP within our borders, we can decide who we sell/ disseminate the chips and information too. These are key aspects that help provide security, quality, and other targeted initiatives that has a renewed focus in China. The shifting focus is a core reason why expectations for a shift in chip manufacturing will increase in China. It takes years and billions of dollars to build these facilities, so it is easy to project growth profiles over the next decade based on current investments. The bigger shift (as described above) will be to become more self sufficient on IP, chip design, software, and other high-level technology innovations. The “new” domestic target is just a continuation of Made in China 2025 by supporting local: “The Chinese government has launched “Made in China 2025,” a state-led industrial policy that seeks to make China dominant in global high-tech manufacturing. The program aims to use government subsidies, mobilize state-owned enterprises, and pursue intellectual property acquisition to catch up with—and then surpass—Western technological prowess in advanced industries. Released in 2015, Made in China 2025 is the government’s ten year plan to update China’s manufacturing base by rapidly developing ten high-tech industries. Chief among these are electric cars and other new energy vehicles, next-generation information technology (IT) and telecommunications, and advanced robotics and artificial intelligence.”[15] Within China, productivity is slowing as well, which is also driving a bigger shift to focus on the domestic angle. We are also seeing China talk more about spurring rural demand with a renewed drive for spending within the urban and rural setting. The problem remains the slowing productivity throughout China that has plagued the system since the beginning of 2011. Chinese growth remained fairly stable into the first part of 2011, but when money started to slow- so did a large part of their growth engine. This was quickly made up by government investment, but the game can only go on for so long without a return on capital. Foreign investment has already slowed as capital shifted into other regions starting as early as 2014 and has only accelerated with the rise of the trade war. As I have said previously, we remain on a path to a cold war that hasn’t deviated. Government intervention has been the key driver to provide subsize for state owned enterprises and support the growth in exports. As the Chinese economy rises, to purchase GDP growth becomes more expensive and the restrictions are mounting with the level of debt sitting on balance sheets. “A worsening liquidity crunch is sweeping through some of the biggest Chinese conglomerates like Citic Guoan, underscoring concerns that the funding pain is far from over despite bouts of stimulus measures. Bonds from at least 44 companies totaling $42.9 billion face repayment pressure, a 23 percent jump from the tally at end-March, data compiled by Bloomberg show.” Bad debt has increased at various banking levels, but in the face of the mounting costs the PBoC is directing more cash into the market to prop up business and consumers. The draft revisions provide a legal basis for some of the new responsibilities the PBoC has recently taken on, including: Managing macroprudential regulationOverseeing “systemically important” financial institutions, financial holding companies, and financial infrastructureDrafting major laws and regulations for the financial sectorCoordinating efforts to prevent systemic risks With a surge in banks' non-performing assets looming, the PBoC's leadership may soon be tested. The government and PBoC are using various loan structures to help provide support but the leverage and rising bad debt continues to mount with rolling defaults and insolvent companies. To answer the question of the day- I go back to Tiananmen Square and the slow disintegration of relations that proceeded it. Nothing dies in a straight line- especially on a geopolitical front, but the damage was done and public support quickly turned away from the CCP. There have been peaks and valleys along the way, but the trend has been moving in the wrong direction since this pivotal event. Fast forward to today, and we can see how President Xi came in with a splash by ending the Japan-China tension (lifting ban on rare earth exports). He also wanted to push China into the center stage with Made in China 2025/ Belt and Road Initiative/ Attracting more Foreign Investment/ Investing in local infrastructure. But the expansion kept getting more aggressive in the worst way possible, and things started to sour with our "Pivot to Asia" shifting military resources and focusing on building more relationships in South East Asia. China began to get aggressive across the false 9-Dash Line by claiming islands/ fishing grounds/ oil and gas resources. When President Obama pressed the issue in the Rose Garden, President Xi claimed they were only for scientific purposes, but within 6 months they had air strips, advanced radar, satellite interlinks, all forms of missile protection, and military barracks. The goal was to push the U.S. Navy further away from the Chinese Coast and protect their false claims of the 9-dash line that was unanimously defeated in UN arbitration. President Obama launched a review of stolen IP and overall damage through the IP Commission Reports- identifying the true economic cost and passing laws to protect U.S. assets. The stage has been set for a ramp in tensions- especially as it came out the terrible structure and debt loads created through the BRI. The documents were leaked out of Africa early last year. The depth of espionage was finally appreciated with the Huawei backdoors installed in all the hardware they created/support. In my opinion, a trade war/cold war was the next logical step in the process of mounting pressure against China. I fear the cold war is going to quickly escalate into a "hot war" as China starts to make moves against- Hong Kong, Taiwan, and India. This is just a quick summary of the progression of China-US on the world stage... Just remember- China will enforce a contract as long as it is in their favor- the moment that stops... so does the contract terms in their eyes. [1] https://mailchi.mp/5f95f3f88492/becoming-like-the-us?e=21cdcdff2c[2] https://mailchi.mp/5f95f3f88492/becoming-like-the-us?e=21cdcdff2c[3] https://www.cfr.org/backgrounder/made-china-2025-threat-global-trade[4] https://mailchi.mp/5f95f3f88492/becoming-like-the-us?e=21cdcdff2c[5] https://alhambrapartners.com/2020/11/16/six-point-nine-times-two-equals-what-it-had-in-twenty-fourteen/[6] https://www.bloombergquint.com/china/china-conglomerate-s-debt-woes-worsen-after-missing-bond-payment[7] https://www.asiatimesfinancial.com/why-china-s-official-data-don-t-add-up[8] https://www.cnbc.com/2020/10/16/china-is-open-to-more-debt-to-support-its-economy.html[9] https://www.yuantalks.com/chinas-cabinet-pledges-more-efforts-to-boost-consumption-to-drive-car-sales-in-rural-areas/[10] https://www.brookings.edu/blog/order-from-chaos/2020/11/16/rcep-a-new-trade-agreement-that-will-shape-global-economics-and-politics/[11] https://www.theguardian.com/australia-news/2020/nov/17/australia-and-japan-agree-in-principle-to-defence-pact-that-will-increase-military-ties[12] https://www.dailymail.co.uk/news/article-8962087/China-launches-extraordinary-attack-Australia.html[13] https://mailchi.mp/24223fadc84d/14-things-i-hate-about-you?e=21cdcdff2c[14] https://worldview.stratfor.com/situation-report/us-china-republican-senators-back-multilateral-push-against-beijing?id=030c4e7823&e=0772360d2a&uuid=f9fd83ac-423d-4bb4-8826-721167d3ec15&utm_source=Situation+Reports&utm_campaign=ecdaf213ae [15] https://www.cfr.org/backgrounder/made-china-2025-threat-global-trade [/ihc-hide-content]