[ihc-hide-content ihc_mb_type="show" ihc_mb_who="10,13,14,16,18,19" ihc_mb_template="1"] By Mark Rossano The spread count is set to start moving higher into the beginning of June at a steady rate to 230-235. The growth will remain in Texas as the Permian pushes back to 120 spreads, and we keep seeing a seasonal recovery in the Williston. The Western Gulf and Permian will be the push back to 230, but the move past that will be driven by the smaller basins as well as Anadarko and Williston. In order to get a sustainable push, rig activations will need to keep rising to replenish DUCs that have been worked through over the last 12 months. The U.S. is seeing a pick-up in crude exports as Europe pulls in more crude as refiners start back up and increase total runs. This will keep us firmly in our target of 2.6M-2.8M barrels a day as we head into the summer. Rig activations have increased, which have stopped the DUC decline in the Permian. It isn’t enough to rebuild some inventory, but it is enough to stop the drawdowns. The same still can’t be said about other areas- especially Eagle Ford and Bakken. The uncertain around DAPL will keep activations muted, but we will see enough in spreads and rigs to at least stem the declines on DUC inventory and crude production. The overarching theme right now is the Iran nuclear deal that has been talked about crossing the finish line over the next few weeks. I still believe we will wait for the Iran election to conclude before we officially sign on the dotted line. To sign the deal ahead of the election, would provide campaigning support for the hardline government, but by working this far allows for a framework in place “if” (And that is a big IF) there is a bigger change at the government level. We have written about how the local populace doesn’t support the current administration and their anger has been growing, but the current election is already being protested. This will limit the ability for a big change at the federal level. The other impact is the pressure India (and Asia in general) is putting on the US/Europe to allow more Iranian barrels to come back to market. Iran has been pushing an additional 500k barrels or so into the market as demand has steadily risen for “cheaper” barrels as prices have moved higher. India has already offered support for buying Iranian crude the moment the deal is signed. Iran and India have been friends for over a thousand years (since the Persian Empire and Silk Road), and several Indian refiners were built specifically for Iranian barrels. Iran would also be able to get more condensate into the market- so the rise would be more than just the quoted oil barrels as 2M barrels a day of crude and condensate would quickly hit the market. I still think the deal is a low probability in the near term (pre-election), but there is growing demand to see a change in the market. China has also changed their levy system to increase costs of bitumen mix, light-cycle oil, and mixed aromatics. This will hit Shandong refiners that try to blend the cheapest barrel, which is just another push by the CCP to protect SOE margins. Teapots were already being investigated, and this is just another round of pressure on their margins as well as general operation. This will leave more semi-refined product in the market hitting South Korea, Japan, and Singapore refiners the hardest. While it will pull more crude into China, it will decrease their total runs at Teapots and reduce their imports of semi-refined products. The reduction will force refiners in other regions to reduce run rates and cut their crude consumption- so on an aggregate basis- there will be no change or growth in oil consumption. It will just shift general supply chains and flow of crude/product. This has supported some additional buying of ESPO and ME grades, but it has forced other nations to adjust their purchasing. Below is the growth of flow over the last 2 years: Malaysia has also been a big seller of bitumen mix (most Venezuelan barrels) into the Asian market, which will but new pressure in the market as those barrels back up into LatAm. “After the tax changes, refiners may instead increase imports of heavy grades such as Iraqi Basrah Heavy, Colombian Castilla, and Napo from Ecuador, according to analytics firm JLC.” The biggest shift I think is summarized in this quote: ““The biggest impact of this tax is that it diverted overall crude demand and refining to China from other parts in Asia,” said Yuntao Liu, a London-based oil analyst with Energy Aspects.” On a net basis, it won’t be increasing crude buying- instead- just shifting who is buying the crude and what grades are in demand. The underlying problem with the crude market remains the Asian slowdown of buying that persists into another month of buying. Nigeria is still sitting on 2 April deferrals with more getting shifted out of May and into June. There was a big shift of about 200k barrels a day that have been moved into June- on top of the April deferrals. The WAF and ME market saw some bids come in that have lifted differentials off the lows, but still well below seasonal norms. India showed up to buy oil for July, but it was well below expectations after skipping a full month of buying. Their storage (of both crude and products) remains near tank tops, which is pushing more product into the export market. Indian product has accelerated into Europe with Middle East and Asian product pushing at an elevated rate into the Atlantic Basin. As the US supply disruption (Colonial) normalizes, we will see a big increase of gasoline imports pushing storage levels higher. China credit impulses have rolled over, which will provide a pause in the commodity price rally as the CCP targets inflation. China is cutting liquidity from the system in order to adjust their inflation rates and bring some of these commodity prices to slow. The supply constraints remain, which will support pricing metrics- but China is struggling on an economic front. This is pulling down credit impulses as the PBoC pulls money from the system, and they try to cool the bond/loan market. The CCP is stopping/slowing investments into infrastructure projects to limit provinces from trying to prop up growth. Provinces (and local governments) have relied on infrastructure spending to drive growth that is now being financed with tax revenue. The PBoC and CCP have had to open up lines for funding to the local level as governments can’t even finance salaries let alone trying to support growth or CCP economic targets. The pressure is going to keep growing- and inflation isn’t helping as export prices rise and geopolitical tensions increase. As the inflation narrative progresses, it is important to look at the supply chain and where we have seen price increase throughout the system. We are seeing price increases at the consumer level, but there remains more that has yet to reach the end user. PPI (Producer Price Index) has increased around the world- especially in countries that are the largest trade partners with the U.S. The steady rise at the manufacturing level will get passed down the supply chain, which has only accelerated over the last few months. Given the remaining spread between input & output prices, there will be more cost to be recovered. China is the largest trade partner, which is also where prices have accelerated over the last few months. This is the widest the price differences have been in China going back to 2008 and given the underlying trend- we won’t see any slow down in pricing. China has cut back on stimulus across the fiscal and monetary level to reign in credit and reduce liquidity. This will push companies to increase costs on their products to protect some sort of margin. We expect to see commodity price increase to slow as China tackles inflationary pressures across their system. The issue is a mixture of demand, but also persistent supply disruptions limiting availability. It is a mixture of local mine strikes, pervasive shortages in shipping, and geopolitical tensions- such as China vs Australia. So even as credit impulses (a measure of debt availability) roll-over, commodity prices will give up some of their gains, but more likely just pause the recent rally. Even with a reversal of some commodity prices, there still remains a gap between pricing so even if prices pause their rise- they won’t be falling anytime soon at the manufacturing level. There is typically a lag time between price increases at the input and output level. Therefore, PPI is a leading indicator of where output pricing will go. The market could reject the price increases, which just means that customer A could adjust supply chains to say a Japanese or South Korean company that might be offering a cheaper price. This all may seem easy, but the whole system is experiencing pricing pressures- so there are limited opportunities to protect pricing. The other issue is the shortage of inventory, which is pushing companies to pay “any pricing available” in order to keep their supply chain at least somewhat flowing. I think the period of 2016-2018 is an interesting backdrop for PPI in China because even as we had commodity prices shift lower- underlying prices remained elevated. Prices were passed along slowly, but there were also other drivers: Tight labor market driving up pricing.Expanding global economy Chinese stimulus These impacted the PPI numbers over a broader period as companies looked to capture rising internal prices as well as some commodities seeing price appreciations. We are in a period of additional complications given the underlying geopolitical theater and COVID19 impacting supply chains on a broader scale. Once you purchase the product within a country, a company needs to get it on a boat to make the long journey into the U.S. The shortages in shipping are massive and only growing as we come into a “high demand” season with little headwind progress made during the seasonal slowdown in March-April to help alleviate some of the underlying pressures. Instead, we had a small dip- but the issue is more pervasive than just some small backlogs. There is a limitation on available containers due to slow backhauls due to problems at the ports and within the countries supply chains. For example, India has declared force majeure at several ports through May because of COVID19, which is limiting load times and sailor availability. Sailors are being left on boats for over a year with little way to get home or make normal stops/transfers. This is leaving ships stranded for months at a time. On the container side, the limitations onshore due to worker shortages to droughts are slowing down the offload and reload process. Droughts lower river levels and cut the weight capacity that can be put on a barge to move product, which slows transit time. The shortage of truck drivers in the U.S. and extensive port delays are exacerbating things on our side (I will cover that more in a bit). Shipping prices pass through fuel and labor costs, so as we see ULSD prices keep trending higher- it will only push rates higher. We have heard many stories of companies willing to pay “any price” to get on a boat, but there is physically no room or ability to achieve it at “any price.” Now that it is on a boat- you need to offload it at the port. There have been rolling strikes around the world as well as limitations of port capacity due to COVID19 restrictions. The rush to backfill supply chains have caused backlogs at ports already, so the issues on trucking/rail are just exacerbating the underlying issues. The below is just one snapshot of port congestion as the percent of import volumes keep growing on a week over week basis. The length of time at port keeps expanding with many of these TEUs “slipping” from one week to the next. The reason is not only offloading, but the ability to get it onto a truck/train and put on a full or empty container to backhaul along the set route. This means that ships are in port much longer and limits slip space available for other boats. There is a big shortage of truck drivers with companies offering elevated hourly wages and sign on bonuses to increase capacity. The market had a big upheaval in 2019 when several large trucking firms went bankrupt due to overbuilding in 2018 and slowing demand in 2019 as the global (and US) economy slowed down. We predicted that 2020 was going to create a huge drain on assets due to a shift in inventories from the wholesale/retail level down to the consumer. Typically, this would quickly be replenished but with the world shut down and shortages- trucking became the favored way to move cargoes to be nimble around lockdowns and national restrictions. This absorbed all the spare drivers and trucking capacity quickly as “load demand” kept growing. Rates have also pressed higher as diesel and labor costs are passed through. Freight rates remain supportive on multiple metrics and areas that we monitor pricing due to the shortages in the system. “The embedded rates rose another 3.4% m/m on a seasonally adjusted basis in April, following a 3.5% m/m increase in March consistent with the rising trend of the past five months. With much of the annual contract freight market repriced at this point, we expect these increases to begin to slow near-term. However, with strong freight demand and supply constraints on both drivers and trucks, spot and contract rates should continue to rise.” Even as the Cass Shipment Rates moved higher, we saw a decline in total shipments by a small number that just reversed underlying gains. The dip was also reflected in the “Internet Truckstop Demand Index”, but the more real time metric has not only recovered from the slow down- but has made a new all time high. This will keep rates well supported on a demand level, but diesel prices have also shifted higher again due to demand and the Colonial Pipeline disruption. Even as the Colonial pipeline returns to normal operation, the price increases are unlikely to decline as they reflect the rise we typically see on a seasonal basis. The difficulty for drivers right now as well is the backhaul because companies are so behind on their inventory- they have to wait for the other container to be loaded and sent back to the port. So between labor, diesel, and demand- we are far away from prices declining. You might ask yourself- why not just slow down purchasing and survive a bit longer on inventory? The reason- inventories have been absolutely destroyed due to the prolonged supply chain disruption and retail buying more with government money. There is a record number of shortages at the corporate level that is keeping them as active as possible to tread water. They are struggling to just maintain current operation- let alone actually build up their inventory levels. The below shortages will keep purchases elevated even after things start to normalize at the consumer level. These shortages also leave them open to whatever the market price is, which keeps pressing higher because everyone is experiencing similar problems. Another example- going back to 1992 retail sales exceeded inventory as of April. The below chart just puts into perspective how short the market is and why corporations are subject to whatever price they can get- which is still in the process of getting passed down to the consumer. The inventory shortage is keeping companies active and using all means necessary to try to pull product through the supply chain. It is also supported by the number of unfilled orders piling up and waiting to be met. Some of these unfilled orders were agreed upon at a lower price point, so as these orders sit in the system- it will take longer for the company to recoup costs. The delays in getting product to market will also cause some bigger price increases to new orders because companies will expect delays in these as well. They will also try to factor in the delays that are expanding for raw materials and semi-finished products. The lead time for many underlying goods is causing companies to re-price new orders to match the big spike in pricing. Even with some of the adjustments there remains more in the supply chain. The delays across US factory wait times for materials and supplies is now the longest on record going back to 1987. Delays are impacting all parts of the supply chain, and in areas that are typically deflationary- such as technology/semiconductors. The U.S. has been exporting inflation for 20+ years as factories, labor, and just general costs were farmed out to the lowest bidder. This spread the supply chain out to the cheapest place, which also had to cover the distance and additional shipping cost. All of this works out perfectly in a “normal” market. The next step to cut costs was to reduce inventory aka cost & overhead while running “at-time deliveries” enhancing profits. So we were already running at reduced inventory levels when a massive shock hit the system, but costs were already starting to rise with logistic and labor costs becoming more problematic with China. The geopolitical backdrop between China and the U.S. was worsening well before Trump, but the trade war just solidified the issues as tariffs went higher and relations spiraled. The relationship between the two countries is on a death spiral, which has caused countries to accelerate their supply chain diversifications into other parts of Asia- relying more and more on Southeast Asia. The shift will accelerate into other nations, but that will also increase underlying costs keeping pressure on the system. We can look at pricing within the U.S. through the different Fed metrics that show prices paid vs prices received. This helps highlight the transfer of costs from the corporation down to the consumer. The below chart has played out across all metrics with upward pressure on current prices, but very little adjustments expected over the next 6 months. Companies are looking down their supply chains and evaluating the underlying issues- with little respite expected. Many of these price increases at the corporate level are still being transferred to the consumer. Nothing happens in a straight line, so the movement of prices will be a steady shift in order for companies to protect margin and attempt to recover rising costs. The increase in prices also don’t reflect a big increase in wages, which is a big driver of underlying costs. So even as the supply chain normalizes, wage growth will have to enter into the equation and that remains at its infancy and still a bit in the future. We have already started to see it creeping into some sectors of the economy as wages and incentives increase, but it still remains in pockets and not as broad. The Atlanta Fed has a breakdown of some wage growth expectations and slow deployment of full-time workers. We are just not seeing wages match what the Beveridge Curve is highlighting given the amount of job openings in the country married with such an elevated unemployment backdrop. The below heat map puts into perspective that many of the underlying pressures in the wage/labor system happen in a monetary (Fed policy) tightening mode, and shouldn’t be occurring in one of the easiest liquidity market in history- in both monetary AND fiscal policy. In April 2020, we made a call that many companies were operating with a lot of slack on the employment side as well as zombie corporations that would take advantage of COVID to dump employees. Companies have been unwilling to increase wages for specific rolls for multiple reasons- some being: Unable to pass on the increase costs.Belief that someone “cheaper” or accepting lower wage will come along. Mismatch in skill sets and given the amount of unemployed waiting for a better fit. Many people remain on the sidelines of the jobs market with a large portion of them now unemployed for an extended period. I make the comment regularly that a person is similar to a warm stacked or cold stacked rig- someone who has been unemployed for a month or two is “warm-stacked” and will be able to catch up quickly/ while someone who has been unemployed for 6 months or more is “cold-stacked” and will take time to get up to speed. This will leave more slack in the market with employers trying to avoid those were unemployed for an extended period. It is important to appreciate that job openings never really fell during the pandemic- instead they essentially flat lined as the lockdown progressed. As the U.S. started to reopen, job openings accelerated as companies started to see activity pick-up. The numbers below are a bit backwards because based on the curve- you would expect a pickup in hiring and underlying wages. I know when I was applying for a job several years ago- I ran into multiple situations where: I interviewed for the job.Called back for a 2nd and 3rd round.Waited several weeks to hear back.Either never heard back (with the position sitting open) or the job was frozen (no hire) or canceled all together as the position was terminated. Based on the ease to post a job on Indeed/ LinkedIn/ Job Boards, is there a chance that some of these jobs’ openings are inflated? There is probably a mixture of all the above, but the situation remains a bigger problem as companies attempt to do more with less. I believe the biggest factor remains the mismatch in skill sets. Employers are seeing their work loads increase based on order backlog and unfilled orders, so they need workers that can jump in and start up with limited training. Given the shifts in the employment sector, it is unlikely they will be able to find some that doesn’t require some training. This creates more inefficiency and cost for the company (they have to train), which is typically recouped by paying a lower salary. In this market, employers are unwilling to train and potential employees to take a lower wage. They are receiving decent benefits to wait for the “right” job to come along, and companies have a plethora of potential candidates and want the perfect one. The other important shift is not just in number of employees, but also what the average work week will look like going forward. The expectation is for additional employees will be hired, but at a reduced workweek. It isn’t just the NY Fed showing the pressure, but the small business index as well as employment and compensation remains well off pace and below pre-Pandemic levels. The trend remains higher, but the pace of the wage increases is slowing. Small Business are also seeing pressure to raise prices to cover rising costs. On a national level, wage growth remains well below normal as companies attempt to manage pricing and have employees work longer hours vs hiring a new individual. This helps manage some cost and try to minimize the pain as companies wait for some price stability before they feel comfortable hiring in a great fashion. These underlying issues are causing companies to talk more and more about inflation in the market. The expectations are a piece of the puzzle, but the underlying shift in costs are very clear causing companies to address them on earnings calls. This will hit smaller companies harder because they are unable to pass through as much of the cost and have less product to spread the additional costs across. Small businesses will be under additional pressure- especially on the wages side where they don’t have the ability to pay a more competitive wage. The jobs that did get added were of a lower income bracket, which also drags down the average hourly wage metrics. If you have more jobs (denominator) across a small hourly wage (numerator) everything will look a bit worse. But for the point of this report, it is worse because wages are NOT rising and leaving people more susceptible to price swings in their daily life. The return to work is being driven by expiration of extended benefits, rising costs, end to the moratorium on evictions, and other COVID benefits. The shifts are sending people back to work, but it is happening slowly after the seasonal surge happened in March with April numbers missing by a huge margin. The extended benefits remain elevated while new claims are slowing, but the biggest issue (as described earlier) is the longevity of people out of work. The rise in underlying costs for people will limit their spending capacity for items outside of daily necessities. The below charts are where all the above data points converge into pricing impacts for the corporations as the trends remain higher and top estimates. The import price is a catchall for some of the increases on average, which can also be said for the broad PPI increase in the U.S. As the supply chain remains challenged, prices will keep getting pushed higher as cost is recovered. Inflation at the consumer level is being driven across multiple asset classes, and it has really accelerated over the rolling 3-month period. I know a lot of people discuss about the base effect and the “Transitory” nature of inflation, but it has really accelerated since March. It is easy to see the “base effect” when you follow that white line in 2020, but a large part of that was realized by the end of the year. We had the rise in COVID19 cases in Jan-Feb, so some “deflation” came through on some of the basket (airlines/ lodging), but the things that matter (everyday items) have been pressing higher with more pressure to the upside given shortages in everything from food to inventory. The consumer is seeing price increase across the board, but some places that have been big areas- energy and food slowed down, but given the Colonial pipeline issues/ crude pricing/ seasonal increases- energy prices will recover again in May. While used cars will start to pare back over the next 6 months, the “shelter” costs are going to rise as rents normalize. We talked earlier about the moratorium on evictions and foreclosures coming to an end, which will push rents back up. For example, if a landlord is “unsure” of collecting rent- the CPI plugs in $0 for that figure. This keeps the calculation low, so we will get a “make up” number but also see percent increases across the country to match the spike in housing prices. Food prices will remain higher around the world, but the biggest near-term driver will be housing. It is also one of the biggest components of the CPI calculation and will see a strong move higher from the current lows. COVID19 restrictions have kept things fairly capped, but those restrictions are ending and has already started to send rents higher. FedEx just announced that they will double large-shipper peak residential surcharges. There are surcharges being places across the home delivery space, which is just sending costs higher (again) with a new round heading our way as diesel prices trend towards $3.30. The recent announcement of PMI today just shows another surge higher in prices across manufacturing and services: “Increasing cost burdens continued to be keenly felt, as the rate of input price inflation soared to a new survey record high, often linked to a further marked worsening of supplier performance. Commonly noted were increases in PPE, fuel, metals and freight costs amid significant supplier delays. The steep rise in costs fed through to the sharpest increase in output charges since data collection began in October 2009, with record rates of inflation registered for both goods and services as soaring demand boosted firms’ pricing power."[1] The price push in the system keeps sending prices higher throughout the system, and the U.S. isn’t the only one facing problems. “At the same time, input costs rose in May at a pace not seen since July 2008. The uptick in inflation was widely attributed to higher logistics, raw material and fuel costs, with firms commonly reporting soaring vendor prices and difficulties sourcing materials amid a further severe lengthening of supplier delivery times. Companies made efforts to pass higher cost burdens on to clients, causing output charges to rise at the steepest rate on record.” This is a quote that fits around the world that is driving up costs around the world… and not stopping. [1] https://www.markiteconomics.com/Public/Home/PressRelease/392edb090fd34a7cb68bf22a1ddb7789 [/ihc-hide-content]