By Mark Rossano [ihc-hide-content ihc_mb_type="show" ihc_mb_who="10,13,14,16,18,19" ihc_mb_template="1"] SUMMARY • U.S. Completions- Cushing vs PADD 3 and the Physical Market • Powell and U.S. Inflation • Global Growth or Lack There of • Broad China Update • U.S. Growth Pressure Points- Wages vs Inflation • U.S. Completions- Cushing vs PADD 3 and the Physical Market The U.S. completion market will keep moving higher and hit our target of 275 spreads by the end of Oct or 1st week of November. There is more work being deployed in the dry gas/ wet gas regions around Oklahoma and Louisiana. The Permian is already fully operational with some additional spreads to activate (3-5) but we are running a bit tight in the area. Plus- the demand for natural gas/ NGLs globally will help keep prices supportive as LNG/ LPG/ Ethane-Ethylene exports hold near records. Rigs will continue to drive growth the next few quarters as DUCs are replenished heading into Q1-22. The below chart helps to show where Permian production sits and will close out a new record by the end of 2021. The DUC count continues to get drawn down, but there still remains enough running room in some key areas of growth- Permian and Haynesville. We are still getting close to the 2017 lows, which will be addressed as frac spread work levels off and rigs keep running into year end and well into Q2-22. This will not only stabilize the drop, but put more into inventory allowing for another steady expansion of production increases to about 12.3M barrels a day exit rate in 2022. The newest topic is the shift in PADD 2 vs PADD 3 crude storage with a laser focus on Cushing. We are approaching the 2018 levels of Cushing storage. So far- the estimate for Cushing draws this week is 2.5m-2.8M barrels which would push is below the 2018 level. My view was that we would start to reverse higher and see builds start to pick up inline with a “Slope” similar to 2014 but at a higher level. This would have sent us below the 2018 level but move us closer to the 15-year average. The unknown now is the relationship between PADD 3 and Cushing/PADD2. In PADD3, we have a very different story with exports slow, imports increasing, and storage just off record levels. When we compare the same months, you can see how things are a bit different for PADD 3, which is only below 2016 and 2020- sitting at the 3rd highest ever with more pressure pushing storage higher. When we look at the total U.S. crude storage backdrop, PADD 3 is 6M over the 5-year average with the shortage against historics driven by PADD2. At some point, we will see draws out of Cushing stop- especially with Line 3 fully operational this week and beyond bringing a steady 760k barrels a day into PADD2 and further to PADD3. The storage situation in Cushing is grabbing headlines and is the reason being explained for the recent spike in WTI pricing. There is a mixture of timing as well as backwardation that is pulling this crude out of storage. In the current setup, you are incentivized to sell the product- but there will be enough in the system to meet the Dec roll. There is still a lot of time to close the gap by limiting flow into PADD 3 (that doesn’t need it) and backfilling with Canadian flow. This will be a spot to watch as we progress into Nov to see how much of this is addressed- especially given how expensive U.S. crude is vs the global stage. There were some movements in the global markets, but very muted after Indian Oil Company only took 6M barrels from the Middle East and 2M from West Africa. China (especially Teapots) have also been very quiet after only purchasing one Djeno (Congo) crude and their normal Angolan allotment. Russia is increasing exports as internal activity is curbed driven by COVID cases rising again putting more crude on the water. This should show up in Nov/Dec data as more crude is diverted- especially ESPO. ESPO is trading at just over $6 premium and at a 24-month high as demand remains strong for this specific grade, while Urals are still trading at a steep discount of $2.40 below dated Brent. We had a small bounce in North Sea pricing and Forties by about $.05 while discounts remain the norm out of West Africa. Even with broad discounts offered to IOC, Nigeria still struggled to sell cargoes and are now sitting on a significant amount of product heading into the Dec loading schedule announcement. The areas to watch will remain Asia as the arb opens up to pull fuel oil out of Europe into the Asian markets (West to East Suez). Gasoil builds started to increase in Europe as ships started offloading and refiners target the lighter end of the stack. Now with the arb open, they can run a bit harder with a viable option to offload the heavier products they were already struggling with in storage. Heavy distillate/Residual still remains available in the market, but the tightness is increasing on the middle disty side (especially in Singapore) which will be one to watch as Japan, South Korea, and India increase refinery run rates to capture that spread. Costs still remain very elevated across hydrogen/NG, but depending on the process/crude grade- as long as it is weighted to middle disty- there is money to be made. In theory, this should support the purchase of WAF crude grades, which is why India’s purchases being weighted to ME means they got some very aggressive pricing from them. SK and Japan should step in and start picking up some of these stranded WAF barrels, but so far, we haven’t seen any real movement. Floating storage remains elevated and when you merge it with current onshore storage- we are still in line with historical norms. There were also a lot of buying in 2020 by non-OECD buyers that makes it a bit harder to track vs the below charts. China is still sitting on a record amount of fuel oil and 2nd most crude in storage (behind 2020). Floating storage will remain elevated, but we will start to see some reductions in Asia while increases continue in the Middle East/ WAF/ U.S. • Powell and U.S. Inflation We now have Powell coming out to say it is “time to taper” as inflation is facing competing levels and now, he says: “We don’t know how long it will take for inflation to abate.” He is finally coming to realize that when you let the inflation genie out of the bottle it is very difficult to put it back in without more aggressive measures. We have always believed that Powell and the Fed would keep Nov as the timeline to start tapering, but we believe that the market will force them to raise rates sooner than they would like- Q1’22. Many in the industry expect a Q2-Q3 raise, but we could see that start to get pulled forward based on these comments. As we have been saying CONSTANTLY (and do a brief update at the end), inflation is running well ahead of their expectations with a lot of staying power across the varying metrics. Every metric you can see is either running extremely hot or accelerating over the last several months: It won’t be easy to curb these increases on inflation, but the first step will be to stop buying MBS (Mortgage-Backed Securities), but the issue will be on slowing the purchase of treasuries as the government issues a significant amount more to carry the growing deficit. Over half of the budget has to be borrowed, and with a NEW spending bill slated to come through- we will have even more borrowing coming to the table. This is all happening as food prices surge to new 10-year highs creating a much bigger problem not just for the U.S., but globally as the price of food shifts higher. The rise in prices is helping to support our exports, but it is also leaving us tighter at home- especially as the shortage expands abroad. China has been a big buyer, but we have seen some tender offers pulled (Egypt) as costs run hot waiting (hoping) for a pause in pricing. The shortages in global wheat continue to grow though driving up prices and forcing some into other crops. Even though some of them are still more expensive, it also comes down to availability vs price. • Global Growth or Lack There of Estimates for growth in the global market are finally starting to reverse lower as pressure remains across the supply chain. Inflation expectations keep shifting higher as actual numbers blow through estimates and current/leading economic indicators miss estimates to the downside. The pressure is mounting on the underlying foundation of a “recovery” that has been purchased with trillions of dollars. Central banks are facing a tough challenge to manage inflation while not stifling the budding recovery that is facing more problems. Everything from supply chain issues to raw material shortages have driven up input costs that are fueling the endless cycle of price increase. Emerging markets are leading the charge on raising rates to stay ahead of ramping inflation given their sensitivity to any adjustments. Many of them are already running well ahead of targets, which will result in more aggressive actions to assert more control. We had some inflationary pressures slow down the last 2 months, but they are now accelerating again with more pressure to the upside as we close out the year. The leading indicators are shifting higher with Producer Price Indexes moving to new all time highs in key producing regions and exporting nations, which is the tip of the iceberg from the pricing pressure. The surprise index for inflation and economic data help to tell the broader disconnect story. This has also driven EMs to purchase more reserves in order to help insulate from more stress in the system. These banks will keep purchasing treasuries to provide some cover while also raising rates to stabilize currencies and “cool off” some of the recent runs. While they are taking action, they are reaching a limit on the amount of capital that can be deployed to shore up balance sheets and will rely more on raising rates over the next few quarters. The cost of imports are rising in dollar terms, which is also a key reason CBs need to ensure there are enough dollars to backstop the increasing flow of imports- IE energy and food- to help maintain normal operations. It isn’t just emerging markets seeing the pressure as South Korea is also likely to increase rates to help counter pressure. Russia had a surprise increase while Turkey had a surprise cut- a tale of two cities. Turkey is facing a huge surge in inflation (Spain is the most exposed) while Brazil follows a similar strategy (more below). It is likely we get another small bump from South Korea to help stem some of the recent run up in inflation, but wholesale prices accelerated again as well as input costs- so we can expect to see more inflationary pressures. These inflation expectations are also showing up across the U.S. and Europe as we have expectations moving higher in the debt market. The shifts keep moving higher as inflation swaps breakout to multi-year highs with more pressure coming to the upside. The rise in food and energy prices (among other input costs) will keep CBs active in the market to maintain elevated reserve holdings, but not all countries are in the same position. Brazil for example is going through a big repricing on the yield curve as President Bolsonaro plans to breach spending limits sending the yield curve gapping higher. This has sent borrowing costs straight up resulting in growing inflation fears. The move in spending is big shift from the initial policy discussed and has created additional pressure for the economy. The budget moving back up will increase their need for new debt, which has caused the yield curve to reprice quickly higher. Brazil is just an example of how difficult it is for Emerging Markets to keep stimulating their local economies. This is another driving force of a broader slowdown in the global market that is impacting demand. This is driving up local currency government bonds around the world, which is keep stress in the market as economies face rising costs. Local consumption in many regions have been limited as inflation bites hard and limits spending patterns. The rise in prices across around the world have hit global manufacturing output as activity stabilizes after an initial spike. We still expect to see growth just at a more moderate pace to close out the year as companies work through backlog and pause new orders. Activity will be supported by the backlog of work, but as new work slows it will weigh on future growth and expectations. We believe that as the backlog clears and commodity prices come down a bit- new orders will start to increase again because companies are still running well short of normal inventory. The U.S. has an example (and the largest importer/buyer in the world) is still well below normal across all inventory metrics. Sales have been relatively flat on a volume side (up when looking at value aka inflation) so a lot of the below movements have been driven by a small bounce in inventory. We are still well off normal, which is an issue around the world, and will be supportive of manufacturing even as the consumer slows. The global consumer is still the pivotal driver, but the corporate side will help soften the blow as consumers pare back. New orders have had a big dip, and they are unlikely to bounce back higher- but rather sit in a growth profile but just move closer to “50.” Backlog continues to shift higher, which is being driven from everything including labor and raw material shortages. Backlogs will remain well above normal, which will keep new orders trapped and press it further down. The manufacturing delays may have “bottomed” but we are far away from seeing a return to some sort of normalcy. Depending on the region, we are seeing companies report widespread shortages. In the U.S. over 94% of developers have a shortage in at least 1 item and in Germany it is over 80%. The broad swath of limitations will keep supply delays elevated well into 2022. When we look around the world- this gives you an idea of how many companies are reporting delays and labor shortages. The broader slow down on new orders and elevated backlogs will keep trade elevated especially on the water as flights remain depressed. Air Freight has seen a big drop- especially on international flights- that has put more pressure on the ports and shipping network as companies scrambled to replace flows. The issues work on both sides of the ocean with delays spreading as ports in Asia (especially China) are massively congested after pushing hard in front of Golden Week (1st week of Oct). Between golden week and the recent typhoon Kompasu, there have been broad delays that will take time to clear. The sheer volume that normally comes into the region is already massive so the recent outbreak of COVID mixed with the typhoon and slowing industrial production within China is exacerbating the issues. The problems don’t stop at the coast for China as their local economy face headwinds that hit on all facets of growth and general GDP. The global supply chain concern has been growing with more than 70% of global economies showing concerns about logistics. It is a huge concern for many-especially as we head into the holiday season and availability of goods drives purchases. • Broad China Update Before I go deeper on the China side, it is important to look at where spot commodity prices are now vs other points in time seasonally adjusted. We are sitting at all-time highs and have no surged way above the highest points. The difference between 2008 and 2021 has been trillions of dollars in stimulus that has been a huge tailwind as the “reflation” trade remains a driving force. In the market, we currently have people that are panicking or FOMO taking hold that is pushing us higher. As we have learned over the last cycle, you either get a bigger response from supply or demand is sacrificed as the pain is magnified. It is why I think this chart helps to drive home just where we sit in the current cycle. We are already pulling back across the manufacturing front as the business cycle moves into the late-stage cycle. The commodity price surge has sent PPI to multi-year highs that is still being passed down to consumers. The shifts in economic data and accelerating inflation have many estimates getting pulled lower on global GDP. It is always hard (impossible?) to really nail down what will happen even 2 years out- let alone 10, but the underlying issues I think are becoming clear as we close out 2021 and head into 2022. The broad economic impacts of fiscal drag, supply chains, labor, and inherent inflation is a drag on growth. China will also be a much bigger drag on expectations as many official data sets miss estimates, and it is important to reiterate that even manipulated data is missing- so just think about what the real numbers are in comparison. We could just as easily invent something completely revolutionary changing the back-end of the curve, but when looking at near term issues we are competing with collapsing credit impulses, credit rising cycle, and fiscal drag on a global level. The change in financing is firmly negative across many markets- especially the U.S. and China. For those have been reading/ listening to us, the above chart is no surprise as we have highlighted those estimates are dead wrong and we agree with the “true-up” on India and Eurozone growth seeing big retractions. But China remains massively off base with way more headwinds cropping up vs what the market appreciates. There hasn’t been any sector within China that has emerged to drive growth as the biggest engine- real estate- has been sidelined. We have more potential defaults as Evergrande’s grace period ends this weekend. “In today's China developer news: - Sinic has technically defaulted, according to S&P - Kaisa mgmt cancels creditor meetings this week - Evergrande's 30-day grace period could end as soon as Saturday.” Evergrande officially canceled their $2.6B stake sale of unit as well as the Chinese developer Modern Land canceled $250M bond repayment plan. The pain is spreading, which has pushed more property loans to be generated outside of the formal banking system and shifting back into the shadow lending programs. China has been cracking down on Shadow Banking since 2016 and really accelerated their push in 2018/2019 but have seen a big increase so far in 2021. This just increases the amount of potential leverage and collateral “abuse” when you factor in assets being used to collateralize multiple bonds/loans. Loans/ mortgages across the board have been dropping with “loans to developers” taking a nose dive after President Xi’s “three red lines.” “Developers wanting to refinance are being assessed against three thresholds: • a 70% ceiling on liabilities to assets, excluding advance proceeds from projects sold on contract, • a 100% cap on net debt to equity, • a cash to short-term borrowing ratio of at least one. Developers will be categorized based on how many limits they breach, and their debt growth will be capped accordingly. If a firm passes all three, it can increase its debt a maximum of 15% in the next year. As the regulator hasn’t announced its official calculations, some definitions aren’t clear.[1] ” This shift is another driver for the increase in “shadow banking” as developers went into other areas to get lending. But- it also directly impacted the sales process with a sizeable shift in housing mortgages that have been trending in the wrong direction since the 2018 peak. As the last stimulus ended in 2018, there was a big shift in total activity across the real estate sector even as building activity spiked. Many developers were relying more on SPBs (Special Purpose Bonds) and LGFVs (Local Government Finance Vehicles) to fund the next leg of development. This has now increased the exposure of local governments to the weakening sector and on the hook for assets that are proving to be far below collateral value. Evergrande was able to pay their interest due Oct 23rd (end of the grace period) of $83.5M, which helped kick the can a bit further as other issues remain in the system. • China’s real estate sector makes up almost half of the world’s distressed dollar-denominated debt, with speculative-grade yields topping 20% earlier this month -- the highest in a decade. As authorities in Beijing seek to defuse moral hazard and deleverage the economy, some companies are being allowed to fail as long as there’s no messy spillover into the broader financial system. • Modern Land Co. suspended trading in its shares Thursday after canceling its request to extend the maturity of a $250 million bond by three months. The note, which matures Oct. 25, was indicated at about 55 cents last Friday, down from about par at the start of the month. Modern Land’s shares have slumped 34% in October. • Another domino could fall Friday, when Kaisa Group Holdings Ltd. is due to pay $35.9 million of interest on a dollar note. Investors are pricing in a high likelihood of default, with the note trading at less than 40% of face value after the company canceled meetings with some investors that had been scheduled to take place this week. Moody’s Investors Service has downgraded the firm to B2 from B1.[2] Modern Land is the next even to watch as they have until this Monday to pay out the $250M, which is unlikely to come through. Fitch cuts property developer #Sinic Holdings' long-term foreign-currency issuer default rating to Restricted Default from C. Sinic’s rating on its USD bonds at C with a Recovery Rating of RR5. *Sinic fails to repay its $250 million senior notes due October, no grace period. Evergrande has been trying to sell down assets, but they have all failed to materialize leaving the company stressed as they try to navigate the current environment. The company announced a cut in annual real estate sales to 200B Yuan, and the chairman Hui Ka Yan says they will adjust the underlying business away from building sales and transform into a NEV (New Energy Vehicle) company from real estate within 10 years. Another caveat in the whole saga is the slow down in sales pre-dates COVID as the government has actively tried to move the economy further away from real estate. The goal was to do it slowly with adjustments to shadow banking and underlying lending, but now the band-aid has to be ripped off because many of these big companies have large interest payments or bonds/loans coming due without an ability to roll or pay off. The pressure in the market has essentially halted construction activity across the country, which leaves about 90M units either unfinished or unsold. There is a huge overhang in the market as many assets try to find buyers with companies trying to recapitalize. But, the market to market on these transactions would be devasting causing many of them to fail at the negotiation table. The government has been pushing the consumer to do more, and the local populace has picked up a huge amount of credit/debt since 2008. The consumer has been borrowing and investing in real estate along many of these other entities, which is why they are so levered to the real estate bubble. Here is the backdrop of exposure for the underlying economy- ESPECIALLY the local consumer. While the PBoC has been trying (and succeeding) at reducing liquidity, they have wanted local governments to maintain borrowing below 2020, but still at elevated levels. Local governments have been resistant to heed the call because many previous loans are being financed with tax revenue and not the underlying project. The poor investment profile of growth has created almost 200x debt-to-gdp as investments fail to even remotely cover interest let alone principal. In order to move some real estate, prices have continued to fall and now new-home prices saw its first monthly decline since 2015. The struggling companies are still sitting on a huge share of inventory as total assets creating the stress on the balance sheet. They are unable to convert the inventory into cash flow keeping them asset rich and cash poor. But- the underlying Chinese data continues to worsen across the board with pressure in every spot of the economy. We said that the consumer was going to see a bounce in Sept (which they did), but now Oct is worse vs Sept even when factoring in Golden Week. Tourism revenue keeps disappointing to the downside as headwinds persist in the underlying market, and even with an expected bad month/ quarter- it came in below expectations. China's Fixed-Asset Investment Grew 7.3% Y/Y In Jan - Sept, Vs Expected 7.8%, Previous 8.9% China's Retail Sales Grew 4.4% Y/Y In Sept, Vs Expected 3.5%, Previous 2.5%. China's Industrial Output Grew 3.1% Y/Y In Sept, Vs Expected 3.8%, Previous 5.3%. The slow down continues across the board for retail sales and now rolling over for industrial production as new orders dip and we see pressure building across the global market. Companies are also unable or limited by the government to pass on the rise in costs sending the spread between the PPI and CPI to the highest it has been since the mid-90’s. This is their attempt to protect consumer spending while trying to “off-shore” or export the rise in manufacturing costs. The problem is- the rest of the world is looking elsewhere with more frequency as prices keep heading higher in China. But, the rest of the world is also seeing a huge spike in underlying prices so the ability to offset these increases is limited at best. Markets were expecting a weak print, and that’s what they got: • The economy expanded 4.9% y/y in real terms last quarter – down from 7.9% y/y growth in Q2. • GDP in Q3 3021 increased just 0.2% versus the previous three months. • The slowdown was driven by a sharp moderation in activity in the key industrial sector: • Value-added output in the secondary sector increased by just 3.6% y/y in the third quarter, down from 7.5% in Q2. • Power outages were one reason for weaker industrial activity, but a slump in real estate construction didn’t help: • Real estate floor space under construction fell 19.0% y/y in Q3. • The monthly econ numbers show that real estate is likely to remain a drag on overall economic growth for some time: • Home sales fell 17.0% y/y last month. • Funding for real estate developers dropped 11.3% y/y in September, which led to a 3.5% y/y fall in real estate investment in the month. • Despite that, there remains virtually no sign of a policy response to take the edge off China’s real estate slowdown. The two traditional channels for counter-cyclical spending remained weak last month: • Infrastructure fixed-asset investment fell 4.5% y/y – the fifth consecutive month of negative growth. • Spending at SOEs dropped 1.6% y/y. • Get smart: All signs are pointing to an even weaker Q4 GDP print. • U.S. Growth Pressure Points- Wages vs Inflation The U.S. is facing a lot of pressure points in the underlying economy as activity on the manufacturing continues to slow while we get a bounce in services (which has been our expectations.) As services bounce, we have seen a huge surge in pricing as well taking prices charged to all-time highs as the pressure shifts down the curve to the consumer. The pressure on the consumer is sending more people to get cash advances and payday loans, which will likely pull forward some holiday spending but also helps to demonstrate the growing stress on the lowest income earner even as wages increase. Wages are still unable to keep pace with inflation as real wages slip further below, but the hope is to have compensation increase over the next few quarters. This is also not a good backdrop because wages moving in that kind of capacity is also a big inflationary driver as companies have to recoup the cost by increasing prices charged. We are entering this endless cycle of inflation/stagflation until we get a much broader slowdown ushering in broader deflation. The lowest quartile has seen another big bump in wages along with the 2nd quartile, but those with the most discretionary income the 3rd and 4th have seen wages degrade over the same period. This is a tough mix because the this will help support consistent spending for everyday items, but put more pressure on “non-essential” goods as the people with the most spare cash are getting squeezed. The spread between the lowest and highest is at the widest since the late ‘90s with more pressure coming over the coming months. The hope is that wages will keep accelerating higher and reverse the extended down trend reverses, but it would also be a huge inflationary driver. Therefore, I think the response higher will be muted as companies try to manage costs until the supply chain catches up and other input costs stabilize. As those adjust, companies will have more spare cost to feed down to workers. The shifts between supply chain and wages will be a huge driver while housing and rent sit in the background just moving higher monthly. We have a lot of ground to cover to see rents and owners equivalent priced into the market. [1] https://www.bloomberg.com/news/articles/2020-10-08/what-china-s-three-red-lines-mean-for-property-firms-quicktake?sref=9yOLp5hz[2] https://www.bloomberg.com/news/articles/2021-10-21/china-property-purge-hammers-weak-players-while-the-strong-gain?sref=9yOLp5hz [/ihc-hide-content]