Macro Letter – No 14 – 20-06-2014

Oil, Emerging Markets and Inflation

The political situation in Iraq – OPEC’s third largest producer in 2012 – has prompted a sharp increase in crude oil prices, however, unlike some other industrial commodities, oil has remained at elevated levels since 2002. Global oil inventories have remained tight which is reflected in the backwardation of futures markets. WTI has narrowed relative to Brent as the US economy has recovered and domestic distribution bottlenecks have emerged, the backwardation in WTI is more pronounced but it is also evident in Brent futures.

Here is a monthly chart for Brent crude going back to 2003: –

Source: Barchart.com

Despite a large correction in 2008 the price recovered swiftly. During the last three years it has consolidated into a relatively narrow range but needs to break above the 2011 and 2012 highs to confirm a significant breakout to the upside. With stronger GDP growth in the US and EU this year, I believe the conditions are in place for an increase in global demand. According to the IEA the emerging market countries will account for 90% of the increase in energy demand between now and 2035, as this chart of OECD and non-OECD demand illustrates, the process is already in train: –

Source: Yardeni.com/OECD/Oil Market Intelligence

Even during the great recession of 2008/2009 non-OECD demand increased. China has seen the largest growth in demand for oil. Their energy security policies can be seen across the globe. For example, between 2005 and 2012 the PRC invested $18.5bln in Brazilian energy, their governments have entered into technology sharing agreements and since 2009 China has been Brazil’s largest trading partner.

Asia’s Energy Challenge

April 2013 saw the publication of an excellent paper on the state of energy markets in Asia – Asian Development Bank – Asia’s Energy Challenge – 2013, here are some extracts.

On the rebalancing of Asian economies – this push towards increased domestic consumption is not just confined to China:-

…Southeast Asia is benefiting from robust domestic demand and greater trade with its neighbors in the region.

…The process of global rebalancing continues. Strong domestic demand and intraregional trade, coupled with weak demand from advanced economies, have further narrowed developing Asia’s current account surplus. The surplus dropped from 2.5% of GDP in 2011 to 2.0% in 2012. Although exports are projected to pick up, imports will likely rise even more quickly, tightening the overall current account surplus further to 1.9% of GDP in 2013 and 1.8% in 2014.

On the risks of inflation: –

… Price pressures must be closely monitored in this environment of continued global liquidity expansion. Robust growth has largely eliminated slack productive capacity in many regional economies such that loose monetary policy risks reigniting inflation. Inflation is expected to tick up from 3.7% in 2012 to 4.0% in 2013 and 4.2% in 2014.

… Inflation is expected to remain in check, but price pressures should be closely monitored. In general, inflation in developing Asia remains contained, partly because food prices are stable throughout the region. But tame inflation does not translate at this juncture into a free hand to wield monetary policy to stimulate economic activity. In an environment of excess global liquidity, central banks in economies where forecast output is close to long-term trend must monitor the potential for price pressures to build up and stand ready to intervene to avoid accelerating inflation. Several countries are already dealing with higher inflation or structural imbalances. Stabilization should be their priority.

The heart of the paper is a discussion of Asia’s energy and commodity needs:-

Asia must secure sufficient energy to drive economic expansion in the decades to come. The region already consumes roughly a third of global energy, and this is set to rise to over half by 2035.

…Rising consumption and investment demand has turned developing Asia into a net importer of commodities. While the major industrial economies have struggled to recover from the global financial crisis, resilient growth has made Asia a heavyweight in markets for commodities such as copper, iron, coal, oil, and cotton. In 2011, the PRC‘s share of global commodity consumption was 20% for nonrenewable energy resources, 23% for major agricultural crops, and 40% for base metals. The region’s expanded role in commodity markets makes it an important “shock emitter” to resource-rich countries through commodity prices.

The PRC sources commodities globally, while India looks to its neighbors. Because its demand for commodities is so large, the PRC cannot limit itself to regional markets. In fact, 9 of the 10 countries that rely the heaviest on PRC commodity purchases are outside of developing Asia. India, on the other hand, tends to rely on regional resource exporters for commodities other than petroleum products. As such, fluctuations in PRC demand have global consequences, while India’s impacts are largely contained within the region. The large ASEAN economies are generally net commodity exporters but, like the PRC and India, source petroleum products from outside the region.

Developing Asia’s energy needs have risen in tandem with its economic expansion. The region consumes roughly a third of global primary energy. Coal remains the dominant energy source, fueling more than half of the region’s production, followed by petroleum. Natural gas consumption is still limited but rising quickly. The price volatility of energy complicates efforts to maintain macroeconomic stability. Looking past this short-term issue, developing Asia’s sustainable growth will depend critically on securing adequate energy supply.

…Critical energy needs for the Asian Century Energy systems will be challenged to satisfy developing Asia’s economic aspirations. With 6% annual growth, developing Asia could produce 44% of global GDP by 2035. This Asian Century scenario would see the region’s share of world energy consumption rise rapidly from barely a third in 2010 to 51%–56% by 2035. With insufficient energy, developing Asia would need to scale back its growth ambitions.

Securing adequate energy is a serious challenge because Asia cannot rely solely on its endowment. The region has abundant coal but currently commands only 16% of the world’s proven conventional gas reserves and 15% of technically recoverable oil and natural gas liquids. More renewable energy and nuclear power generation are planned, but not enough to keep pace with demand. To fill the gap, oil imports would have to rise from the current 11 million barrels per day to more than 30 million barrels per day by 2035, making Asia more vulnerable to external energy shocks.

Geo-political tensions are evident, not just in Iraq, but also in Chinese disputes with its neighbours around the South and East China Seas; the most recent example being a territorial dispute with Vietnam over the location of a Chinese Oil rig which flared up at the end of April. In some senses the timing of this dispute is ironic since Chinese oil demand hit a nine month low of -0.7% in May. Nonetheless the IEA continue to predict Chinese Oil demand to be 3.5% higher in 2014.

India, under the new its new BJP government, is considering a reversal of its recent policy to reduce diesel subsidies. The catalyst for this “about turn” is concern that monsoon rainfall will be only 93% of trend, prompting the need for intensive irrigation. Yet Asian demand for diesel, often viewed as a leading indicator of GDP growth, is at its second lowest level since the Asian crisis of 1998. Commentators have attributed this weakness to slower GDP growth (so much for its “leading indicator” status) and attempts to reduce fuel subsidies across the region. Indian diesel use was 1% lower in the fiscal year to March 2014 – the first decline in more than a decade.

Indonesian oil demand continues to decline; after a fall of 3.9% in 2013, Wood Mackenzie forecast a 4.6% decline in 2014. Indonesian growth has been slowing steadily since 2011 but, after an up-tick in Q4 2013, the decline accelerated following a government ban on exports of unprocessed minerals in January 2014. Q1 GDP was +5.21% – the average growth rate between 2000 and 2014 is 5.42% – in other words its only slightly below its long term trend rate. Bank Indonesia note in their April monetary policy minutes that “externaldemand is improving and substituting moderating domestic demand as a source ofeconomic growth…Exports are also following a more favourable trend on theback of exports from the manufacturing sector in harmony with the economic recoveriesreported in advanced countries.” It is important to remember that Indonesia is energy resource rich. The EIA – Energy Information Administration rank Indonesia 22^nd by total oil production and 11^th by gas and 5^th by coal production. Rising oil prices will therefore benefit their economy.

Both Indonesia and India – until last week – have been attempting to reduce their levels of fuel subsidies, however, the chart below shows that, at a global level, fuel subsidies are back to within striking distance of their 2008 highs. In 2011 more than 50% of these subsidies were concentrated on reducing oil prices.

Source: Worldwatch/IEA/OECD

Global Oil Demand

With near-term energy needs from Asia looking undemanding, should we be concerned about the impact of reduced Iraqi production on oil prices longer term?  Back in February the IEA cut its forecast for Emerging Market demand citing higher interest rates and currency related economic uncertainty, yet, at the global level, they still forecast increased demand due to the recovery of the US and other developed market economies. The IEA June report is more sanguine. Their 2014 forecast anticipates a 1.3mln bpd increase from 2013 with the greatest acceleration occurring in Q4.

The International Energy Agency – World Energy Outlook 2013 Factsheet – looks at the longer term global tends:-

…In the New Policies Scenario, our central scenario, global energy demand increases by one-third from 2011 to 2035. Demand grows for all forms of energy, but the share of fossil fuels in the world’s energy mix falls from 82% to 76% in 2035.

…Energy demand growth in Asia is led by China this decade, but shifts towards India and, to a lesser extent, Southeast Asia after 2025. The Middle East emerges as a major energy consumer, with its gas demand growing by more than the entire gas demand of the OECD: the Middle East is the second-largest gas consumer by 2020 and third-largest oil consumer by 2030, redefining its role in energy markets.

…Global energy trade is re-oriented from the Atlantic basin to the Asia-Pacific region. China is becoming the largest oil-importing country; India becomes the largest importer of coal by the early 2020s.

…Non-OPEC supply plays the major role in meeting net oil demand growth this decade, but OPEC plays a far greater role after 2020. Technology unlocks new types of oil resources and improves recovery rates in existing fields, pushing up estimates of the amount of oil that remains to be produced. But this does not mean that the world is on the cusp of a new era of oil abundance. An oil price that rises steadily to $128 per barrel (in year-2012 dollars) in 2035 supports the development of these new resources.

In the near-term there are a number of downside risks for oil prices:-

1. Higher interest rates in the US leading to a moderation of consumption.
2. New production. Iran is expected to increase production as sanctions are reduced after their meeting in Vienna next week (+1mln bpd). Libyan production should recover having declined by 80% during the recent regime change (+500,000 bpd). Venezuelan production should recover after the recent political turmoil (+250,000 bpd)
3. Increased supply from unconventional sources in US and Canada – US production continues to increase. The chart below shows the revival in US production during the last few years. The benefit to domestic US industry in cheaper energy has been substantial. This windfall will continue.

Source: Bloomberg/US Global Investors

Set against this backdrop of slower US growth and increased supply is the potential increase in oil demand as emerging economies benefit from the lagged effect of the current economic recovery of the US, UK and other developed economies. Developing Asia and some other emerging markets will also benefit as “rebalancing” towards domestic demand bares fruit.

Many emerging market countries have seen a sharp depreciation in their currencies and subsequent rise in inflation. Their central banks have responded by raising interest rates aggressively. These currency devaluations have now improved their export competitiveness and, with the worst of the inflation shock behind them, they should benefit from an export led recovery, accompanied by lower interest rates and increased foreign capital investment flows. This will lead, eventually, to stronger currencies and lower inflation. As emerging markets complete this virtuous circle, currency appreciation will lessen the impact of higher energy costs in domestic terms, thus maintaining oil demand.

Iraqi oil production has recently reached levels last seen in the 1970’s as the chart below shows: –

Source: Energy Insights

Iraqi supply will undoubtedly be curtailed in the near-term. The effect of the ISIL insurgency may well spill over into conflict with Iran. Iranian production is running at 3.8mln bpd and they claim this can be increased to 4mln bpd once sanctions have been lifted; a regional conflict with Sunni militia will delay production increases.

The impact of Russian energy policy in relation to the Ukraine – and its knock-on effect on Europe – still points to upside risks. Gazprom stopped their supply of gas to the Ukraine this week. The new Ukrainian government report that their gas reserves will be depleted by the autumn.

Of more importance than the near-term geo-political risks, energy demand in emerging Asia is set to grow, not just in the longer term but, I believe, over the next two or three years as the impact of the gradual US economic recovery stimulates demand. The IMF cut their forecast for US GDP growth this week after weak Q1 data, but this will delay Federal Reserve tightening, prompting increased capital flows to emerging Asia.  Oil demand will continue to increase as the chart below is from Energy Insights shows. Incidentally, they are advocates of the theory of “peak oil” – my jury is still out on that subject.

Source: EnergyInsights.net

Conclusion

The recent rise in oil prices may herald the re-pricing of a number of other industrial commodity markets. This process will be driven by the pace of recovery of emerging market economies, led principally by China and India. The “reflation” maybe punctured by rising interest rates in the US but this looks unlikely in the medium term. Emerging market equities remain cheap relative to the developed markets despite their recent strength. Emerging market bond yields are beginning to fall as their currencies stabilise; the “quest for yield” will support further foreign capital in-flows.

Commodity markets, such as Australian Coking Coal and Iron Ore, languish close to multi-year lows, yet Chinese Steel Mills are expected to produce record quantities again in 2014 and Chinese steel consumption continues to rise despite the slowing pace of economic growth. Chinese steel mills are heavily reliant on bank credit to finance their operations and many mills have been producing at zero profit margins as a result of the tightening of credit conditions. Last month saw a significant surge in bank lending although total credit remained unchanged as tightening of conditions for the shadow banking sector continues.

Chinese industrial production was unchanged from April at 8.8% in May, still low by historic standards but stable, and retail sales rose to 12.8%, a small rebound from the levels of earlier in the year. Copper climbed a little from its recent lows. It would be foolish to call the bottom for Iron Ore prices but I believe we will see steel mills return to profitability as new bank lending is sanctioned by the Xi administration.

It is still too soon to call the final wave of the multi-year commodity bull-market, underway, but I see risks on the upside as consumer demand and tighter supply push oil prices higher. Those central bankers fixated with deflation risks may soon have new Hydra to confront. When demand pull inflation returns the big five central banks will test the political resolve of their masters.

Emerging market stocks in general, and Chinese equities in particular, look cheap by comparison with developed markets. Forward P/E’s on many Chinese stocks are in single digits and few analysts are predicting much earnings growth over the next two years. I think the macro environment is more favourable. The slower the recover in developed market growth, the more likely that emerging market equities outperform developed markets.