Saudi Arabian bonds and stocks – is it time to buy?


Macro Letter – No 64 – 28-10-2016

Saudi Arabian bonds and stocks – is it time to buy?

  • Saudi Arabia issued $17.5bln of US$ denominated sovereign bonds – the largest issue ever
  • Saudi Aramco may float 5% of their business in the largest IPO ever
  • The TASI stock index is down more than 50% from its 2014 high
  • OPEC agreed to cut output by 640,000 to 1,140,000 bpd

The sovereign bond issue

The Saudi Arabia’s first international bond deal raised $17.5bln. They tapped the market across the yield curve issuing 5yr, 10yr and 30yr bonds. The auction was a success – international investors, mostly from the US, placed $67bln of bids. The issues were priced slightly higher than Qatar, which raised $9bln in May, and Abu Dhabi, which issued $2.5bln each of 5yr and 10yr paper in April.

The Saudi issue appears to have been priced to go, as the table below, showing the basis point spread over US Treasuries, indicates. According to the prospectus the Kingdom of Saudi Arabia (KSA) want to tap the US$ sovereign bond market extensively in the future, raising as much as $120bln; attracting investors has therefore been a critical aspect of their recent charm offensive:-

Issuer 5yr Spread 10yr Spread 30yr Spread Bid to Cover
Saudi Arabia 135 165 210 3.82
Qatar 120 150 210 2.56
Abu Dhabi 85 125 N/A 3.4

Source: Bloomberg

The high bid to cover ratio (3.8 times) enabled the Kingdom to issue $2.5bln more paper than had been originally indicated: and on better terms – 40bp over, higher rated, Qatar rather than 50bp which had been expected prior to the auction.

The bonds immediately rose in secondary market trading and other Gulf Cooperation Council (GCC) issues also caught a bid. The Saudi issue was also unusual in that the largest tranche ($6.5bln) was also the longest maturity (30yr). The high demand is indicative of the global quest for yield among investors. This is the largest ever Emerging Market bond issue, eclipsing Argentina’s $16.5bln offering in April.

The Aramco IPO

Another means by which the Kingdom plans to balance the books is through the Saudi Aramco IPO – part of the Vision 2030 plan – which may float as much as 5% of the company, worth around $100bln, in early 2018. This would be four times larger than the previous record for an IPO set by Alibaba in September 2014.

An interesting, if Machiavellian, view about the motivation behind the Aramco deal is provided by – Robert Boslego – Why Saudi Arabia Will Cut Production To Achieve Vision 2030:-

As part of the implementation of this plan, Saudi Aramco and Shell (NYSE:RDS.A) (NYSE:RDS.B) are dividing up their U.S. joint venture, Motiva, which will result in Saudi’s full ownership of the Port Author refinery. Aramco will fully own Motiva on April 1, 2017, and has been in talks of buying Lyondell’s Houston refinery.

I suspect Motiva may also purchase U.S. oil shale properties (or companies) that are in financial trouble as a result of the drop in prices since 2014. According to restructuring specialists, about 100 North American oil and gas companies have filed for bankruptcy, and there may be another 100 to go. This would enable Aramco to expand market share as well as control how fast production is brought back online if prices rise.

By using its ability to cut production to create additional spare capacity, Aramco can use that spare capacity to control prices as it wishes. It probably does not want prices much above $50/b to keep U.S. shale production to about where it is now, 8.5 mmbd. And it doesn’t want prices below $45/b because of the adverse impact of such low prices on its budget. And so it will likely adjust its production accordingly to keep prices in a $45-$55/b range.


Although I authored a series of articles stating that OPEC was bluffing (and it was), I now think that Saudi Arabia has formulated a plan and will assume the role of swing producer to satisfy its goals. It can and will cut unilaterally to create excess spare capacity, which it needs to control oil prices.

This will make the company attractive for its IPO. And by selling shares, Aramco can use some of the proceeds to buy U.S. shale reserves “on the cheap,” not unlike John D. Rockefeller, who bankrupted competitors to acquire them.

The Saudi’s long-term plan is to convert Aramco’s assets into a $2 trillion fund, which can safely reside in Swiss banks. And that is a much safer investment than oil reserves in the ground subject to external and internal political threats.

Whatever the motives behind Vision 2030, it is clear that radical action is needed. The Tadawul TASI Stock Index hit its lowest level since 2011 on 3rd October at 5418, down more than 50% from its high of 11,150 in September 2014 – back when oil was around $90/bbl.

As a starting point here is a brief review of the Saudi economy.

The Saudi Economy

The table below compares KSA with its GCC neighbours; Iran and Iraq have been added to broaden the picture of the oil producing states of the Middle East:-

Country GDP YoY Interest rate Inflation rate Jobless rate Gov. Budget Debt/GDP C/A Pop.
Saudi Arabia 1.40% 2.00% 3.30% 5.60% -15.00% 5.90% -8.2 31.52
Iran 0.60% 20.00% 9.40% 11.80% -2.58% 16.36% 0.41 78.8
UAE 3.40% 1.25% 0.60% 4.20% 5.00% 15.68% 5.8 9.16
Iraq 2.40% 4.00% 0.20% 16.40% -2.69% 37.02% -0.8 35.87
Qatar 1.10% 4.50% 2.60% 0.20% 16.10% 35.80% 8.3 2.34
Kuwait 1.80% 2.25% 2.90% 2.20% 26.59% 7.10% 11.5 3.89
Oman -14.10% 1.00% 1.30% 7.20% -17.10% 9.20% -15.4 4.15
Bahrain 2.50% 0.75% 2.60% 3.70% -5.00% 42.00% 3.3 1.37

Source: Trading Economics

In terms of inflation the KSA is in a better position than Iran and its unemployment rate is well below that of Iran or Iraq, but on several measures it looks weaker than its neighbours.

Moody’s downgraded KSA in May – click here for details – citing concern about their reliance on oil. They pointed to a 13.5% decline in nominal GDP during 2015 and forecast a further fall this year. This concurs with the IMF forecast of 1.2% in 2016 versus 3.5% GDP growth in 2015. It looks likely to be the weakest economic growth since 2009.

The government’s fiscal position has deteriorated in line with the oil price. In 2014 the deficit was 2.3%, by 2015 it was 15%:-


Source: Trading Economics, SAMA

Despite austerity measures, including proposals to introduce a value added tax, the deficit is unlikely to improve beyond -13.5% in 2016. It is estimated that to balance the Saudi budget the oil price would need to be above $79/bbl.

At $98bln, the 2015 government deficit was the largest of the G20, of which Saudi Arabia is a member. According to the prospectus of the new bond issue Saudi debt increased from $37.9bln in December 2015 to $72.9bln in August 2016. Between now and 2020 Moody’s estimate the Kingdom will have a cumulative financing requirement of US$324bln. More than half the needs of the GCC states combined.  Despite the recent deterioration, Government debt to GDP was only 5.8% in 2015:-


Source: Trading Economics, SAMA

They have temporary room for manoeuvre, but Moody’s forecast this ratio rising beyond 35% by 2018 – which is inconsistent with an Aa3 rating. Even the Saudi government see it rising to 30% by 2030.

The fiscal drag has also impacted foreign exchange reserves. From a peak of US$731bln in August 2014 they have fallen by 23% to US$562bln in August 2016:-


Source: Trading Economics, SAMA

Reserves will continue to decline, but it will be some time before the Kingdom loses its fourth ranked position by FX reserves globally. Total private and public sector external debt to GDP was only 15% in 2015 up from 12.3% in 2014 and 11.6% in 2013. There is room for this to grow without undermining the Riyal peg to the US$, which has been at 3.75 since January 2003. A rise in the ratio to above 50% could undermine confidence but otherwise the external debt outlook appears stable.

The fall in the oil price has also led to a dramatic reversal in the current account, from a surplus of 9.8% in 2014 to a deficit of 8.2% last year. In 2016 the deficit may reach 12% or more. It has been worse, as the chart below shows, but not since the 1980’s and the speed of deterioration, when there is no global recession to blame for the fall from grace, is alarming:-


Source: Trading Economics, SAMA

The National Vision 2030 reform plan has been launched, ostensibly, to wean the Kingdom away from its reliance on oil – which represents 85% of exports and 90% of fiscal revenues. In many ways this is an austerity plan but, if fully implemented, it could substantially improve the economic position of Saudi Arabia. There are, however, significant social challenges which may hamper its delivery.

Perhaps the greatest challenge domestically is youth unemployment. More than two thirds of Saudi Arabia’s population (31mln) is under 30 years of age. A demographic blessing and a curse. Official unemployment is 5.8% but for Saudis aged 15 to 24 it is nearer to 30%. A paper, from 2011, by The Woodrow Wilson International Center – Saudi Arabia’s Youth and the Kingdom’s Future – estimated that 37% of all Saudis were 14 years or younger. That means the KSA needs to create 3mln jobs by 2020. The table below shows the rising number unemployed:-


Source: Trading Economics, Central Department of Statistics and Economics

If you compare the chart above with the unemployment percentage shown below you would be forgiven for describing the government’s work creation endeavours as Sisyphean:-


Source: Trading Economics, Central Department of Statistics and Economics

Another and more immediate issue is the cost of hostilities with Yemen – and elsewhere. Exiting these conflicts could improve the government’s fiscal position swiftly. More than 25% ($56.8bln) of the 2016 budget has been allocated to military and security expenditure. It has been rising by 19% per annum since the Arab spring of 2011 and, according to IHS estimates, will reach $62bln by 2020.

The OPEC deal and tightness in the supply of oil

After meeting in Algiers at the end of September, OPEC members agreed, in principle, to reduce production to between 32.5 and 33mln bpd. A further meeting next month, in Vienna, should see a more concrete commitment. This is, after all, the first OPEC production agreement in eight years, and, despite continuing animosity between the KSA and Iran, the Saudi Energy Minister, Khalid al-Falih, made a dramatic concession, stating that Iran, Nigeria and Libya would be allowed to produce:-

…at maximum levels that make sense as part of any output limits.

Iranian production reached 3.65mln bpd in August – the highest since 2013 and 10.85% of the OPEC total. Nigeria pumped 1.39mln bpd (4.1%) and although Libya produced only 363,000 bpd, in line with its negligible output since 2013, it is important to remember they used to produce around 1.4mln bpd. Nigeria likewise has seen production fall from 2.6mln bpd in 2012. Putting this in perspective, total OPEC production reached a new high of 33.64mln bpd in September.

The oil price responded to the “good news from Algiers” moving swiftly higher. Russia has also been in tentative discussions with OPEC since the early summer. President Putin followed the OPEC communique by announcing that Russia will also freeze production. Russian production of 11.11mln bpd in September, is the highest since its peak in 1988. Other non-OPEC nations are rumoured to be considering joining the concert party.

Saudi Arabia is currently the largest producer of oil globally, followed by the USA. In August Saudi production fell from 10.67mln bpd to 10.63mln bpd. It rebounded slightly to 10.65mln bpd in September – this represents 32% of OPEC output.

There are a range of possible outcomes, assuming the OPEC deal goes ahead. Under the proposed terms of the agreement, production is to be reduced by between 1.14mln and 640,000 bpd. Saudi Arabia, as the swing producer, is obliged to foot the bill for an Iranian production freeze and adjust for any change in Nigerian and Libyan output. The chart below, which is taken from the Federal Reserve Bank of Dallas – Signs of Recovery Emerge in the U.S. Oil Market – Third Quarter 2016 make no assumptions about Saudi Arabia taking up the slack but it provides a useful visual aid:-


Source: EIA, OPEC, Dallas Fed

They go on to state in relation to US production:-

While drilling activity has edged up, industry participants believe it will be awhile before activity significantly increases. When queried in the third quarter 2016 Dallas Fed Energy Survey, most respondents said prices need to exceed $55 per barrel for solid gains to occur, with a ramp-up unlikely until at least second quarter 2017.

Assuming the minimum reduction in output to 33mln bpd and Iran, Nigeria and Libya maintaining production at current levels, Saudi Arabian must reduce its output by 300,000 bpd. If the output cut is the maximum, Iran freezes at current levels but Nigeria and Libya return to the production levels of 2012, Saudi Arabia will need to reduce its output by 623,000 bpd. The indications are that Nigeria and Libya will only be able to raise output by, at most, 500,000 bpd each, so a 623,000 bpd cut by Saudi Arabia is unlikely to be needed, but even in the worst case scenario, if the oil price can be raised by $3.11/bbl the Saudi production cut would be self-financing. My “Median” forecast below assumes Nigeria and Libya increase output by 1mln bpd in total:-

OPEC Cut ‘000s bpd KSA Cut ‘000s bpd KSA % of total OPEC Cut Oil Price B/E for KSA/bbl
Max 1,140 623 54.68% +$3.11
Median 890 422 47.41% +$2.06
Minimum 640 300 47.07% +$1.45

Source: OPEC

Many commentators are predicting lower oil prices for longer; they believe OPEC no longer has the power to influence the global oil price. This article by David Yager for Oil Price – Why Oil Prices Will Rise More And Sooner Than Most Believe – takes a different view. His argument revolves around the amount of spare capacity globally. The author thinks OPEC is near to full production, but it is his analysis of non-OPEC capacity which is sobering:-

…RBC Capital Markets was of the view oil prices would indeed rise but not until 2019. RBC says 2.2 million b/d of new non-OPEC production will enter the markets this year, 1.3 million b/d next year and 1.6 million b/d in 2018. Somehow U.S. production will rise by 900,000 b/d from 2017 and 2019 despite falling by 1.1 million b/d in the past 15 months and with rigs count at historic lows. At the same time RBC reported the 124 E&P companies it follows will cut spending another 32 percent in 2016 from 2015, a $US106 billion reduction.

…The Telegraph ran it under the title, “When oil turns it will be with such lightning speed that it could upend the market again”. Citing the lowest levels of oil discoveries since 1952, annual investment in new supplies down 42 percent in the past two years and how the International Energy Agency (IEA) estimates 9 percent average annual global reservoir depletion, the article stated, “…the global economy is becoming dangerously reliant on crude supply from political hotspots”. “Drillers are not finding enough oil to replace these (depletion) barrels, preparing the ground for an oil price spike and raising serious questions about energy security”.

Depletion of 9 percent per year is about 8.6 million b/d. Add demand growth and you’re approaching 10 million b/d. How do the crystal ball polishers of the world who see flat oil prices for the foreseeable future figure producers can replace this output when others report $US1 trillion in capital projects have been cancelled or delayed over the rest of the decade?

The last ingredient in the oil price confusion in inventory levels. OECD countries currently hold 3.1 billion barrels of oil inventory. That sounds like lot. But what nobody reports is the five-year average is about 2.7 billion barrels. Refinery storage tanks. Pipelines. Field locations. Tankers in transit. It’s huge. The current overhang is about 6 days of production higher than it has been for years, about 60 days. So inventories are up roughly 10 percent from where they have been.

Obviously this is going to take a change in the global supply/demand balance to return to historic levels and will dampen prices until it does. But don’t believe OECD inventories must go to zero.

…The current production overhang suppressing markets is only about 1 million b/d or less depending upon which forecast you’re looking at. Both the IEA (Paris) and the EIA (Washington) see the curves very close if they haven’t crossed already. Neither agency sees any overhang by the end of the next year.

…OPEC has no meaningful excess capacity. Non-OPEC production is flat out and, in the face of massive spending cuts, is more likely to fall than rise because production increases will be more than offset by natural reservoir depletion.

Since this article was published OECD inventories have declined a fraction. Here is the latest EIA data:-

  2014 2015 2016 2017
Non-OPEC Production 55.9 57.49 56.84 56.94
OPEC Production 37.45 38.32 39.2 40.07
OPEC Crude Oil Portion 30.99 31.76 32.45 33.03
Total World Production 93.35 95.81 96.04 97.01
OECD Commercial Inventory (end-of-year) 2688 2967 3049 3073
Total OPEC surplus crude oil production capacity 2.08 1.6 1.34 1.21
OECD Consumption 45.86 46.41 46.53 46.6
Non-OECD Consumption 46.69 47.63 48.8 50.07
Total World Consumption 92.55 94.04 95.33 96.67

Source: EIA

Whether or not David Yager is correct about supply, the direct cost to Saudi Arabia, of a 623,000 bpd reduction in output, pales into insignificance beside the cost of domestic oil and gas subsidies – around $61bln last year. Subsidies on electricity and water add another $10bln to the annual bill. These subsidies are being reduced as part of the Vison 2030 austerity plan. The government claim they can save $100bln by 2020, but given the impact of removing subsidies on domestic growth, I remain sceptical.

The Kingdom’s domestic demand for crude oil continues to grow. Brookings – Saudi Arabia’s economic time bomb forecast that it will reach 8.2mln bpd by 2030. By some estimates they may become a net importer of oil by their centenary in 2032. Saudi oil reserves are estimated at 268bln bbl. Her gas reserves are estimated to be 8.6trln M3 (2014) but exploration may yield considerable increases in these figures.

The Kingdom is also planning to build 16 nuclear power stations over the next 20 years, along with extensive expansion of solar power generating capacity. Improvements in technology mean that solar power stations will, given the right weather conditions, produce cheaper electricity than gas powered generation by the end of this year. This article from the Guardian – Solar and wind ‘cheaper than new nuclear’ by the time Hinkley is built – looks longer term.

According to EIA data US production in July totalled 8.69mln bpd down from 9.62mln bpd in March 2015. A further 200,000 bpd reduction is forecast for next year.

The table below, which is taken from the IEA – Medium Term Oil Market Report – 2016suggests this tightness in supply may last well beyond 2018:-


Source: IEA – MTOMR 2016

According to Baker Hughes data, US rig count has rebounded to 443 since the low of 316 at the end of May, but this is still 72% below its October 2014 peak of 1609. This March 2016 article from Futures Magazine – How quickly will U.S. energy producers respond to rising prices? Explains the dynamics of the US oil industry:-

Crude oil produced by shale made up 48% of total U.S. crude oil production in 2015, up from 22% in 2007 according to the Energy Information Administration (EIA), which warns that the horizontal wells drilled into tight formations tend to have very high initial production rates–but they also have steep initial decline rates. Some wells lose as much as 70% of their initial production the first year. With steep decline rates, constant drilling and development of new wells is necessary to maintain or increase production levels. The problem is that many of these smaller shale companies do not have the capital nor the manpower to keep drilling and keep production going.

This is one of the reasons that the EIA is predicting that U.S. oil production will fall by 7.4%, or roughly 700,000 barrels a day. That may be a modest assessment as we are hearing of more stress and bankruptcies in the space. The EIA warns that with the U.S. oil rig count down 76% since the fall of 2014, that unless capital spending picks up, the EIA says that U.S. oil production will keep falling in 2017, ending up 1.2 million barrels a day lower than the 2015 average at 8.2 million barrels a day.

The bearish argument that shale will save the day and keep prices under control does not fit with the longer term reality. When more traditional energy projects with much slower decline rates get shelved, there is the thought that the cash strapped shale producers can just drill, drill. Drill to make up that difference is a fantasy. The problem is that while shale may replace that oil for a while, in the long run it can never make up for the loss of projects that are more sustainable.

OPEC might just have the whip hand for the first time in several years.

The chart below, taken from the New York Federal Reserve – Oil Price Dynamics Report – 24th October 2016 – shows how increased supply since 2012 has pushed oil prices lower. Now oversupply appears to be abating once more; combine this with the inability of the fracking industry to “just drill” and the reduction in inventories and conditions may be ripe for an aggressive short squeeze:-


Source: NY Federal Reserve, Haver Analytics, Reuters, Bloomberg

But, how sustainable is any oil price increase?

Longer term prospects for oil demand


Source: Trading Economics

In the short term there are, as always, a plethora of conflicting opinions about the direction of the price of oil. Longer term, advances in drilling techniques and other technologies – especially those relating to fracking – will exert a downward pressure on prices, especially as these methods are adopted more widely across the globe. Recent evidence supports the view that tight-oil extraction is economic at between $40 and $60 per bbl, although the Manhattan Institute – Shale 2:0 – May 2015 – suggests:-

In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

These reductions in extraction costs, combined with improvements in fuel efficiency and the falling cost of alternative energy, such as solar power, will constrain prices from rising for any length of time.

Published earlier this month, the World Energy Council – World Energy Scenarios 2016 – The Grand Transitionpropose three, very different, global outlooks, with rather memorable names:-

  1. Modern Jazz – digital disruption, innovation and market based reform
  2. Unfinished Symphony – intelligent and sustainable economic growth with low carbon
  3. Hard Rock – fragmented, weaker, inward-looking and unsustainable growth

They go on to point out that, despite economic growth – especially in countries like China and India – global reliance on fossil fuels has fallen from 86% in 1970 to 81% in 2014 – although in transportation reliance remains a spectacular 92%. The table below shows rising energy consumption under all three scenarios, but an astonishing divergence in its rise and source of supply, under the different regimes:-

Scenario – 2060 % increase in energy consumption % reliance on oil Transport % reliance on oil
Modern Jazz 22 50 67
Unfinished Symphony 38 63 60
Hard Rock 46 70 78

Source: World Energy Council

The authors expect demand for electricity to double by 2060 requiring $35trln to $43trln of infrastructure investment. Solar and Wind power are expected to increase their share of supply from 4% in 2014 to between 20% and 39% dependent upon the scenario.

As to the outlook for fossil fuels, global demand for coal is expected to peak between 2020 and 2040 and for oil, between 2030 and 2040.

…peaks for coal and oil have the potential to take the world from stranded assets predominantly in the private sector to state-owned stranded resources and could cause significant stress to the current global economic equilibrium with unforeseen consequences on geopolitical agendas. Carefully weighed exit strategies spanning several decades need to come to the top of the political agenda, or the destruction of vast amounts of public and private shareholder value is unavoidable. Economic diversification and employment strategies for growing populations will be a critical element of navigating the challenges of peak demand.

The economic diversification, to which the World Energy Council refer, is a global phenomenon but the impact on nations which are dependent on oil exports, such as Saudi Arabia, will be even more pronounced.

Conclusion and investment opportunities

As part of Vision 2030 – which was launched in the spring by the King Salman’s second son, Prince Mohammed bin Salman – the Saudi government introduced some new measures last month. They cancelled bonus payments to state employees and cut ministers’ salaries by 20%. Ministers’ perks – including the provision of cars and mobile phones – will also be withdrawn. In addition, legislative advisors to the monarchy have been subjected to a 15% pay cut.

These measures are scheduled to take effect this month. They are largely cosmetic, but the longer term aim of the plan is to reduce the public-sector wage bill by 5% – bringing it down to 40% of spending by 2020. Government jobs pay much better than the private sector and the 90/90 rule applies –that is 90% of Saudi Arabians work for the government and the 10% of workers in the private sector are 90% non-Saudi in origin. The proposed pay cuts will be deeply unpopular. Finally, unofficial sources claim, the government has begun cancelling $20bln of the $69bln of investment projects it had previously approved. All this austerity will be a drag on economic growth – it begins to sound more like Division 2030, I anticipate social unrest.

The impact of last month’s announcement on the stock market was unsurprisingly negative – the TASI Index fell 4% – largely negating the SAR20bln ($5.3bln) capital injection by the Saudi Arabian Monetary Agency (SAMA) from the previous day.

Saudi Bonds

Considering the geo-political uncertainty surrounding the KSA, is the spread over US Treasuries sufficient? In the short term – two to five years – I think it is, but from a longer term perspective this should be regarded as a trading asset. If US bond yield return to a more normal level – they have averaged 6.5% since 1974 – the credit spread is likely to widen. Its current level is a function of the lack of alternative assets offering an acceptable yield, pushing investors towards markets with which many are unfamiliar. KSA bonds do have advantages over some other emerging markets, their currency is pegged to the US$ and their foreign exchange reserves remain substantial, nonetheless, they will also be sensitive to the price of oil.

Saudi stocks

For foreign investors ETFs are still the only way to access the Saudi stock market, unless you already have $5bln of AUM – then you are limited to 5% of any company and a number of the 170 listed stocks remain restricted. For those not deterred, the iShares MSCI Saudi Arabia Capped ETF (KSA) is an example of a way to gain access.

Given how much of the economy of KSA relies on oil revenues, it is not surprising that the TASI Index correlates with the price of oil. It makes the Saudi stock exchange a traders market with energy prices dominating direction. Several emerging stock markets have rallied dramatically this year, as the chart below illustrates, the TASI has not been among their number:-


Source: Saudi Stock Exchange, Trading Economics


Tightness in supply makes it likely that oil will find a higher trading range, but previous OPEC deals have been wrecked by cheating on quotas. Longer term, improvements in technology will reduce the cost of extraction, increase the amount of recoverable reserves and diminish our dependence on fossil fuels by improving energy efficiency and developing, affordable, renewable, alternative sources of energy. By all means trade the range but remember commodities have always had a negative real expected return in the long run.

China – Coal, Steel, Water and Demographics – Which way now?


Macro Letter – No 62 – 30-09-2016

China – Coal, Steel, Water and Demographics – Which way now?

  • The price of coking coal has risen 164% this year, doubling since July
  • The NDRC is still attempting to reduce both coal and steel production this year
  • The April stimulus package has boosted construction and infrastructure demand
  • The pace of Chinese growth has stabilised but at a much reduced level

This year several commodity markets saw significant price increases. I discussed this in Macro Letter – No 51 – 11-3-2016 – How do we square the decline in trade with the rebound in industrial commodities?

The price of Iron Ore, Aluminium and other industrial metals has rallied sharply over the last few weeks – WTI now seems to have followed suit. Most commentators regard this as a short covering rally.

Over the last six months the US economy has maintaining momentum, albeit at a disappointingly modest pace. Elsewhere the economic headwinds are blowing harder, with Europe and Japan still mired in a “slow-growth/no-growth” environment. Yet during the last few weeks the spot price of premium coking coal – one of the key inputs for steel production – has doubled to more than $200/tonne. Although this is from multi-year lows seen in 2015, coking coal is now the top performing commodity market year to date:-


Source: Steel Index,

According to CME data, the futures curve for Australian Coking Coal is in steep backwardation out to December 2017 delivery. This suggests a short-term supply shortage rather than a generalised increase in demand. – Stunning coking coal rally wreaks havoc in steel, iron ore explains what has been happening:-

The rise in the price of coking is upending the economics of the iron ore and steel markets with the Australian export benchmark price climbing 164% so far this year.

Metallurgical coal was exchanging hands at $206.40 on Monday according to data provided by Steel Index as it consolidates at higher levels following weeks of panic buying not seen since 2011, when floods in key export region in Queensland sent the price surging to $335 a tonne (albeit not for long).

The rally was triggered by Beijing’s decision to limit coal mines’ operating days to 276 or fewer a year from 330 before as it seeks to restructure the industry. Safety closures and weather related supply curbs in China and Australia only added fuel to the fire.


Source: TSI, Bloomberg, SGX

The price of Iron Ore has also risen by 31% to around $55/tonne, but, as the chart above makes clear, the ratio between the price of iron ore and coking coal is now at its lowest this century.

China’s coking coal output has fallen more than 10% due to the government edict to curtail domestic production. In response import volumes rose 45% in August alone. Goldman Sachs and Macquarie have both increased their price forecasts for 2017 and 2018.

The National Development and Reform Commission (NDRC) – the agency responsible for implementing production cuts – had achieved only 39% of the annual target for reducing coal capacity and 47% of the annual reduction in steel capacity as of the end of July. The Peterson – Institute – State of Play in the Chinese Steel Industry explains the reasons for this policy. Suffice to say, China’s domestic steel production tripled between 2005 and 2015 taking its share of global steel production from 31% to 50%. Under WTO rules it will have Market Economy Status from December 2016 – a wave of anti-dumping laws suits may well follow unless it curtails production.

Despite common knowledge of official policy, commentators have suggested that the recent production cut was intended to deliberately squeeze coal prices, allowing heavily indebted coal producers to repay loans to domestic Chinese banks. After two meetings between the China Iron and Steel Association and the NDRC, coal producers will now be allowed to produce an additional 50 tonne/day from October to alleviate shortages.

The steel industry was under margin pressure even before the rise in coal prices – the government has been forcing an industry wide consolidation. The high price of coal accelerates this “oligopolisation” of the sector. It is part of a broader reform and consolidation of State Owned Enterprises (SOEs). The Peterson Institute – China’s SOE Reform—The Wrong Path takes issue with this policy. It has its attractions in the short-term nonetheless – consolidation reduces competition within industries, the pricing power of these consolidated “oligopolies” should rise, enabling them to increase profitability and reduce their indebtedness. President Xi has called for “Stronger, bigger, better” state-owned enterprises. I fear for the squeezed private sector in this environment.

A more important structural reform was announced last month when the Supreme People’s Court ordered the establishment of more special divisions to handle liquidation and bankruptcy cases in intermediate courts. China has an undeveloped bankruptcy code – defaulting borrowers linger, acting as a drag on the economy. At the G20 summit President Xi said, “China has taken the most robust and solid measures in cutting excess capacity and we will honour our commitment with actions”. An efficient method of “zombie corporation liquidation” would expedite this process.

Another explanation for the government’s decision to reduce the number working days at coal mines is its commitment to reducing pollution. Brookings – The end of coal-fired growth in China looks at the bigger picture:-

China’s coal consumption grew from 1.36 billion tons per year in 2000 to 4.24 billion tons per year in 2013, an annual growth rate of 12 percent. As of 2015, the country accounts for approximately 50 percent of global demand for coal. In other words, China’s economic miracle was fueled primarily by coal.

…China’s coal consumption decreased by 2.9 percent in 2014 and 3.6 percent in 2015, and the economy has maintained a moderate speed of growth. This indicates that there is a decoupling of economic growth from the growth in coal consumption. China’s coal consumption might have in fact already peaked.

Over the past 35 years, coal powered the engine of China’s rapidly developing economy. Coal represented 75 percent of overall energy consumption. This number decreased to 64.4 percent in 2015—the lowest in China’s modern history—as the country’s energy intensity decreased by 65 percent relative to 35 years ago. In fact, though rarely noticed until the recent peak, this has been part of a fundamental shift in the Chinese economy’s relationship with coal.

The authors present three arguments to support their view that China’s reliance on coal is in structural decline. Firstly, a decrease in manufacturing and construction, which have seen over-investment during the last decade or more. Second, policies on climate change and air pollution—especially the Paris Agreement’s, signed this month, which calls for a 20% clean energy target by 2030. Read China-United States Exchange Foundation – After the Paris Climate Agreement, What’s Next? for more details. Finally, China’s adoption of technological innovation in energy, communications, and manufacturing.

In his G20 speech President Xi said “…green mountains and clear water are as good as mountains of gold and silver”. The problem of clean water is probably the single greatest resource challenge facing China today as this article from CEAC – China that once thrived on water, faces water problems today points out:-

The total amount of water resources in China is so huge as to reach 2325.85 billion cubic meters, which is the 4th largest in the world. However, Chinese population is so large that the per capita amount of water resources is only 1730.4 cubic meters. This is extremely small in the world. Moreover, water resources are distributed unevenly by the region. Generally speaking, water is scarce in northern parts of China, including the Northeast, the North, and the Northwest regions. Beijing is in the North region. On the other hand, water is abundant in the South Central, the South, and the Southwest regions. The problem is that water is growing scarcer, while its consumption is rising. Particularly, people in Northwest China suffer from chronic shortage of water.

…It is not the quantity of water that matters critically in China. The quality of water is deteriorating rapidly. According to “The Monthly Report of Ground Water” which was released by the Ministry of Water Resources of China this January, they conducted water quality observation researches of 2,103 wells in the Songliao plain of the Northeast region and the Jianghan plain in an inland area last year, and it turned out that 80% of ground water is too severely contaminated to drink. Ground water pollution is serious, particularly in the regions of water scarcity.

In the shorter-term there has been some increase in demand. Steel usage has risen in response to the mini-stimulus package implemented in April. It was aimed largely at railway and housing construction. Electricity demand picked up again in May +2.1% from April +1.9%, fuelling an increase in demand for thermal coal. Other leading indicators, also suggest that the slowdown in Chinese growth may have run its course. There has been an increase in railway freight volumes and pickup in copper output:-


Source: Market Realist, National Bureau of Statistics

Outside China the picture looks mixed. LME stocks of Copper and Zinc have recovered but Nickle and Aluminium stocks remain depleted. Global demand still appears to be subdued.

Chinese economy is unlikely to return to the double digit growth rates seen prior to the great recession, but, despite its indebtedness, the world’s largest command economy may be able to avoid an imminent banking crisis.

The Debt to GDP ratio continues to rise. A source of grave concern which is noted in the BIS Quarterly Review, September 2016. At the end of July total Chinese debt reached $28trln – greater than the government debt of the US and Japan combined. Corporate debt, which is fortunately denominated primarily in local currency, now stands at 171% of GDP whilst total debt stands at 255%. A favourite BIS measure is the Credit to GDP gap. A figure above 10 is a warning signal that an economy may be approaching a “Minsky Moment” – China scores 30.1, the highest of any large economy.

China has also continued to reduce its vast foreign exchange reserves, although at a more moderate pace than in 2014 and 2015. In July it reduced its holding of US Treasuries by $22bln – the largest one month decline in three years. It also released information about its gold holdings which, as many market participants had predicted, have risen substantially – it last reported this information in 2009. The US Bond sales may, therefore, have been to insure the stability of the RMB versus the US$ ahead of the G20 summit which was hosted by China this month.

Should we be concerned about a Chinese banking crisis? According to Michael PettisChina Financial Markets – Does it matter if China cleans up its banks? banking solvency is not the issue, but the indebtedness of the economy is:-

The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.

The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe, and most of us do, that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.

…If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0-3.5%, which I think is probably still too high), then for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:

Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or

Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.

Pettis remains pessimistic about China’s ability to grow its way out of debt. History is certainly on his side in this respect, however, policies such as the One Belt One Road Initiative, which aims to improve cross-border infrastructure in order to reduce transportation costs between China and its trading partners, still makes sense at this stage of China’s development. Comparisons have been made with the US Marshall Plan which helped to regenerate Europe after WWII but with an indicated aim of financing $4trln of new projects, its scale is much larger. Chatham House – Westward ho—the China dream and ‘one belt, one road’: Chinese foreign policy under Xi Jinping reviews the policy in detail, as does Peterson Institute – China’s Belt and Road Initiative.

Meanwhile, the great rebalancing towards domestic consumption continues, at what, in other countries, would be considered break-neck speed. This may, nonetheless, be too slow for China – the mini-stimulus package, in April, was a clear political capitulation. The Kansas City Federal Reserve – Consumer Spending in China: The Past and the Future looks at the success of rebalancing to date and the prospects going forward. They point out that Chinese consumption as a share of GDP declined between 1970 and 2000 largely as a result of demographic forces – low birth rate and aging population – together with urbanisation. Post 2000 rapid house price appreciation accelerated this trend. Since 2010 consumption has begun to rise from a low point of 37% of GDP, this coincides with the peak in household savings at 42% – it is now around 38.5%. The authors predict:-

In a benchmark scenario of relatively stable income growth and a further modest decline in the household saving rate, consumption growth in China remains at around 9 percent per year over the next five years, causing the share of Chinese consumption in GDP to increase by about 5 percentage points to 44 percent by 2020. This scenario has two implications. First, it suggests that strong consumption growth is sustainable in the near future, allowing China to continue transitioning toward a consumption-driven economy. Second, it suggests that strength in near-term Chinese consumption growth will partly rely on a further decline in the household saving rate. As the household saving rate cannot decline indefinitely, consumption growth may need to rely more heavily on household income to be sustainable in the long run.

Parallels have been made with Japan where the savings rate has declined from 40% to 19% of GDP since 1970. If China follows this pattern, savings as a percentage of income will continue to decline. The transition could be relatively smooth provided the residential property market does not collapse in the interim. The FRBKC article concludes:-

The declining saving rate in China reflects both a changing demographic structure—an expected increase in the young dependency ratio after multiple decades of decline—and a changing consumption pattern of young people, who face less pressure to save thanks to financial support from their parents and grandparents.

In the long run, transitioning to a consumption-driven economy may require some policy changes. Specifically, China may need to implement successful supply-side reforms—which are on the government’s agenda but haven’t yet been significantly pushed forward—to enable domestic production to meet rising domestic demand. Although the Chinese household saving rate is declining from a very high level, the downward trend cannot last forever. A truly consumption-driven economy must rely on strong household income growth, which is ultimately driven by improved technology and investment.

In the long run, demographic forces will affect China more than any other factor. According to the Ministry of Human Resources China’s working population hit a record 774.5mln in 2015, however, the UN estimate China will have 212mln fewer workers by 2050. The UN Demographic Profile is found on page 189.

Market impact and investment opportunities

Next week the RMB will be included in the SDR – the Peterson Institute – China’s Renminbi Is about to Break the Financial Glass Ceiling discusses this in more detail. There is widespread speculation that the PBoC will widen the RMB currency bands at any moment. In other respects the PBoC is in a more difficult position. The RMB has already weakened by 5% against the US$ this year. Cutting interest rates would probably cause the currency to weaken further, riling the US voters ahead of the election. They are not impotent, however, and injected a record RMB 310bln into the money market in August – part of an overt policy to support the official banking sector, diminishing the influence of shadow banks.

Domestic investors have favoured bonds over equities for the past couple of months, while the spread between corporate bonds and government bonds has narrowed. Chinese 10yr government bond yields have fallen around 50bp this year, but official policy, encouraging investors to purchase higher yielding bonds and reduce their exposure to leveraged wealth management products and other non-standard assets, is boosting demand for corporate issues.

Retail investors, who were badly burnt in the stock market collapse of 2015, remain obsessed with the property market despite massive over-supply. Equity broker margin balances remain low. Institutional portfolio managers have reduced exposure to stocks from 62% in July to 49% this month. In the post-crash environment IPO issuance has been subdued with only RMB 955bln of capital raised in the seven months to July. This compares to RMB 1.55trln in 2015. The final quarter may see better sentiment. Stocks may get a boost from local government spending in Q3 and Q4 – if only to insure their budgets are not reduced next year. The table below, from Star Capital, ranks forty of the world’s major stock markets. Using their metrics, China is second cheapest and has the lowest PE, Price to Cash flow and Price to Book:-

Country CAPE PE PC PB PS DY Rank
Russia 4.9 7.5 3.6 0.8 0.8 4.10% 1
China 12.4 6.1 3.2 0.8 0.6 4.70% 2
Brazil 8.5 44.1 6.6 1.4 1.1 3.40% 3
South Korea 12.6 11 5.5 1 0.6 1.80% 5
Hungary 9.9 ? 5.1 1.2 0.6 2.80% 6
Czech 8.7 11.8 5.5 1.2 1 7.50% 8
Turkey 9.7 10.8 6.2 1.3 0.9 2.70% 9


The Shanghai Composite Index (SHCOMP) is down 8.85% YTD and by 41.84% since its high in June 2015, however it is up 48.25% from June 2014. Russia’s RTS Index by contrast is up 72.81% from its December 2014 low but still 29.68% below its level of June 2014.

Looking outside China, several Australia-centric mining stocks have already risen on the back of the move in coking coal but it seems unlikely that the supply imbalance will prove protracted. Anglo American (AAL) is still looking to sell more of its Australian coal mines – they may well find Chinese buyers.

Outside of China, infrastructure investment across Asia Pacific is on the rise, which is supportive for industrial commodities in general. KPMG – 10 emerging trends in 2016, published in January, takes a very optimistic long term view:-

Ultimately, however, we believe that this may well be the tipping point that ushers in 50 years (or more) of prosperity as capital starts to match up with projects which, in turn, will drive economic growth in the developing world and shore up retirement savings in the mature markets.

Commodity markets tend to exhibit very individual characteristics, however, several industrial and agricultural commodities have formed a longer term base this year. Is this the beginning of the next commodity super-cycle? It’s too soon to call, but without a rise in global demand the prospects for substantial gains are likely to be limited – Indian GDP growth is slowing. The IMF WEO July update revised its India GDP forecast for 2016 to 7.4% from 7.5% – in 2015 it was 7.6%. Its China forecast was revised up 0.1% and its overall Emerging Market and Developing Economy forecast for 2016 and 2017 was unchanged at 4.1% and 4.6%, although, world economic growth was revised 0.1% lower.

China’s stock market remains cheap by many metrics, but the level of indebtedness is an impediment to economic growth. The property market, although over-supplied, continues to attract investment, but this is economically unproductive in the long run. Government policy is attempting to steer the economy towards higher domestic consumption and technologically driven, productivity enhancing, investments. Environmental issues are finally being addressed, yet the challenge of clean water remains substantial.

Near term, debt reduction – and it has yet to begin – will hamper growth, which will, in turn, reduce the attractiveness of Chinese stocks. Reform of the SOEs will involve consolidation into a smaller number of vast enterprises. Private enterprises will suffer. “Zombie” companies will start to be dealt with as bankruptcy procedures become standardised, but, as with all policy in China, a gradualist approach is likely to be implemented. Commodity markets may continue to rise due to supply side factors but I doubt that Chinese demand will rebound even to the level of 2013/2014, let alone the early part of the century.

How do we square the decline in trade with the rebound in industrial commodities?


Macro Letter – No 51 – 11-3-2016

How do we square the decline in trade with the rebound in industrial commodities?

  • Global Manufacturing and Service PMI are in sharp decline
  • Chinese Iron Ore rallied 19% on Monday alone
  • Chinese GDP and trade data points to a continued decline
  • The EIA forecast US oil production to be 8.7mln bpd in 2016 vs 9.4mln last year

The price of Iron Ore, Aluminium and other industrial metals has rallied sharply over the last few weeks – WTI now seems to have followed suit. Most commentators regard this as a short covering rally. World trade continues to slow as the chart of Manufacturing and Services PMI below reveals:-

JP Morgan - services-vs-manufacturing-pmi

Source: Bloomberg, JP Morgan

Chinese February trade data adds to the picture of a slowdown. Exports declined 25.4% YoY, while imports fell 13.8%. Analysts had forecast a 12.5% drop exports, and 10.0% in imports. The trade surplus fell to $32.59bln – against expectations of $50.15bln. This exceptionally sharp decline may be the result of the date of the Chinese New Year but the trend is disquieting.

At last weekends National People’s Congress the 2016 GDP growth forecast was revised downwards to 6.5 – 7%. This followed the release of Q4 2015 GDP at 6.8% and the PBoC’s decision to cut the reserve requirement ratio by 0.5% in order to insure ample liquidity – for large banks the ratio is now 17%.

These charts from the Wall Street Journal put things in a global perspective:-


Source: WSJ, WTO

Further evidence comes from this week’s Monday briefing from Deloitte – Carry on Consuming:-

Manufacturing activity is shrinking in the US and China, the world’s two largest economies. Output is still rising in the euro area, but at the slowest pace in a year. Britain’s manufacturing sector is back in recession.

Part of the problem is lacklustre global demand for manufactured products, particularly in emerging market economies. This has contributed to a slowdown in trade, one of the pre-crisis drivers of global growth. The value of global goods exports last year fell by 13.8% in dollar terms, the first contraction since 2009.

…And yet for me the big conclusion from last week’s meeting in Beijing was that, despite the storm clouds, the world economy should keep growing this year. None of my colleagues, in the US, China, India, Europe, Japan or Australia, anticipate a sharp slowdown in GDP growth in their region this year. All expect consumer spending, the dominant element in GDP everywhere, to hold up.

The performance of many emerging markets has been particularly dire of late, as so many, in order to balance government budgets and meet debt servicing obligations, are reliant on a high price for their commodities.

In an LSE Lecture, given at the beginning of February, Jaime Caruana – General Manager of the BIS – Credit, commodities and currencies – made a number of observations about commodity prices, emerging market debt and the rise of the US$:-

The global economy now finds itself at the centre of three major economic developments. The first is disappointing growth and downward revisions of projections, especially in emerging economies; the second is the large shifts in exchange rates, again especially for emerging market currencies against the US dollar; and the third is the sharp fall in commodity prices, hitting a number of commodity-exporting countries particularly hard, but at the same time providing a positive dividend to other economies.

…Total debt in the global economy, including public debt, has increased significantly since the crisis (end of 2007). True, private debt has been reduced in some countries, namely Ireland, Spain, the United Kingdom, the United States and others. However, public debt has increased significantly in advanced economies, and private debt has increased in emerging economies and some advanced economies less affected by the 2008 financial crisis.


Source: BIS, IMF, World Bank

…Increased leverage would be less of a concern if debt is used to finance productive and profitable investments. However, the profitability of EME non-financial companies has fallen. Traditionally, EME firms have been more profitable than their advanced economy peers, but this is no longer the case…


Source: BIS, Datastream, S&P, Capital IQ

…Based on the most recent reading for the third quarter of 2015, global liquidity conditions may have begun to tighten for emerging economies. A key yardstick is the US dollar-denominated debt of non-bank borrowers outside the United States. It stood at $9.8 trillion in September 2015, unchanged from the previous reading in June, and the dollar borrowing by non-banks in the emerging economies stood at $3.3 trillion, again unchanged from June (Graph 3). This is the first time since 2009 that the latter has stopped increasing.

BIS - US Debt outside US

Source: BIS

One important aspect of this additional borrowing in dollars is the strong association between the strength of the dollar and dollar-denominated borrowing by EME borrowers.

…As a rule of thumb, a 1% depreciation of the US dollar is associated with a 0.6 percentage point increase in the quarterly growth rate of US dollar-denominated cross-border lending outside the United States.

…Unlike in previous EME crises in the 1980s and 1990s that had the attributes of a sharp “sudden stop” in lending to EME sovereigns or a run on the banking system, the borrowing in dollars in recent years has been undertaken by private sector non-bank borrowers – mainly non-financial firms. Even if a firm operates in a country whose central bank holds large foreign exchange reserves, there is the question of how the dollars are transferred from the central bank to the firm itself. Unless there is some mechanism that transfers resources from the foreign exchange reserves to the firms themselves, the firms with dollar debts will need to curtail operations and reduce leverage, leading to a direct hit on overall economic growth.

Commodity Rebound

Mr Caruana’s concerns seem at odds with the sudden upturn in a number of industrial commodities, commodity related equities and resource-centric currencies. The rebound started with Aluminium and spread to Copper:-

LME_Aluminum_5yr_-_Kitco (1)

Source: Kitco


Source: Kitco

Collapsing warehouse stocks tell a part of the story:-


Source: Kitco


Source: Kitco

The move has been even more pronounced in Zinc:-

LME_Zinc_5yr_-_Kitco (2)

Source: Kitco

A similar pattern has begun to occur in Iron Ore, which bottomed at the end of December; I regret, the five year Swap Futures chart below doesn’t capture the dramatic rise from $52 to $62 seen in the spot price on Monday:-

China 62 percent Iron Ore Swap 5yr - Barchart


This move occurred in the face of data from the World Steel Association – January 2016 crude steel production showing a 7.1% decline globally.

Energy prices have remained subdued, with crude oil making fresh lows in February, but even here the sentiment may have changed:-

WTI 5yr - Barchart


Although Coal and Natural Gas have yet to catch a significant bid:-

Coal 5yr - Trading Economics, ICE

Source: Trading Economics, ICE

Nat Gas 5yr - Barchart



A nascent rally is also evident amongst the precious metals complex, here are Palladium and Platinum for good measure:-

Paladium 5yr - Barchart


Platinum 5yr - Barchart


As to whether the real economy is beginning to recover I would not put too much weight on the recent rebound in the Baltic Dry Index, it tends to be, at best, lagging indicator:-

BDI 5yr - Stockcharts


The inelastic nature of prices in many commodity markets and the shipping sector in particular, make it extremely dangerous to imply that a small “flight of swallows makes a summer”.

Conclusion and investment opportunities

Whilst have I written about specific aspects of commodity markets, it has been some while since I last focused on commodities in a general sense. In February of last year I wrote – Where is the oil price heading in 2015? In which I looked at the oil futures contango – despite a decline of almost a third in the spot price of WTI (from $45 to $30 per bbl) the contango has not increased as shown by a comparison of the one year futures spreads (March 15-16 vs March 16-17):-

WTI March 16-17 vs March 15-16 CME

Source: CME,

Producer pain also shows up in US energy production data. Crude oil rig count peaked at 1,609 rigs in October 2014 reaching a low of 439 in February. The Kansas City Federal Reserve – The Reallocation of Energy-Sector Workers after Oil Price Booms and Busts is a timely research response to the 140,000 mining jobs lost during 2015.

Oil production peaked at 9.6mln bpd in April 2015 and is estimated to be down by more than 400,000 bpd. The EIA – Short-Term Energy Outlook forecasts production will decrease to 8.7mln bpd in 2016 and to 8.2mln bpd in 2017.

In December 2014 in How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks I wrote: –

The decline in the oil price, if it holds, should have a long-term benign effect on US growth and inflation. In the shorter term, however, the rebalancing of the economy away from the energy sector may take its toll, not just on the energy sector, but also on financial services – both the banks, which have lent the energy companies money, and the investors, who have purchased energy related debt. This will breed contagion with other speculative investment markets – lower quality bonds, small cap growth stocks and leveraged derivative investments of many colours.

Looking even farther back to my second Macro Letter in December 2013 – Commodity super-cycles in a fiat currency world I concluded:-

Looking ahead to 2014 I can see little reason, thus far, to be broadly long commodities – as mentioned at the beginning I encourage all investors to view each market on its own particular merits. However, just like 2013, I am waiting for bearish sentiment to turn. To misquote St Augustine’s teenage prayer “Give me commodities Lord, but not yet!”

With anaemic growth and slowing global trade, I believe the current rebound in commodity prices will be relatively short-lived. Chart patterns suggest room for further upside in the next couple of months, possibly aided by seasonal factors, but, with a mounting burden of debt hanging over the global economy – especially those parts which are expected to deliver stronger structural growth – I do not anticipate the beginning of the next commodity upturn for a while.

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?


Macro Letter – No 48 – 29-01-2016

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?


Copryright: Universal Pictures

  • Freight rates have fallen below 2008 levels
  • With the oil price below $30 many US producers are unprofitable
  • The Fed has tightened but global QE gathers pace
  • Chinese stimulus is fighting domestic strong headwinds

Just in case you’re not familiar with it here is a You Tube video of the famous Queen song. It is seven years since the Great Financial Crisis; major stock markets are still relatively close to their highs and major government bond yields remain near historic lows. If another crisis is about to engulf the developed world, do the central banks (CBs) have the means to avert catastrophe once again? Here are some of the factors which may help us to reach a conclusion.

Freight Rates

Last week I was asked to comment of the prospects for commodity prices, especially energy. Setting aside the geo-politics of oil production, I looked at the Baltic Dry Index (BDI) which has been plumbing fresh depths this year – 337 (28/1/16) down from August 2015 highs of 1200. Back in May 2008 it touched 11,440 – only to plummet to 715 by November of the same year. How helpful is the BDI at predicting the direction of the economy? Not very – as this 2009 article from Business Insider – Shipping Rates Are Lousy For Predicting The Economy – points out. Nonetheless, the weakness in freight rates is indicative of an inherent lack of demand for goods. The chart below is from an article published by Zero Hedge at the beginning of January – they quote research from Deutsche Bank.

BDI_-_1985_-_2016 (4)

Source: Zerohedge

A “Perfect Storm Is Coming” Deutsche Warns As Baltic Dry Falls To New Record Low:

…a “perfect storm” is brewing in the dry bulk industry, as year-end improvements in rates failed to materialize, which indicates a looming surge in bankruptcies.

The improvement in dry bulk rates we expected into year-end has not materialized.

…we believe a number of dry bulk companies are contemplating asset sales to raise liquidity, lower daily cash burn, and reduce capital commitments. The glut of “for sale” tonnage has negative implications for asset and equity values. More critically, it can easily lead to breaches in loan-to-value covenants at many dry bulk companies, shortening the cash runway and likely necessitating additional dilutive actions.

Dry bulk companies generally have enough cash for the next 1yr or so, but most are not well positioned for another leg down in asset values.


The slowing and rebalancing of the Chinese economy may be having a significant impact on global trade flows. Here is a recent article on the subject from Mauldin Economics – China’s Year of the Monkees:-

China isn’t the only reason markets got off to a terrible start this month, but it is definitely a big factor (at least psychologically). Between impractical circuit breakers, weaker economic data, stronger capital controls, and renewed currency confusion, China has investors everywhere scratching their heads.

When we focused on China back in August (see “When China Stopped Acting Chinese”), my best sources said the Chinese economy was on a much better footing than its stock market, which was in utter chaos. While the manufacturing sector was clearly in a slump, the services sector was pulling more than its fair share of the GDP load. Those same sources have new data now, which leads them to quite different conclusions.

…Now, it may well be the case that China’s economy is faltering, but its GDP data is not the best evidence.

…To whom can we turn for reliable data? My go-to source is Leland Miller and company at the China Beige Book.

…China Beige Book started collecting data in 2010. For the entire time since then, the Chinese economy has been in what Leland calls “stable deceleration.” Slowing down, but in an orderly way that has generally avoided anything resembling crisis. 

…China Beige Book noticed in mid-2014 that Chinese businesses had changed their behavior. Instead of responding to slower growth by doubling down and building more capacity, they did the rational thing (at least from a Western point of view): they curbed capital investment and hoarded cash. With Beijing still injecting cash that businesses refused to spend, the liquidity that flowed into Chinese stocks produced the massive rally that peaked in mid-2015. It also allowed money to begin to flow offshore in larger amounts. I mean really massively larger amounts.

Dealing with a Different China

China Beige Book’s fourth-quarter report revealed a rude interruption to the positive “stable deceleration” trend. Their observers in cities all over that vast country reported weakness in every sector of the economy. Capital expenditures dropped sharply; there were signs of price deflation and labor market weakness; and both manufacturing and service activity slowed markedly.

That last point deserves some comment. China experts everywhere tell us the country is transitioning from manufacturing for export to supplying consumer-driven services. So if both manufacturing and service activity are slowing, is that transition still happening?

The answer might be “yes” if manufacturing were decelerating faster than services. For this purpose, relative growth is what counts. Unfortunately, manufacturing is slowing while service activity is not picking up all the slack. That’s not the combination we want to see.

Something else China Beige Book noticed last quarter: both business and consumer loan volume did not grow in response to lower interest rates. That’s an important change, and probably not a good one. It means monetary stimulus from Beijing can’t save the day this time. Leland thinks fiscal stimulus isn’t likely to help, either. Like other governments and their central banks, China is running out of economic ammunition.

Mauldin goes on to discuss the devaluation of the RMB – which I also discussed in my last letter – Is the ascension of the RMB to the SDR basket more than merely symbolic? The RMB has been closely pegged to the US$ since 1978 though with more latitude since 2005, this has meant a steady appreciation in its currency relative to many of its emerging market trading partners. Now, as China begins to move towards full convertibility, the RMB will begin to float more freely. Here is a five year chart of the Indian Rupee and the CNY vs the US$:-

INR vs RMB - Yahoo

Source: Yahoo finance

The Chinese currency could sink significantly should their government deem it necessary, however, expectations of a collapse of growth in China may be premature as this article from the Peterson Institute – The Price of Oil, China, and Stock Market Herding – indicates:-

A collapse of growth in China would indeed be a world changing event. But there is just no evidence of such a collapse. At most there is suggestive evidence of a mild slowdown, and even that is far from certain. The mechanical effects of such a mild decrease on the US economy should, by all accounts, and all the models we have, be limited. Trade channels are limited (US exports to China represent less than 2 percent of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the United States.

Peterson go on to suggest:-

Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy, a slowdown that has now gone on for a few years. While there has been no significant news in the last two weeks, maybe markets are only realizing that growth in emerging markets will be lower for a long time, that growth in advanced economies will be unexciting. Maybe…

I think the explanation is largely elsewhere. I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices. Why now? Perhaps because we have entered a period of higher uncertainty. The world economy, at the start of 2016, is a genuinely confusing place. Political uncertainty at home and geopolitical uncertainty abroad are both high. The Fed has entered a new regime. The ability of the Chinese government to control its economy is in question. In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fearmongers to gain popularity.

They are honest enough to admit that economics won’t provide the answers.

Energy Prices

The June 2015 BP – Statistical Review of World Energy – made the following comments:-

Global primary energy consumption increased by just 0.9% in 2014, a marked deceleration over 2013 (+2.0%) and well below the 10-year average of 2.1%. Growth in 2014 slowed for every fuel other than nuclear power, which was also the only fuel to grow at an above-average rate. Growth was significantly below the 10-year average for Asia Pacific, Europe & Eurasia, and South & Central America. Oil remained the world’s leading fuel, with 32.6% of global energy consumption, but lost market share for the fifteenth consecutive year.

Although emerging economies continued to dominate the growth in global energy consumption, growth in these countries (+2.4%) was well below its 10-year average of 4.2%. China (+2.6%) and India (+7.1%) recorded the largest national increments to global energy consumption. OECD consumption fell by 0.9%, which was a larger fall than the recent historical average. A second consecutive year of robust US growth (+1.2%) was more than offset by declines in energy consumption in the EU (-3.9%) and Japan (-3.0%). The fall in EU energy consumption was the second-largest percentage decline on record (exceeded only in the aftermath of the financial crisis in 2009).

The FT – The world energy outlook in five charts – looked at five charts from the IEA World Energy Outlook – November 2015:-


Source: IEA

With 315m of its population expected to live in urban areas by 2040, and its manufacturing base expanding, India is forecast to account for quarter of global energy demand growth by 2040, up from about 6 per cent currently.


Source: IEA

Oil demand in India is expected to increase by more than in any other country to about 10m barrels per day (bpd). The country is also forecast to become the world’s largest coal importer in five years. But India is also expected to rely on solar and wind power to have a 40 per cent share of non-fossil fuel capacity by 2030.


Source: IEA

China’s total energy demand is set to nearly double that of the US by 2040. But a structural shift in the Asian country away from investment-led growth to domestic-demand based economy will “mean that 85 per cent less energy is required to generate each unit of future economic growth than was the case in the past 25 years.”


Source: IEA

US shale oil production is expected to “stumble” in the short term, but rise as oil price recovers. However the IEA does not expect crude oil to reach $80 a barrel until 2020, under its “central scenario”. The chart shows that if prices out to 2020 remain under $60 per barrel, production will decline sharply.


Source: IEA

Renewables are set to overtake coal to become the largest source of power by 2030. The share of coal in the production of electricity will fall from 41 per cent to 30 per cent by 2040, while renewables will account for more than half the increase in electricity generation by then.

The cost of solar energy continues to fall and is now set to “eclipse” natural gas, as this article from Seeking Alpha by Siddharth Dalal – Falling Solar Costs: End Of Natural Gas Is Near? Explains:-

A gas turbine power plant uses 11,371 Btu/kWh. The current price utilities are paying per Btu of natural gas are $3.23/1000 cubic feet. 1000 cubic feet of natural gas have 1,020,000 BTUs. So $3.23 for 90kWh. That translates to 3.59c/kWh in fuel costs alone.

A combined cycle power plant uses 7667 Btu/kWh, which translates to 2.42c/kWh.

Adding in operating and maintenance costs, we get 4.11c/kWh for gas turbines and 3.3c/kWh for combined cycle power plants. This still doesn’t include any construction costs.

…The average solar PPA is likely to go under 4c/kWh next year. Note that this is the total cost that the utility pays and includes all costs.

And the trend puts total solar PPA costs under gas turbine fuel costs and competitive with combined cycle plant total operating costs next year.

At this point it becomes a no brainer for a utility to buy cheap solar PPAs compared to building their own gas power plants.

The only problem here is that gas plants are dispatchable, while solar is not. This is a problem that is easily solved by batteries. So utilities would be better served by spending capex on batteries as opposed to any kind of gas plant, especially anything for peak generation.

The influence of the oil price, whilst diminishing, still dominates. In the near term the importance of the oil price on financial market prices will relate to the breakeven cost of production for companies involved in oil exploration. Oil companies have shelved more than $400bln of planned investment since 2014. The FT – US junk-rated energy debt hits two-decade lowtakes up the story:-

US-High Yield - Thompson Reuters

Source: Thomson Reuters Datastream, FT

The average high-yield energy bond has slid to just 56 cents on the dollar, below levels touched during the financial crisis in 2008-09, as investors brace for a wave of bankruptcies.

…The US shale revolution which sent the country’s oil production soaring from 2009 to 2015 was led by small and midsized companies that typically borrowed to finance their growth. They sold $241bn worth of bonds during 2007-15 and many are now struggling under the debts they took on.

Very few US shale oil developments can be profitable with crude at about $30 a barrel, industry executives and advisers say. Production costs in shale have fallen as much as 40 per cent, but that has not been enough to keep pace with the decline in oil prices.

…On Friday, Moody’s placed 120 oil and gas companies on review for downgrade, including 69 in the US.

…The yield on the Bank of America Merrill Lynch US energy high-yield index has climbed to the highest level since the index was created, rising to 19.3 per cent last week, surpassing the 17 per cent peak hit in late 2008.

More than half of junk-rated energy groups in the US have fallen into distress territory, where bond yields rise more than 1,000 basis points above their benchmark Treasury counterpart, according to S&P.

All other things equal, the price of oil is unlikely to rally much from these levels, but, outside the US, geo-political risks exist which may create an upward bias. Many Middle Eastern countries have made assumptions about the oil price in their estimates of tax receipts. Saudi Arabia has responded to lower revenues by radical cuts in public spending and privatisations – including a proposed IPO for Saudi Aramco. As The Guardian – Saudi Aramco privatisation plans shock oil sector – explains, it will certainly be difficult to value – market capitalisation estimates range from $1trln to $10trln.

Outright energy company bankruptcies are likely to be relatively subdued, unless interest rates rise dramatically – these companies locked in extremely attractive borrowing rates and their bankers will prefer to renegotiate payment schedules rather than write off the loans completely. New issuance, however, will be a rare phenomenon.


“We don’t want technology simply because it’s dazzling. We want it, create it and support it because it improves people’s lives.”

These words were uttered by Canadian Prime Minister, Justin Trudeau, at Davos last week. The commodity markets have been dealing with technology since the rise of Sumer. The Manhattan Institutes – SHALE 2.0 Technology and the Coming Big-Data Revolution in America’s Shale Oil Fields highlights some examples which go a long way to explaining the downward trajectory in oil prices over the last 18 months – emphasis is mine:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

…Compared with 1986—the last time the world was oversupplied with oil—there are now 2 billion more people living on earth, the world economy is $30 trillion bigger, and 30 million more barrels of oil are consumed daily. The current 33 billion-barrel annual global appetite for crude will undoubtedly rise in coming decades. Considering that fluctuations in supply of 1–2 MMbd can swing global oil prices, the infusion of 4 MMbd from U.S. shale did to petroleum prices precisely what would be expected in cyclical markets with huge underlying productive capacity.

Shipbuilding has also benefitted from technological advances in a variety of areas, not just fuel efficiency. This article (please excuse the author’s English) from Marine Insight – 7 Technologies That Can Change The Future of Shipbuilding – highlights several, I’ve chosen five:-

3-D Printing Technology:…Recently, NSWC Carderock made a fabricated model of the hospital ship USNS Comfort (T-AH 20) using its 3-D printer, first uploading CAD drawings of ship model in it. Further developments in this process can lead the industry to use this technique to build complex geometries of ship like bulbous bow easily. The prospect of using 3-D printers to seek quick replacement of ship’s part for repairing purpose is also being investigated. The Economist claims use this technology to be the “Third Industrial Revolution“.

Shipbuilding Robotics: Recent trends suggest that the shipbuilding industry is recognizing robotics as a driver of efficiency along with a method to prevent workers from doing dangerous tasks such as welding. The shortage of skilled labour is also one of the reasons to look upon robotics. Robots can carry out welding, blasting, painting, heavy lifting and other tasks in shipyards.

LNG Fueled engines

…In the LNG engines, CO2 emission is reduced by 20-25% as compared to diesel engines, NOX emissions are cut by almost 92%, while SOX and particulates emissions are almost completely eliminated.

…Besides being an environmental friendly fuel, LNG is also cheaper than diesel, which helps the ship to save significant amount of money over time.

…Solar & Wind Powered Ships:

…The world’s largest solar powered ship named ‘Turanor’ is a 100 metric ton catamaran which motored around the world without using any fuel and is currently being used as a research vessel. Though exclusive solar or wind powered ships look commercially and practically not viable today, they can’t be ruled out of future use with more technical advancements.

Recently, many technologies have come which support the big ships to reduce fuel consumption by utilizing solar panels or rigid sails. A device named Energy Sail (patent pending) has been developed by Eco Marine Power will help the ships to extract power from wind and sun so as to reduce fuel costs and emission of greenhouse gases. It is exclusively designed for shipping and can be fitted to wide variety of vessels from oil carrier to patrol ships.

Buckypaper: Buckypaper is a thin sheet made up of carbon nanotubes (CNT). Each CNT is 50,000 thinner than human air. Comparing with the conventional shipbuilding material (i.e. steel), buckypaper is 1/10th the weight of steel but potentially 500 times stronger in strength  and 2 times harder than diamond when its sheets are compiled to form a composite. The vessel built from this lighter material would require less fuel, hence increasing energy efficiency. It is corrosion resistant and flame retardant which could prevent fire on ships. A research has already been initiated for the use of buckypaper as a construction material of a future aeroplane. So, a similar trend can’t be ruled out in case of shipbuilding.

Shipping has always been a cyclical business, driven by global demand for freight on the one hand and improvements in technology on the other. The cost of production continues to fall, old inventory rapidly becomes uncompetitive and obsolete. The other factor effecting the cycle is the cost of finance; this is true also of energy exploration and development. Which brings us to the actions of the CBs.

The central role of the central banks

Had $100 per barrel oil encouraged a rise in consumer price inflation in the major economies, it might have been appropriate for their CBs to raise interest rates, however, high levels of debt kept inflation subdued. The “unintended consequences” or, perhaps we should say “collateral damage” of allowing interest rates to remain unrealistically low, is overinvestment. The BIS – Self-oriented monetary policy, global financial markets and excess volatility of international capital flows – looks at the effect developed country CB policy – specifically the Federal Reserve – has had on emerging markets:-

A major policy question arising from these events is whether US monetary policy imparts a global ‘externality’ through spillover effects on world capital flows, credit growth and asset prices. Many policy makers in emerging markets (e.g. Rajan, 2014) have argued that the US Federal Reserve should adjust its monetary policy decisions to take account of the excess sensitivity of international capital flows to US policy. This criticism questions the view that a ‘self-oriented’ monetary policy based on inflation targeting principles represents an efficient mechanism for the world monetary system (e.g. Obstfeld and Rogoff, 2002), without the need for any cross-country coordination of policies.

…Our results indicate that the simple prescriptions about the benefits of flexible exchange rates and inflation targeting are very unlikely to hold in a global financial environment dominated by the currency and policy of a large financial centre, such as the current situation with the US dollar and US monetary policy. Our preliminary analysis does suggest however that an optimal monetary policy can substantially improve the workings of the international system, even in the absence of direct intervention in capital markets through macro-prudential policies or capital controls. Moreover, under the specific assumptions maintained in this paper, this outcome can still be consistent with national independence in policy, or in other words, a system of ‘self-oriented’ monetary policy making.

Whether CBs should consider the international implications of their actions is not a new subject, but this Cobden Centre article by Alisdair Macleod – Why the Fed Will Never Succeed – suggests that the Fed should be mandated to accept a broader role:-

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, over-values financial assets, and encourages businesses to take on projects that are not genuinely profitable. Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Macleod goes on to discuss the Cantillon effect, at what point we are in the Credit Cycle and why the Fed decided to raise rates now:-

We must put ourselves in the Fed’s shoes to try to understand why it has raised rates. It has seen the official unemployment rate decline for a prolonged period, and more recently energy and commodity prices have fallen sharply. Assuming it believes government unemployment figures, as well as the GDP and its deflator, the Fed is likely to think the economy has at least stabilised and is fundamentally healthy. That being the case, it will take the view the business cycle has turned. Note, business cycle, not credit-driven business cycle: the Fed doesn’t accept monetary policy is responsible for cyclical phenomena. Therefore, demand for energy and commodities is expected to increase on a one or two-year view, so inflation can be expected to pick up towards the 2% target, particularly when the falls in commodity and energy prices drop out of the back-end of the inflation numbers. Note again, inflation is thought to be a demand-for-goods phenomenon, not a monetary phenomenon, though according to the Fed, monetary policy can be used to stimulate or control it.

Unfortunately, the evidence from multiple surveys is that after nine years since the Lehman crisis the state of the economy remains suppressed while debt has continued to increase, so this cycle is not in the normal pattern. It is clear from the evidence that the American economy, in common with the European and Japanese, is overburdened by the accumulation of malinvestments and associated debt. Furthermore, nine years of wealth attrition through monetary inflation (as described above) has reduced the purchasing power of the average consumer’s earnings significantly in real terms. So instead of a phase of sustainable growth, it is likely America has arrived at a point where the economy can no longer bear the depredations of further “monetary stimulus”. It is also increasingly clear that a relatively small rise in the general interest rate level will bring on the next crisis.

So what will the Fed – and, for that matter, other major CBs – do? I look back to the crisis of 2008/2009 – one of the unique aspects of this period was the coordinated action of the big five: the Fed, ECB, BoJ, BoE and SNB. In 1987 the Fed was the “saviour of the universe”. Their actions became so transparent in the years that followed, that the phase “Greenspan Put” was coined to describe the way the Fed saved stock market investors and corporate creditors. CEPR – Deleveraging? What deleveraging? which I have quoted from in previous letters, is an excellent introduction to the unintended consequences of CB largesse.

Since 2009 economic growth has remained sluggish; this has occurred despite historically low interest rates – it’s not unreasonable to surmise that the massive overhang of debt, globally, is weighing on both demand pull inflation and economic growth. Stock buy-backs have been rife and the long inverted relationship between dividend yields and government bond yields has reversed. Paying higher dividends may be consistent with diversifying a company’s investor base but buying back stock suggests a lack of imagination by the “C” Suite. Or perhaps these executives are uncomfortable investing when interest rates are artificially low.

I believe the vast majority of the rise in stock markets since 2009 has been the result of CB policy, therefore the Fed rate increase is highly significant. The actions of the other CBs – and here I would include the PBoC alongside the big five – is also of significant importance. Whilst the Fed has tightened the ECB and the PBoC continue to ease. The Fed appears determined to raise rates again, but the other CBs are likely to neutralise the overall effect. Currency markets will take the majority of the strain, as they have been for the last couple of years.

A collapse in equity markets will puncture confidence and this will undermine growth prospects globally. Whilst some of the malinvestments of the last seven years will be unwound, I expect CBs to provide further support. The BoJ is currently the only CB with an overt policy of “qualitative easing” – by which I mean the purchasing of common stock – I fully expect the other CBs to follow to adopt a similar approach. For some radical ideas on this subject this paper by Professor Roger Farmer – Qualitative Easing: How it Works and Why it Matters – which was presented at the St Louis Federal Reserve conference in 2012 – makes interesting reading.

Investment opportunities

In comparison to Europe– especially Germany – the US economy is relatively immune to the weakness of China. This is already being reflected in both the currency and stocks markets. The trend is likely to continue. In the emerging market arena Brazil still looks sickly and the plummeting price of oil isn’t helping, meanwhile India should be a beneficiary of cheaper oil. Some High yield non-energy bonds are likely to be “tarred” (pardon the pun) with the energy brush. Meanwhile, from an international perspective the US$ remains robust even as the US$ Index approaches resistance at 100.


Source: Marketwatch

US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment?


Macro Letter – No 38 – 19-06-2015

US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment?

  • Last year’s oil price falls are still feeding through to the wider economy
  • Oil producing states have remained resilient despite the continued lower price of WTI
  • The wider economy has rebounded after the slowdown in Q1
  • Stock earnings growth is regaining upward momentum

At the end of last year I became cautious about the prospects for the US stock market. The principal concern was the effect a sustained decline in the price of oil was likely to have on the prospects for employment and economic growth.

The Texan Experience

Oil rich Texas represents a microcosm of the effect lower energy prices may be having on employment and growth. This article from December 2014 by Mauldin Economics – Oil, Employment, and Growth – neatly sums up my concerns at the end of last year:-

…we need to research in depth as we try to peer into the future and think about how 2015 will unfold. In forecasting US growth, I wrote that we really need to understand the relationships between the boom in energy production on the one hand and employment and overall growth in the US on the other. The old saw that falling oil prices are like a tax cut and are thus a net benefit to the US economy and consumers is not altogether clear to me. I certainly hope the net effect will be positive, but hope is not a realistic basis for a forecast. Let’s go back to two paragraphs I wrote last week:

Texas has been home to 40% of all new jobs created since June 2009. In 2013, the city of Houston had more housing starts than all of California. Much, though not all, of that growth is due directly to oil. Estimates are that 35–40% of total capital expenditure growth is related to energy. But it’s no secret that not only will energy-related capital expenditures not grow next year, they are likely to drop significantly. The news is full of stories about companies slashing their production budgets. This means lower employment, with all of the knock-on effects.

As we will see, energy production has been the main driver of growth in the US economy for the last five years. But changing demographics suggest that we might not need the job-creation machine of energy production as much in the future to ensure overall employment growth.

…The oil-rig count is already dropping, and it will continue to drop as long as oil stays below $60. That said, however, there is the real possibility that oil production in the United States will actually rise in 2015 because of projects already in the works. If you have already spent (or committed to spend) 30 or 40% of the cost of a well, you’re probably going to go ahead and finish that well. There’s enough work in the pipeline (pardon the pun) that drilling and production are not going to fall off a cliff next quarter. But by the close of 2015 we will see a significant reduction in drilling.

Given present supply and demand characteristics, oil in the $40 range is entirely plausible. It may not stay down there for all that long (in the grand scheme of things), but it will reduce the likelihood that loans of the nature and size that were extended the last few years will be made in the future. Which is entirely the purpose of the Saudis’ refusing to reduce their own production. A side benefit to them (and the rest of the world) is that they also hurt Russia and Iran.

Employment associated with energy production is going to fall over the course of next year. It’s not all bad news, though. Employment that benefits from lower energy prices is likely to remain stable or even rise. Think chemical companies that use natural gas as an input as an example.

I am, however, at a loss to think of what could replace the jobs and GDP growth that the energy complex has recently created. Certainly, reduced production is going to impact capital expenditures. This all leads one to begin thinking about a much softer economy in the US in 2015.

Last month’s employment report suggests we may have avoided the downturn from cheaper oil, but uncertainty remains. Earlier this month the Dallas Fed – Robust Regional Banking Sector Faces New Economic Hurdles whilst focusing on the health of the banking sector, worried that the effect of lower oil prices, combined with higher interest rates, may yet wreak havoc in the Eleventh District. Here are some of the highlights:-

Not only have district banks achieved greater profitability than their counterparts nationwide, but their loan portfolios also have grown twice as fast. District banks returned to lending sooner than banks in the rest of the country and experienced more rapid loan growth due to the region’s economic strength.

…Possibly reflecting banks’ quest for yield in a low-interest-rate environment, the so-called three-year asset/ liability gap has been growing, particularly for district banks. This measure subtracts liabilities with maturities greater than three years (certificates of deposit, for example) from loans and securities with maturities greater than three years and divides the difference by total assets. A bigger gap means that banks would be hurt by rising interest rates because their assets are tied up for a longer time relative to their liabilities. Consequently, when interest rates rise, banks’ funding costs could rise while interest income remains stagnant, squeezing profitability.

…The other big concern is potential fallout from recent dramatic oil and gas price declines, which affects Texas banks in particular. In July 2014, the West Texas Intermediate (WTI) spot price exceeded $105 a barrel; by March, it had tumbled to below $50 before bouncing back to near $60 at the start of May. The size and rapidity of the decline raised concerns about the impact on the Texas economy and Texas banks, especially given the experiences of the energy and financial collapses of the 1980s. While the state’s economy has become more diverse and thus less reliant on the oil and gas industry, the price drop has still negatively affected the Texas economy and labor market. Some pockets of the state remain heavily dependent on the energy sector, making local industries vulnerable to spillover effects. And because of community banks’ close ties to the areas they serve, they are more exposed than large banks.

…One measure of potential distress is the so-called Texas ratio, the book value of an institution’s nonperforming assets as a percent of its tangible equity capital and its loan-loss reserves. Essentially, the Texas ratio compares an institution’s bad assets to its available capital. A Texas ratio above 1 (expressed as 100 percent) indicates that probable and potential losses exceed an institution’s immediate loss-absorbing cushion, putting it at greater risk of bankruptcy. There have been two instances of dramatic oil price declines since 1980; one gives rise to concern and the other to hope.

Between June 1980 and September 1986, the WTI price declined 74 percent in real (inflation-adjusted) terms. Roughly 20 percent of all Texas institutions had a Texas ratio greater than 100 percent by year-end 1988. A staggering 706 Texas banks and thrifts failed—including nine of the 10 largest banking institutions—between September 1986 and year-end 1990.9

A more recent oil price decline, in the second half of 2008 and early 2009, was also dramatic, but in a different way. Over a nine-month period beginning in June 2008, the price fell more than 71 percent. Yet less than 1 percent of Texas banks had a Texas ratio exceeding 100 percent and only seven failed in 2008–09. The slight pickup in bank troubles in 2010 is likely attributable to generally difficult financial and economic conditions that year.

From June 2014 through March 2015, the price of WTI fell 58 percent. Nevertheless, not one Texas bank had a Texas ratio greater than 100 percent as of the first quarter and only one bank had failed as of March.

The bottom line: The persistence of low oil prices seems to matter more for banks than the magnitude of falling prices. A precipitous, but short-lived, decline is likely to have only a minor impact on the banking industry. Even a longer-term decline similar to that seen in the 1980s is unlikely to provoke the same scope of disruption now as it did then.

…Mitigating factors also make Texas banks better able to weather falling oil prices. Memories of the 1980s crisis linger, and the 2008–09 financial crisis is also fresh in the minds of bankers and regulators. Apart from regulatory changes, Texas bankers manage their risks more prudently, using better risk diversification. The Shared National Credit (SNC) program is one example. Generally, large loans are held by multiple institutions through the SNC program, allowing individual institutions to spread the risk of large credit exposures. While the SNC program has been around since 1977, it has grown in importance and coverage. SNC industry trends by sector show that commodities credits, including those tied to the oil and gas industry, increased from $395 billion in 2002 to $798 billion in 2014. Regulatory filings and investor conference calls suggest that energy exposure at the larger banks in Texas is now predominantly through these shared credits.

…The low-interest-rate environment and a flat yield curve with relatively little difference in interest rates across various maturities have pressured bank earnings over the past five years. Banks have responded by extending their maturity profile in an attempt to generate more robust returns. As interest rates normalize, regulators will need to monitor banks’ ability to restructure their maturity profiles and adapt to the new environment.

The impact of recent oil price declines on banks also bears watching, particularly in Texas. While banks appear to be managing their energy exposure well—and a relatively short spell of low energy prices is not expected to have a severe, adverse effect on local banks—the importance of energy in certain regions points to the possibility of relatively large localized disruptions. The banking system has navigated a post crisis path to recovery. Conditions have improved markedly, but the industry must remain vigilant to potential risks to its financial health and stability.

According to the Dallas Fed – Texas Economic Indicatorspublished on 4th June, the region is showing mixed performance:-

Region Employment Growth
Austin 7.70%
Dallas 2.20%
El Paso 3.30%
Houston 0%
San Antonio -0.50%
Southern New Mexico -0.90%

Source: Dallas Federal Reserve

For the state as a whole, April employment was 1% higher versus the US +1.9%. The largest fall was seen in Oil and Gas Extraction (-14.4%) followed by Manufacturing (-4%) and Construction (-2.6%). Leisure and Hospitality led employment increases (5.3%) Information (4.6%) Education and Health (2.6%) and Trade, Transportation and Utilities (2.3%).

The importance of Oil and Gas to Texas, from an employment perspective, is small– only 2.5% of the workforce – but the sector’s impact on the rest of the region’s economy is much greater. Many ancillary sectors, including manufacturing, banking and finance rely on energy. The most encouraging aspect of the data above is the 2.3% increase in Trades, Transportation and Utilities. As an employer this sector amounts to 20.2% of the total. For this sector, lower energy prices are like the tax cut John Mauldin alluded back in December.

The Energy Complex and US growth

The recent energy technology boom has increased the oil and gas sector’s importance – please revisit Manhattan Institute – New Technology for Old Fuels – my personal favourite essay on this subject. The share of oil and gas in total employment peaked in the early 1980s at 0.8% it’s now back to 0.5%. Its share of GDP followed a similar path, falling from 4% in the 1980’s to less than 1% at the start of the millennium; it’s now back around 2%. Energy self-sufficiency remains elusive – the US is still a net oil importer and therefore benefits from lower oil prices. The Energy Information Administration (EIA) estimates a $700 per household saving from the decline in gasoline prices in 2015. This should also spur an increase in capital investment. The traditional estimate of a halving of output has increased dramatically; meanwhile energy efficiency has significantly improved. The fall from $105 to $60 – assuming the market remains around the current level – will probably add 0.4% to GDP.

As one might expect, the direct impact of cheaper oil on the energy sector has been negative. The US rig count fell by 850 between December 2014 and March 2015. Many energy exploration firms have reduced headcount and cut capital expenditure. I don’t believe the benefits of technology have been exhausted by the energy exploration firms, especially the shale-industry. The Manhattan Institute – Shale 2.0 – takes up the story and go on to make some policy recommendations:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

The shale industry is unlike any other conventional hydrocarbon or alternative energy sector, in that it shares a growth trajectory far more similar to that of Silicon Valley’s tech firms. In less than a decade, U.S. shale oil revenues have soared, from nearly zero to more than $70 billion annually (even after accounting for the recent price plunge). Such growth is 600 percent greater than that experienced by America’s heavily subsidized solar industry over the same period.

Shale’s spectacular rise is also generating massive quantities of data: the $600 billion in U.S. shale infrastructure investments and the nearly 2,000 million well-feet drilled have produced hundreds of petabytes of relevant data. This vast, diverse shale data domain—comparable in scale with the global digital health care data domain—remains largely untapped and is ripe to be mined by emerging big-data analytics.

Shale 2.0 will thus be data-driven. It will be centered in the United States. And it will be one in which entrepreneurs, especially those skilled in analytics, will create vast wealth and further disrupt oil geopolitics. The transition to Shale 2.0 will take the following steps: 1.Oil from Shale 1.0 will be sold from the oversupply currently filling up storage tanks. 2. More oil will be unleashed from the surplus of shale wells already drilled but not in production. 3. Companies will “high-grade” shale assets, replacing older techniques with the newest, most productive technologies in the richest parts of the fields. 4. And as the shale industry begins to embrace big-data analytics, Shale 2.0 begins.

Further, if the U.S. is to fully reap the economic and geopolitical benefits of Shale 2.0, Congress and the administration should: 1. Remove the old, no longer relevant, rules prohibiting American companies from selling crude oil overseas. 2. Remove constraints, established by the 1920 Merchant Marine Act, on transporting domestic hydrocarbons by ship. 3. Avoid inflicting further regulatory hurdles on an already heavily regulated industry. 4. Open up and accelerate access to exploration and production on federally controlled lands.

Nonetheless, in the near-term, states which benefitted from $100+ crude oil and the energy related innovations it spawned, are now feeling the effects of what appears to be a sustained period of lower energy prices. The EIA predicts WTI crude will average $60 over the course of 2015.

The CFR – Energy Brief – October 2013 – predicted that a 50% oil price fall would affect the employment prospects of eight states in particular:-

State Fall in Employment
Alaska -1.70%
Louisiana -1.60%
North Dakota -2%
New Mexico -0.70%
Oklahoma -2.30%
Texas -1.20%
West Virginia -0.70%
Wyoming -4.30%

Source: Council for Foreign Relations

So far, if Texas is any guide, the negative effects of the oil price decline have failed to materialise.

The effect of a 25% rise in crude oil prices is also worth considering:-

State Employment Change State Employment Change
Wisconsin -0.74 Ohio -0.61
Minnesota -0.73 Missouri -0.6
Tennessee -0.72 Illinois -0.59
Rhode Island -0.71 Massachusetts -0.59
Florida -0.71 Delaware -0.58
New Hampshire -0.7 South Dakota -0.57
Idaho -0.69 New York -0.57
Nevada -0.69 California -0.56
Arizona -0.68 Alabama -0.56
Indiana -0.68 DC -0.5
Nebraska -0.67 Kentucky -0.48
Vermont -0.66 Pennsylvania -0.47
Iowa -0.66 Utah -0.38
New Jersey -0.65 Kansas -0.35
Washington -0.64 Mississippi -0.35
Maryland -0.64 Arkansas -0.34
Georgia -0.64 Montana -0.31
Michigan -0.64 Colorado -0.15
Virginia -0.64 New Mexico 0.36
South Carolina -0.64 West Virginia 0.36
Oregon -0.64 Texas 0.6
Connecticut -0.63 Louisiana 0.78
Maine -0.62 Alaska 0.87
North Carolina -0.62 North Dakota 1.01
Hawaii -0.61 Oklahoma 1.16
Wyoming 2.14

Sources: CFR, U.S. Bureau of Labor Statistics and the Wall Street Journal

The effect on the US as a whole is estimated at -0.43%. In other words, a fall in crude oil is good for employment and should also act as a cathartic stimulus to GDP growth.

A final measure of the vulnerability of the US economy to the recent oil price decline is shown by the next table. This shows the substantial diversification away from the energy sector seen in every one of the major oil producing states since the 1980’s:-

Share of Oil and Gas Extraction as a % of GDP
1981 2000 2010
Alaska 49.5 15.1 19.1
Louisiana 35.5 11.1 9.7
New Mexico 26.1 5.2 5.1
North Dakota 20.3 0.9 4.3
Oklahoma 21.6 4.8 9.1
Texas 19.1 5.8 7.8
West Virginia 2.4 1 1.5
Wyoming 37.1 9.8 18.5

Source: CFR, U.S. Bureau of Economic Analysis

Looking at how unemployment has changed across the 51 states over the last 12 months:-

State April April 12-month net change
2014 2015
Alabama 7.1 5.8 -1.3
Alaska 6.9 6.7 -0.2
Arizona 6.9 6 -0.9
Arkansas 6.3 5.7 -0.6
California 7.8 6.3 -1.5
Colorado 5.4 4.2 -1.2
Connecticut 6.8 6.3 -0.5
Delaware 5.9 4.5 -1.4
DC 7.8 7.5 -0.3
Florida 6.4 5.6 -0.8
Georgia 7.3 6.3 -1
Hawaii 4.5 4.1 -0.4
Idaho 4.9 3.8 -1.1
Illinois 7.4 6 -1.4
Indiana 6 5.4 -0.6
Iowa 4.4 3.8 -0.6
Kansas 4.5 4.3 -0.2
Kentucky 7 5 -2
Louisiana 5.7 6.6 0.9
Maine 5.8 4.7 -1.1
Maryland 5.9 5.3 -0.6
Massachusetts 5.8 4.7 -1.1
Michigan 7.5 5.4 -2.1
Minnesota 4.2 3.7 -0.5
Mississippi 7.8 6.6 -1.2
Missouri 6.3 5.7 -0.6
Montana 4.7 4 -0.7
Nebraska 3.4 2.5 -0.9
Nevada 8.1 7.1 -1
New Hampshire 4.5 3.8 -0.7
New Jersey 6.7 6.5 -0.2
New Mexico 6.7 6.2 -0.5
New York 6.5 5.7 -0.8
North Carolina 6.4 5.5 -0.9
North Dakota 2.7 3.1 0.4
Ohio 5.9 5.2 -0.7
Oklahoma 4.7 4.1 -0.6
Oregon 7 5.2 -1.8
Pennsylvania 6 5.3 -0.7
Rhode Island 8.1 6.1 -2
South Carolina 6.1 6.7 0.6
South Dakota 3.4 3.6 0.2
Tennessee 6.5 6 -0.5
Texas 5.2 4.2 -1
Utah 3.8 3.4 -0.4
Vermont 4 3.6 -0.4
Virginia 5.3 4.8 -0.5
Washington 6.2 5.5 -0.7
West Virginia 6.8 7 0.2
Wisconsin 5.5 4.4 -1.1
Wyoming 4.3 4.1 -0.2

Source: Bureau of Labor Statistics

Only Louisiana (+0.9%) North Dakota (+0.4%) and West Virginia (+0.2%) of the top oil producing states, have witnessed increased levels of unemployment. South Dakota (+0.2%) and South Carolina (+0.6%) were the only other states in the union to see unemployment rise. This is not the picture of a faltering economy.

The Federal Reserve Leading Index, whilst it hit a low point of +0.9% in January – down from +2% in July 2014 – has rebounded – April +1.12% – and has remained in positive territory since August 2009. The Conference Board Leading Economic Index increased 0.7% in April to 122.3, following a +0.4% in March, and a -0.2% February. The Conference Board commented:-

April’s sharp increase in the LEI seems to have helped stabilize its slowing trend, suggesting the paltry economic growth in the first quarter may be temporary. However, the growth of the LEI does not support a significant strengthening in the economic outlook at this time. The improvement in building permits helped to drive the index up this month, but gains in other components, in particular the financial indicators, have been somewhat more muted.

The outlook appears steady rather than robust but this has been the pattern of the economic recovery ever since the first round of quantitative easing (QE) in November 2008.

Conclusion and Equity Investment Opportunities

The US economic recovery remains intact. The long run economic benefits of structurally lower energy prices and energy security are slowly feeding through to the wider economy. This is good for the US and, as long as the US continues to run a trade deficit with the rest of the world, it’s good for the US main trading partners too.

After a sharp correction in October 2014 the S&P500 recovered. Since its January lows the market has ground slowly higher:-

S&P500 - 1yr


The table below shows a series of additional valuation measures:-

Indicator Ratio Date Start of Data
Trailing 12 month P/E 20.53
Mean 15.54
Min 5.31 Dec 1917
Max 123.73 May 2009 1875
Shiller Case P/E 27.1
Mean 16.61
Min 4.78 Dec 1920
Max 44.19 Dec 1999 1885
Price to Sales 1.81
Mean 1.4
Min 0.8 Mar 2009
Max 1.81 Jun 2015 2001
Price to Book 2.89
Mean 2.75
Min 1.78 Mar 2009
Max 5.06 Mar 2000 2000


On most of these metrics the market looks relatively expensive but the current level of interest rates is unprecedented. JP Morgan Asset Management predict average corporate earnings to grow by 4% in 2015 – stripping out energy stocks this rises to 11%. They also remind investors that the S&P has seen 10 bear markets since 1926. Eight occurred as a result of economic recessions or commodity price shocks (price increases not decreases) and extreme valuations were a contributing factor only on four occasions. They go on to refute the idea that interest rate increases by the Federal Reserve will derail the bull market, pointing to the positive correlation between rising interest rates and rising equity prices when interest rates start from a low point. They make the caveat that the initial reaction to interest rate increases is negative but in the longer term stocks tend to rise.

At the risk of uttering that most dangerous of phrases – “this time it’s different” – I believe the majority of the rise in equity prices was a function of the reduction in the level of interest rates since 2008. This had two effects; investors switched from interest bearing securities to equities, hoping that capital appreciation would offset the declining income from bonds: and corporations, faced with negative real interest rates, decided to raise dividends and buy back stock, rather than make capital investments when interest rates were artificially low. The chart below shows US 10yr Government Bond yields since 1790:-

US 10 yr Bond Yield Global Financial Data

Source: Global Financial Data

The chart ends in 2013, since when yields have plumbed new depths. Ignoring the inflation shock of the 1970’s and 1980’s it would be reasonable to expect US Treasuries to yield around 3% but that was before the Federal Reserve moved from a stable price target – i.e. around zero – to a 2% inflation target. I think it is reasonable for corporates to assume a long-term cost of finance based on a 3% real yield for US Treasuries plus an appropriate credit spread. Is it any wonder that corporates continue to buy back stock?

The impact of the oil price collapse is still feeding through the US economy but, since the most vulnerable states have learnt the lessons of the 1980’s and diversified away from an excessive reliance of on the energy sector, the short-run downturn will be muted whilst the long-run benefits of new technology will be transformative. US oil production at $10/barrel would have sounded ludicrous less than five years ago: today it seems almost plausible.

US stocks are not cheap, but Q1 earnings declines have been reversed and, whilst growth is muted, the longer term benefits of lower energy prices are just beginning to feed through. At the beginning of the year I was cautious and considering reducing exposure to the US market. Now, I am still cautious, but, if earnings start to improve, today’s valuations will prove justified and further upside may be well ensue. The US bond market is doing the Fed’s work for it – 10yr yields have risen from a low of 1.64% in January to 2.30% today. Whilst the first rise in official rates is likely to act as a negative for stocks, the market will recover as long as the momentum of earnings growth remains positive and energy prices remain subdued.

Australia and Canada – Commodities and Growth


Macro Letter – No 30 – 20-02-2015

Australia and Canada – Commodities and Growth

  • Industrial commodities continue to weaken
  • The BoC and RBA have cut official rates in response to falling inflation and slower growth
  • The RBA has more room to manoeuvre in cutting rates, Australian Bonds will outperform

The price of Crude Oil has dominated the headlines for the past few months as Saudi Arabia continued pumping as the price fell in response to increased US supply. However, anaemic growth in Europe and a continued slowdown in China has taken its toll on two of the largest commodity exporting countries. This has prompted both the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) to cut interest rates by 25 bp each – Canada to 0.75% and Australia to 2.25% – even as CAD and AUD declined against the US$.

In this letter I will look at Iron Ore, Natural Gas and Coal, before going on to examine other factors which may have prompted central bank action. I will go on to assess the prospects for asset markets over the coming year.

Iron Ore

The price of Iron Ore continues to make fresh lows, driven by weakness in demand from China and Japan and the EU.

Iron Ore Fines 6 yr


Iron Ore is Australia’s largest export market, significantly eclipsing Coal, Gold and Natural Gas. It is the second largest producer in the world behind China. 2013 production was estimated at 530 Mt. Canada, with 40 Mt is ranked ninth by production but is the fourth largest exporter. Needless to say, Iron Ore production is of significant importance to both countries, although for Canada Crude Oil comes first followed by vehicle and vehicle parts, then Gold, Gas – including Propane – and Coal. It is also worth noting that the two largest Steel exporters are China and Japan – both major Iron Ore importers. The health of these economies is vital to the fortunes of the Iron Ore industry.

Natural Gas

Natural Gas is a more difficult product to transport and therefore the price differential between different regions is quite pronounced. Japan pays the highest price of all the major economies – exacerbated by its reduction of nuclear generating capacity – closely followed by Singapore, Taiwan and South Korea. The US – Henry Hub – and AECO – Alberta – prices are broadly similar, whilst Europe and Japan pay a significant premium:-


Source: Federal Reserve, World Bank, CGA

Here is an extract from the International Gas Union report – IGU Wholesale Gas Price Survey Report – 2014 Edition:-

Wholesale prices can obviously vary significantly from year to year, but the top two regions are Asia Pacific followed by Europe – both with average prices over $11.00. OPE* remains the primary pricing mechanism in Asia Pacific and still a key mechanism in Europe.

*Oil Price Escalation – in this type of contract, the price is linked, usually through a base price and an escalation clause, to competing fuels, typically crude oil, gas oil and/or fuel oil. In some cases coal prices can be used as can electricity prices.

Canada has significant Gas reserves and is actively developing Liquefied Natural Gas (LNG) capacity. 13 plant proposals are underway but exports are still negligible. It also produces significant quantities of Propane which commands a premium over Natural Gas as this chart shows: –


Source: StatsCan, Kent Group, CGA

Australia, by comparison, is already a major source of LNG production. The IGU – World LNG Report – 2014 Edition:-

Though Australia was the third largest LNG capacity holder in 2013, it will be the predominant source of new liquefaction over the next five years, eclipsing Qatari capacity by 2017. With Pluto LNG online in 2012, seven Australian projects are now under construction with a total nameplate capacity of 61.8 MTPA (53% of global under construction capacity).


Australia is the fourth largest Coal producer globally. According to the World Coal Association, it produced 459 Mt in 2013. Canada did not feature in the top 10. However when measured in terms of Coking Coal – used for steel production – Australia ranked second, behind China, at 158 Mt whilst Canada ranked sixth at 34 Mt.

The price of Australian Coal has been falling since January 2011 and is heading back towards the lows last seen in 2009, driven primarily by the weakness in demand for Coking Coal from China.

Australian Coal Price - Macro Business 2012 - 2014

Source: Macro Business

This is how the Minerals Council of Australia describes the Coal export market:-

Coal accounted for almost 13 per cent of Australia’s total goods and services exports in 2012-13 down from 15 per cent in 2011-12. This made coal the nation’s second largest export earner after iron ore. Over the last five years, coal has accounted, on average, for more than 15 per cent of Australia’s total exports – with export earnings either on par or greater than Australia’s total agricultural exports.

Australia’s metallurgical coal export volumes are estimated at 154 million tonnes in 2012-13, up 8.5 per cent from 2011-12. However, owing to lower prices the value of exports decreased by almost 27 per cent to be $22.4 billion in 2012-13.

Whilst the scale of the Coal industry in Canada is not so vast, this is how the Coal Association of Canada describes Canadian Coal production:-


Canada produced 60 million close to 67 million tonnes (Mt) of coal in 2012. 31 million tonnes was metallurgical (steel-making) coal and 36 million tonnes (Mt) was thermal coal. The majority of coal produced in Canada was produced in Alberta and B.C.

Alberta produced 28.3 Mt of coal in 2012

British Columbia produced 28.8 Mt (most was metallurgical coal) – 43% of all production

To meet its rapid infrastructure growth and consumer demand for things such as vehicles and home appliances, Asia has turned to Canada for its high-quality steel-making coal. As Canada’s largest coal trading partner, coal exports to Asia accounted for 73% of total exports in 2010.

Steel-Making Coal

Global steel production is dependent on coal and more and more the world is turning to Canada for its supply of quality steel-making coal.

The production of steel -making coal increased by 5.5% from 29.5 Mt in 2011 to 31.1 Mt in 2012.

Almost all of Canada’s steel-making coal produced was exported.

Thermal Coal

Approximately 36 million tonnes of thermal coal was produced in 2012.

The vast majority of Canadian thermal coal produced is used domestically.

Currency Pressures

Until the autumn of 2014 the CAD was performing strongly despite weakness in several of its main export markets as the chart below of the Canadian Effective Exchange Rate (CERI) shows:-

CAD CERI - 1yr to sept 2014

Source: Business in Canada, BoC

Since September the CERI index has declined from around 112 to below 100.

For Australia the weakening of their trade weighted index has been less extreme due to less reliance on the US. There is a sector of the RBA website devoted the management of the exchange rate, this is a chart showing the Trade Weighted Index and the AUDUSD rate superimposed (RHS):-


Source: RBA, Reuters

Taking a closer look at the monthly charts for USDCAD:-


Source: Trading Economics



Source: Trading Economics

These charts show the delayed reaction both currencies have had to the decline in the price of their key export commodities – they may fall further.

Central Bank Policy

The chart below shows the evolution of BoC and RBA policy since 2008. Australian rates are on the left hand scale (LHS), Canadian on the right:-

australia and canadian -interest-rate 2008 - 2015

Source: Trading Economics

To understand the sudden change in currency valuation it is worth reviewing the central banks most recent remarks.

The BoC expect Oil to average around $60/barrel in 2015. Here are some of the other highlights of the latest BoC monetary policy report:-

The sharp drop in global crude oil prices will be negative for Canadian growth and underlying inflation.

Global economic growth is expected to pick up to 3 1/2 per cent over the next two years.

Growth in Canada is expected to slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015.

Canada’s economy is expected to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016, with a return to full capacity around the end of 2016, a little later than was expected in October.

Total CPI inflation is projected to be temporarily below the inflation-control range during 2015 because of weaker energy prices, and to move back up to target the following year. Underlying inflation will ease in the near term but then return gradually to 2 per cent over the projection horizon.

On 21 January 2015, the Bank announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 3/4 per cent.

…Although there is considerable uncertainty around the outlook, the Bank is projecting real GDP growth will slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015. The negative impact of lower oil prices will gradually be mitigated by a stronger U.S. economy, a weaker Canadian dollar, and the Bank’s monetary policy response. The Bank expects Canada’s economy to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016.

The RBA Statement on Monetary Policy – February 2015 provides a similar insight into the concerns of the Australian central banks:-

…Australia’s MTP growth is expected to continue at around its pace of recent years in 2015 as a number of effects offset each other. Growth in China is expected to be a little lower in 2015, while growth in the US economy is expected to pick up further. The significant fall in oil prices, which has largely reflected an increase in global production, represents a sizeable positive supply shock for the global economy and is expected to provide a stimulus to growth for Australia’s MTPs. The fall in oil prices is also putting downward pressure on global prices of goods and services. Other commodity prices have also declined in the past three months, though by much less than oil prices. This includes iron ore and, to a lesser extent, base metals prices. Prices of Australia’s liquefied natural gas (LNG) exports are generally linked to the price of oil and are expected to fall in the period ahead. The Australian terms of trade are expected to be lower as a result of these price developments, notwithstanding the benefit from the lower price of oil, of which Australia is a net importer.

…Available data since the previous Statement suggest that the domestic economy continued to grow at a below-trend pace over the second half of 2014. Resource exports and dwelling investment have grown strongly. Consumption growth remains a bit below average. Growth of private non-mining business investment and public demand remain subdued, while mining investment has fallen further. Export volumes continued to grow strongly over the second half of 2014, driven by resource exports. Australian production of coal and iron ore is expected to remain at high levels, despite the large fall in prices over the past year. The production capacity for LNG is expected to rise over 2015. Service exports, including education and tourism, have increased a little over the past two years or so and are expected to rise further in response to the exchange rate depreciation.

…Household consumption growth has picked up since early 2013, but is still below average. Consumption is being supported by very low interest rates, rising wealth, the decision by households to reduce their saving ratio gradually and, more recently, the decline in petrol prices. These factors have been offset to an extent by weak growth in labour income, reflecting subdued conditions in the labour market. Consumption growth is still expected to be a little faster than income growth, which implies a further gradual decline in the household saving ratio.

…Prior to the February Board meeting, the cash rate had been at the same level since August 2013. Interest rates faced by households and firms had declined a little over this period. Very low interest rates have contributed to a pick-up in the growth of non-mining activity. The recent large fall in oil prices, if sustained, will also help to bolster domestic demand. However, over recent months there have been fewer indications of a near-term strengthening in growth than previous forecasts would have implied. Hence, growth overall is now forecast to remain at a below trend pace somewhat longer than had earlier been expected. Accordingly, the economy is expected to be operating with a degree of spare capacity for some time yet, and domestic cost pressures are likely to remain subdued and inflation well contained. In addition, while the exchange rate has depreciated, it remains above most estimates of its fundamental value, particularly given the significant falls in key commodity prices, and so is providing less assistance in delivering balanced growth in the economy than it could.

Given this assessment, and informed by a set of forecasts based on an unchanged cash rate, the Board judged at its February meeting that a further 25 basis point reduction in the cash rate was appropriate. This decision is expected to provide some additional support to demand, thus fostering sustainable growth and inflation outcomes consistent with the inflation target.

Real Estate

Neither central bank makes much reference to the domestic housing market. Western Canada has been buoyed by international demand from Asia. Elsewhere the overvaluation has been driven by the low interest rates environment. Overall prices are 3.1% higher than December 2014. Vancouver and Toronto are higher but other regions are slightly lower according to the January report from the Canadian Real Estate Association . The chart below shows the national average house price:-



Canada natl_chartA04_hi-res_en

Source: Canadian Real estate Association

The Australian market has moderated somewhat during the last 18 months, perhaps due to the actions of the RBA, raising rates from 3% to 4.75% in the aftermath of the Great Recession, however, the combination of lower RBA rates since Q4 2011, population growth and Chinese demand has propelled the market higher once more. Prices in Western Australia have moderated somewhat due to the fall in commodity prices but in Eastern Australia, the market is still making new highs. The chart below goes up to 2014 but prices have continued to rise, albeit moderately (less than 2% per quarter) since then:-

Australian House Prices 2006 - 2014

Source: ABS

This chart from the IMF/OECD shows global Price to Income ratios, Canada and Australia are still at the expensive end of the global range:-

House pricetoincome IMF

Source: IMF and OECD

The lowering of official rates by the BoC and RBA will not help to alleviate the overvaluation.


This chart shows the monthly evolution of 10 year Government Bond yields since 2008 in Australia (LHS) and Canada (RHS):-


Source: Trading Economics

Whilst the two markets have moved in a correlated manner Canadian yields have tended to be between 300 and 100 bp lower over the last seven years. The Australian yield curve is flatter than the Canadian curve but this is principally a function of higher base rates. Both central banks have cut rates in anticipation of lower inflation and slower growth. This is likely to support the bond market in each country but investors will benefit from the more favourable carry characteristics of the Canadian market.


To understand the differential performance of the Australian and Canadian stocks markets I have taken account of the strong performance of commodity markets prior to the Great Recession, in the chart below you will observe that both economies benefitted significantly from the rally in industrial commodities between 2003 and 2008. Both stock markets suffered severe corrections during the financial crisis but the Canadian market has steadily outperformed since 2010:-

canada australian -stock-market 2000-2015

Source Trading Economics

This outperformance may have been due to Canada’s proximity to, and reliance on, the US – 77% of Exports and 52% of Imports. The Australian economy, by contrast, is reliant on Asia for exports – China 27%, Japan 17% – however, I believe that the structurally lower interest rate regime in Canada is a more significant factor.

Conclusions and investment opportunities

With industrial commodity prices remaining under pressure neither Canada nor Australia is likely to exhibit strong growth. Inflation will be subdued, unemployment may rise. These are the factors which prompted both central banks to cut interest rates in the last month. However, both economies have been growing reasonable strongly when compared with countries such as those of the Eurozone. Canada GDP 2.59%, Australia GDP 2.7%.

The BoC has little room for manoeuvre with the base rate at 0.75% but the RBA is in a stronger position. For this reason I believe the AUD is likely to weaken against the CAD if world growth slows, but the negative carry implications of this trade are unattractive.

Canadian Real Estate is more vulnerable than Australia to any increase in interest rates – although this seems an unlikely scenario in the near-term – more importantly, in the longer term, Canadian demographics and slowly population growth should alleviate Real Estate demand pressure. In Australia these trends are working in the opposite direction. Neither Real Estate market is cheap but Australia remains better value.

The Australian All-Ordinaries should outperform the Canadian TSX as any weakness in the Australian economy can be more easily supported by RBA accommodation. The All-Ordinaries is also trading on a less demanding earnings multiple than the TSX.

The RBA’s greater room to ease monetary conditions should also support the Australian Government Bond market, added to which the Australian government debt to GDP ratio is an undemanding 28% whilst Canadian debt to GDP is at 89%. The Canadian curve may offer more carry but the RBA ability to ease policy rates is greater. My preferred investment is in Australian Government Bonds. Both Canadian and Australian 10 year yields have risen since the start of February. The last Australian bond retracement saw yields rise 46 bp to 3.75% in September 2014. Since the recent rate cut yields have risen 30 bp to a high of 2.67% earlier this week. Don’t wait too long for better levels.

Where is the oil price heading in 2015?


Macro Letter – Supplemental – No 1 – 13-02-2015

Where is the oil price heading in 2015?

  • Growth in oil demand remains anaemic
  • Supply will gradually fall as contracts expire
  • Consolidation and declining volatility are the most likely outcome

The price of crude oil has rebounded strongly since the end of January. Is this the beginning of a new trend, a short-term correction prior to a further decline or the start of a period of consolidation?

Here is the price action for March 2015 WTI futures over the last four months:-

4month Mar15 WTI


Before jumping to any conclusions about the next trend it is worth taking a look at a longer term chart. This is the spot price chart for the period since 2005, it shows the period of the leveraged boom and the collapse during the Great Recession:-

10yr Oil


The collapse during the Great Recession was largely due to a reduction in demand as the world economy slowed dramatically. The price decline since the summer of 2014 has been driven by a combination of a delayed reaction to increased supply – specifically from the US – and a moderation in the rate of increase in demand associated with the slowing of Chinese growth and its policy of “rebalancing” towards domestic consumption. An additional factor has been the slowing of growth in Europe. An IEA report last December estimated that global oil demand had increased by only 0.75% between 2013 and 2014 – better, by 3.6%, than the 2009/2013 period but not excessive.

During 2013 and early 2014 geopolitical tension in the Middle East and Ukraine kept prices elevated amid expectations of supply disruptions. These disruptions failed to materialise. This coincided with an increase in US oil production. Finally the markets woke-up to the lack of geopolitical risk, the slowdown of growth in the EU and China, and the acceleration in US production. The price began to correct downwards taking out the 2012 lows. From here on it gathered momentum and, having taken out the majority of trading stop-losses, stabilised last month, not far from the 2009 lows.

Another look at the 10 year price chart shows the recovery in 2010/2011. At this stage the improvements in fracking and drilling technology were already becoming widely known, had it not been for geopolitical concerns the price would probably have begun to decline from this point – around $85. The widening price spread between Brent Crude and WTI shows the effect of increased US production:-

brent wti spread Goldman Sachs ZeroHedge

Source: Goldman Sachs and Zero Hedge

WTI begins to lag Brent Crude towards the end of 2010. Here is a chart of US versus World Oil production:-


Source: EIA and Carpe Diem Blog


Price Prospects

What we have seen during the last six months is a delayed reaction to the increased supply of crude oil from the US. The recent decline has been very rapid and may have run its course, or may have further to fall. Either way, volatility is heightened and the price is likely to remain variable.

From a technical perspective I would expect the corrective rally to continue possibly to test the 2012 lows around $75/barrel. After such a rapid rise in the last few weeks, however, the price may retest the low first; there is an outside chance that the market takes out the January low to retest the 2009 bottom. The $75 level may be retested in the autumn as forward contracts expire and supply shortages appear. From this point a renewed decline is most likely, this phase will also be marked by declining volatility.

I have one concern with this technically bullish prediction – the steep contango in the futures market. At close of business on Wednesday 11th February the WTI futures settlements were as follows:-

Contract Last
CLY00 (Cash) 48.87s
CLH15 (Mar ’15) 50.43
CLU15 (Sep ’15) 57.15
CLH16 (Mar ’16) 60.14s
CLU16 (Sep ’16) 62.39s


Source: NYMEX and

The shape of the forward curve suggests that oil producers are not feeling quite as much pain as is implied by the spot price, the supply overhang may last into 2016.

Market views, as always, vary. At this week’s International Petroleum Week conference in London Igor Sechin – CEO of Rosneft predicted that oil prices may surge later this year due to supply shortages as a result of the precipitous decline. Meanwhile at the same conference Ian Taylor – CEO of Vitoil, questioned where oil demand would emanate from. His outlook was decidedly more bearish.

Moody’s research, published earlier this week, put a price target for 2015 is $55/barrel which makes sense if global growth slows: they see no boost to growth in China, Japan or the EU from a lower oil price but expect it to benefit India and the US.

I listened to a panel debate at the ICMA/JSDA – Japan Securities Summit on Wednesday where Takahiro Sato of the BoJ alluded to the positive impact lower oil prices might have on Japanese growth. He inferred that it would mean the BoJ undershot its inflation target. Here is a brief extract:-

On the price front, the inflation rates in major countries, including Japan, have been declining as a trend mainly due to the recent drop in crude oil prices. Under those circumstances, central banks in major countries have a common concern that major economies are trapped in a feedback-loop — the decline in the inflation rates would lead to a fall in people’s medium- to long-term inflation expectations, and it would result in a further decline in the actual inflation rates. That is why the Bank decided to expand the QQE last October.

As I cast a dissenting vote on that decision, I may not be an appropriate person to explain this policy.

The NY Times reported – KKR profits were down 89% in Q4 2014 due to turmoil in the US energy sector. New drilling has dried up in the last few months and concerns are growing about potential defaults by over-leveraged energy companies. This could slow US growth if the financial sector is wracked with contagion.

The prospects for the oil price is unclear; it will remain so for the next six months. For this reason I expect Moody’s price target of $55/barrel to be reasonably accurate even if their growth expectations prove wrong.

Obvious risk factors which could undermine my expectations include:-

  1. A dramatic slowdown in China
  2. An unravelling of the Eurozone currency union
  3. Russia and the US going head to head in the Ukraine

I think China is more likely to surprise on the upside if it does surprise at all. The Eurozone is still a difficult situation to predict but I think the Euro currency will survive and lower oil prices will aid Germany among other countries in the Euro area. The US may be performing well economically but its appetite for foreign conflict when the country is heading towards energy independence makes little strategic sense. They are likely to deploy their resources on dealing with ISIS first.

My 2015 outside range for WTI crude oil is $40 to $75 with an average of $55/barrel.