Oil prices and China.
The key question that we need to answer is not if the Chinese economy is slowing down. It is how China is going to drive crude oil demand for the next two years. If and when the Chinese dragon roll, which direction will crude oil head in?
The thinking around gross Chinese GDP growth figures has been that they are managed and massaged (no surprises there for a leading Asian economy). Even then targeted official GDP growth is clearly slowing down. Estimates range from a low of 4.3% to an official high of 6.9%. Rather than looking at gross growth figures that are distorted by growing consumer demand and changes in retail sales, China desks suggest looking at indicators industrial production growth. Industrial growth drives jobs, jobs drives consumption and consumption drives demand in the long run.
Oil Prices and China. Industrial Growth
For industrial growth, Chinese insiders recommend electricity consumption and coastal freight volumes. You can build your own Li Keqiang index by using data released by the Chinese bureau of national statistics or look at many existing variations of the same index.
Data released as of November 2015 (the latest available dataset as of the date of this note) suggests that after a long slow down industrial growth may finally be stabilizing. But there is a catch. Other leading indicators released post November 2015 indicate that November may have been an uptick.
December and January numbers including trade figures, prices, electricity consumption, steel production all suggest that we may be stagnant or heading south. It will take a few months before the official data set at the Chinese statistical agency edges past January 2016 but if we had to take a guess the vote would be for a continued industrial slow down rather than weak growth or stability. And if the January figures are anything but a seasonal adjustment we may be looking at a much longer and rougher ride.
Oil Prices and China. The Yuan devaluation
That is the industrial sector. Let’s take a look at Yuan. The Yuan depreciation is what triggered the rout in commodity prices in August 2015. In addition to internal drivers, it’s the latest chapter in the hedge funds against the central bank story.
The story is driven by the conflict raised by domestic conditions in China that make it difficult to effectively use classical defenses against currency speculators. So while the official stance remains that there will be no further devaluation, a number of hedge fund managers are betting against the stance.
While PBOC foreign currency reserves stand at 3.3 trillion USD the Chinese central bank has spent over a 100 billion USD a month in December 2015 and January 2016 selling dollars and buying Yuan in Hong Kong markets to release pressure on the currency. The fight is going to get more intense and ugly as we get closer to the 1st October 2016 date of adding the Yuan to IMF’s Special Drawing Rights. Smart money in this war would still rests with hedge funds rather than PBOC but a good predictive indicator would be capital flight figures after the Chinese New Year. That bet is not driven by size of PBOC FX reserves but by the limitation of responses in its domestic arsenal, the challenge with capital controls, the SDR inclusion and historical precedent when it comes to similar bets in the past. The house has never won against a fund in recent years.
The question that then needs to be asked is would this unanticipated and forced devaluation help Chinese exports? More importantly if and when the devaluation happens what would that do to commodity markets and more specifically to oil prices. If the market sees the devaluation as an additional sign of weakness, the immediate impact on oil prices would be negative.
Oil Prices and China. Chinese crude imports.
The one silver lining and a source of support for the floor on oil prices was Chinese purchases of crude oil for its strategic oil reserve. Throughout 2015 China kept on buying crude when prices flirted with historical lows. Chinese crude oil reserves doubled to 190m barrels in addition to significant planned expansion in domestic storage capacity in China with a stated aim to cover 90 days of oil imports. EIA data quotes 218 million barrels of existing storage capacity and another 280 million barrels of planned and under construction storage projects in China. If existing crude oil storage capacity is almost full (as reported by Reuters and other news sources in late October) and planned and under construction projects take another two year or more before they come online, this silver lining will disappear in 2016.
January figures and expected February numbers for Chinese crude oil imports indicate that the floor is indeed no longer there. Chinese crude imports dropped in January by 20% to 6.3 million barrels per day as Chinese refiners cut operating capacity to 77% in view of slowing demand. Compare this to peak import rate of 7.4 million barrels per day in 2015 during the reserve building exercise. Net refined products exports also fell in the same month as refineries faced the supply glut head on in regional markets. From a buyer point of view Chinese producers and refineries may now be the best source of prices for purchase of refined fuel products (motor gasoline, diesel and fuel oil). But the drop in import, net exports, available storage capacity and refining capacity do not augur well for crude prices.
Oil Prices and China. The dragon roll.
To summarize here is what have we learnt.
The Chinese slowdown is real and while temporary respite may provide relief, it is likely to be a long road. A devaluation in the Yuan is likely over the next few months and when that happens, it will drive crude oil and other commodity prices lower. The devaluation will be driven by a list of internal factors, smart money betting against the Yuan and the inability of PBOC to wage war using classical defenses due to domestic economic environment and the SDR inclusion. There has also been a significant shift in Chinese crude oil purchases in January and the shift is likely to continue in February. If the shift is temporary it is great news. We will know for sure in the next two months once new data becomes available after the Chinese New Year. However given the storage, refining and net petrochemical exports equation, this change in Chinese crude oil imports may be here to stay.
The three signals – industrial growth, exchange rate gyrations and crude purchases – are sending a clear message. When the Chinese dragon finally decides to shift or roll, oil prices will only head one way.
Updates: 25 Feb 2016. China negative data disappears.
See the complete series on dissecting crude oil at The knives are out in the oil market.