China and oil: investors’ major concerns
January was not a kind month for equity investors. The volatility was discerning and uncomfortable. While markets may correct further (nobody knows for sure) it's very important to realise that market sell-offs are par for the course. In times like these it is important to focus on your long term plan and what you own. I believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. The source of the recent angst is driven by a couple of major concerns: China and Oil.
China is large enough to matter. It accounts for about one-third of global growth. What many people may be missing is that Chinese GDP has already downshifted considerably in nominal terms. The press fixates on Chinese real GDP figures but nominal GDP growth in local currency terms has shown a nearly 18 per cent contraction already. Henry McVey from KKR has noted: “While real GDP growth is important, nominal GDP growth tracks the actual income earned, which can have a significant impact on the global economy … Key to our thinking is that many countries no longer have the same buying power they once did because, despite their real GDP growing, their nominal GDP growth — which is most often connected to their income growth — has actually turned negative.”
The massive downshift we are seeing in global merchandise exports and global trade is a direct result of this worldwide contraction of purchasing power seen in many emerging markets. Furthermore, China has begun to shift its strategy from a more focused export strategy to one of local consumption and vertical manufacturing. The transition from an investment driven export economy towards an economy driven by domestic consumption was never going to be easy.
Retail sales growth was 10.6 per cent in 2015 compared to 11 per cent in 2014 and 12 per cent in 2013. Auto sales ended the year at record highs, growing 11.6 per cent for the year. Future growth will be driven by consumption of goods and services and not on investment in hard industries.
This means that companies levered towards consumer products and services are well positioned while those firms exporting raw materials to China will continue to be under pressure.
Whether this transition is successful will hinge to some extent on the government's ability to manage the yuan and control the damage associated with mal-investment. On the former, it's crucial that authorities do not lose control of the yuan exchange rate and suffer a devastating capital flight.
On the latter, the government has the ability to absorb what is likely to be a sizeable increase in non-performing loans from poor capacity investments. China has the reserves and financial flexibility to manage this but it will undoubtedly be a headwind to growth. Our opinion is that China will not have a hard landing but economies dependent on commodity exports will need to right-size these industries to the new reality of lower demand for basic materials.
If one wants to describe the price of oil in one word it is “unsustainable”. Prices are now approaching inflation adjusted lows of the past 30 years and nearing the 1986 oil crash levels. Yet today's market dynamics are much stronger than three decades ago.
The current situation is not tenable on many dimensions when one considers simple supply demand dynamics over time. Economics suggests that supply and demand will meet the equilibrium price at some point. We would suggest that it will happen with some falling supply and rising demand.
While some will argue that the plunging price of oil is evidence of a weakening economy, oil demand is actually trending up and even accelerating; driven by low prices. In 2015, demand for crude oil increased by 2.3 million barrels per day (2.5 per cent). This compares to demand growth of 1.1 and 1.6 million barrels of oil growth in 2014 and 2013, respectively.
As noted above, China continues to buy cars and US car sales have jumped as well, climbing 12 per cent from 2013 to 2015. What is noteworthy about the US sales is the huge surge in light truck sales (SUVs) of 24 per cent as consumers become unconcerned about the cost of filling larger and more inefficient vehicles.
Since transportation fuel is still the number one use of crude's end demand, we would suggest more (larger) cars on the road will only help bid up demand.
The real reason for crude's sell-off has obviously been supply. Over the past two years supply has grown by 5.5 million barrels per day while demand has grown by 3.5 million barrels per day, leaving the market in an oversupply position of about 2 million barrels per day. However, with oil prices hovering around $30, the pain is simply too much for certain producers and the economics just don't work.
Many companies lose money at these levels. Canadian bitumen prices are flowing red ink at these levels. The obvious response is a curtailment of production and investment over time. With global rig counts down 45 per cent in 2015, we expect supply to be relatively flat in 2016.
Producers which are suffering from contracted cash flows are slashing spending plans, and billions of dollars for longer term investments have been shelved. For example, Continental Resources, Anadarko, Hess Corporation and Noble Energy have all slashed their 2016 spending plans in the range of 50 per cent. Thus, in the medium term, additional supply looks limited as there will be a lag between new investment and production.
All this discussion does not consider the potential for a “geopolitical event” which could disrupt supply suddenly in a world of much tighter spare capacity. According to ARC Financial Corp, 1986 spare capacity was equal to 12 million barrels per day or 20 per cent of global demand. Thus the cushion available was very large and explained the call for “lower for longer”.
Today, however, spare capacity plus the amount of crude oil that the world is producing equates to under 4 million barrels per day, or only 4 per cent of global demand.
While energy prices could drift lower near term we would suggest that the present conditions are strengthening the forces that will ultimately lead to tighter markets and a price recovery. As the saying goes, the cure for low prices is low prices.
• Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and can be reached at firstname.lastname@example.org
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