Most market participants are having a hard time explaining why the price of crude oil dropped like a rock during a time when the United States began to enforce sanctions on Iranian exports on November 4 – sanctions centered on the extraordinary demand that the world stop buying Iranian oil (with generous exemptions). I’d say that a 20% decline in the price of oil in about a month falls into the category of rare events and may not have anything to do with supply, but rather that other driver of prices called demand.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Which country is the largest importer of oil, and therefore the largest driver of crude oil prices on global markets? China. In 2017, China overtook the U.S. as the largest importer of oil, so economic developments in China should be closely monitored by oil traders, as the Chinese economy is likely headed into a massive recession, and not due to the present trade frictions with the Trump administration.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
The previous time we had such a sharp drop was in 2014-15, and that was clearly due to Chinese economic deceleration coupled with surging U.S. shale production. In 2018, we again have surging U.S. shale production, which surged past 11 million barrels per day, and we also have a decelerating Chinese economy driven by the belated actions of the Chinese government to deleverage their financial system.
It is true that in prior years we have had bigger declines that were not primarily driven by China, the most notable of which was 2008, but China was not the dominant force in the crude oil market then. Today it is.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
The way to know if this move in crude oil is a demand-side issue is to look at the prices of industrial metals, which are also very economically sensitive. There has been a heavy correlation between the London Metals Exchange Index and the price of crude oil over the years, and, albeit not perfect, it has held up pretty well over time. Sometimes the LME Index leads, and sometimes it’s the price of oil, but over time both industrial metals and energy prices correspond very well to major economic shifts (above).
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
During the most recent weakening in the price of oil, the metals led the decline. The LME Index has been weak since June, while the price of crude oil weakened dramatically during October. It was the price of crude oil that caused this fascinating divergence over the past six months of a surging dollar and an overall firm commodity index, when one looks at either the CRB or the S&P GSCI Commodity Index. That bizarre positive correlation between a strong dollar and strong commodity indexes is now over.
Is This China’s Tipping Point?
Last week the Chinese government made history by specifying exactly how much new lending should be directed at the private sector. Previously, Chinese authorities had been more concerned with the overall level of new loans, not necessarily whether they go to private or to state-owned enterprises (for more, see November 8 Bloomberg story “China Banks Fall on Concern Loan Targets Are a Step Too Far”). Chinese banks sold off on the news as many investors, rightfully so, interpreted this as a move of desperation.
I have stated on multiple occasions in this column over the past couple of years that China is in the midst of a credit bubble, the deflation of which is likely to cause a bad recession. Many investors erroneously assume that China’s trade friction with the United States, which is frankly overdue, is the cause of the declining Chinese stock market. It is not, in my view. It is the deflating Chinese credit bubble.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
One way to know that China is in a credit bubble is by looking at the surging credit aggregates and the slowing economy. The Chinese “economic miracle” is built on a mountain of debt. As Chinese GDP grew over 12-fold in 20 years to $12.24 trillion at the end of 2017, credit in the Chinese financial system grew over 40-fold, taking the debt-to-GDP ratio from 100% to 400%, if one counts the shadow banking system.
The Chinese government finally decided to reign in unregulated lending over the past couple of years, since it had grown disproportionately high relative to the regulated financial system that the Chinese authorities have firm control over. The trouble is that clamping down on such unregulated lending activities may push an overly-indebted economy over the edge.
Many observers have tried to call a recession in China since 2010. The reason for their failure is precisely this forced lending business. Every time the economy weakens, the Chinese authorities jack up the lending quotas in the banking system they control.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
My point is simple: The fact that such centralized macroeconomic management has worked for 25 years does not mean that it will keep working forever. I do not believe the Chinese can eliminate the economic cycle. Instead, the credit bubble that they have engineered will cause the coming recession to be a lot worse than it otherwise would have been, drawing parallels to the 1930s Great Depression in the U.S.
The U.S. has had two major tops in credit growth in the past 100 years, one in 1929 and one in 2008. The first created the Great Depression and the second created the Great Recession. I think that what we will see in China, soon, will be the equivalent of what we saw in 2008. The final outcome will depend entirely on the policy response of the Chinese authorities. The American authorities made a lot of mistakes in 1929 and following years, resulting in the Great Depression. In 2008, the authorities did not repeat those mistakes. I think we will find out soon enough what outcome the Chinese authorities will end up creating.
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