China Drag

Jim Brown
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A new low for China's PMI for July offset a fourth week of declines in inventories to drag crude prices lower. Even the news of a major increase in Chinese imports in June could not support prices.

The July HSBC flash PMI for China fell from 48.2 to 47.7 and an eleven month low. The employment sub-index declined from 47.6 to 47.3 and has been in contraction below 50 for the last four months. New orders also fell.

On Tuesday China's government said the GDP would not fall below 7.0%. That was a decline from the 7.5% claim the prior week. They still claim the economy will grow at a 7.5% rate in 2013 but many prominent analysts claim that is the biggest public lie in recent history.

The Chinese president issued an order to halt all government construction in the nation for the next five years. The order bans construction of government buildings in order to cut government waste and expenses. Chinese government officials have a tendency to order construction of lavish buildings to house their offices in an effort to show how important they are. The sometimes grandiose structures cost millions of dollars and are many times not fitting for the area they are in.

Beijing recently halted a Pentagon sized building started by a local government in an impoverished corner of Anhui Province in central China. When these local governments are using the national checkbook the sky is the limit. The U.S. Pentagon has 6.5 million square feet and it is the largest low rise office building in the world.

For instance there are multiple governmental buildings that copied the U.S. White House and capital buildings. This one is the Peoples Court in Shanghai. Architects spare no expense with government money.

Shanghai Peoples Court

The construction halt in China is going to cause unemployment to rise sharply. Add that to the decline in manufacturing and the slowing GDP and it is hard to believe their oil imports soared in June. Platts reported an 11.7% increase in imports in June. Oil imports rose to 9.99 mbpd and the highest level since February 2011. Oil product imports spiked +50% in June. That is refined products like diesel, jet fuel and chemicals. For the first half of 2013 China's oil demand has grown by +3.9% compared to +0.7% in the first six months of 2012. Remember, China's economic growth has been declining for the last four quarters and is at the lowest rate today in the last four years. If China was to see growth accelerate we could expect oil demand to accelerate as well.

I have been telling readers for years that China new found love affair with the automobile was going to increase demand significantly. China expects to sell 20 million vehicles in 2013. The economy can't be doing too bad with that kind of vehicle sales.

The wrongly implied demand decline from the drop in the PMI overcame positive news from Europe and a fourth consecutive weekly inventory loss.

Eurozone Composite PMI rebounded from 48.7 in June to 50.4 in July and an 18-month high. The services PMI rose from 48.3 to 49.6 and while still in contraction that is also an 18-month high. The manufacturing PMI rebounded from 48.8 to 50.1 and a 24-month high. After nearly two years of economic weakness in the Eurozone there are real signs of life but it was not enough to overcome China's PMI weakness.

WTI Chart

In the U.S. crude inventories declined -2.8 million barrels for the fourth weekly decline. It would have been much worse by imports rebounded by +327,000 bpd and domestic crude production rose +65,000 bpd to a new 18 year high at 7.56 mbpd.

Refinery utilization declined half a point from 92.8% to 92.3%. Refinery demand for crude declined -206,000 bpd. After overproducing the prior two weeks they are probably going into cruise mode for the rest of the summer.

Gasoline demand rebounded to 8.98 mbpd and diesel demand rose sharply with a +492,000 bpd increase. I find that number hard to believe and I suspect there are some timing issues in the reporting that will be equalized next week.

Gasoline inventories declined -1.2 million barrels and distillates lost -1.4 million barrels.

Cushing inventories continued to decline, dropping from 46.1 million barrels to 44.0 million. The decline in Cushing inventories has been dramatic since the near record high of 51.2 million barrels in April. The increased shipment of crude by rail to alternate locations other than Cushing is helping to alleviate the storage pressure and allowing prices to rise.

It appears refiners have lightened up on crude imports on expectations for greater domestic production. They may have been a little premature and that has allowed inventories to decline faster than expected. U.S. production is expected to rise to 8.0 mbpd by year end and possibly 9.0 mbpd by the end of 2014. At that level it will likely slow its growth as rapid depletion rates from shale wells make it harder to grow production by a measurable amount.

(Inventory Snapshot guide: Green squares are multiyear highs. Yellow is multiyear low. Orange is multi month high. Pink is multi-week highs. The number of active gas rigs at 350 is an 18 year low. Oil rigs at 1,412 is an eight-month high. Crude oil at 397.6 mb is the highest since 1931.)

Inventory Snapshot

Oil Inventory Chart

Gasoline Inventory Chart

Distillate Inventory Chart

National gasoline prices rose to $3.68 and +19 cents over the same week in 2012. The East Coast rose +7 cents to $3.66, Gulf Coast +6 cents to $3.51 and the West Coast +3 cents to $3.95. The Rocky Mountain region rose a penny to $3.62. Diesel fuel rose +4 cents to $3.90 in the nationwide average.

Tropical storm Dorian has formed off the west coast of Africa and is heading our way. The storm currently has winds of up to 50 mph and is moving westward at 20 mph. The storm is expected to hit Puerto Rico on Monday and potentially make its way into the Gulf of Mexico. The most likely change in direction would be towards Florida and orange juice prices are already rising on the threat to the orange groves.

This is far too early to worry about it hitting the Gulf and damaging the oil patch. That particular tracking data will not be available until early next week.

Tropical Storm Outlook Map

Storm Track

Hercules Offshore (HERO) reported the Hercules 265 jackup rig caught fire after a "well control incident" in the Gulf of Mexico. In English that means a blowout. All 44 workers on the rig evacuated safely. The rig is continuing to burn and the beans supporting the derrick and the rig floor have folded and collapsed over the rig structure. Two fireboats battling the blaze have moved off to a safe location in expectation the rig will sink.

This is a gas well and over flights have reported only a minor sheen in the water surrounding the well. Hercules already has another jackup rig on the way to the location in case a relief well needs to be drilled. The rig was drilling for Walter Oil and Gas at the time of the blowout. The rig is located in 154 feet of water and shallow enough for divers to work on the seafloor if needed to halt the blowout.

Hercules 265 Jackup Rig

We hear all the time about the huge number of coal fired electric generation plants being built in China. While that may be true there is another story not often heard. Water shortages are limiting the number of active coal mines and power generation facilities. Power plants require water for cooling. Coal mines require millions of gallons of water for extracting, washing and processing the coal.

About half of China's rives have dried up since 1990. More than 28,000 rivers have vanished in the last 23 years. Those that remain are so contaminated the water can't be used. Severe water pollution affects 75% of China's remaining lakes and rivers and 28% is not even suitable for agriculture. Entire villages are being relocated because mining polluted the local water supplies.

The coal industry uses as much as 17% of China's water and many of those plants and mines are in the driest regions in the country. The United Nations claims 80% of China's coal comes from areas where water supplies are either "stressed" or in "absolute scarcity."

The government plans to boost coal mining and power plants is expected to raise water demand by 141% by 2015. With aquifers drying up and deserts expanding China can no longer afford to continue this expansion program. Analysts claim after five years there will not be enough water in Ordos and Inner Mongolia to support agriculture and human life. Groundwater levels near Ordos have fallen more than 100 meters and drying out all the artesian wells in the region. Only about 25% of the water available the North China Plain, an area that includes Beijing and Tianjin, is fit for human consumption.

China already mines 45% of the world's coal but the lack of water to mine coal is expected to force a +25% increase in imports by 2015. China already accounts for 25% of global coal imports. Analysts believe this could force China to go on an acquisition binge to acquire coal mines outside China.

China may be limited on where they can buy coal reserves. BTU and BHP control large blocks of reserves in Australia and elsewhere. While buying those reserves is possible they would not be cheap. China can't buy any U.S. companies because the coal is considered a national security asset.

Peabody Energy (BTU) reported earnings of 39 cents compared to estimates for a -5 cent loss. Revenue of $1.73 billion missed estimates of $1.82 billion due to lower prices for coal. The earnings beat was made possible by aggressive cost cutting with U.S. costs declining -6% and Australian costs down -20%. Peabody said U.S. demand for thermal coal would grow by 50-70 million tons as the fuel has regained "significant market share" as a result of high natural gas prices. Demand rose +11% in the first half and natural gas demand declined -15%. BTU shares rose +5% for the day. Peabody said demand from China was continuing to rise and they were increasing plans for additional future production in Australia.

In earnings news Whiting Petroleum (WLL) reported earnings of $1.02 and beating estimates by +12 cents. Revenues rose +32% to $663.3 million compared to estimates of $617.3 million. They affirmed prior guidance despite selling off 7,560 boepd in the Postle sale that just completed.

Oceaneering International (OIS) reported earnings of 91 cents that beat estimates by 7 cents. Guidance was in line with prior estimates. Revenues rose +22% to $820 million. Order backlog rose from $621 million in the year ago quarter to $902 million. That was also up sequentially from the $776 million at the end of March.

Almost no energy stocks closed positive today. The decline in oil prices plus the worries over weak demand from China depressed the sector. Big losers included EOG -4.57, CRR -3.47 and CLR -3.09.

Reporting earnings on Thursday are CAM, CRR, DO, DRC, HERO, NBL, NR, OXY and PTEN.


The equity markets in general were weak for the third day. The Nasdaq finished fractionally higher but all the other indexes closed lower. The Dow came back from an intraday loss of -70 to close down -25. The S&P lost -6 points and closed +4 off the low of the day.

We are reaching the point where investors are losing their excitement over Q2 earnings and thinking more about vacations before school starts. The next 9 weeks are typically a rough period for the market with August and September the worst months of the year.

Nobody knows if this year will follow the seasonal patterns but I would want to err on the side of caution rather than load up with long positions on the first dip.

Crude prices typically decline in August-September and then rebound in the fall as winter heating oil demand increases. Investors should wait for the normal end of summer weakness to add long positions.

Jim Brown

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