So Much For Chinese Demand

"The International Energy Agency cut its oil demand estimates for every year through 2013 by about 3 million barrels a day, it said in its Medium- Term Oil Market Report today. Consumption will average 86.76 million barrels a day in 2012, the first year it will rise above 2008’s level of 85.76 million barrels a day, according to the Paris-based agency."

Well so much for demand for Energy from China. This demand growth has always been hyped by Energy bulls, but as I and many others have stated previously, what really matters is demand growth from the the U.S. and other industrialized nations.

Here is how the math works:

Oil demand in 2009 for the OECD countries is 45.2 million barrels per day, down 2.3 million barrels per day from 2008.

China oil demand is 7.9 million barrels per day. Let's assume that it grows at 5% a year, or about 400,000 barrels per day.

As you can see, the fall in demand from the OECD easily wipes out demand growth from China by a factor of at least five.

An Ominous Cloud

The June report on Japan's trade surplus shows why oil should keep falling in price. The highlights of the report:

1) Exports to the U.S. were down 15.4 percent, the tenth straight monthly drop and the largest since November 2003.

2) Exports to Europe fell 11.2 percent, the second straight decline.

3) Total exports decreased 1.7 percent in June from a year earlier.

An Oil Bull then pops his head up and screams, "Oh don't worry, China and the rest of the emerging markets will make up the slack, you'll see."

Well, not quite:

4)Exports to Asia grew 1.5 percent, the slowest in two years.

5)Exports to China grew 5.1 percent, less than the 12.2 percent growth in May 2008, and down from 23% growth in May 2007.

It won't be long until official figures from China show a slowdown and/or decline in China exports.

A global slowdown in economic activity starts in the U.S., spreads to Europe and Japan, and then hits China and the rest of the emerging economies of the World. This makes perfect sense since we are the largest consumers in the world, and it takes some time for a slowdown in that consumer spending to work its way through the supply chain.

Confirmatory Bias and Oil Investing - Part Three

I recently came across a post on the Victor Niederhoffer Blog about the concept of Confirmatory Bias. I shall reprint the standard quote from Sir Francis Bacon that is used in much of the literature on this subject:

"The human understanding when it has once adopted an opinion (either as being the received opinion or as being agreeable to itself) draws all things else to support and agree with it. And though there be a greater number and weight of instances to be found on the other side, yet these it either neglects and despises, or else by some distinction sets aside and rejects; in order that by this great and pernicious predetermination the authority of its former conclusions may remain inviolate..."

After searching further, I came across a paper published in the Review of General Psychology in 1998 authored by Raymond S. Nickerson of Tufts University. I believe that the concepts he discusses have applicability to current beliefs by bullish energy investors in the oil market.

He presents a modern definition of the concept of Confirmatory Bias;

"...the seeking or interpreting of evidence in ways that are partial to existing beliefs, expectations, or a hypothesis in hand."

In his paper he reduces the concept to its component parts.

I have already discussed the first two parts last week, and parts three and four here.

Today I present my own concepts. They don't really come under the strict definition of Confirmatory Bias, but they are certainly biases that support the bubble, and after all, its my blog and if I want to write about them I will.

Glorification of results or the market must be right.

Oil and Energy has been in a multi year bull market and if there is one thing I have noticed in investing, it is the presumption that because the "market" says something, then the "market" must be right. This is a situation where the "psychological high" that accompanies good investment results is substituted by investors for thorough analytical thought.

Commodities are up 50% this year, well there must be something to it. "These guys must know what they are doing, I guess I'm just not smart enough to figure it out," an investor mumbles under his breath as he heads to his broker, bitter about missing out on the good times.

I can find quotes to apply to other bubbles as well. How about this one for the Housing Bubble. "My neighbor owns five houses and flipped three last year, why can't I do the same? Home prices never go down so what do I have to worry about."

The Cheerleader Effect or talking heads on TV as the second coming of Jesus

Investors are constantly bombarded with information in support of the bull from talking heads on Television, either from professional investors, or from sell side analysts, the great facilitators of the bull market whose job it is to hold our hands while we continue our journey through commodity investing. All of these people have vested financial interests in the bull, and although this is disclosed, usually at the conclusion of the appearance, I don't think that it is generally understood.

This positive reinforcement has a huge unconscious effect on investors. I think that being on television somehow leads to this aura of omniscience that filters down to investors who watch them. Is it that hard to get on television? I don't know - they do need a constant flow of material to entertain us with.

What I do know is that sometimes it is hard to take what they say seriously when two weeks earlier, I saw the same guy during a conference, trying to fondle an 18 year old stripper who was bouncing around on his lap during the evening entertainment hour. Incidents like that tend to dissipate any aura around them in my eyes. These people are not Gods, they are not divine and they did not spring from the head of Zeus.

Investors will usually deny this effect, which can be subtitled "cult investing," but if you read between the lines you will see it is true. These analysts and pundits let you down before when it came to Internet stocks, and they let you down when it came to Real Estate. Are you going to believe them this time? Remember, Growth always disappoints in the end.

The misinterpretation of information usually by twisting it intentionally.

There is an entire cottage industry of analysts and talking heads whose job it is to manage and shape investors thoughts. If, God forbid, any bearish or contrary ideas begin to bubble up to the surface, it is their job to squash it in its womb, so nothing will impede the march of the Bull. As contradictory and bearish evidence begins to mount during the late part of a cycle, this becomes more and more difficult to do. This is the Wall Street equivalent of "spin control" in politics. Here is an example:

China and other Asian countries have partially removed subsidies on products refined from Oil, and sold to its citizens, many of whom have been shielded from the soaring cost of oil, and the resulting soaring cost of gasoline. So common sense would tell you that as the price of gasoline and other products go up, people should use less of it thus reducing demand. While this demand response tends to be closer to inelastic than elastic in the short term, there is an effect. Anyone who doubts this should look at highway miles driven in the United States the last three months.

Somehow this negative data point has been ridiculously twisted to instead mean that Asian countries will actually import more oil to refine into product because they can now lose less money than before, since they can charge more. So here's how it really works - if you sell 5 million gallons of gas and lose 50 cents a gallon you have lost $2.5 million. If you sell 10 million gallons and lose only 25 cents a gallon, well guess what, you've lost the same thing.

This reminds me of an old story that my father used to tell me. He worked in the garment or "schmata" business. After reviewing a new line of clothes, it was determined that to sell them at a competitive price, they would lose money on every piece they sold. The executive just leaned back in his chair, smiled and said, "don't worry, we'll make it up on volume."

Japan Export Slowdown

Japan just released its May trade surplus report, and although it beat expectations, it was down for the third straight month, hurt by rising prices for the Oil that Japan imports.

While exports to China and the rest of Asia were strong, analysts said the gain was a little deceptive, as shipments to China were artificially boosted after the recent earthquake on May 12.

Even more important was that:

1) Exports to the U.S. fell 9.5% as demand for Japanese cars and other products slowed.

2) Exports to Europe were down for the first time in 31 months.

Is this more evidence that the decoupling theory is not valid? Last week it was reported that exports from Singapore to the developed world were down as well.

Here is a list of important questions to answer:

Is it possible that the economic recession in the U.S will lead to a decline in Consumer spending on discretionary items?

Is it possible that this decline in consumer spending will be exacerbated by the increasing price of gasoline and food?

Is it possible that some Asian economies, who are heavily dependent on exports, will not be able to export as much as in the past because there aren't as many buyers?

Is it possible that these Asian economies will not grow as fast as in previous years or as much as the market or pundits expect?

Is it possible that when these Asian economies don't grow as fast, they will use less energy (oil) than the market expects?

Is it possible that the supply and demand fundamentals for oil will not meet the market expectations and we will have a surplus of oil over the next 12 months leading to a rapid rise in inventories?

Is it possible that I am out of my mind?

Next Up China?

Singapore Exports Fall as Western Demand Ebbs

WSJ
By JOHN JANNARONE
June 18, 2008

SINGAPORE -- Exports from Singapore in May fell the most in more than two years as shipments to the U.S. and Europe tumbled, highlighting the island state's exposure to weaker demand from Western developed economies....Nonoil domestic exports fell 9.8% in May from April in seasonally adjusted terms....Shipments to Western countries were much weaker in May, and healthier demand from Singapore's Asian trading partners wasn't sufficient to keep overall exports afloat.

Decoupling theory may you rest in peace.

Oil and the Great Deception

"What matters is growth from the emerging markets, not the United States or other mature markets."

Oil Bulls love to trot out China, and to a lesser extent, India, when discussing the unbelievable growth from emerging markets. I heard a money manager call such growth "massive." Well let's see just how massive this growth is. In 2006, China consumed 7.2 million barrels a day, and in 2007 it consumed 7.58 million barrels a day. This is "astounding" growth of 380 thousand barrels a day. In 2008, the barrel per day growth is estimated to be 420 thousand barrels. While the growth rate is fairly impressive on a percent basis, the absolute increase is hardly more than a rounding error in an 87 million barrel a day market.

Now let's look at the "mature" markets that don't matter. Demand from the 30 countries countries belonging to the Organization for Economic Cooperation and Development (OECD), was 48.96 million barrels per day in 2007. This demand has been flat for several years and is roughly the same as it was in 2003. This demand will begin to fall, as it has done in the past when oil prices reach very high levels. We have already seen evidence of this in reports on miles driven on U.S. highways which fell 4.3% in March 2008.

Let's look at what that impact will be:

OECD Demand declines one percent - 490,000 barrel per day decline.
OECD Demand declines two percent - 880,000 barrel per day decline.

As you can see, a one percent decline in demand from "mature" economies would wipe out all China's absolute growth last year. A two percent decline would be equal to twice China's barrel per day growth. So emerging markets don't really matter except in the context of the entire market. Are the OECD demand declines I listed above realistic? Yes, demand has fallen in previous years when prices were high.

I Just Don't Get It

So here is what I don't get. The United States economy is slowing down, the extent of which is unknown, but certainly below its trend line growth of 3%. The consumer, which powered the economy, is stretched, suffering from the effects of the housing bust and high oil prices.

Oil, however, continues to strengthen in price, reaching $100 a barrel, based on continued strong demand from emerging economies, particularly China. Yet China is America's "factory floor" as one pundit put it. So how long will it take for the slowdown in spending to work its way through the supply chain. The conversation I suppose would go something like this:

Executive: Hey Li Shao...how are things?

Li Shao: Great...how is U.S doing?

Executive: Good. The reason I am calling is about the order we have pending with you guys.

Li Shao: Yes, we are working hard on it.

Executive: Well the thing is, we are going to have to cut it back by 50%.

Li Shao: What?

Executive: Well you know, the American consumer is stumbling a little with the housing crisis, high gas prices so we just wanted to be a little prudent about our inventory this year.

Li Shao: What? You can't do that.

Executive: Well actually we can. Why do you think we outsourced our manufacturing?

So here is the current consensus on Wall Street - the bull markets in emerging economies and therefore by extension commodities will continue despite the Housing debacle in the United States because these emerging economies have "decoupled" from the United States due in part to those emerging economies developing their own domestic consumption markets.

The rest of the world is no longer "dependent" on the U.S. economy. Not only will Commodities and emerging economies continue to boom, but all the domestic stocks that feed that boom will continue to grow. This would include the Energy Sector, most Basic Materials, Industrials and any other company that sells to export markets, dry bulk and other shippers that serve Asia, etc.

If this is true, then all power to them I say, but if it is not and the old saying "when the U.S catches cold, the rest of the world catches the flu" is still true then the short of a lifetime is developing here.

China exported $ 287 billion in goods to the U.S in 2006. This was 29% of its exports to the world, which totaled $969.1 billion. Although the conventional wisdom is that the slowdown in the US will not impact China because they have other markets now to sell to, this is not true. We are their largest customer. Also, if you look at the top export categories, they are the categories that are slowing down the most in the U.S:

Exports to U.S from China in 2006 (Billions)

Toys & games $20.9
Apparel $19.9
Furniture $19.4
Footwear & parts $13.9


Source

Oil finally cracked a little on Friday after the jobs report, but it would seem that there is a huge downside still to come on it and other commodities.