President Donald Trump sent a bold message, but it is unclear who it was directed towards. The President said that China’s President Xi was moving too slow on trade and therefore he would impose a 10% tariff on the remaining $300 billion of Chinese imports starting September first. Yet it came just one day after the President criticized Fed Chairman Jerome Powell for not signaling a more aggressive rate-cutting posture tweeting that, “As usual, Powell let us down.” And with more Chinese tariffs, that will help the President prove his point. The ten-year treasury yields plunged to the lowest since 2016. Gold prices, that fell after the Fed announcement, reversed course. And of course, oil tanked but did hold key support.
The oil market had already been under pressure as the Wall Street Journal in a headline declared that oil was in a bear market. They did not make clear by what measurement they made that determination but they did cite some very bearish predictions from Citigroup (NYSE:C) and JPMorgan Chase (NYSE:JPM) analysts currently projecting supply growth roughly one million barrels a day more than demand in 2020, resulting in a surplus each quarter of next year. While I doubt that was one of the reasons that oil was on a tear before the Fed announcement, it was dragged down kicking and screaming after Fed Chairman Powell mentioned the rate cut was a mid-cycle adjustment. The U.S. oil inventory draws were very bullish and while we keep looking to U.S. shale to grow, there are more signs of trouble in the shale patch.
The Wall Street Journal warns that “Concerns about shale have roared in recently like a Texas tornado—sudden and violent.” The Wall Street Journal is pointing to risng cost for shale output and bad earnings from shale companies. The Journal says that, “Shareholders have become more sensitive to the cost side of the equation recently and have pressured drillers to rein in spending and to focus on returning cash. It isn’t working. In the first quarter of this year a basket of seven unconventional oil-focused drillers collectively reported free cash flow of negative $1.58 billion, according to Wood Mackenzie—more than twice their free-cash-flow burn in the fourth quarter of 2018 and more than four times worse than during the first quarter of 2018. Shale is uniquely problematic because of rapid production-decline rates and the constant need to reinvest. Other drilling, like deep-water, has high upfront costs but relatively modest ongoing investment.”
True, other producers are less nimble than shale producers and are making more of an outright long-term bet on commodity prices, but investors seem to have rediscovered the charms of conventional oil production. For example, Hess Corp (NYSE:HES), in a partnership with Exxon Mobil (NYSE:XOM), has plunged into a big project in Guyana. Hess’s return on invested capital has been negative since oil prices collapsed in 2014, yet its shares are suddenly in favor again, rising almost 60% so far this year.
Of course, there are some that believe Trump’s latest tariffs will be the final straw that pushes the globe into a recession. Reuters oil king John Kemp has been warning about a major global economic slowdown as well as a slowdown in oil demand for some time. He writes, "Rising tariffs and heightened business uncertainty have pushed the manufacturing sector of both the United States and China close to recession. The fallout from the U.S.-Chinese conflict has also caught manufacturers, exporters and commodity producers across Europe and the rest of Asia in the crossfire. The broader global slowdown is in turn rebounding on activity in the United States and China, a point the U.S. Federal Reserve highlighted on Wednesday when it cut interest rates and terminated its bond sales program early.”
The Federal Open Market Committee cited, "the implications of global developments for the economic outlook, as well as persistently low inflation, in explaining its decision. In June, U.S. manufacturers reported a marginal expansion in activity, but it was the smallest increase since the mid-cycle slowdown of 2015/16, according to the Institute for Supply Management (ISM). In July, businesses in Chicago reported a sharp drop in regional activity, with activity falling at the fastest rate since December 2015 and before that the recession of 2008/09, according to the ISM’s local affiliate. The Chicago purchasing managers' survey is a useful leading indicator for the national survey and suggests national activity is likely to weaken further in the near term. Eurozone manufacturers, caught between the United States and China, reported their activity contracted at the fastest rate for six years in July.
Eurozone manufacturers have now reported a decline in activity for six consecutive months, the worst performance since 2013. In China, manufacturing activity has fallen in six out of the last eight months, according to the government-run purchasing managers' survey. Other indicators point to a deep and worsening slowdown. China's internal freight volumes were up by less than 5% in April-June compared with the same period a year earlier, and by just 1% in the month of June. China's motor vehicle output was down by almost 19% in April-June compared with a year earlier, according to the National Bureau of Statistics. Global motor vehicle production declined 1% last year, the first fall since the recession of 2008/09, and looks set to drop again in 2019, given that China is the world’s largest automaker. Motor manufacturing is one of the world's largest industries, so the slump is spreading through the supply chain to parts makers, raw-materials producers and services providers. Similar pressures are evident in the softening market for heavy industrial machinery and other major manufacturing sectors. Faltering manufacturing output is translating into a slowdown in worldwide freight movements and consumption of diesel and other middle distillate fuels."
Kemp warns that “Neither the United States nor China can be sure that a further escalation of their conflict will not turn the current slowdown into a full-blown recession.”
On the other hand, we are seeing central banks respond. The tariffs almost assure us of another rate cut from the Fed. It will also force China to kick up stimulus spending and will assure us that central banks around the globe will lower rates and print money. Maybe that's what President Trump wants. More accommodative policy in a world where the Fed sees a mid-cycle cut and where Trump sees it as only the beginning of the cycle.
Oil also bounced off of key support suggesting the move was overdone. We wrote on July 24th that if oil held recent lows and built off of it, it is very possible that crude oil has set a low that won’t be tested for the rest of this year. That all changed by the tariff threat but it does not change our base case that we think there are too many people that are too bearish. Oil will shake off the terror threat and stimulus will perk up demand. U.S. inventories will also continue to trend lower into seasonal maintenance.
The natural gas rally might be over. Natural gas could not shake off its bearish report. The EIA reported that working gas in storage was 2,634 Bcf as of Friday, July 26, 2019, according to EIA estimates. This represents a net increase of 65 Bcf from the previous week. Stocks were 334 Bcf higher than last year at this time and 123 Bcf below the five-year average of 2,757 Bcf. At 2,634 Bcf, total working gas is within the five-year historical range.