24 Oct 2017

Economic Insights - October 16 - 20, 2017

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Insights for October 16 - 20
by Robert F. Baur, Ph.D. , Executive Director, Chief Global Economist
Table of Contents: 

Topic Summaries:

  • Making China great again: That was the message from a super-long speech by China’s president Xi Jinping at the opening session of the current Communist Party Congress. The speech extolled the virtue of China’s one-party rule and suggested that market reforms will likely be pushed aside over Xi’s next five-year term.
  • Giving OPEC an unintended break: The price of Brent crude oil pushed above two-year highs in September as U.S. oil stocks and the number of active oil rigs declined somewhat. But, the price rise was probably caused by two isolated and temporary events, and is likely not a harbinger of further price hikes to come.

Making China great again

That was the message from the three-and-a-half-hour, 32,000-word speech by China’s President Xi Jinping to about 2,300 attendees at the opening session of the 19th National Congress of the Communist Party of China on Wednesday. It was the beginning of a twice-a-decade confab, which selects Party leadership and confirms policy direction for the next five years. President Xi called upon China to become “a great power in the world and a modern socialist country by 2050.” He warned that China should not copy any foreign political system, but should fortify the Party, which governs and “leads everything.” He suggested that other developing nations should see China’s successful one-party system and its “new era of socialism with Chinese characteristics” as a “new choice” for how to govern and modernize their own countries.

The speech was a significant change in emphasis; it was not a series of numerical goals for production, income, jobs or education for the next five years. Instead, Xi laid out a broad roadmap to guide China’s development for the next three decades through 2050. At these twice-a-decade leadership conferences, the president usually describes a “principal contradiction” that China confronts or will soon have to tackle. Since described by Deng Xiaoping in June 1981, the conflict facing China has always been the growing material and cultural needs of a rapidly expanding population versus a low level of production. So, the imperative of the Party was to grow: expand capacity, increase output of everything, and do it as fast as possible. It was borrow, invest, grow, produce at all costs, more food, material, equipment, manufacturing facilities, consumer goods.

Quality over quantity:

Xi recognized that China had mostly overcome that first conflict and was ready to take on another. He noted now that “the principal contradiction facing Chinese society today is unbalanced and inadequate development and the people’s ever-growing need for a better life.” In other words, the quantity of material goods has been achieved; now, the focus is to be on the quality of life. From high-speed growth to high-quality development, rebalancing the economy away from heavy industry and toward satisfying consumers’ wants and desires, upgrading production, cleaning up the environment, creating and using all technology, and fostering innovation. This was a marked change in emphasis from the past and will show up in all future Party writings and directives.

The thirty-year plan consists of two parts. By 2035, China should become an economic, innovative, and creative technology power with an expanding middle class and much-improved air and environmental quality. By 2050, Xi said that China will become a military power with “national strength and international influence.”

In his marathon address, Xi touted his anti-corruption campaign as important and necessary to keep confidence in the Party and to rule efficiently over a country of 1.4 billion people. To that end, over 1.5 million people had been punished over the last five years according to the Minister of Supervision at the Central Commission for Discipline Inspection.

Observations:

First, the stature and power of the Communist Party has been reaffirmed. Xi said, “The Party exercises overall leadership over all areas of endeavor in every part of the country.” The purpose of the government is to carry out the edicts of the Party. Second, economic reform seems to have taken a back seat; the role of the market in allocating resources or in the economy has become a lower priority. The Party will exercise more control, even over large private-sector companies. Further, there were no numerical growth targets mentioned, which suggests a recognition that economic growth will be slower than in the past. In addition, it’s quite possible that Xi intends to serve a third term, even though he would be older than the customary retirement age in 2022. If true, that will become evident when the Politburo and the Standing Committee members are named on October 25th. Xi is clearly the strongest unrivaled Party leader since at least Deng Xiaoping or perhaps even Mao Zedong, the founder of modern China. Finally, the focus moving away from market reforms does not bode well for the goal of an innovative, creative society. Innovation comes from entrepreneurs, who function most effectively in free markets and in countries with strong legal institutions.

Giving OPEC an unintended break

Is the U.S. shale industry giving OPEC an unintended break? Well, sort of. The price of Brent crude oil pushed through the two-year high of $56 dollars per barrel (/b) in September and has stayed there over a month. The price of West Texas Intermediate (WTI) has gone up a bit, but is still below the level at the beginning of the year. The divergence is from two events that propelled the price of Brent, which is sold in Europe, more than the price of U.S. WTI.

Price rises may be temporary:

First, the horrible hurricane season caused U.S. oil activity to dip.

Hurricane Harvey closed many port facilities on the Gulf Coast; this lasted for a couple of weeks and surely reduced U.S. exports of WTI crude. Global refineries then bought more Brent crude in Europe, which led to a higher price for Brent.

South Texas had major refinery operations which were negatively impacted by Harvey as well. Gasoline prices spiked by $0.50 per gallon in late August, according to the Energy Information Administration (EIA), reflecting lower supply at refiners. But, gasoline pump prices have since moved back down. Crude oil production dipped 8% to 8.8 million barrels per day (mb/d) the week of September 1st, according to the EIA, but have rebounded quickly.

The second event was in Iraq, where an important oil field in the Kurdish region was jeopardized when local Kurds voted to be independent from the Iraqi national government. That area of Iraq contains the important oil hub of Kirkuk, which was heretofore controlled by Kurdish military forces. Baghdad, home to the official Iraqi national government, soon sent troops to the area to regain control of the facility. There was no reported effect on oil output, but the risk of the hub going offline likely raised the price of Brent crude oil. With the Iraqi military now controlling Kirkuk now, supply disruptions seem unlikely.

Geopolitical events and severe storms have propelled oil prices higher before. They are tragic events, but the price effects have historically been temporary.

Oil’s marginal producer:

The U.S. shale oil industry has become the world’s price setter and marginal producer. OPEC agreed in November 2016 to cut production by 1.2 mb/d and produce no more than 32.5 mb/d. Producing above a country’s quota has always been a traditional part of OPEC membership. Compliance today, however, has been stunningly good. S&P Global Platts data show the cartel’s production has been at target through September. Nigeria and Libya were exempt from the agreement because security disruptions that left their output well below normal going into the deal.

Oil prices fell over 10% in March 2017, since the OPEC deal would not have an immediate effect on excess supply. U.S. stocks of crude oil and products (gasoline, jet fuel, etc.) measured by the EIA were very high at the time, about 27% above the level prior to the 2014 price collapse. Stocks have fallen, but are still 21% above that level.

U.S. production is rebounding. The Baker Hughes count of active oil rigs was well above summer lows and soon brought record U.S. production. The number of active rigs has fallen a bit after making a soft peak in July. The U.S. rig count is now 913, down from 958 in the summer.

With oil prices now a fair bit higher, there could be another surge in U.S. shale activity. A WTI price below, say, $45/b could result in less new drilling and a drop in output. Prices at $60/b would surely bring shale industry expansion. The price that brings an equilibrium between more U.S. shale output a decline in demand will likely be the trend oil price in the future. That price may be $50/b or a little higher in 2018, compared to $50/b or somewhat lower seen in 2017 before the current price increase.

 

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