Do not
underestimate China

Luc Synaeghel, CIO 2016-10-06

It has been only six months since Chinese policymakers announced their plan to develop the North Western part of their country and already more than 300 projects, totalling some USD 150 billion, are ready for roll-out. There should be no doubt that China is serious about its infrastructure spending, with major consequences for commodity prices and the industrial sector at large. Yet financial markets have been paying little attention.

Take the substantial rebound in daily freight rates for capesize ships for instance. These rates are rising because Chinese imports of iron ore and coal – the two cargoes that are typically transported on capesize ships (meaning ships so large that they cannot cross the Panama canal and have to navigate around the Cape of Africa) – are surging. Building highways, railways and cities in North West China will require iron ore, a key raw material for steelmaking. It will also need energy, which – initially at least – tends to be provided by coal-fired power plants. And China’s ultimate ambitions extend well beyond its own borders. Restoration of the ancient Silk Road, a project now termed “one belt, one road”, will enable the country to move up the export value ladder and provide Europe with much more than basic consumer goods.

Oil is but one example of this. China is currently in the process of building a large number of refineries and securing crude oil supply contracts with producers in different areas of the globe – of which a 30-year contract with Russia (perhaps as a form of reciprocity for gaining passage of the Silk Road through Russian-influenced countries?) Eventually, China’s refined oil output will exceed its own needs and it will transport and sell it to European customers. That said, while China has certainly played a part in the oil price rebound this year, it is not the main factor. Nor really is the recent agreement by OPEC (Organisation for Petroleum Exporting Countries) members to cap their output. OPEC production will fall to the level targeted for November just by virtue of normal seasonality. No, in our view the real story on oil lies in the continuous drop in inventories since May, together with a collective underestimation of the required inventory level.

As such, we believe that the market is much closer to equilibrium than most assume, meaning that the oil price could approach USD 60 during the first half of 2017 – at which point some suspended shale oil production should return to the market, probably causing volatility in prices. All told, we confirm our positive stance on oil, on financially-strong companies in the (still disliked) bulk shipping and commodity sectors, and on (still cheap) Chinese equities.
In contrast, wary of the eventual impact of higher commodity and oil prices on interest rates, at a time when central bank interventions are reaching their limits, we again recommend caution in the fixed income space.


To Westerners, five years is considered long term. To the Chinese, fifty years is still short term. This difference in perspective is crucial in analysing current developments in China. Surging iron ore and coal imports are not just temporary restocking, they are part of the structural plan to develop North West China – in the vein (if not to the scale) of what has already been achieved in the South East. At USD 720 billion over the next three years, the investment involved will be, in nominal terms, larger than the post- Great Financial Crisis stimulus program.

Baltic Capesize Index1 (2014 to date)
Investment Letter 2016 October Baltic CapesizeSource: Bloomberg

Only months since the plan was announced, it transpires that some USD 150 billion in infrastructure projects have already been approved, the majority of which will be in the Mongolian region. Greenlight has also been given to the building of nine(!) highways in Western China. Given the associated requirements for iron ore and coal inputs, the rising number of such cargoes and improving freight rates for capesize vessels (see Chart 1) should come as no surprise.

But, might one object, what about the financing of such huge investments?
First, the much berated Chinese debt overhang mostly consists of borrowing by State-Owned Enterprises from State banks, i.e. a form of zero-sum game. Second, and very different to the Western situation, Chinese land is property of the State. As was done when developing the South East, policymakers can sell land to private companies and finance infrastructure projects with the proceeds. Private investments in industrial projects and housing should then go hand in hand with the public spending, meaning that overall developments could actually be a multiple of the stated USD 720 billion figure.


Markets reacted enthusiastically to OPEC’s recent informal pact to trim production. While we share this positive outlook for oil, we feel that it should be rooted not in the amount by which OPEC production will supposedly fall, but in the ongoing swing of the supply-demand imbalance.

Bringing OPEC production down by some 700,000 barrels per day from the August peak will be no impressive feat: it always falls as summer airconditioning-related demand in the Middle East abates. The true test of the “ceiling” will thus come in the summer of 2017, when the usual upward seasonality in Middle Eastern production will find itself hindered.

US commercial crude oil inventories (2010 to date, in 000s of barrels)
Investment Letter 2016 October oil inventories
source: Bloomberg

Meanwhile, though, let us focus on the presumed excess supply over demand. While oil production data is readily available and reliable, consumption is much more difficult to assess – generally projected on the basis of its historical correlation to economic growth. As for global inventory, analysts typically use land-based storage in the US as a proxy, making for flawed estimates. Particularly when, as is currently the case, floating storage (i.e. oil stored on vessels) is falling. We would thus argue that the ongoing drawdown in inventories is even more pronounced than depicted in Chart 2. Put differently, oil consumption is much higher than officially estimated and has exceeded production for several months already.

Importantly also, the « normal » inventory level is probably higher than the 10-year average figure that is commonly used. As Chart 2 suggests, required oil inventories trend up as demand grows – just as food supplies would in a grocery shop that is gaining customers – meaning that the oil market is already close, if not back, to equilibrium, and about to shift into undersupply. Once financial markets become fully aware of this paradigm change, oil prices will resume their upward trend – with a USD 60 per barrel level attainable in the relatively near future.