China to Loosen its Covid Grip?

9 December 2022

As the Western world heads towards recession, China could well buck the trend, thanks to a long-awaited easing of Covid restrictions. While this move probably has more to do with social stability concerns than economic growth, the fact of the matter is that it will push up Chinese activity – with implications in turn for commodity prices, oil notably.

The TV footage of Chinese students holding up blank posters and singing mock government-support songs make clear how dangerous it is to challenge the regime, but also how much suffering the Covid lockdowns have inflicted on the population over the past three years. Add to that a number of possible enemies made by President Xi Jinping within the ranks of the Chinese Communist Party, as he revamped the Politburo Standing Committee (the country’s top decision-making body) to comprise only allies, and one realises what a tight rope the country is currently treading. It is thus not surprising to see restrictions finally be lifted in some large cities and isolation protocols become less stringent. Officially, obviously, such easing is attributed not to the protests but to the virus strain having become less potent…

Should, as we expect, this reopening of China gather steam over the next months, the incremental growth will be welcome in a globally slowing (indeed soon recessionary) context. One market, however, could do without this additional demand: oil. Indeed, it is estimated that just the resumption of international flights to/from China and domestic air traffic will require some 2 million extra barrels of oil per day. To which must be added the oil that will be needed for other purposes, notably greater industrial production.

Meanwhile, on the oil supply side, the picture remains rather constrained. US inventories currently stand at very low levels, even including strategic reserves. Pushing up significantly shale output will be difficult, given how focused producers now are on balance sheet discipline and their legitimate concerns regarding the economic outlook – not to mention environmental considerations dear to the Democrats. More than 600.000 – 700.000 barrels extra production per day should not be expected in 2023. Which is probably why the Biden government recently signalled a loosening of its sanctions on Venezuela, allowing Chevron to resume its operations there. Officially, obviously, this decision is attributed not to an insufficient global oil supply, but to the resumption of dialogue between the Venezuelan government and the opposition group…

The key question pertains to Venezuela’s true productive capacity. In terms of share of world reserves, the country boasts the number one position (18%), even ahead of Saudi Arabia (16%). Many of its installations are, however, in a sorry state, requiring time and foreign company help to get back into production. Relative to a theoretical capacity of 2-2.5 million barrels per day, Venezuela is currently pumping only ca. 700,000, up from a low of ca. 300,000 in October 2020. Even pre-Covid, the country’s output was considerably less than theoretical capacity, at ca. 1.7 million barrels per day. For the foreseeable future, oil flowing out of Venezuela is unlikely to exceed 1 million barrels per day – well below the incremental Chinese demand.

What of Iranian oil then? There too, international sanctions are severely restraining output: some 2.5 million barrels per day are currently produced, versus a theoretical capacity of 4.2-4.5 million. During the short 2016-2018 period when sanctions were lifted, Iranian oil production hit 3.8 million barrels per day – meaning that a potential upside of 1.3 million barrels per day could materialise if an international agreement over the country nuclear programme is reached. But while this has been in the making for some time already, the ongoing protest movement complicates matters as Western countries will not want to be seen dialoguing with a contested Iranian government. Anyhow, reaching the 2016-2018 production level again would take a lot of time.

Finally, we come to OPEC+. As we wrote a couple of months ago, the basic reality is that the cartel’s members are currently unable to increase production. And what capacity Russia does have will be side-lined by the European embargo starting this December. Note that it cannot simply be diverted to China, because of limitations on transport infrastructure. There are practically no tankers available right now, as witnessed by the sky-high freight rates.

All told, if the Chinese economy does shift back to full speed in the next quarters, energy prices are liable to trend up, going against the widespread investor anticipation of receding inflation – and thus of a central bank pivot. Indeed, we believe the market is being overly optimistic on this count, and not only because of the oil supply-demand outlook. Upward wage pressures are just starting to kick in, driven by rising food and energy prices of course, and also because of still severe labour shortages.

Following the recent sharp bear market rally, we are tactically thus adopting a more cautious view on equities, preferring to go into 2023 with option protections. A means of retaining upside exposure (against paying a premium), while limiting losses in the event of a renewed downtrend. All that while, on the fixed income side, we remain on the lookout for opportunities in European credit – albeit selectively and focusing on investment grade issuers.

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