Senior Market Analyst, Commodities and Energy
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Jun 11, 2009

White House to continue allowing mountaintop mining

The White House continues to disappoint environmentalists hoping for a maximalist line on climate change and energy issues. 
 
The Washington Post reports the U.S. Environmental Protection Agency (EPA) is set to allow mountaintop coal mining to continue.  The issue is an emotive one for environmental groups since it involves removing surface soil and blasting tops from mountains to recover coal, often dumping the overburden into neighbouring valleys, causing substantial changes to the landscape (or damage, depending on your view point). 
 
Mountaintop mining projects need multiple permits, including from the federal government.  EPA’s announcement earlier this year that it would review all 200 pending permit applications over six Appalachian states encouraged some environmental groups that the administration would declare a moratorium, to demonstrate its commitment to conservation and its opposition to increased use of coal as a source of energy high in CO2 emissions. 
 
But coal is plentiful and does not have to be imported.  It is too important an energy source for the administration to agree to a “no more coal” strategy as some green groups would prefer.  It is vital to the economies of states in Appalachia that the administration needs to retain for President Barack Obama’s re-election bid in 2012, and from which he needs support in the Senate to reach 60 votes to pass climate change legislation to establish a cap and trade programme. 
 
So the administration is backing away from an outright prohibition towards continued mountaintop mining, albeit under even more strict conditions designed to placate environmental groups.

Jun 8, 2009

Pension funds seek review of Chrysler sale in U.S. High Court

A group of Indiana pension funds made an emergency application to the U.S. Supreme Court at the weekend asking the justices to halt the bankruptcy sale of Chrysler pending review of the treatment of certain classes of senior creditors.  
 
This is not my area of expertise but will be interesting to see if the Court intervenes to stay the bankruptcy.  Supreme Court stays are very rare.  But two points argue in favour one in this case: 
 
(1) Claimants would suffer irreparable harm if the bankruptcy proceeds.  There is no realistic remedy the Court could supply later if the petitioners prevailed on the merits/substance of the case.  So there is a good legal case for granting a stay — *IF* the Court believes the petitioners have an arguable case. 
 
(2)  There is mounting disquiet about the fairness and legality of some of these large accelerated bankruptcies.  The Lehman bankruptcy is already the subject of contention – with some creditors arguing the hurried bankruptcy sold the securities firm’s assets too cheaply and failed to protect the interests of all creditors. 
 
While there is a clear need for the courts to act expeditiously to preserve value in the case of failed trading firms (whose principal asset is their creditworthiness and ability to do deals) and perhaps in the case of large industrial combines, such rapid bankruptcies limit the scope for effective judicial oversight and have been resulting in some controversial allocations of costs and benefits. 
 
Initially, the case will go to Justice Ruth Bader Ginsburg as the supervising justice for the Second Circuit.  She can accept/reject the decision, set an early hearing date, or refer it to the full court. If the matter is referred to the whole court, five votes are needed to grant the stay (though only four are needed to decide to hear the case).

Jun 5, 2009

Doing the inventory swing – Sources of GDP growth in the year after recession

With a lot of fog drifting across the analytical battlefied, we need to start distinguishing between two statements:
 
(1)  The economy is approaching the cyclical trough;
 
and
 
(2) A strong sustained recovery is set to get underway. 
 
There is good evidence to support proposition (1), but it does not necessarily imply proposition (2).  It is possible to be optimistic the worst of the downturn may now be over (or very nearly so) while remaining cautious about the prospects for recovery when the cyclical turning point is passed. 
 
To understand the point, think back to the last recession.   The National Bureau of Economic Research (NBER), official arbiter of the U.S. business cycle, dates the cyclical trough to November 2001 (eight months after the peak in March 2001 — and just two months after the attack on the World Trade Centre in New York).  But it was not until more than two years later that there were signs of a strong and sustained recovery. 
 
The fitful nature of the expansion during 2002 and 2003 is why the Fed kept rates low for so long.  In fact, the Fed was still cutting interest rates to 1% in June 2003 because the expansion was so anaemic, and did not feel confident to begin raising them from this ultra-low level until June 2004.   Uncertainty caused by impending war between the United States and Iraq was one factor holding the expansion back, but not the only one.  The recovery failed to become “self-sustaining” for almost three years.  
 
The same could easily happen again. 
 
The attached chartbook is an attempt to look beyond the downswing of the cycle at how the U.S. economy behaves in the first twelve months of recovery.

 
First a quick technical digression. As I have explained before, the national income and product accounts (NIPAs) of which gross domestic product (GDP) is the focal point add up domestic production in three ways:  by summing expenditures, by summing incomes, and by summing production. 
 
In analytical terms, the three approaches are identical (for every unit of output there are corresponding incomes and expenditures).  But as a practical matter, it is far easier and faster to estimate GDP by adding up expenditures and working back to income and output.  The federal government makes separate estimates based on incomes and output when tax returns and the quinquennial business surveys become available later (and then has to adjust all the measures to try to make them consistent). 
 
The only problem with this expenditure –> output approach is the need to adjust the data to take account of items produced in one period but consumed in another (ie changes in the amount of produced but unsold raw materials, work in progress and finished products held by manufacturers, distributors and retailers as “inventories”). 
 
Inventories are one of the most volatile components of the output-income-expenditure system and a key driver of cyclical behaviour. 
 
For analytical purposes we can separate GDP growth into two components: 
 
Growth in GDP = Growth in final demand (consumer spending + business investment + government spending + exports – imports) + Change in the Level of Inventories. 
 
Large inventory changes are usually unsustainable and tend to be quickly reversed.  A large build up in inventories one quarter is normally followed by an equally sharp decline in the following one (see Chart 3 in the chartbook). 
 
Charts 1-3 and Table 1 look at how these three measures (headline GDP, final demand, and inventories) have behaved on a quarter-to-quarter basis since 1948.  For clarity, I have reported all growth rates as simple quarter-to-quarter rates, rather than the quarter-to-quarter annualised ones that are normally used by the Bureau of Economic Analysis, since this is more useful for the type of quarterly analysis we are looking at here.  I have reverse engineered the annualised data by the simple expedient of dividing by four — which is not strictly accurate but good enough for our purposes here, especially since the percentage changes are small. 
 
The immediate point is that headline GDP and final demand are much more stable than the inventory component.  Headline GDP and final sales have been negative in only 37 and 35 quarters respectively out of a total of 245 since 1948.  In contrast, inventory changes subtracted from GDP about half the time (119) and added to it roughly as often (126). 
 
Of the two main components, final demand was slightly more stable than GDP (reflecting the volatility of inventories).  The average increase/decrease in headline GDP between one quarter and the next (ignoring signs) was 1.06 percent, a slightly larger change than the average change in final demand (0.95 percent).  Headline GDP changes have a slightly higher standard deviation (1.03 percentage points) than final demand (0.85 percentage points) confirming that headline GDP is more variable. 
 
Before anyone points out inventories (with a mean change of 0.48 percent and standard deviation of 0.67) are more stable than either — this appears true, but recall that inventories are only a very small component of GDP and this is the contribution which they make to the total growth/fall each quarter — so they are actually a source of enormous volatility for their size. 
 
Armed with this understanding, we can start to analyse the recessions since 1948. 
 
I am going to divide them into two groups. 
 
The first group is “severe recessions” in which FINAL DEMAND fell for at least two consecutive quarters.  There are four of these ending in 1954, 1974, 1982 and 1991 respectively. 
 
The second group is “other recessions” where final demand remained positive (most of the time) but the economy was pushed into recession (two or more quarters of negative growth) by changes in the inventory component.  There are five of these “other recessions” or “inventory recessions” ending in 1949, 1958, 1960, 1970 and 2001 (1960 and 2001 do not strictly fit the pattern since there were at least two quarters of negative growth but not consecutive, but they are near enough to be included and both are generally regarded as being recessions). 
 
So now we have our “deep recessions” and “inventory/other recessions”, we can look at how the economy behaved in the four quarters after the cyclical trough was reached in terms of both growth in final demand and inventory rebuilding. 
 
There are crucial differences. 
 
In the case of deep recessions, recovery was led by final demand.  Inventory rebuilding played a role, but only after a lag.  After all four deep recessions, inventory changes actually subtracted from GDP growth in the first quarter after the recession was officially over.  They made a small positive contribution in the second quarter of the recovery in three of four cases, but only a modest one.  It was not until the third quarter after the recession ended that they gave a significant boost to GDP. 
 
The pattern after inventory/other recessions is very different.  In four of the five cases, inventories made a positive contribution to GDP in the first quarter after the recession ended (the exception was the anaemic recovery after the 2001 recesssion, and the lack of a stronger inventory response here may have contributed to the failure to achieve self-sustaining recovery in this case).  The inventory-driven recovery fell away somewhat in the second quarter before becoming more resurgent in the fourth.  In contrast to the deep recessions, growth in final demand was much less important in the early months of recovery, with inventory rebuilding supplying most of the initial impetus for expansion. 
 
To summarise, recoveries from deep recessions are led by final demand, with inventory rebuilding not providing a significant source of stimulus for six months.  In contrast, recoveries from inventory/other recessions are led by inventory rebuilding, with final demand playing a more limited role until later, though the initial boost from inventories can dip in the second and sometimes third quarter after recovery begins. 
 
So what type of recession and recovery are we in this time? 
 
A quick look at Chart 2 reveals that the current recession is a deep recession that has seen significant destruction of final demand.  So it is part of group 1. 
 
If this is the correct characterisation, inventory changes might play only a limited role in the early stages of the recovery.  Assuming the economy hits the cyclical trough at the end of Q2 or sometime in Q3, inventory changes might not play a significant stimulative role until Q1 2010. 
 
One caveat:  our sample size of post-1948 recessions is very small, so we should be careful about drawing strong conclusions. 
 
But the experience of inventory-driven and final-demand driven recessions over the last sixty years suggests we should be cautious about pencilling in a strong inventory-driven rebound in H2 2009.

Jun 5, 2009

U.S. nonfarm payrolls signal turning point is near

Businesses outside the farm sector plus federal, state and local governments continued to eliminate positions on net last month (-345,000) but the rate of job losses was the smallest since the recession worsened in Sep 2008.  
 
The data is consistent with recent business surveys suggesting the pace of contraction is slowing, and the turning point in the economic cycle is drawing near. 
 
The relatively small decline in nonfarm payrolls should be reflected in a smaller decline in industrial output when the Federal Reserve reports its May 09 estimate later this month (not least because the Fed bases its estimate, in part, on the payroll data). 
 
In the past two months, the data flow has become consistently positive, in the sense that it points to a slower rate of decline and a nearing end to the contraction phase of the cycle, helping fuel the broad-based rally across equity and commodity markets.  Today’s data will reinforce that optimism, and has already sent WTI futures (briefly) back above $70. 
 
(Un)-employment is a lagging indicator.  Job losses are likely to continue even once the economy starts to expand again and will act as a (moderate) drag on growth going forward (as well as contributing to further defaults on home mortgages and consumer lending over H2 2009 and throughout H1 2010). 
 
But the payrolls report does indicate the worst of the downturn is now over.

Jun 5, 2009

Manias and panics – here we go again

Like a party of drunken millenarians not sure whether to anticipate rapture or apocalypse but certain they are on the brink of something big, financial markets and commentators lurch from one extreme to another – absurd over-optimism to doom-laden pessimism.  Reality is almost always more prosaic.  Economic history is about “muddling through”. 
 
The Black Death (1348-1351), to take perhaps the greatest catastrophe to befall Europe, carried away a third of the population, but two thirds survived, and somehow life went on.  The Great Depression cut U.S. manufacturing output in half between 1929 and 1933, but still left plenty of factories working — albeit on severely reduced time.  Cars were still produced, crops harvested, and a few houses and factories built. 
 
Bread lines and work camps make better copy than thousands of people somehow struggling to cope and survive.  But they are only part of a more complex reality.  While John Steinbeck was the greatest reporter of the Depression, the bleakness of “The Grapes of Wrath” is only one part of rich heritage that includes characters coping in straitened circumstances in “Cannery Row”.  
 
Financial history is about the highs and lows, exuberance and panic.  Social and economic history is about the middle ground, continuity as much as change. 
 
At the moment, markets are seized by the excitement of “green shoots” of recovery.  Not for the first time, participants are in danger of losing perspective. 
 
While the pace of decline has slowed in North America, Western Europe and Japan after the free-fall contraction of Q4 and Q1, manufacturing activity is still shrinking. Even if the economy hits the trough in the next 1-4 months, as expected, and a recovery begins, it is likely to be fitful and uneven. 
 
The attached chart on rail freight volumes in the United States (a good proxy for manufacturing and construction activity) provides some indication of the continuing difficulties.  
 
Freight volumes are still trending lower.  The year-on-year deficit has widened from -14% at beginning of Mar to -18% at the beginning of Apr, -21.6% at the beginning of May and -23.5% at the start of Jun. 
 
While a recovery is coming, it is not here yet, and the trajectory when it comes is anything but certain.

Jun 3, 2009

Other oils — a worldwide best-seller

I realise there are a small number of people for whom the weekly US REFINING SUMMARY is not the most compulsive reading material, with a plot line to rival John Grisham and prose that bears comparison with Shakespeare. 
 
So for these few benighted individuals, I attach a simple graphic: 
 
http://graphics.thomsonreuters.com/ce-insight/EIA-OTHER-OILS.pdf
 
It shows the stock of “other oils” reported by refiners, pipeline companies and tank farm operators across the United States each week in the EIA’s weekly survey. 
 
Other oils is a miscellaneous category of refinery products after gasoline, distillate, jet fuel, propane, residual fuel oil and part-finished oils have been separately accounted for. 
 
It includes, according to the EIA, “aviation gasoline, kerosene, natural gas liquids, LRGs, other hydrocarbons and oxygenates, aviation gasoline blending components, naphtha and other oils for petrochemical feedstock use, special naphthas, lube oils, waxes, coke, asphalt, road oil, and miscellaneous oils. Includes naphtha-type jet fuel beginning in 2004.”
 
Now these are hardly what you might expect as major refinery products.  But it is one of the fastest growing parts of the US product inventory. 
 
The inventory of “other oils” has risen by +24.202 million bbl (+18%) in the seven weeks since Apr 10.  Other oil stocks (158.600 million bbl) are now +20.500 million bbl (+14.8%) higher than at the same time last year (138.100 million).  They are climbing exponentially, up by +3.600 million bbl last week alone. 
 
That amounts to a large amount of extra lube, asphalt, or petchem feedstocks.
 
So what exactly ARE the refiners producing and presumably storing here? 
 
It also looks rather like refiners have been producing and reporting these “other oils” in a bid to reduce over-production of something else (gasoline? distillate? resid?) amid soft demand. 
 
The implication is that the market is rather more over-supplied with refined products than a simple tally of gasoline and distillate inventories would suggest.

Jun 3, 2009

US refining system (week ending 29 May 2009)

Crude inventories built (+409,000 b/d), according to the EIA, defying market predictions of a decline (-200,000 b/d).  Imports jumped (+868,000 b/d) to the highest level for four weeks (9.646 million b/d). 
 
Higher crude arrivals were recorded into the PADD III Gulf Coast refining region (+558,000 b/d) and PADD I North-East (+195,000 b/d). But this merely reversed the previous weakness, taking import rates back to year-ago levels, after several weeks in which arrivals had been unusually low.  PADD V West Coast arrivals also rose (+293,000 b/d) but were partly offset by slower imports into PADD II Midwest (-126,000 b/d). 
 
Refinery operating rates continued to rise (+1.15 percentage points) to the highest level this year (86.26%) though rates remain far below last year’s level (89.72%). 
 
BUT the jump in refinery operating rates WAS NOT accompanied by an increase in the volume of crude processed.  In fact, crude throughput actually fell marginally (-8,000 b/d).  Instead, non-crude inputs jumped sharply (+203,000 b/d).  The percentage of crude oil in total refinery inputs fell to its lowest level for since mid-Jan and before that for any time in the last five years.  Crude oil inputs accounted for just 96.60% of all refinery inputs last week, down from 98.00% the previous week.  Refiners must have drawn down stocks of other, semi-processed, oils.  But the series is volatile and week-to-week variations tend to reverse rapidly.  Other things being equal, next week should see a sharp increase in reported crude oil processing rates. 
 
Reported gasoline inventories fell (-31,000 b/d).  The substantial gap between reported inventories (-31,000 b/d) and the change (+726,000 b/d) implied by domestic production + imports – product supplied points to continued strong exporting and/or recording errors (-757,000 b/d). 
 
Domestic production fell (-581,000 b/d) and imports slowed (-56,000 b/d) more than offsetting weaker consumption in the holiday-week (-518,000 b/d).  Gasoline stocks were broadly unchanged (203.202 million bbl) down 5.888 million bbl  (-2.8%) compared with last year (209.090 million bbl).  Stocks are relativley low and firmly in the bottom half of the five-year range. 
 
There was no relief on the distillate side.  Stocks continued to build (+237,000 b/d), amid little change in production or imports from the prior week and slackening consumption.  Ultra-low sulphur stocks in PADD I North-East, already +5.664 million bbl (+41%) higher than last at a record 19.976 million bbl continued to trend higher.  Stocks are also far above year-ago levels in PADD II (+4.379 million bbl, +19.5%) and in PADD III (+8.652 million bbl, +42.7%). 
 
In a development that should also worry refiners, stocks of semi-processed “unfinished oils” and miscellenaneous “other oils” continue to rise — in the case of “other oils” inventories rose +3.600 million (+2.3%) to another record (158.600 million bbl).  The overhang of such “other oils” is now +20.500 million bbl (+14.8%) higher than at the same time last year (138.100 million bbl). 
 
While crude oil inventories look high, the massive stock of refined products, other than gasoline and residual fuel oil, is even larger. 
 
For graphical analysis of this week’s EIA report on inventories, production, imports and exports of crude oil and refined products see the links below: 
 
http://graphics.thomsonreuters.com/ce-insight/US-REFINING-SUMMARY.pdf
http://graphics.thomsonreuters.com/ce-insight/EIA-INVENTORIES.pdf
http://graphics.thomsonreuters.com/ce-insight/EIA-CUSHING.pdf
http://graphics.thomsonreuters.com/ce-insight/EIA-PRODUCTION.pdf
http://graphics.thomsonreuters.com/ce-insight/EIA-REFOPRATE.pdf
http://graphics.thomsonreuters.com/ce-insight/EIA-REFTHRUPUT.pdf
http://graphics.thomsonreuters.com/ce-insight/EIA-IMPORTS.pdf
http://graphics.thomsonreuters.com/ce-insight/EIA-EXPORTS.pdf

May 28, 2009

U.S. benchmark bond sell-off accelerates

Benchmark 10YR US Treasury bonds continued to sell off heavily yesterday, sending yields to the highest level since Nov 2008.  
 
The adjustment in the US Treasuries market is THE story in financial markets, and will wash across all other asset classes. 
 
The key question is how to interpret it:
 
(1) Is this simply an unwinding of the unsustainable “bubble” that had emerged in US Treasuries during the flight from risk, that is now gradually deflating as risk aversion ebbs.  If so, the movement should be fairly limited and could be interpreted as part of the “normalisation” of financial conditions. 
 
(2) Is it the start of a flight away from Treasuries as fears about inflation and record issuance and debt levels trigger a fundamental reassessment — in which case the move could be much larger and far more destabilising. 
 
Either way, this is the single most important story for all asset classes at the moment — with washover into FX as well as equities and commodities.

    • About John

      "John joined Reuters in 2008 as one of its first financial columnists, specialising in commodities and energy. While his main focus is on oil markets, he has written broadly on the emergence of commodities as an asset class, regulatory issues and macroeconomic themes. Before joining Reuters, John spent seven years as a senior analyst for Sempra Commodities (now part of JP Morgan) covering base metals and crude oil. Previously, he worked as an analyst on world trade, banking and financial regulation for consultancy Oxford Analytica."
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