An October 6th report from Societe Generale suggests there’s still a very good chance of a “hard landing” in China, or perhaps even worse, a slow-grinding “lost decade” for China and most emerging market economies, especially those dependent on commodities.
A quote from the introduction to the report highlights the worrisome perspectives of Global Head of Research Patrick Legland and the Societe Generale team: “China “hard landing” risks remain elevated at 30%, but we see a “lost decade” as a more significant risk at 40%. We shock the NiGEM model to simulate the economic outcomes that markets could price over a 6-12 month horizon should such risks materialize. For emerging economies, trade links to China are powerful shock transmitters. For the advanced economies, the financial market response matters most.”
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EM currency woes add to commodity price declines
The SG report argues that significant declines in the foreign exchange rates of various commodity-producing countries have exacerbated commodity price declines, and this trend is likely to continue. Keep in mind that China’s currency depreciation from 6.2 to 6.4 to the dollar is really quite small compared to the currencies of most commodity-producing nations. The Chilean peso is off 14% since the first of the year, while the Russian ruble has plummeted 31% in the last five months. The Brazilian real is in free fall, hitting a record low of 4.12, a drop of almost 60% since January (and we expect it could fall further to 4.40).
Of note, even non-EM commodity-producing nations have been impacted. The Canadian dollar is down 15% since October of last year. The dynamic is clear — given a drop in demand from a major commodities consumer like China, commodity prices are going to fall as well. Barring other factors, the currency of producers of the commodity will also decline, as the producer exports less and its economy suffers. EM currencies are especially vulnerable as their economies are typically dependent on commodity production. During times of oversupply such as the current commodity environment, lower commodity prices driven by lower demand frequently lead to EM currency depreciation.
Oil prices likely to remain “lower for longer”
Leland et al. suggest that the oversupply situation in the oil market is likely to continue through next year because of strong production (it is gradually declining) high OPEC output with both Saudi Arabia and Iraq boosting market share; and the return of Iran to the oil market in the second quarter of 2016 when sanctions are expected to be rolled back. The SG analysts argue the “persistent global oversupply is in large part driven by declining full-cycle production costs, not just for US shale oil (costs down 20% so far this year), but also for other expensive sources of non-OPEC supply (costs down an estimated 10% so far this year).”
The report advances the argument that oil prices are going to be “lower for longer”. This means that oil prices need to be yet lower to rebalance the market, particularly given lower production costs keeping supply resilient. Moreover, a real rebalancing of the oil market will require demand growth to increase while non-OPEC supply must decrease.
The analysts flesh out their argument: “The relationship between prices and supply/demand is circular. Prices are assumed inputs into the fundamentals forecasts, but at the same time, prices are also the result of fundamentals forecasts. This explains why, in a “lower for longer” world, we are revising down our price outlook, even as global demand growth is healthy.”
Hard landing “lost decade” scenario would see oil prices below $60 in 2020
Legland and colleagues hypothesize a scenario where a China hard landing leads to a “lost decade” for many commodity producing EMs. This scenario assumes a short-term boost from fiscal policy in China, but weaker growth following from that point due to the lack of structural reforms. This would likely result in the oil market rebalancing being delayed through 2016 and into 2017, and shut-ins of expensive non-shale production in North America would also be probable. Under this worst case hard landing and lost decade scenario, the projections for Brent crude in 2016 and 2017 are $36.90 and $44.1, respectively.
The SG team also says that demand growth will be weaker under this scenario, and there will be little need for expensive non-OPEC crude from Canadian oil sands and offshore projects. They project that Brent crude will be trading at $50.9 in 2019 – 2020 and move up to $57.6 in 2021 – 2025.