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Midweek Sector Update: China’s Stock Market Crash Looming Large Over Oil Prices

Midweek Sector Update: China’s Stock Market Crash Looming Large Over Oil Prices

Oil prices continue to defy even some of the most pessimistic expectations, with WTI falling substantially below $50 per barrel, dropping near $47 on July 27. WTI is now within $3 of its March low, essentially erasing all the gains made in the intervening months. The reasons for renewed descent to such lowly depths are multiple, many of which we have covered extensively in recent weeks – the Iran nuclear deal, ongoing surpluses in supply, and the turmoil in China’s stock markets.

The latter point, in fact, appears to be the main culprit for the dive in recent days. China had appeared to get a handle on the mini-meltdown it suffered last month after the government came to the rescue. However, on July 27, the Shanghai Composite dropped a jaw-dropping 8.5 percent, the largest decline since 2007. China’s financial system suddenly looks frighteningly unstable, although the unfolding crash should not exactly come as a surprise.

China has achieved incredibly impressive levels of economic expansion over the years, but the stock market started to detach from reality last year, rising faster than the underlying economy appeared to justify. The Shanghai Composite, for example, surged more than 140 percent between last summer and the June 2015 peak. The run up in the financial system was intoxicating, and more and more average Chinese investors of modest means began pouring their savings into the stock market.

But at the same time that the stock market was skyrocketing, the real Chinese economy was slowing, hitting its lowest growth rate in decades. The divergence couldn’t continue forever, so it was only a matter of time before there was a (rather large) correction in the stock market. That’s the optimistic case – that we are merely witnessing an overdue correction. A greater risk lies in the possibility that the stock market keeps falling and falling, infecting other financial systems around the world. While still limited, the turmoil is spreading to a certain degree: on July 27, the FTSE 100 dropped by more than 1 percent, the stock markets in Frankfurt and Paris were down 2.5 percent, NASDAQ was off by nearly 1 percent. Emerging markets are even more vulnerable – India, Russia, and Saudi Arabia saw their markets down by more than 2 percent. Related: 9 Reasons Why We Should Be More Worried About Low Oil Prices

The silver lining is that China’s stock market does not represent as large a share of its economy as financial markets do elsewhere – 40 percent of GDP in China, as compared to more than 100 percent in many developed countries. That means that even if the market continues to contract, there is less of a chance of financial contagion as would be the case if the U.S. markets were melting down.

Still, the financial turmoil is causing some of the worst oil market pessimism in months. Hedge funds and other institutional investors are shorting oil and retreating from bullish positions. Net-long positions on crude are at their lowest levels in five years, suggesting that, on balance, traders think oil prices are going to continue to fall.

Moving on from China’s stock market and oil prices…

BP (NYSE: BP) and ExxonMobil (NYSE: XOM) are submitting petitions to Alaskan regulators to allow more natural gas to be produced from the North Slope. Back in 1977 Alaska limited gas production from the Prudhoe Bay field to 2.7 billion cubic feet per day (Bcf/d). But Alaska is now planning on allowing LNG exports, and BP and ExxonMobil want to increase production to 4.1 Bcf/d to supply the project. However, it isn’t as simple as just allowing more gas to be produced. Already, the companies produce around 8 Bcf/d, but reinject much of that back into the field to maintain reservoir pressure for oil production. The state is required to pursue maximum hydrocarbon production by law, so if diverting more gas for export results in a loss of reservoir pressure, that may be an unacceptable trade off. A public hearing is set for August 27. Related: Oil Price Rout Set To Inflict Real Pain On Russia

Speaking of BP, the British oil giant reported second quarter earnings, and included in the figures are what appears to be the firm’s last significant charge from the Deepwater Horizon disaster. The company reported a $9.8 billion charge for the latest legal settlement. In total, BP coughed up $54.6 billion for the legal and environmental fallout.

BP also took a $600 million impairment charge for its assets in Libya in the second quarter (three months ago French oil major Total (NYSE: TOT) wrote off $755 million from its Libyan assets). Violence there has halted BP’s oil exploration program. Adjusted for one-time charges, BP’s quarterly profit dropped to $1.3 billion, the worst performance in 10 years. For the year, BP said that it expects to drop capital spending to under $20 billion, a deeper cut than previously expected.

Statoil (NYSE: STO) also reported a decline in quarterly earnings, falling to $1.2 billion for the second quarter from $1.5 billion for the same period a year ago. On the other hand, Statoil also reported higher production figures, with output rising to 1.873 million barrels of oil equivalent per day, a 4 percent jump from 2014 numbers.

Gazprom’s production portfolio is heading in the opposite direction. The Russian gas company will likely see its natural gas production hit an all-time low this year, falling to just 414 billion cubic meters on the back of weak demand and a lack of investment, according to Russia’s Economy Ministry. Pricing disputes with Ukraine have slashed Russia’s gas exports to Europe, and Gazprom’s upstream investments fell by 60 percent from January to April of this year. Related: Pessimism Amongst Oil Traders Reaches 5 Year High

Finally, modular construction of nuclear power plants, held up as the solution to an age-old problem of cost overruns at nuclear power plants, is not working out quite as planned, according to a Wall Street Journal report. Two nuclear power plants under construction in the United States are facing the same construction delays that plagued the previous generation of nuclear technology. Modular construction, in which equipment and parts are manufactured in a factory and then shipped to site, have not sped up construction times. Georgia Power (NYSE: GPE-A), a 46 percent owner of the Vogtle Power Plant, projects it will spend $7.5 billion on building two reactors, $1.4 billion higher than expected. The new generation of nuclear technology may be better, but for now, it is not exactly proving to be much cheaper.

By Evan Kelly

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