London, June 2010

Report from Societe Generale (SG): As front-month crude prices rose into the mid-to-upper $70s over the last week, the big question for the oil markets today was “what will be the impact of China's recent currency move?” Over the weekend, the People's Bank of China announced that it would be ending the two-year de-facto peg of the yuan to the US dollar, with the implicit indication that the yuan would be allowed to gradually appreciate. Indeed, on Monday, the yuan gained 0.42%, closing at 6.7976 against the dollar. (The central bank sets the reference rate each day, and the yuan is allowed to trade up to 0.5% above or below the reference mid-point each day.)

The carefully worded announcement said that the case for “large-scale appreciate of the RMB exchange rate does not exist”. The statement further said that despite the announced flexibility, the RMB should be “basically stable at an adaptive and equilibrium level” going forward. According to our Asian macroeconomics team, China clearly does not believe that the yuan is significantly undervalued. The announcement was balanced and was written to placate critics of yuan policy, while avoiding a deliberate invitation of speculative inflows.

For SG, China has clearly moved to elevate the role of the exchange rate to its principal macroeconomic policy tool. The PBoC is considered very unlikely to lift interest rates while it still pursues an infrastructure and investment-heavy growth model. As a result, SG believes that the yuan is likely to appreciate by 3-5% by the end of 2010.

We already expected a stronger yuan and continued strong growth in China GDP and oil demand

By increasing the purchasing power of the Chinese currency, a stronger yuan should alleviate the inflationary pressures in the Chinese economy. To a large extent, inflation was at the core of market concerns and jitters over Chinese GDP growth in recent months. Markets were worried that the authorities were starting to take various measures to prevent over-heating, but that in doing so, they would end up over-tightening and would slow down both the economy and oil demand growth. SG was not overly concerned, maintaining China GDP growth forecasts of 10.0% for this year and 9.0% for next year. This was based, in part, on an assumption of yuan appreciation, which the Chinese authorities now appear to have given their blessing to. The market's level of confidence in the Chinese economy should be increased, which should improve risk appetite and be constructive for oil prices.

The expected yuan appreciation will increase the purchasing power of China's businesses and consumers. In the abstract, this will boost overall domestic demand, including that for commodities. For oil, however, we had already factored in strong demand growth of 580 kb/d for 2010 (+6.8%) and 510 kb/d in 2011 (+5.7%); China's de-pegging of the yuan has not made us change this forecast. Why?

There are two key things to remember for Chinese oil demand: first, product demand for consumers, transportation, industry, and power generation has been strong for most of 2009 and into 2010, and we expect this continue. Second, due to guaranteed healthy domestic refining margins, crude demand from the two large Chinese refiners/state companies has also been strong, and we also expect this to continue. For oil, we simply do not expect a modest appreciation in the yuan to make any appreciable difference in demand. In short, we do not believe that there is any pent-up crude or product demand in China.

Chinese demand has already exceeded expectations; it has been strong and we had already forecast it to continue that way. This can be clearly seen on the Chinese product demand chart above; the latest date for May shows total demand of 8.56 Mb/d, almost flat m-o-m near record levels, but representing growth of almost 0.8 Mb/d y-o-y. As the baseline for comparison strengthens, y-o-y growth should weaken as this year progresses; however, we demand to remain robust in absolute terms, on a sequential basis.

Note that the demand figures above are “apparent” demand; in our methodology, this is calculated as refinery crude runs plus net product imports. Therefore, this excludes (by definition) any crude stock changes; there have been reports recently that the government has been encouraging the two large state companies to build commercial stocks. Phase II of China's strategic crude reserve has not yet begun filling as far as we know. We do not even know of any sites that are operational yet, and do not expect this until next year, perhaps Q4 10 at the earliest. The point, however, is that since the two dominant oil companies in China are state controlled, the dividing line between “commercial” and “government” stocks is blurred. It also should be noted that although the crude balances imply supply in excess of demand (crude runs), part of this is due to non-discretionary one-off stockbuilds associated with new infrastructure. The new refineries, pipelines, terminals, and commercial storage facilities being built in China all need to be filled for the first time, which results in a significant “disappearance” of the crude oil from the balances.

We reiterate our oil price forecasts

The bottom line for our view on the oil markets is that we had already factored in yuan appreciation this year, as well as strong Chinese economic and oil demand growth. As a result, we reiterate our oil demand and oil price forecasts, as recently published in the quarterly Commodities Review.

Ends --

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