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Introduction
In a recent article, I argued that the wheels were coming off the Green Energy Revolution. It aroused a lot of passionate debate and, at last count, 297 comments – a new record for me. It should be noted that among these, probably a third was my own replying to commenters. Something I rarely do, as my time is generally better spent researching and writing articles and participating in my marketplace community, The Daily Drilling Report.
Mostly the commenters bought into my thesis and were complimentary. I added over a hundred followers, which is an unusual response to one of my articles. Followers occasionally turn into subscribers, so a gain is a good thing! There were a few old soreheads who thought I was full of it and told me so. Some people are just so hoodwinked by the popular “Climate Emergency” narrative that you just can’t have a decent conversation with them. Moving on to our topic today.
Jeff Currie is a global thought leader in commodities research. As Head of Commodities Research for Goldman Sachs, he has insight and a platform that few others can obtain. I listened to a recent podcast where he was featured and found it fascinating. The thinking behind his remarks was clear and linear and explains a lot of what we are seeing in the markets. Mere mortals don’t ordinarily get access to thinking this deep and evolved without paying princely sums. We lucked out here. This is well worth a listen if you have an hour to spare.
Difference from past commodity price spikes and inflation
The first point Currie made was that the global policy response to oil in the last few years, in favor of “sustainable” energy sources, has created a massive period of under-investment in traditional energy. This has been pretty well documented in multiple sources. Often called, “Fossil Fuels” these sources have supported modern civilization and population growth for the last 150 years.
What this abrupt, let’s face it 10 years ago this was a pretty muted theme, policy shift away from traditional fuels has rolled back two decades of increasing energy liberalization. What is meant by liberalization? During the period from the early 2000s to the mid-2010s, producers were incentivized through government policy and supported by capital investment. Oftentimes there was a glut of oil and gas, thanks to this regulatory and financial framework, and prices and inflation were low.
Now, similar to 1970s, the current policy response of higher taxes, price controls and redistribution creates a harsh environment that discourages investment, while doing nothing for increased supply. That’s important because our present predicament is a story of underinvestment, Currie emphasized.
“Revenge of the old economy” is a term Currie uses to describe the shifting of capex from one sector to another. It shows up in every commodity supercycle. In the case of 2000, the dot-com boom choked off investment in the old economy-steel, energy, cement and other essentials suffered. The FAANG – Facebook (META), Apple (AAPL), Netflix (NFLX), (Nvidia (NVDA), Alphabet (GOOG, GOOGL) – boom drew investor dollars away from the old economy, in an expansion that lasted for about 10 years, and has only just recently hit some snags. The result is a dearth of infrastructure and resources that were starved for capex in this cycle.
In summary, what makes this new era different from older commodity cycles is the adverse policy response globally to traditional energy sources has made the underinvestment story worse. It means this era of high prices and high inflation will be really difficult to correct. Why will people invest when policy discourages long-term investment? They won’t, of course.
What happened with supply – oil, metals, food?
The supply story and lack of investment in the traditional economy go back to 2008/09. There is the uncertainty that followed the stock market and real estate crash meant investors were unwilling to invest in long-cycle capex. The way Currie puts it, “they preferred iPhones over copper mines essentially.” Flash forward to today, the demand story following Covid-19 exposed supply constraints or bottlenecks from underinvestment. Shipping backed up, prices rose from too much cash chasing too few goods, and inflation took off.
On a larger scale, commodity bull markets are driven by low-income groups. Commodity markets are volumetric in nature. Meaning that when volume of demand exceeds volume of supply, prices will rise. This always happens this way according to Currie and it makes sense to me.
For example, high-income people control dollars and prices of equities. They can control financial inflation by pumping money into markets and increasing GDP. But, there are not enough of them to cause commodity inflation. Low-income groups control commodity price inflation and demand through strength of numbers.
In the early 2000s, an exogenous event occurred with China’s entry into World Trade Organization (“WTO”). It created arbitrage between rich Americans and Europeans and low-wage Chinese labor. As a result, capex flowed toward China and 400 mm rural Chinese with new paychecks began to buy stuff. This was the new demand, which drove the commodity supercycle of the early 2000s
Then came the 2008 U.S. subprime crisis. This was driven by lending too much money to low-income groups, on a misguided policy to redistribute wealth. Once the bubble burst in the real estate and the commodities market, governments cut credit to low-income groups through various actions, primary raising interest rates to tamp down inflation. They also began to practice fiscal austerity, and finally through the Federal Reserve, introduced quantitative easing, or QE, to keep interest rates at near-zero levels to restart the economy. According to Currie, this effectively crushed demand for an extended period until March of 2020. What happened then?
A government policy response to Covid-19 was conducive to lower-income demand growth – remember all those “free money checks?” This created a huge surge of demand that overwhelmed infrastructure and supply lines, on a simultaneous global basis. The very definition of inflation!
So let’s move on to energy spike
Europe made itself very dependent on wind power over the last couple of decades. In 2020, the wind stopped blowing in the North Sea and created excess demand for gas. Two decades of underinvestment caused a spike in gas prices from a lack of supply and the threat of shortage around the world as government tried to make up deficits.
Policymakers, particularly in the U.S., like to blame the current price spike of the Russian invasion of Ukraine. If you look at when Putin begin massing troops on the border, you see it was in October of last year, well after the price spike, taking oil from the low $40s to the upper $90s. Causality for the invasion goes to this price spike, which funded the invasion. This is the exact opposite of what policymakers would like us to believe. The actual invasion resulted in additional stimulus that took prices to the mid-$120s, but not a cause of high oil prices or inflation itself.
Currie sums it up by saying that, “underinvestment caused by bad environmental policies over the last couple of decades, have had a far larger impact on prices than any supply dislocation from the war.”
Ok, that’s energy, what’s up with metals?
China, which has been the marginal consumer of all commodities for the last couple of decades, dropped their consumption by 10% due to their soft property market and Covid-19 earlier this year. Given their position of consuming half the metals production on the planet, this had a huge impact on prices of commodities. The government response was massive stimulus, and Currie noted, “the property market is rebounding.” Currie is bullish on metals in the second half of 2022 as Chinese demand picks up. With the caveat, “this stimulus only pumps up demand, it does nothing for supply.”
Currie also makes the point that carbohydrates – food largely – and hydrocarbons are the only sectors that are up this year. These two are interdependent. Nitrogen drawn from ammonia, extracted from natural gas, is in short supply as fertilizer. There is no governmental policy that is currently addressing this particular problem. Food shortages, exacerbated by the hostilities in Ukraine, are forecast as a result.
So far, it’s not happening. Redistribution – giving money to low-income groups – is not ending. California has announced subsidies to deal with food and energy price spikes to low-income groups. In the UK, a windfall profits tax has been enacted to recycle to low-income groups. This will only stimulate demand!
How does the world work on a macro scale?
Hydrocarbons or carbohydrates have powered our society for Millenia. Drawing on Vaclav Smil’s book, “How the World Really Works” (which I am reading now), Currie points out the key building blocks of modern society as being Ammonia, Concrete, Steel, Plastics. All are carbon-based and supplied with traditional energy sources. It’s very difficult to get wind or solar to impact any of these critical elements of our society. And, of course, it’s difficult to replace lost volumes as the current shortages of gas due to the gap created by underperformance of wind reveal. Many industries have been told they will be curtailed in the near future. This could have ripple-effects through the economy.
The current economic policy response-raising rates is not a long-term solution to the supply problem. Crushing demand through a recession only has short-term effects. The only long-term solution is investment, or capex! Policymakers are making it hard to crush inflation by discouraging capex and stimulating demand at the same time.
Wrapping it up
Policymakers need to create an environment conducive to investment. Clear and consistent policy to stimulate investment. The exact opposite of what policy makers are sending now. Globally coordinated this would have an effect that would stimulate producers by taking the uncertainty out of the market.
It’s needs global coordination, as the three big emitters – America, Europe, China – generate 66% of CO2 emissions. Passing a carbon tax, which is bad policy, would level the playing field is very difficult, particularly in the U.S. Globally coordinated, this would send a clear message to producers!
What we have now is a jumbled, but negative message. A Windfall Profit tax being discussed sends a disincentive signal for oil companies to invest, but promotes higher demand by subsidizing low-income demand. It’s the same story with the tax holiday being proposed on the federal gas tax. It stimulates demand without sending an investment signal to oil companies.
These factors will only have the effect of pushing prices higher as they all come to fruition. For whatever little good it’s done – in terms of trying to bring down gas prices, the releases from the Strategic Petroleum Reserve – SPR – will come to an end in November. Finally, when you note that OPEC spare capacity (maybe 1.5 mm BOPD) is exhausted toward the end of this year, we are headed for a sharp upward price signal in oil in the next year or so.
Your takeaway
There is a lot of noise in the market just now. Anywhere you turn you read the commodity supercycle is over and price forecasts for crude are decidedly lower. All the usual agencies are revising prices down. This doesn’t ring true for me from my own knowledge, so it was interesting to hear Currie’s thesis spelled out in such detail.
One additional thing Currie covered which makes sense to me is the relation of commodity cycles to capex surges. Investors want a track record of about three years of returns before they will invest. Once that signal is sent you have about three years of debottlenecking, followed by about six years of expansion. In short-12 year commodity cycles. If that’s true then we are still at the very early stage of this cycle with only about 2-years of positive returns in the energy sector. That fits with my thesis about what happens with oil. I’ve been proponent of the notion the crude market was under-supplied for a long time. If that turns out as Curries thinks it will, it makes this current sell-off of energy equities a buying opportunity.
What am I looking at? Devon Energy (NYSE:DVN) for one. I wrote a bullish article on them in late May where I increased my previous $80 target to the high end of the analyst range of $57 to $103 per share. (Investors should read that article to understand my complete thesis for the company.)
That $100 forecast is looking a little flakey, as Devon topped out in early June at $78, succumbing to the current market crash. Just today it broke $50 before rebounding along with WTI in late-day trading. DVN is trading at a 5.5X OCF multiple, down from ~8X earlier this month. I liked it then, so I added some shares today, at a 40% discount, and will add more consistent with my thesis for crude. Long-term, DVN is a company you want to own if you think $100 oil has legs.
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