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Energy Investing
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Interest rates, oil, macroI continue to believe that the equities market is moving ahead of the physical commodity markets because the equities see economic developments that aren't showing up in the backward-looking physical tightness yet. Let me start with inflation problem. There are several narrative definitions of inflation: the Austrian one is simply that money creation is inflation. The preferred central banking narrative is that Core CPI is inflation. The latter attempts to look through oil price moves, but this pretense is laid bare when oil moves enough to swing freight rates and manufacturing costs, rather than just pump prices. Then, everything in Core CPI is also nudged along with oil. As a practical matter, this means that the Central Bank often operates in one of two modes: 1- Oil is plentiful, print massive amounts of money, and run up asset prices (which are definitely not included in Core CPI) 2- Oil is scarce, tighten until the economy crashes, and all the oil-shipped goods in Core CPI stabilize. We are clearly operating in Mode 2 right now, and the market sees that. It's not 2008, because the financial system isn't on the ropes, but the Fed objective is still the same. And recall in 2008 the USA produced a lot less oil, and the dollar was crashing rather than surging. This leads us to the bond market. Bonds had a Wiley Coyote moment earlier this year; they were priced for the economic stagnation and suppressed consumer spending of a permanent pandemic; that permanent stagnation pandemic narrative was demonstrably false. So bonds crashed as the market searched for a pain point. Something very interesting happened to bonds back in June. I use TLT as a proxy, since it is easy to put on a stock watch list. TLT put in a massive hammer bottom, and rallied sharply. This bottom in TLT corresponded to mortgage rates above 6%. At that point loan demand completely dried up. We now know how high rates can go before cratering the economy. 3% mortgages were a gift, 4% were the market expectation, 5% are manageable but require home buyers to make compromises. Above 6% mortgage rates crash the economy. The character of markets has completely changed since June, where Fed tightening and lower oil prices both cause TLT to surge. The market has found a sensitivity zone, where the real economy has a significant negative beta to interest rates. Enter oil. The higher oil goes the more volatile it gets, because the price doesn't elicit more supply, and demand destruction is limited. What's the difference between $100 and $140 on oil? For supply, none. Only a little bit of conservation matters. The floor for oil is hard to pick. It could be $50-60, wherein immediate capex cuts would be meaningful. It could be $65-75 where OPEC cuts might kick in. It could be $80-100 where demand destruction fades away. The market realized back in June, when TLT hit the pain point, that a slowdown in new home orders in USA (and a crash in Europe's industrial economy) would eventually lead to less demand for materials, and less energy needed to ship said materials. The risk was that oil would eventually trade back into one of the above three price ranges. The physical market didn't see that drops in future durable and capital goods orders would eventually hit oil demand, because in-progress orders still meant tight physical markets. Financial markets led, physical markets figure it out later. What's happening in oil today is similar to what happened in bonds in June. There are enough levers to pull including SPR releases, Persian Gulf begging, and a sharp slowdown in construction, to loosen up the oil market a bit. But the oil stocks are now dropping at 0.3x the rate of oil, instead of at 3x the rate of oil. Investors are concerned about the economy, but recognize the oil stocks are already priced at levels where OPEC would likely support the market-- and at a time where we are begging hat in hand for OPEC to do the opposite and flood the market. This is constructive action. The equity markets led the futures in anticipating an economic slowdown, and are now doing so again in anticipating a floor. With mortgages stabilizing at an uncomfortable but manageable range of 5-6% and oil heading into a range that will lessen demand destruction, markets are recognizing oil stocks are investable at an even lower implied oil price. If the economy completely crashes, sure oil equities could drop another 20+%, but again this isn't 2008 because the financial system has lots of capital. There are still clouds on the horizon, because the Fed is increasingly deranged and narrative driven. Just as the Fed didn't want to be a Grandma killer in 2020 and therefore printed $6 trillion or so, the Fed today doesn't want to allow oil price hikes to pass through into core CPI; and it won't. Ironically though I think the narrative obsession of the Fed is why we will have slightly higher than average inflation over the long-run. The Fed believes a lot of its own literature from the 1970s about wage-price spirals, inflation expectations, and so on. But it's not clear how a wage-price spiral works if the Fed is constricting the money supply, which it never had the backbone to do in the 1970s. The counterfactual wasn't tested back then. The ease with which the Fed chases narratives like a cat chasing a laser pointer, is to me, a sign of weakening credibility. It's only a matter of time before the Fed moves onto its next obsessive plaything, like keeping the government funded, or income inequality, or climate change, or supporting supply chain repatriation. They showed in 2020 they are willing to blow up any semblance of responsibility if their social duty calls on them. And regardless of how tough they are on oil prices this cycle, we won't know how much money they will print in the next crisis until the crisis is upon us. I doubt oil stocks go roaring back up, because there is far too much economic uncertainty until the Fed is satiated. We still don't know if the Fed will stop around 3%, or rip all the way to 4%. It might not matter in the long-run, as bonds since June are moving against short rates, rather than in lockstep with them. The anticipatory nature of markets is showing up everywhere. Bonds delinking from short rates. Oil equities becoming more resilient on down days. And coal stocks breaking the correlation with spot oil. I also look at my new favorite CNQ, that is trading at a lower price than when war broke out, and at the same enterprise value as fall 2021. In fall 2021, oil was in the 60s when the "permanent pandemic" was consensus, the Omicron wave was developing, and many countries had ongoing lockdowns. Companies like CNQ will continue to shrink their enterprise values through buybacks and balance sheet enhancements. And be well positioned once the SPR runs dry. And be coiled springs if the market ever gets confidence in a higher price range for oil. Like $80-100 instead of $65-75. The price spikes are completely unnecessary. |
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