"The End of Abundant Energy: Shale Production and Hubbert's Peak"

[Previously from Goehring & Rozencwajg: "Why Won't Energy Companies Drill?", Q2 (2022) Natural Resource Market Commentary, "The Distortions of Cheap Energy" and Goehring & Rozencwajg and Horizon Kinetics on Commodities.]

Highlights from Goehring & Rozencwajg's fourth quarter 2022 Natural Resource Market Commentary, "The End of Abundant Energy: Shale Production and Hubbert's Peak".

• Few of us properly appreciate the importance of the shales. Not only were they the only source of incremental growth over the past decade, but they were also tremendous in absolute terms. Between 2010 and 2020, US shale oil production grew by 7.6 mm b/d, while natural gas liquids (nearly all from shale) increased by 4.0 m b/d. Total liquid production from the US shales grew by 11.6 mm b/d – more than Saudi Arabia’s production of 10.5 m b/d.
• Shale gas production grew an incredible 65 bcf/d over the same period. When converted to barrels of oil equivalent, shale gas added another 10.8 m boe/d – equivalent to a second Saudi Arabia.
• In recent years, Goehring & Rozencwajg has become convinced that shale production growth will slow and eventually turn negative. So far, the data has confirmed our thesis. If current trends continue and the shales do indeed plateau and roll over, global oil markets will have lost their only source of growth. Many of the resource depletion theories of the 2000s will likely return as critical issues in the 2020s. Investors would be wise to study them now.
• The development of shale oil spelled the end of public interest in Peak Oil. Like Professor Hall, many openly dismissed and even ridiculed Hubbert’s work., US production bottomed at 4 mm b/d in 2008 and, driven entirely by the shales, has grown since to become the largest oil producer in the world.
• While Hubbert’s predictions look ridiculous when considering total US liquids production, focusing only on conventional crude production suggests Peak Oil is alive and well. Last year, the US produced 3 m b/d of conventional crude oil – 7 m b/d or 70% below the peak reached 52 years ago. In other words, the shales bailed out total US production but did nothing to change the forces underpinning Peak Oil and depletion. On a global basis, conventional oil production (total production ex shale and Canadian oil sands) has exhibited no growth in 17 years.
• E&P companies successfully determined over time the “sweet spots” of the basins, where attributes such as thermal maturity, thickness, permeability, porosity, and organic content were ideal. In 2014, we estimate 45% of all drilling occurred within Tier 1 areas, whereas by 2018, it had surged to over 65%. If the industry were getting better at drilling wells, then previously low-productivity drilling locations would be converted into high-productivity locations, allowing production to continue to surge. Instead, we determined the industry was “high-grading” or drilling its best wells first. Our neural network told us that companies were drilling their best top-tier locations in all their basins. If our neural network was correct, we argued in 2019 that per well productivity would peak and begin to fall as tier 1 prospects dwindled, leaving the industry to either drill many less productive wells or, if not, see their production decline.
• Given the shale’s prodigious production growth, almost everyone believed they were limitless. Analysts talked about chronic oversupply without once thinking about the underlying geological constraints. Although the shales are extremely large, we determined they behaved precisely like traditional (albeit enormous) fields. We concluded that shale basins exhibited Hubbert-style production profiles: they ramped up, plateaued, peaked, and declined. The two earliest shale basins, the Barnett and Fayetteville, peaked between 2011 and 2014 and have both since declined by 70%.
• Interestingly, the Permian has been the only basin to grow drilling activity since the end of 2019. In the Bakken and Eagle Ford, activity remains 10% below pre-COVID levels, whereas, in the Permian, activity is 5% above late-2019 levels. The answer is the superior inventory of remaining Tier 1 locations. Unfortunately, this superior inventory is being drawn down. We estimate that closer to 45% of all Tier 1 Permian locations have been drilled. The Permian is quickly approaching the same level of development as the Bakken and Eagle Ford in 2019. Our models tell us the results will be similar: Permian production will peak, plateau, and decline much sooner than anyone expects.
• All five companies in our super-major survey increased capital spending and production in 4Q2022. Spending grew 22% compared with 2Q2022 from $11.1 bn to $13.6 bn. Year-over-year, super-major capital spending is up 25%. Increased spending was driven by Chevron (up 37%), Exxon (up 28%), and Shell (up 22%). BP and Total grew their spending much less: 10% and 5%, respectively.
• Crude demand has proved far more resilient than most analysts have expected for nearly two decades. For example, economic activity slowed following the 1980 oil price spike, and demand fell almost 10%. It took nearly ten years for demand to surpass the 1980 peak. On the other hand, economic activity plummeted following the 2008 price spike and the global financial crisis. Instead of falling by 10% (or even more), crude demand fell by only 1.5%, surpassing the 2007 peak in 2010. The difference was that in 1980, OECD countries made up 68% of global oil demand, whereas by 2010 it was only half. Emerging markets have a much different price elasticity and demand profile than developed countries: consumption is far more resilient. More recently, during COVID, energy analysts argued vociferously that global demand would never again regain 2019 levels. Less than three years later, the International Energy Agency (IEA) expects 2023 demand will be 1.4 m b/d greater than in 2019.
  

Friday Night Links

• In Dickens's novels anything in the nature of work happens off-stage. The only one of his heroes who has a plausible profession is David Copperfield, who is first a shorthand writer and then a novelist, like Dickens himself. With most of the others, the way they earn their living is very much in the background. Pip, for instance, ‘goes into business’ in Egypt; we are not told what business, and Pip's working life occupies about half a page of the book. Clennam has been in some unspecified business in China, and later goes into another barely specified business with Doyce; Martin Chuzzlewit is an architect, but does not seem to get much time for practising. In no case do their adventures spring directly out of their work. Here the contrast between Dickens and, say, Trollope is startling. And one reason for this is undoubtedly that Dickens knows very little about the professions his characters are supposed to follow. What exactly went on in Gradgrind's factories? How did Podsnap make his money? How did Merdle work his swindles? One knows that Dickens could never follow up the details of Parliamentary elections and Stock Exchange rackets as Trollope could. As soon as he has to deal with trade, finance, industry or politics he takes refuge in vagueness, or in satire. This is the case even with legal processes, about which actually he must have known a good deal. Compare any lawsuit in Dickens with the lawsuit in Orley Farm, for instance. [George Orwell]
• Mindbody founder Stollmeyer is the key protagonist in this drama. Stollmeyer is an impressive person. He started his business career as a child helping in his parents’ retail lighting fixture store. He attended the United States Naval Academy and served as a nuclear submarine officer for six years after graduation. He next landed a position as a program manager at Vandenberg Air Force Base, which took him to California’s Central Coast. In the mid-1990s, a friend showed Stollmeyer software he had written to support owners of yoga, Pilates, and spinning studios. This software inspired Stollmeyer to launch Mindbody with his friend. By fall 2000, Stollmeyer “leapt off a cliff,” in his words, by quitting his engineering job and taking out a second mortgage to start Mindbody in his garage in San Luis Obispo. From these humble beginnings, Stollmeyer grew Mindbody into a software-as-a-service (“SaaS”) platform that serves the fitness, wellness, and beauty industry. Stollmeyer took Mindbody public in 2015. By 2018, Stollmeyer had grown Mindbody to over $1 billion market capitalization, yet Stollmeyer had never experienced a big liquidity event. And he had made substantial financial commitments in the meantime. Stollmeyer had (i) invested nearly $1 million into his wife’s wellness company, (ii) invested at least $300,000 into “Stollmeyer Technologies, LLC,” (iii) loaned his brothers and his former business partner money for their own real estate purchases, and (iv) pledged $3 million to a local college, of which $2.4 million was unpaid. Stollmeyer described his unhappiness with his pre-Merger financial situation in a post-Merger interview for Alejandro Cremades’s “dealmakers” podcast. During the interview, Stollmeyer described how “98% of [his] net worth” was “locked inside” Mindbody’s “extremely volatile” stock, while Stollmeyer could only sell “tiny bits” of his stake in the public market under his 10b5-1 plan. Stollmeyer described those sales as “kind of like sucking through a very small straw”. [In re Mindbody, Inc. Stockholders Litigation]
• Most Americans have happily moved on from the 2020 Black Lives Matter (BLM)-driven ransacking of some 200 American cities, which resulted in as much as $2 billion in property damage and at least 25 deaths. But that time must be remembered for more than rioting and destruction. The BLM pressure campaigns, harassment, and moral blackmail also amounted to possibly the most lucrative shakedown of corporate America in its history. Today the Claremont Institute's Center for the American Way of Life published the most comprehensive database to date tracking corporate contributions and pledges to the Black Lives Matter movement and related causes from 2020 to the present. Companies and corporations pledged or contributed an astonishing $82.9 billion to the BLM movement and related causes. This includes more than $123 million to the BLM parent organizations directly. These figures, while shocking, likely underrepresent the true magnitude of the shakedown as some companies failed to make known their contributions, and many BLM organizations remain unknown. [Claremont Institute Center for the American Way of Life]
• Today, the U.S. Food and Drug Administration authorized U.S. Smokeless Tobacco Company’s Copenhagen Classic Snuff, a loose moist snuff smokeless tobacco product, to be marketed as a modified risk tobacco product (MRTP). Copenhagen’s moist snuff smokeless tobacco product is a pre-existing tobacco product that has been marketed in the U.S. for years without modified risk information. Today’s action now allows the product to be marketed as a modified risk product with the claim: “IF YOU SMOKE, CONSIDER THIS: Switching completely to this product from cigarettes reduces risk of lung cancer.” [FDA]
• I have a theory: the [epi]genetics that provide the foundation for some of the greatest physiques may be suboptimal for cardiorenal function, so we see a lot of heart & kidney-related disease in this population. Ultra-high intensity exercise (at intensities much higher than what normal humans can muster) plus high dose chronic year-round PED abuse = recipe for disaster as some of those compounds are specifically toxic for heart, kidneys, and liver (and remember, these people may have suboptimal organ function to begin with). [Bill Lagakos]
  

Fed Tightening (April 13, 2022 - March 8, 2023)

We wrote in our Energy - Q4 2022 Earnings Season post that we have been fighting two headwinds for the past year in our investments: tightening by the central bank, and releases of crude oil from the Strategic Petroleum Reserve.

The Federal Reserve began shrinking its balance sheet the week of April 13, 2022, after it had just hit an all time high of $8.96 trillion of assets. (The Federal Reserve prints money to buy the assets that it owns, which are mostly U.S. Treasury and mortgage-backed securities, so the size of the balance sheet essentially reflects the cumulative amount of money printed since the inception of this central bank.)

Prior to the bank failures last week, the size of the balance sheet had been reduced to $8.34 trillion, a reduction of about seven percent. The latest release shows that the assets have started to grow again:

The balance sheet now has $8.64 trillion of total assets. That is a weekly increase of $300 billion, or 3.6%, which means that it retraced half of the total reduction of $600 billion that took almost a year (from April 13, 2022 - March 8, 2023) to accomplish.

We have seen since 2008 that the Fed's attempts to shrink its balance sheet (i.e. "taper") are bearish for risk assets, and that they have been short lived, and also associated with rebounds that are much larger than the amount of reduction. That is why the balance sheet has grown over time and is an order of magnitude larger than it was twenty years ago.

As we wrote over the weekend, it seemed likely that the bank failures of Silicon Valley Bank and Signature Bank (and threatened failures of several other big, important banks) would bring this episode of tightening to an end:

Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks.

But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles.

However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups.

We have only one data point to go on, but we seem to have reached the point where the path of least resistance is to go back to printing money. Our cynical view was that it was only a matter of time until they reached this point:

We like ConvexityMaven's theory that the Fed is going to do yield curve control. Instead of letting the bond market crash and taking everything else with it, print money and buy bonds - keep the yields capped. But as the Maven says, in this scenario, "the other side of the balloon gets squishy" - meaning inflation.

If you look around the world, you will notice tons of countries with fiat currencies are running high inflation rates. Meanwhile, deflationary collapses are rare. Can you imagine the central banks of Brazil, Argentina, or Ghana tightening enough to cause a deflationary collapse? It has never happened, because the path of least resistance is inflation.

Betting on inflation is the cynical bet. But we have to be cynical enough to realize that the central bank doesn't want us hoarding real assets and is going to try to trick us with jawboning talk. People will believe the talk and there will be violent selloffs. This is why we like "first class" inflation protected assets and not leveraged junk.

We actually mentioned back in October 2022 that banks would be a casualty from tightening that might force the Fed to stop:

Banks own tons of treasuries, and their balance sheets have been devastated by the increase in the ten year bond yield, something that is being chronicled over at Oddball Stocks. Higher interest rates also mean that the interest on the $31 trillion federal debt grows, which is a positive feedback loop since the debt is not being serviced. And high interest rates choke the economy, which is unpleasant and also lowers tax revenue - worsening the debt spiral - and causes banks' loans to default. So it has seemed clear to us that printing money to buy bonds (yield curve control, capping bond yields) is the path of least resistance, "kick the can" approach that the regime will choose.

This cynicism about the Fed taking the path of least resistance dates back to our "Rethinking Inflation" post from September 2021:

So it starts to seem that the people in this country who make the decisions are not even interested in playing the old deflationary squeeze game because, even if their precarious balance sheets could withstand it, their political Mandate of Heaven probably couldn't. Plus, baby boomer rich are very unlike the old school rich - they do not like seeing things marked down on their net worth spreadsheet. (Every baby boomer has a net worth spreadsheet.) If a big devaluation is going to happen, it would be best to own attractively priced assets that will grow earnings at least as fast as the currency is devaluing. Luckily for us, a major inflationary shock is brewing at the same time that people allocating capital are under the delusion that electric vehicles have "disrupted" oil.

Retracing half of the balance sheet reduction that took a year in only one week is consistent with the results of the previous attempts at tightening.

Note also that Berkshire was buying Occidental Petroleum every day this week while the market (and particularly energy stocks) were crashing.

Bank of Ghana Redenomination Song

Sunday Night Links

• I am seeing estimates that over 97% of the funds are not FDIC insured, and many of those accounts are held by start-ups.  An outright failure would be calamitous for the Silicon Valley start-up ecosystem.  Likely the best outcome is if a major bank steps up and buys the thing, rendering depositors whole.  Without such a buyout, regulators are in an awkward position.  Leaving depositors hanging might generate additional bank runs or financial market runs.  Making depositors whole, however, sets a crazy precedent (“in fact, we’re raising the guarantee to $10 million!). So what exactly does the FDIC/Fed/Treasury have to do to get a deal consummated ASAP?  What kind of behind the scenes horsetrading will be involved? Here is NYT coverage of the basic facts.  Note that every now and then the U.S. banking system is semi-insolvent, but matters work out because “on paper” losses do not have to be either realized or reported as such.  Remember the 1980s?  One danger is that if other banks start selling their bonds at a loss, the problems in the system will become increasingly transparent and compound themselves. [Marginal Revolution]
• Financial regulators are discussing two different facilities to manage the fallout from the closure of Silicon Valley Bank if no buyer materializes, according to a source close to the situation. One way that the regulators would step in would be to create a backstop for uninsured deposits at Silicon Valley Bank, using an authority from the Federal Deposit Insurance Act, according to the source. The move would also touch the systemic risk exception that allows the Fed to take extraordinary action to stem contagion fears. [CNBC]
• Since 2007, the FDIC has served as receiver for over 525 banks. Only 9 of these failed banks had assets over $10 billion. Thus, the overwhelming majority, over 98 percent, had assets under $10 billion. Approximately 95 percent of resolutions conducted by the FDIC since 2007 involved purchase and assumption transactions, generally involving a single acquirer assuming nearly all of the failing bank's liabilities. This resolution approach, particularly applicable to community banks, is generally the least disruptive both to depositors and the local community, and the easiest for the FDIC to execute. Only 25 banks since 2007 were resolved through insured deposit payouts, reflecting the general availability of acquirers for purchase and assumption transactions for smaller institutions. In only three resolutions since 2007 was a bridge bank utilized, and only one of those three cases involved an institution with assets above $10 billion. [FDIC]
• Marlboro Friday refers to April 2, 1993, when Philip Morris announced a 20% price cut to their Marlboro cigarettes to fight back against generic competitors, which were increasingly eating into their market share. As a result, Philip Morris's stock fell 26%, and the share value of other branded consumer product companies, including Coca-Cola and RJR Nabisco, fell as well. The broad index fell 1.98% that day. Fortune magazine deemed Marlboro Friday "the day the Marlboro Man fell off his horse. [wiki]
• If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. In the 2000s that was mortgages, at other times it has been other investments like railroads. Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest delusion. [CBS]
• More Americans now favor legal cannabis than legal tobacco, surveys show, signaling a sharp societal shift from an era when cigarette-smoking was legal pretty much everywhere and pot-smoking was legal absolutely nowhere. [The Hill]
• Empire of Pain: The Secret History of the Sackler Dynasty is timely given that a lot of our American brothers, sisters, and binary-resisters were just paid $600/week to stay home for two years and consume drugs and alcohol (this Senate document says there was a 30 percent increase in overdose deaths, but blames the “pandemic” rather than the “lockdown”). The antiracism experts at Mass General say that heavy drinking increased by 21 percent during lockdown. If nothing else, reading the book will make you cautious about taking that first bottle of painkillers that a doctor prescribes! [Phil G]
• Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks. But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles. However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups. [CBS]

Thoughts on Banks with Negative Equity

Banks that invested deposits in long term bonds have lost a lot of money as interest rates have risen. (Not just banks, but also other leveraged institutions like insurers.) This is a topic we have been following closely over at the Oddball Stocks Newsletter. For example, in Issue 43 we said:

We cannot help observing that most bankers have completely fumbled the incredible opportunity that they were given, by the government and by the fickle markets, in the wake of the pandemic.

Banks are nothing more than ultra-leveraged vehicles for investing in fixed income assets. At the same time that their own shares were trading at big discounts to liquidation value and private market or takeover value, their assets (loans and securities) were worth all-time, world-historically high valuations. (That is captured in the record low U.S. ten year bond yield of around 50 basis points in 2020.) A discrepancy where pessimism existed simultaneously with record optimism regarding the same assets.

Yet how many (or how few) bankers took serious advantage of that discrepancy? Remember, last Issue in our “Cheap Cyclicals” commentary, we talked about the importance of looking for “markets that aren't talking to each other” to find opportunity. Banks, as we said, are leveraged fixed income investors. And on one hand, the market was very depressed about banks, while at the same time very enthusiastic, even manic, about the fixed income investments that banks own: the loans and securities.

But what banker, anywhere, took action by selling off his expensive assets, deleveraging, and buying back his own cheap shares? Sure, many small banks (ones that we wrote about) bought back perhaps ten percent of their outstanding shares. But none of them treated this as the career-making, potentially transformative opportunity that it was. (Except, arguably, the banks that did their shareholders a favor and sold out, since the market price for takeovers was far higher than that for fractional interests in banks.) [...]

The last time we had very high inflation in the United States there were not many alternatives for idle cash. One could invest in Treasury bonds, but it was not just a few clicks, it was an involved process and required one to be able to buy in size. One could also purchase gold, but again, it was something physical that needed to be stored. There were no money market funds. You could not buy high-yielding Certificates of Deposit in a Fidelity account with one click. With these high barriers people just sucked it up and kept their cash in the bank.

Fast forward to now: frustrated customers have many alternatives. From TreasuryDirect, to purchasing Treasury bonds directly via online platforms, to easy and convenient money market funds with checkwriting ability. Why keep cash at a bank earning 0% when one can keep cash in a money market fund earning 3.5% and functionally have the exact same experience as the bank account?

That’s exactly what is starting to happen, that is the wildcard of this banking equation. If our example bank experiences a small amount of deposit flight they will be able to handle that with cash on hand. But let’s presume that 20% of their deposits leave for greener pastures. The bank doesn’t have enough cash on hand to handle this. They would need to some of sell their securities, locking in a permanent loss and tangible hit to their regulatory capital.

In our example above the bank could sell securities, handle the deposit outflow, and survive. But not all banks would be able to do this. As you will see in one of this Issue's guest pieces, there are now 30 banks reporting negative equity. There are also 246 banks with equity equal to less than 5% of their assets. For any of these, any deposit outflows are going to result in a situation where they’re either raising capital at a dilutive price, or potentially going out of business or being “taken under” by a competitor.

Where things can also get really bad is if rates continue to increase, further depressing security values. Every positive tick in rates means a further gap between what depositors are getting paid and where market rates are, as well as a further downtick in the value of securities purchased at the top of the market. This is actually such a threat to the banking system and economy that it implies that the Federal Reserve might not be able to tighten much further.

In Issues 41 and 43 of the Newsletter, we published lists of banks that had negative equity (taking into account securities losses) or were getting close. Silicon Valley Bank was actually one that was flagged as having negative equity in Issue 43.

Note that we first raised this as a concern on Credit Bubble Stocks almost eight years ago in our review of the book Panic. Sometimes things take a very long time to happen!

If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. In the 2000s that was mortgages, at other times it has been other investments like railroads.

Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest delusion.

It seems like there are three possibilities for how this will play out, starting Sunday night.

First would be if the Fed keeps tightening and nothing is done for the SIVB depositors. In that case, everyone is going to build mark-to-market balance sheet models for all banks in the country to see who has the worst combinations of negative equity and uninsured deposits that are at risk of running. These models could mark not only the banks' securities investments to markets but also the loans that were originated when rates were much lower. Quite a few banks would have negative equity if they were forced to liquidate all of their securities and loans. (A mortgage originated at 3% has lost a lot of value with mortgage rates now at 7%.)

These lists will circulate on Twitter and these banks will have runs - people will move their deposits to "too big to fail" banks or to brokerage accounts where they can buy Treasuries directly. Not only is that safer, but they also go from earning nearly zero to 5%. (And deposit flight gets all the more likely if the Fed keeps raising rates further, since the gap between low interest bank deposits and money market yields widens.) No one is going to tolerate keeping money on deposit for free and at risk of impairment. These runs would result in further failures. Things get very messy indeed if banks' $50-$100 billion loan portfolios are being put up for fire sale every week. Social media (like finance Twitter) means that these runs can happen in a day. This is already starting to happen as of Saturday, with lines outside of First Republic Bank branches in California, and people on Twitter crowdsourcing research into weak banks.

Second possibility would be various measures aimed at calming bank depositors' concerns. On Saturday night, there has been talk of an FDIC fund to backstop deposits at failed banks. Also, from 2009-2010, the FDIC insurance on transactional accounts was temporarily uncapped: the Temporary Liquidity Guarantee Program. Something like that could be done again.

Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks.

But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles.

However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups.

But they will have to eat some big CPI prints without being able to jawbone about tightening unless they want a banking crisis.

Will "nicotine as a service" be as lucrative as cigarettes were?

Wanted to expand on this week's post about Altria's Bungles because we have been rethinking the tobacco trade more generally. Recall that in order for the big tobacco basket to work as an investment, we needed two things:

1. "Re-nicotinization," where the number of people using nicotine (in whatever form) stops declining and preferably grows.
2. A growing nicotine industry profit pool, with the vast majority of it captured by big tobacco: MO, PM, and BTI.
   

We are still confident in the first proposition. We see plenty of happy Zyn customers. We also see plenty of people vaping.

When oil prices spiked last summer, it hurt cigarette sales. However, when oil prices declined through the end of the year, cigarette sales did not recover or bounce. At Altria, cigarette volumes were down 11% year-over-year in the second quarter of 2022, and down 12% year-over-year in the fourth quarter. 

BTI's U.S. cigarette volume was down 13.4% in the first half of 2022, and was down 15.5% for the full year. If you back out the first half, that means that the U.S. combustible volumes were down 17% for the second half of 2022 vs 2021. 

What happened? We wonder whether high gas prices were a catalyst for some smokers to switch to a reduced risk nicotine product and quit cigarettes. That would explain the lack of a bounce after gas prices fell. If that is true, there is a negative asymmetry in the cigarette business; a one-way ratchet where bad circumstances push smokers away from cigarettes and nothing brings them back.

Why is it bad that people are quitting cigarettes? Wasn't that our "re-nicotinization" thesis? Yes, but that was assuming that the reduced risk product profit pool would be as big or bigger than the cigarette profit pool, and that it would be captured by the incumbent tobacco companies.

The cigarette business is basically a duopoly, hence very profitable. The reduced risk products have tons of competition. When we see people vaping now, we often see them using cheapo, open-tank products. The telltale sign is when the billowing smoke cloud smells like something like fruit or candy.

It is concerning that the big tobacco companies have growing sales of reduced risk products, yet the only reduced risk products that seem to be profitable are Zyn in the U.S. and IQOS in Europe. BTI lost 400 million GBP last year in "new category" (reduced risk products) on 2.9 billion GBP of sales. Altria's only reduced risk product before the NJOY acquisition is the "on!" nicotine pouch, which is almost certainly a money loser.

It is seeming possible that re-nicotinization is happening, but that the nicotine as a service business is going to remain fragmented enough such that the profit pool that used to exist in cigarettes is substantially diminished. 

Big tobacco is at a disadvantage in vaping because it has been playing by the rules. If you can only sell tobacco flavored vapes, you are going to lose out to "disruptors" who do not follow the rules and can sell watermelon or cotton candy flavored ones. BTI's U.S. subsidiary has asked the FDA to crack down on the illegal vapes, but they are still for sale. Can the FDA stop strip mall vape stores and gas stations from selling Chinese vaping trinkets to willing buyers? It's an open question. They do not have a police force.

And even if they can, what assurance do we have that the authorized reduced risk nicotine market is going to be a profitable duopoly the way that cigarettes were?

The premarket tobacco applications (PMTAs) required by the FDA were onerous, but not so onerous that only big tobacco companies participated. They received applications for millions of products. So far, they've approved products created by Japan Tobacco, NJOY, British American, and Philip Morris, and presumably will approve more. 

Also, once they have gone through all of the PMTAs and it is clear what kind of product they will accept, what stops competitors from launching me-too products that are also FDA authorized, so that they can grab some of the fat margins? (And perhaps the illegal black market open tank products are here to stay as well.) If you recall our original tobacco post from 2019, the idea was that big tobacco would have sufficient regulatory capture to have a moat around reduced risk nicotine products. 

Instead, reduced risk nicotine products are seeming like a free-for-all. If true, that would mean that the glory days of tobacco profits are going to come to an end.

It has been a good run. Since our post, "What I Would Buy Instead of Tesla" in October 2020, Altria is up 42% and has paid significant dividends. The performance of Philip Morris and British American has been even better.