Sunday, May 22, 2022

Goehring & Rozencwajg and Horizon Kinetics on Commodities

Highlights from Goehring & Rozencwajg's first quarter 2022 Natural Resource Market Commentary: "The Gas Crisis is Coming to America":

  • Asian and European natural gas prices stand at $35 per mmbtu, versus $8.20 per mmbtu here in the United States. Given the underlying fundamentals that have now developed in US gas markets, we believe prices are about to surge and converge with international prices within the next six months. The natural gas market outside of North America has been in an extreme shortage since the end of last summer. Prices first broke $35 per mmbtu last October, plateaued, and then surged again in December, surpassing $50 per mmbtu – equivalent to $300 per barrel oil.
  • Our models suggest the decades-long protection from international price swings, enjoyed by the North American gas market, is about to change. Slower-than-expected shale growth will push the US market into structural deficit for the first time in 15 years. Almost immediately following the shift, US prices will converge with global gas prices. Given today’s $35 per mmbtu international gas prices, prices could surge by almost four-fold.
  • In just six short years, the US has become the world’s largest LNG exporter. Six export facilities currently operate and a seventh, Calcasieu Pass, will add an additional 1.7 bcf/d of capacity, bringing total US LNG export capacity to 13 bcf/d, surpassing both Qatar and Australia, formerly the world’s two largest LNG exporters. Even though it is now integrated into the global gas market via LNG, US prices remain disconnected from global prices. Why? Surging shale production has far exceeded LNG export demand. The US natural gas market has remained in structural surplus even with surging LNG exports. That is all about to change. Slowing shale production will cause the US to flip from structural surplus to structural deficit.
  • The moment the US gas market swings from even marginal surplus to marginal deficit (i.e., when US demand plus LNG exports exceeds production and imported supply), something shocking will take place: almost immediately, US prices will converge with global prices.
  • Most investors can only extrapolate a trend. In this case, the trend has been near endless growth from the shale gas basins. The idea that gas supply could falter and as a result that US gas prices could nearly instantly rise four-fold is completely off any investors’ radar. And yet, this is exactly what our models are telling us could happen within the next six months. 
  • As you can see, commodities and financial equities have both traded in long cycles that are usually inversely related. Over the last 130 years, there have been four times when commodity markets became radically undervalued versus the stock market: 1929, the late 1960s, the late 1990s, and today. After each period of radical undervaluation, commodities entered into large bull markets and then proceeded to become radically overvalued. If you had invested in commodities or commodity related equities in any of these three previous periods, the returns on both an absolute and related returns basis were huge.
  • These three periods couldn’t have been more different: the 1930s were a period of deflation and global depression; the 1970s were a period of severe inflation and worries over currency debasement; and the 2000s were a little bit of everything including a stock market collapse, a global financial panic, and an oil price spike not seen since the 1970s.
  • These three great commodity buying opportunities were all characterized not only by cheap commodity prices, but by the recurrence of four other events. First, prior to each commodity buying opportunity was a decades-long commodity bear market that produced price declines so severe that capital spending in many extractive industries was impaired. Second, each period was characterized by excessive monetary creation. Third, all three periods saw intense financial speculation. And fourth, each period saw a major shift in global monetary regimes. All four conditions are once again present today and, in many instances, they are far greater in magnitude than in any of the previous three cycles.
  • The deflationary trend of the last 40 years is now over. A new inflationary trend is in place and will last longer and carry on farther than anyone expects. Huge changes in investment flows are about to take place with large implications. Although inflation-sensitive assets have already begun to radically outperform bonds and the general stock market, investors’ interests in these assets remains subdued.
  • We remain wildly bullish on North American natural gas and we continue to recommend large exposure to natural gas focused E&P companies. Even after their big runs in 2021 and into the first quarter of 2022, natural gas related equites are priced extremely cheap. In no way do these stocks incorporate $4.00 per mmbtu gas, let alone today’s $8 price.
  • Internally, we have discussed what we should expect to see as the world runs out of spare pumping capacity. Although extremely challenging and uncertain, we find it valuable to lay out a roadmap with mile makers that we should expect to pass if our premise is correct. We agreed that if we are in fact running out of spare capacity, we should see a series of large releases from strategic petroleum reserves. On March 31st 2022, President Biden announced he would release a record 1 m b/d for six months from the SPR. Other countries followed suit and agreed to release another 1 m b/d for at least two months. Historically, SPR releases have been unsuccessful in reducing oil prices and instead are an indication that the physical crude market is exceptionally tight. The larger the release, the tighter the market. The recent announcement from the US and the rest of the International Energy Agency (IEA) member countries is by far the largest coordinated SPR release in history and we believe confirms our thesis that the oil market has fundamentally changed.
  • In a normal cycle, falling inventory levels, rising prices, and improved profitability would have attracted capital back into the industry by now. Instead, ESG commitments made over the past several years are keeping capital from reentering the oil and gas industry, making the production problems much worse. Oil prices are at 15-year highs and natural gas in Europe and Asia are setting new records and yet E&P capital spending is still down 50% from the peak with shale spending down 60%. Despite record free cash flow, companies prefer to return capital through dividends and share buybacks rather than drill new wells.
  • One question we are often asked is whether high prices will curtail demand and potentially push the world into recession. The topic of demand destruction is extremely interesting and in a future letter we will likely dedicate a whole essay to the subject. Using the relationship of oil expenditures to GDP helps us put the current situation in proper context. The last two major oil tops occurred in 1980 when oil rallied from $3 to $36 per barrel and in 2008 when oil rallied from $11 to $145 per barrel. In 1980, the US consumed 17 m b/d which amounted to $225 bn per year on GDP of $2.9 trillion. In other words, nearly 8% of US GDP was spent on oil. On a global basis, oil demand averaged 61 m b/d, amounting to $800 bn on GDP of $11 trillion, or 7.2%. In 2007, the US consumed 19 m b/d, amounting to $1 tr on GDP of $14.5 tr, or 6.9%. Globally, we consumed 86 m b/d, amounting to $4.5 tr or 7.8% of $58 tr in global GDP. At present, the US consumes 20 m b/d, amounting to $730 bn at $100 per barrel crude. With GDP running at $21 tr, oil expenditures amount to 3.5% -- less than half the prior two peaks. Globally, demand ran at 97.5 m b/d last year (although we believe this is higher), amounting to $3.4 tr or only 4% of global GDP – again only slightly more than half the prior two peaks. Oil prices likely contributed to slowing economic growth in 1980 and 2008, however we are not yet at the same levels of expenditures. Were oil to reach $170 per barrel, expenditures as a percentage of GDP would reach 6-7%, more consistent with previous market tops.
  • The current energy crisis will not be solved until capital comes back into the industry in significant quantities. Normally high commodity prices and improved profitability help attract capital, but ESG pressures are keeping that from happening. E&P capital budgets are indeed up 25% compared with the 2021 lows, however they remain 60% below trendline. Moreover, we are hearing that most of the increase is not the result of increased activity but rather represents cost inflation as bottlenecks have now developed in key equipment, steel, and labor. Energy related IPOs and secondary offerings totaled a mere $1.8 bn over the past six months, 80% below the $10 bn average between 2010 and 2017 and 90% below the $22 bn peak in 2016.
  • Capital remains unavailable even though oil and gas prices are high and even energy hostile politicians are now calling for more upstream investment. Investor interest in the energy sectors also continues to be extremely low. Between January 2021 and today, the XOP (the largest ETF of E&P stocks) has advanced by 120% and yet, over that period, the shares outstanding have actually decreased--investors have actually redeemed shares on balance.

Highlights from Horizon Kinetics' Q1 roundtable discussion

  • The oil service industry, for eight years, that’s from 2014 to now, has been through the greatest depression in its history. And that includes the post-1980 environment, until now the greatest depression ever. And all you can say right now is it’s a little bit better than it was in the second quarter of 2020. It’s not a lot better. It’s a little bit better, from their unique point of view. They don’t make any money to speak of. So, we’re going to get price increases, and that’s going to happen because they don’t have the money to buy new equipment. This is a capital-intensive business. So far, they’re cannibalizing old equipment, but they’re about at the end of that process right now. Therefore, when some energy company states that it is going to spend X billion dollars in capital expenditures, the unfortunate thing is that, in short order, that money, whether it’s $1 billion, or $2 billion, or $3 billion, or $4 billion, is not going to buy what it bought last year. It’s the same money but it will buy less, and that’s going to constrain production.
  • [W]e all talk about oil as if it’s homogeneous, but it’s not homogeneous. Refineries are configured for different types of oil, heavy oil, light oil. Those names refer to what’s called API gravities. API stands for American Petroleum Institute. There are certain kinds of oil that are just better for extracting asphalt and diesel fuel, and there are certain oils that are better for getting gasoline out of it. It has to do with the length and the strength of the hydrocarbon chain. What this means is that if you run a refinery and you’re configured to run on heavy oil, you can get that from Russia, you can get it from Canada, or you can get it from Venezuela. Those are the main sources. If, because of sanctions, or whatever the reason happens to be, you lose the Russian oil, it’s not as if oil from Texas can replace that supply you lost, because your refinery isn’t configured to run on light oil. You’d have to totally rebuild your refinery.
  • One other thing I’ll just mention in passing is that it’s very hard for institutional investors to make energy investments, since they took the pledge to divest themselves of energy. That’s another factor. Therefore, the energy companies will not be spending a lot of money to gear up to produce oil when the major institutions, the financiers of the world, have said they’re going to be divesting. So, that’s not going to happen, either.
  • We’ve been accustomed to 40 years, basically, of one cycle, the whole cycle that we covered in the last quarterly review. Declining interest rates, declining tax rates, all these trends—it’s all come to an end. Not just an end, it’s actually changing. But people haven’t wrapped their heads around that yet. It felt normal, because there was 40 years of it. If you’re 50 or even 60 years old, in terms of being conscious about economics, that’s all you knew.
  • [C]ommodities have been in a recession/depression for 40 or 41 years, other than the occasional few months exceptions to that. Not a recession, but a depression. And for those decades, return on capital for commodity companies was very low, while for businesses globally the return on capital was very high. Technology is a good example, whether it’s Microsoft or Apple or what have you. Accordingly, for 40 years, capital has been gravitating away from the commodities—really the extractive industries.
  • One other dynamic is very important. As if this depression in commodity prices, the competition from the collapsed communist states, the withdrawal of asset allocation capital from these industries, wasn’t bad enough, there’s been the impact of the ESG movement for the last five or six years at least. For the ESG movement, since anything extractive is going to emit some type of greenhouse gas, these companies basically all had to take the pledge to reduce greenhouse gases by three percent a year. But you can’t increase production and decrease greenhouse gases. It doesn’t work that way. So, none of them is in a rush to increase production of anything whatsoever.
  • Another category of presumed inflation beneficiaries are the consumer products businesses, for which there is stable demand, because they’re perceived to be able to raise their prices. But two challenges they faced historically, like in the 1970s, is that you can have cut-rate, no-name brands arising in supermarkets, for instance, for all sorts of high-margin staples like cereal, and peanut butter, and jams, and frozen dinners. At the same time, their input costs go up, too, so their margins contract. That happened to the big consumer products companies. And of course, if that happens, their P/Es contract.
  • Virtually all the oil produced in the United States is light crude oil. Yet, many of the refineries in the United States process heavy oil, as opposed to light oil. The reason for this is that heavy oil is preferable for products such as asphalt, fuel oil, and petrochemical feedstocks. Thus, a shortage of one type of oil cannot be replaced by a different type of oil. In other words, increased U.S. production cannot replace Russian production. Russian production must be replaced with something comparable to Canadian heavy oil. However, to supply refineries located in the United States, pipelines must be built. Apart from Canada, in the Americas, the two biggest sources of heavy oil are California and Venezuela. California will probably not permit meaningful increases in heavy oil production. Actually, it may not permit any increases in any type of oil production. Therefore, Venezuela becomes the next choice. That’s the reason why the government is turning to Venezuela for oil. It’s not merely to replace a given quantity of oil. It’s that the type of oil produced in Venezuela is the type of oil needed for the refineries that currently use Russian oil, because of the way in which they’re configured.

1 comment:

viennacapitalist said...

the G&R piece is fantastic.
This is why I am cautious of buying US chemicals businesses which look cheap from a valuation perspective