Inflationary Pressure & The Incoming Commodity Supercycle (w/ Simon White and Tian Yang)

Inflationary Pressure & The Incoming Commodity Supercycle (w/ Simon White and Tian Yang)

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TIAN YANG: Hello, everyone. My name is Tian  Yang, head of research a Variant Perception.   Today, I am joined by Simon White, managing  editor at Variant Perception. We are going to   have a discussion around a potential new dawn for  commodities. Simon, the commodity new dawn, the   bullish commodity trade, that is being somewhat  of a widowmaker trade for the past few years.   We have seen a number of people try and call the  bottom in things like oil, and things like natural   gas. Today, it does feel like something is a  bit different. Structural and cyclical forces   do seem to be coming together coming out of  this recession. Could you take us through  

what you think are going to be some of the key  drivers for the commodity markets as we head   into 2021? SIMON WHITE: Yes, thanks, Tian. This is  based on a recent report that we put out, we will   release to Real Vision viewers. It is basically,  the title gives it away. The Next Commodity   Supercycle. What we have seen, basically, is  an alignment of drivers that come together.   Normally, you get one or two things happening and  it is makes something quite interesting. Today,   we have got a very compelling lineup, as you said,  structural and cyclical. The way I would think  

about it, we have the overarching theme of the  macro drivers. We are in a very different, what   we call inflationary regime now. We have basically  left the era of monetary policy dominance. Now,   we have much more of activists, fiscal policies.  If you look historically, that tends to   mean that the underlying inflationary risks have  risen. In that environment, financial assets are   unlikely to perform as well as real assets. On  top of that, we were always very data driven in  

Variant Perception. We have built what we call the  capital returns framework, and what that basically   looks at is it looks across all industries, and  we try and find industries that are essentially   capital scarce. They have seen essentially money  coming out of them for an extended period of time,   investment coming out of them, and that leaves  them in a situation where they are really unable   to respond to a change in demand. The companies,  the types of companies that float to the top   of our screen even before we get to this macro  environment, are a lot of commodity sectors, so   that tells us it is very interesting. We have seen  a lot of disinvestment coming out of commodity and   we had the last commodity supercycle, the peak  was maybe 2011. We are coming towards the end   of that. There is not really a situation where  many of these companies could respond properly  

to change in demand. Where is that demand change  going to come from? Well, there is two things.   There is real demand where there is a recovery,  essentially, in demand coming out of this global   recession. It is going to be slow, and but it is  certainly moving in one direction. On top of that,   we have investor demand as well. People,  investors, the whole investment community is very  

largely underweight real assets like commodities.  That means when we are in this new inflationary   environment, people need to start thinking about  hedging inflation risk, and they are worried about   the currency that things are denominated  in either dollar or fiat money in general,   then they are going to have to start looking for  alternatives, real assets, and commodities are   one of those alternatives. TIAN YANG: There is  a number of points there to unpack. Maybe we can   start with, you used the phrase fiscal dominance.  What do you mean by fiscal dominance? What regime   are we being in, and why are we moving towards  this fiscal dominance? SIMON WHITE: It is just a   fancy term, but the term really means fiscal  policy dominance. Really, it is the normal   thing. You look historically over the last  hundred, 200, 300 years of central banking,  

generally, it is the government that  essentially has the upper hand on how   monetary policy is driven, and how  it is-- RAOUL PAL: Hi, I’m Raoul Pal.   Sorry to interrupt your video - I know it’s a  pain in the ass, but look, I want to tell you   something important because I can tell that  you really want to learn about what’s going   in financial markets and understand the global  economy in these complicated times. That’s what   we do at Real Vision. So this YouTube channel  is a small fraction of what we actually do.   You should really come over to and  see the 20 or so videos a week that we produce  

of this kind of quality of content, the deep  analysis and understanding of the world around us.   So, if you click on the link below  or go to, it costs you   $1. I don’t think you can afford to be without it. SIMON WHITE: years of central banking, generally,  

it is the government that essentially has the  upper hand on how monetary policy is driven,   and how it is organized. The last 30 to 40 years  are really a bit of an anomaly and especially the   last 20, 25 years, where you basically have the  situation, the conditions are very low inflation,   low and well behaved inflation that has allowed  governments essentially to allow central banks   to have more upside when it comes to organizing  policy. Basically, we have been in an environment   where what is called monetary dominance, where  central banks can set interest rate policy,   essentially, for the needs to keep employment,  unemployment mandate often and obviously to keep   inflation low as well. That year is coming  to an end. The reason for that is that the   drivers that allowed central banks to be able to  operate policy as they did are now running out   of road. We are realizing that the more central  banks get closer to the zero bound, the harder   it is for them to have actually any discernible  impact on conditions. There is a recent article   from Bill Dudley, ex of the Fed, making that exact  point. The Fed is coming to the end of all it can  

conceivably do. Rates are near zero. There are a  few things it can do. It can make rates negative,   does that make a big difference, or is  it counterproductive? You look at Europe,   quite likely, it is counterproductive. They can  also buy smore debt. They can do more QE. Again,   that seems to have the Law of Diminishing Returns  when it comes to these policies. There is really   only one angle left, and that is what Bill Dudley  said, and that is what a lot of people are saying,   a lot of central bankers are saying is like, we  have run out of road here, we need some help. That  

help comes from the fiscal side. That is basically  what is happening. You are seeing more activist   fiscal policies because it is really the only way  to try and stabilize the economy, especially when   you have crises. The Great Financial Crisis  2007-2008. The only entity that could really   rescue the economy from that is the government.  Then once they are in that situation, it is   very hard for them to get out of that situation.  The latest crisis that befall us, the pandemic,   is just another example. There is no entity big  enough, strong enough that can basically salvage   the economy in such a big crisis situation as the  government, so the government is having to step   up. The difference here is that what we took  as low risk environment for central banks,  

when they practice things like QE, have not led  to inflation. That has lulled people into a false   sense of security because it is very different  when a government begins to borrow and spend with   impunity, because not only to they create-- there  is more money created so it can do the spending,   it also creates the demand that goes with  it. That potentially, historically speaking,   has often led to much high-- or in  extreme cases, hyperinflation. TIAN YANG:  

You cited a few examples here, 2007 and 2008,  and talked about how before this era of central   bank independence, Keynesian, that thinking tend  to dominate. I guess what we are actually trying   to say here is that this expansionary fiscal  policy is likely to become a more permanent state.   Compared to the last 20 years when  fiscal policies are expansionary,   they are going to run deficits for many years  now. It is not like before, where you just run it  

for one or two years, and then you back off, and  then you go back to letting monetary policy drive,   I think what we are seeing is a shift to where  fiscal policy is going to be very expansionary   for a long time. Then the role of monetary policy  is just to help finance that deficit. There is a   number of historical precedents. Previously, we  talked about things like the Fed Treasury Accord   1942, but again, it is very similar, where like  we have the pandemic this year, you have World War   II, and the saying is that central banks have a  moral obligation to help the economy. Therefore,   you should help by buying government debt, keeping  interest rates low, allow governments to borrow   and spend, and that is the setup we have today.  The concern is that we have a repeat of potential  

in 1960s into the 1970s, where, as the situation  persists, inflation expectations become unhinged,   and then obviously, you get a lot more inflation  and then it becomes somewhat problematic.   I was wondering if you could dive a little bit  into some potential lessons learned from the 1960s   and 1970s, and really, how should we think about  inflation? Now, if we all move into this different   world fiscal dominance, what is going to happen  to inflation? SIMON WHITE: The 1960s is a great   example. The way we have characterized it is that  inflationary risks are greater now than they have   been since the late 1960s, to the late 1960s in  the US, that led into the 1970s, the stagflation.   That was a decade that was going to pockmarked  with very high, often double digit inflation,   and very stagnant growth. What is interesting, you  look back at that period, like what kicked off,   you basically had expansionary fiscal policy,  but you also had an at the same time as where   the central bank, the Fed, at the time believed  that it had more room to ease than it really did.  

They were essentially acting in concert  with the governments. You had the Nixon   administration, who was basically wanting easier  policy to probably help with the election in 1972,   and obviously, to help the economy as well.  You had the central bank that was willing to   help the government in that end, and that really  sowed the seeds. Now, the situation got a lot   worse as the 1970s went on. They had a lot of  bad luck. They had Nixon closed the gold window,  

1971. That was the final link between fiat money  and anything actually solid behind it. Then you   had the Arab Oil Embargo in 1973. The end of the  Nixon wages and price controls came after that.   At the very end of the decade, you had the  Iranian Revolution. All these things were like,  

I guess you could say, bad luck. The seeds were  sown by, essentially, fiscal expansion and central   bank aiding of that expansion. The parallels here  that are interesting is we have fiscal expansion   to deal with the crisis, we also have had the  most radical change the Federal Central Bank's   monetary policy for a long time. They have now  moved to an average inflation targeting regime,  

which essentially means that the CNE undershoots  an inflation, they are more than happy to allow an   overshoot inflation. They have not given any idea  about how long they would allow it to overshoot,   or how long they care about an undershoot. That  adds to the uncertainty. Also, they are trying   to target maximum employment too. Well, that  basically tells us that they are willing to play  

with fire, if you like. There is a willingness,  just because we have not seen inflation for such   a long period of time, this, as I said, lulled  people into a false sense of security, there is a   willingness to allow inflation to go a little bit  higher, and then a belief that it is very easy for   the central bank, but once they see inflation, it  stays at 3%, 3.5%, they are like, no, we will put   the brakes on now, and everything will go back  to normal. Our fundamental argument is that that   will not happen because the underlying risks to  inflation have changed. In this new environment,  

we characterize it as the lake regime and the  ocean regime. We came from the lake regime,   where your situation is very calm. If you had  a rise in inflation in the lake regime, they   are unlikely to turn into anything particularly  nasty. Central banks could just tweak interest  

rates a little bit higher, and we could all go  back to sleep. In the ocean regime, which is   basically where we see ourselves now, conditions  can very quickly become much more turbulent.   In the ocean regime, garden variety rise in  inflation, say from a disruption to supply chain,   cost push demand, put all the usual reasons that  you might get a slight move higher in inflation.   In the ocean regime, that can suddenly turn into  much larger rise in inflation that are disorderly.   The takeaway here, as far as we are concerned,  as investors and people that advise investors   is what does that mean for your portfolio? In the  same way that lake going vessels are not suitable   for ocean going travel, how should you be  thinking about your portfolio to make it   more ocean ready? TIAN YANG: I see. There are a  few interesting points you raised. You mentioned   the Fed's shift in monetary policy regime. That  also made me think of all the discussions we were  

having before the crisis hit about MMT, modern  monetary theory, and so forth. It seems like a   lot of the intellectual justification that will be  needed to create an inflationary macro environment   has been laid already. On the one hand, we are  saying we should just spend as much as we can,   until there is inflation. Now, you have the  Central Bank saying, yes, we agree with that,  

let us just keep going until we get inflation.  Let us all do it together. At the same time,   another quite, obviously, extreme shift  in monetary policy regime this year is   the Fed is going out buying corporate debt,  buying high yield debt, causing the deterioration   of their own balance sheets. As you mentioned,  since Nixon took us off the gold standard, the   Fed's balance sheet has continued to deteriorate,  and in turn, obviously, the value of the dollar is   going to become less and less credible over time.  It does seem like a lot of these things are coming   together to take us into this ocean regime, as you  say. Obviously, and when I think about the ocean   regime, I do not think it necessarily means  we are going to 5%, 10% inflation tomorrow.   Even in the 1970s, these things take time.  Typically, you need people to start doubting what  

inflation actually is, to suspect that cost of  living is going on much higher than they expect.   Then when it comes to negotiating wages  and so forth, they demand CPI plus five,   or whatever it is, and then you get these wage  price spirals, and you really lose control.   I guess for investors today, this is more of later  on in the cycle as we use up the excess slack in   the economy, that is more worrying. I guess today,  it is actually just literally about pricing in the   risk of inflation, i.e. the risk premium for  inflation probably needs to start going up.  

When we still look at things like the US Treasury  curve, term premium is still incredibly negative.   Obviously, when our nominal rates are hitting  zero, it just seems like the investors are   really setting themselves up to lock in some very  negative real returns. To that end, obviously,   we have seen the moves in things like gold,  obviously commodities starting to do well.   Really, it is quite hard to think about what  the ways are to actually hedge inflation.   I wonder if you have any thoughts on, what are  the different ways investors can do it? Gold is an   obvious example, but what about others? What about  you go and trading inflation swaps? What about   Bitcoin and the like? What do you think? SIMON  WHITE: We always end up, what is the best way   to do this, and I would tie back to one point you  have mentioned exactly, just because we have moved   into this new regime, it does not mean that all  of a sudden, we are going to hit high inflation.  

We, along with all our longer term indicators, we  look a lot of short term or cyclical indicators,   and they are saying right now that over the  next year, at least, you should be expecting   more disinflation. That is what you would expect  to see coming out of a recession, this inflation   is a lagging indicator, it tends to peak when the  recession is happening. We have probably already   seen that, and then it starts to taper off.  The longer term environment has changed, and   you could be in the ocean for a long time and have  perfectly placid weather. When it changes, it can   change very badly. In that environment, you want  to prepare and as you say, how do you prepare?  

There are two things, there is two ways we are  looking at it. There is a shift towards making   your portfolio more inflation resistant today.  That involves things like, as you said, that   involves adding more exposure to things like gold  or inflation swaps, or other alternatives like   Bitcoin, and maybe we can talk about these things  in a bit more detail later on, but the key is to   start thinking of doing it today. Obviously, the  main thing, the main thing we think that people   would want exposure to in this inflation  environment is commodities. Again, you go back to   the 1970s. We got as the most recent example of a  Western country experiencing very high inflation,  

double digit inflation. If you look by the asset  classes, and you look at commodities, equities,   etc., the only asset class that delivered the  positive real return-- and that is obviously the   key here, real return-- in 1970s, was commodities.  Every other major asset class delivered a negative   real return. We have become so used to, I think,  really conflating real and nominal returns. In a   low inflation environment, it does not really  make much difference. In an environment where   inflation could potentially move much higher,  you really need to start paying attention to your   real returns. Commodities were one of the best  performing asset classes or the best performing  

asset classes in a real return basis in the  1970s. Equities, generally, were a shunned asset.   Equities, essentially, they have got the return on  equity. With a bond, you can negotiate the coupon.   There is a maturity with a bond, whereas equities  have infinite maturity, and equities, essentially,   in this high inflationary, higher rate environment  started to become a shunned asset. Overall,   equities did not do very well at all, in a real or  nominal basis, but within equity, certain sectors   did very well. You look at energy stocks,  industrial stocks, material stocks. These  

sectors performed the best in the 1970s. You want  to start looking to orientating your portfolio   towards essentially real assets or companies  or firms that basically have access or that are   very close to real assets, so they are going to  benefit from real assets upside. Another reason   why you want to start doing that now is because  you will not be the first person to do this. As it   becomes apparent that we are in a new regime, in  this ocean regime, and inflation risks have risen,   more people are going to have to start thinking  about re-allocating more to real assets like   commodities. Obviously, this is the next  part, which I want to throw back at you  

is that could happen at any point. This particular  set up, in some ways, could happen at any point.   We do not know when inflation is going to  come, but we think it is in this cycle.   Why particularly now? Given some of the things  we have looked at, now is a good time to start   looking allocate into some of these commodity  sectors and some of these commodity industries.   TIAN YANG: What makes commodities as a sector  stand out to me is typically, the supply response   tends to take a while. If you are going  to build a new mine or drill a new well,   these are typically timescales measured in  the order of years. A new mine or conventional  

wells could be three to five years. Maybe some  shale can be a bit quicker, one or two years,   something like that. Typically, there is this  pattern where supply responses are very delayed,   and often producers tend to wait as well to really  make sure there is an upturn before they actually   have new projects. What that lends itself to is  prolonged periods of mismatches between demand   and supply. This is something quite unique to  the commodity sector, and obviously for a lot of  

capital intensive sectors. This is a property that  inherently means it has these boom-bust cycles.   What is interesting for commodities is obviously,  we have had quite a long bust. It has been pretty   capital scarce. Most investors have been fleeing  the sector. There is not being a lot of capex,   not a lot of investment going in. A lot of  the preconditions are needed to ensure that   supply remains tight and remains tight for long a  time in place. Now, if you just get picked up in  

demand just for a natural economic recovery, and  eventually from investors moving into the sector,   because of this massive underweight or  structural structure, the fact that very   few investors have commodity positions, I think  those things are going to come together to create   a quite potentially explosive move in  prices. It is very interesting from a   portfolio construction point of view that if you  look at the history of commodity price returns,   typically when commodities have high volatility,  it tends to be to the upside, which actually gives   it quite nice probability, because typically for  things like equities and so forth, usually the   higher volatility fades it when they are crashing.  The volatility smile is priced to be more into the   left. There are a few things that naturally make  commodities a bit more suited as we move away   from fixed income, as we hit the zero bound for  commodities to take on that role. It obviously   had a longer track record, it has been more  proven, and a lot of the demand supply dynamics   actually are a bit easier to judge as well. Now,  obviously, with things like gold, where it is not   really consumed or anything, actually, it is a bit  harder to judge because obviously, whatever supply   there is, there is, but it is not really  consumed. The supply tends to grow over time.  

Arguably, for Bitcoin, obviously, supply does not  really move, but it is not really consumed either.   The que thing about a lot of the commodities, as  you mentioned, energy, metals and mining is that   over time, obviously, they have to get consumed as  well. There is obviously natural rate of decline   on the supply side, and they naturally have to  be replaced. When these sectors lose access to  

capital, you get very extreme tightening in the  supply side. Then obviously, when the demand   picks up, you get the explosive moves higher.  That is basically what we are seeing right now.   The way I think we have really tried to focus in  on this is using the capital returns framework   that you mentioned earlier. Here, if viewers  are interested, I think the best thing to read   is a collection of reports by Marathon Asset  Management in a book called, Capital Returns,   which was edited and put together by Ed  Chancellor. That was really the book that  

originally inspired us to really think about how  to build a quantitative framework around capital   cycles and to really drill down into this, and  so obviously, at Variant Perception, this is what   we have done. We typically look at things like  CapEx, CapEx on R&D relative to the asset base,   things like depreciation amortization relative  to asset base, what is the return on capital?   Typically, in capital scarce sectors, there  is not a lot of CapEx going in. Obviously,   a lot of the asset base is being worn down and  yet returns on capital is actually leveling out   and starting to pick up. This is what we have  been seeing in things like energy, in things   like metals and mining. Those are probably the  average we really want to be drilling down into,   and trying to actually think about, what are the  best parts to invest in? SIMON WHITE: Then looking   back historically, this capital returns framework,  it is worth emphasizing if people spend so much   time focusing on demand, analysts will be trying  to-- how many flights people are going to take?   How many x, y and Zed people are going to  use widgets, whatever? It is very difficult,   obviously, to try and figure out what is happening  with demand, whereas actually trying to gauge   what is going to happen to supply is actually  much easier. In an environment where you see  

capital coming out of a particular industry  over a persistent period of time, or the other   way around, if you see lots of capital coming  in, it really gives you a good sign that that   industry is going to underperform or outperform.  You look at for instance shipping in 2007,   obviously, the lag times there between putting  a ship order in and the ship getting built,   several years. You had the housing market, Spain,  US, Ireland peaked around 2006, same thing, you   had a huge glut of supply coming on just at the  point where a demand was collapsing. TMT boom in  

the late 1990s. All these things, they were great  examples of where you have seen a capital cycle   either peaking or troughing and where we are today  with the commodity cycle, the commodity cycle last   peaked in 2011. Right when you had a lot of these  projects coming on board, this is like coming into   the shale and the other stuff later in the decade,  yet you had a lot of these projects coming on   board at the worst possible time, because at that  point in time, capital was flooding in and a lot   of capital has been mis allocated to bad projects.  Here, we are just at the other end of that cycle.   I think was important to emphasize,  though, is that we did not just run this   on just commodity sectors, this capital returns  analysis just on the commodity sectors, we have   done it for the whole world and for all sectors.  The sectors that appeared at the top are commodity   sectors. They are not just within commodities, we  are looking at, for instance, gold and silver, and  

oil and gas. This is among sectors across  the whole world. It is worth emphasizing that   even without the inflationary backdrop, which  I think is huge in terms of the inflationary   risks changing, the commodity sector is still  primed to outperform over say the next one,   two or three years. TIAN YANG: Yes, and it is  worth also just repeating that the capital cycle   is actually a quite intuitive idea. If you have  lots of money chasing limited opportunities to   make profit, then obviously, over time, it is  going to destroy profit. If this industry looks   very sexy right now, and all the money goes in, in  the end, a lot of infrastructure might get built,   and a lot of nice things might come out of  it, but the investors did not make any money,   like what you mentioned 2000 dotcom boom, building  out the fiber network and things like that.   Typically, if you have too much money chasing  what are actually brilliant ideas, if there is   just too much money there, then nobody makes any  money. Obviously, conversely, if an industry is  

extremely hated, there is no money flowing in,  then by definition, the marginal return needed   to attract investors to go in will be higher, and  there is obviously a lot less competition. Then   the cycle becomes the money flows into the hated  industry, it makes outsized profits. Over time,   that attracts more investors into the sector, and  then the new entrants compete away the profits,   until eventually a lot of the weaker guys  cannot make a profit, and they have to leave.   Then you go back, the cycle starts again and the  survivors do well. There are all these signs now   coming together for things like oil and gas, gold  and mine, as you mentioned. Copper is another one   we have talked about. Maybe this is something  we can dig into a little bit more, because  

when you talk to people about investing in  commodities, people typically wonder, should   we try to do it directly? Should I just invest  by ETF with just a commodity fund, or should I   be looking at just buying ETF in the sectors or  should we be looking to pick stocks, and so forth?   At least for me, the key is actually to emphasize  stock selection within commodity producers.   Typically, commodities as a sector has not  lend itself well to just buy and hold, long the   commodity itself, just because of these boom-bust  cycles that happen. Because of the fact that the   volatility tends to be very much to the upside,  you actually need an actively managed strategy   to be able to capitalize. Basically, when it  is on the way up, you either need to rebalance,   or sell and then rotate to maintain.  Obviously, we have done that. It is showing,  

if you have a rebalancing long commodity strategy  over time, it obviously significantly outperforms   just a buy and hold, just if you just go off  commodity futures contract. There needs to   be an element of actively managing the cycle  to really make the most of it. In many ways,   it is going to be hard for investors to do  that themselves, so you want to probably   outsource it to actively managed fund manager,  or actually buying the equities of companies   if those companies are well managed is almost  another way to outsource the active management.  

Then it is up to the commodity producers  to be able to manage that expense as well,   and as prices go up, to try and monetize  or generate cash flow. I think for us,   there was this underlying understanding that in a  boom-bust cycle, active management is important,   and you cannot just sit in the cycle for the  whole period, picking which parts of the industry   and picking the stocks really becomes very  important. SIMON WHITE: Well, that is a really,   actually critical point. It is another point we  have touched upon in our presentation, is that   in this new regime that we are talking about,  the whole investment world is almost going to be   turned upside down. All the things that people  took for granted in the last 20 or 30 years   are probably going to be turned on our heads to  some extent. People have just got used to the fact  

that stocks and bonds are negatively correlated  but you look historically that when real rates   tend to rise, we play the place bets over higher  inflation environments anyway. The stock-bond   correlation tends to rise. If you look at like  the three-year rolling stock-bond correlation,   it is gradually moving higher. That basically  puts a huge amount of investment strategies at   risk. Essentially, there are two things here.  First of all, you got no real assets exposure,   you got two financial assets, stocks and bonds,  and they are not negatively correlated so they are   not giving you any diversification benefits,  they are, in fact reinforcing one another.   That mindset has fundamentally changed. I  think people are already-- if you look at gold,  

where gold is today, it feels like where gold is  today is where other real assets and commodities   might be in a year, two years, three years' time,  because a lot of people who would not touch gold   even a few years ago are now dipping into it.  A lot of people who are very serious investors   are now beginning to feel that the environment  is changing, and inflation risks are rising.   In that environment, in some ways, the purest  inflation hedge, and the most obvious one is   gold. You are seeing a lot people that  never would have been involved in gold   are involved with gold. The problem with that, of  course, is that when you have lots of people in a   relatively small market, it means gold is now  suddenly trading sometimes like a risk asset,   because market goes down, people still  maybe-- because it is a very liquid thing,   they get rid of their gold so gold goes  down with it. That should put people off  

when it comes to gold, but I think it does mean  that the environment for real assets, in general,   if they are right that people are starting to  have to allocate to more real assets will make   their investment more difficult, which ties back  to your point this is not something that you can   necessarily just buy and hold. We used our capital  returns framework to basically come up with   industries that we see as the most capital scarce.  A lot of these industries are commodity-based,   and a lot of them are actually oil and  gas sectors, so looking at the oil and gas   sector much more closely. Obviously, everyone  knows about the shale boom and bust that we have  

had. Obviously, there is a lot of geopolitical  implications, as well as implications for   investors, but why do you think now is a good  time for people to be looking at oil and gas,   not just from a macro perspective, but looking at  the industry a bit more closely? TIAN YANG: It is   about the lack of access to capital for the sector  that is forcing noticeable changes in behavior.   In the original 2014 bust, even though obviously  share prices initially crashed, oil prices   initially crashed, a lot of companies were able to  survive, raise more financing, and actually keep   drilling, keep trying to grow production. That is  what is really different this time around. On the   back of this crash, access to capital is really  drying up. If you just look at transcripts of   what companies are saying, if you look at just  surveys of CEOs and all these EMP companies,   there is a lot more emphasis now on balance sheet,  on reducing debt, on trying to raise financing,   and simply moving towards maintaining production,  and actually thinking about cash flows.   That is something that has really been a big shift  this time around, which actually should naturally   restrain the actual supply response, even as oil  prices go up this time. As we talked about before,  

to get these major sustained periods of  demand/supply mismatches, you really need to   have supply not be very responsive. Six years  since the bust, what we have seen is obviously   major cuts to CapEx everywhere within the  sector. Research budgets are obviously down,   and now, the lack of access to capital means that  there will not be as much of a supply response as   the economy normalizes. In terms of demand for  oil, yes, obviously, 10 years, 20 years out,   clearly, the world is moving away. In terms of  just this year, next year, these transitions   take time. The demand for oil can still get  back up to roughly where it was pre-COVID.   Obviously, once the virus is more contained, or  there is a vaccine or there is herd immunity,   people still are going to go on holiday in the  future. It is not unreasonable to think that  

demand for energy is going up, yes, the mix  towards renewables will change, but even for   the oil and gas fossil fuel bits, it still has  a reason to exist, and there is still definitely   going to be room in it for another last cycle up.  The key here is that the supply response has been   real in the sector, and it is going to be limited  on the way out, and especially now that you   are going to have this talk about ESG, Green New  Deal, it is going to massively deter new projects,   new CapEx. You got this actually somewhat of a  sweet spot saddle, where there is just not going   to be much of a supply response on the way up at  all compared to usual and that might actually lead   to a more prolonged period of elevated prices  before the next bust cycle comes through.   I would say that that is probably the number one  thing to focus on. Now, having said that, clearly,   it is important to differentiate between the  different parts of the industry and how it works.   Very broadly speaking, you got EMP, so exploration  production guys, who obviously try to drill for   this, look for this in the ground or in the sea,  and try and drill for it, and right through the   pipelines, or the transportation infrastructure  in the middle, right through to the downstream   guys who are doing the refining or doing the  marketing around it. Then you have, obviously,  

the oil or fuel services who are the servicing  equipment providers, so the guys who are providing   the drills, providing equipment, or helping  with production. Those are the various parts.   What is very interesting is actually, oilfield  services, the Schlumberger, Halliburton,   and so forth, they are not actually flagged as  super capital scarce right now, but every other   part of the sector is. Even within the sector,  there is a bit of differentiation. In particular,   what is really being flagged as capital scarce is  more on the EMP and midstream side. Those are the   areas that are truly, truly being left for dead  by investors. Obviously, nobody is interested.   Obviously, we know things like the MLP  structure is basically no longer viable   at prevailing market prices, so that sector has  basically been completely abandoned by investors,   and yet, if you are willing to go do the work,  and look through some of these mystery masses,   you often find you are picking up like a toll road  infrastructure type of asset. In this environment,  

if I will say to you, hey, do you want to buy a  railway? They are trading at very high multiples,   people think of them as critical infrastructure  monopoly and it is not going to be replaced and   they are just collecting their tolls, but they  are valued very highly. Yet, if you go to the   oil and gas space, and you look at the best  pipelines, say from the Gulf of Mexico, that   is absolutely necessary, nobody is going to build  a second one. They are trading at 40% discount of   book values or something like that, even lower.  There is quite a big valuation discount on   quality assets, just because they have the label  of oil and gas on it. These are the things that   actually make it very, very interesting to  dig around. SIMON WHITE: That would be a  

risk that I would bring up because it feels that  certain industries have just been left behind,   as you said, capital starved, because they are  just not ESG compliant. A lot of ESG investing,   it used to be, they try and think about  what is ESG and ticks a lot of boxes, but   some ESG investing, because it is easier, you just  get rid of all sectors that you count as not ESG.   For instance, coal, we discussed coal in  the report as well, probably the least   ESG compliant sector you can think of. Obviously,  that makes it difficult, but what would be your   response to that push back then? People were  saying, hang on a minute, what is the point of   me investing in these industries? Because if no  one else can, then nothing is going to happen.   TIAN YANG: This goes back a little bit to value  investing or what intrinsic value is. Obviously,   a lot of the ESG thing is about whether these  things can rerate or that somebody else to   buy off me at a higher price which is obviously a  critical part of a lot of investment thesis, i.e.  

you need the market to be able to rerate higher  for you to monetize your investment in a lot of   cases. However, if the ESG headwinds are so large,  say in coal, and you get assets that are still   cash flow generative, okay, that can still churn  a lot of cash, just trying to trade at one times   or two times EBITDA. Whether debt is starting to  trade at 60 cents on the dollar, but the debt is   covered by one year of earnings. These are when  you get into extreme extremely cheap valuations,  

where you are like, at some point,  I am not relying on the rerating for   me to get my money back. I am still viewing  businesses, I am viewing shares as businesses,   I still see the cash flow they spit out.  Then all I am going to do is I just need   that cash flow to be made. Then I am being made  whole and everybody everything else is upside.  

Coal is a very interesting one, because obviously,  it is understandable. If people have a value   judgment they want to make, they do not want  to invest in, it is perfectly understandable,   but arguably, that is what is creating the  opportunities in the sector. Globally, coal still   accounts for about 35% of electricity generation.  In a lot of emerging markets, it is 60% to 70%.  

Obviously, in the Western world, US, Europe, it  is more 10% to 15%. Even then, the transition is,   obviously, being sped up, policy will try and  drive the acceleration away. If you just need one   or two years to get your money back, it is looking  very attractive. Obviously, if you go to emerging   markets, there is obviously a much longer runway  for potentially these companies. Because it is so   hated, you look at some of these EM companies,  that return on equity is averaging 30%, 40%,   50% over a cycle, say if 2016 to now is a cycle.  If you just remove the name and show people these   numbers, people definitely want to know, but  obviously, because you stamped that label on,   and it is just gone. These are things where there  is a lot of intrinsic values there that you can  

view as almost, there is a more classic cigar butt  type of investing. There is a decent puff left   in the cigar butt, do you want to invest there or  not? Oil and gas, probably not quite the cigar but   to the same extent, but clearly a similar setup.  If you look at energy share of the S&P, it is a 2%   where they are at all-time lows here. What is very  interesting is that historically, recessions often   mark major changes in market leadership, or trend  reversals. Energy is weighting the S&P. It is   basically seeing quite a big turn after the  last four or five recessions in the US. It is  

obviously a very contrarian setup, but at some  point, the intrinsic value gets so compelling   that it becomes worth looking at. SIMON WHITE:  I think, as you say, there is no such thing as   something being absolutely cheap or expensive. It  is always relative to expectations. That is what   applies to some of these industries we have been  looking at. Another point worth mentioning as well   is that with all this money being thrown at Green  projects now, so you mentioned the EU Green Deal,   that the US, we may have a situation where there  is a lot more money thrown at Green deals there as   well, and that makes it essentially easier for  some of these companies to essentially borrow,   attractive financing to borrow to make their  businesses more environmentally friendly,   be more ESG compliant. That is certainly something  we have begun to see. Certainly, some gold miners   have had access to various forms of green  funding, often business enhanced conditions,   because they are government-backed to make  them more ESG compliant and more Green.  

That is another angle that could obviously  help with some of these commodity companies   in this cycle. TIAN YANG: The talk is obviously  net zero by 2050. That is the more aggressive   targets that people are talking about. Obviously,  in order to hit those, that does not need to be   quite a big shift in the composition of energy  supply, a lot more towards renewables and so   forth. Obviously, the delta versus that to  what is an average expected pace of transition   versus i.e. business as usual, that is still  quite a big delta. It is just more of what   we are seeing, is that would price for very  extreme, probably even more aggressive than that   energy transition path. The reality is that  these things are typically quite messy.  

I think clearly, it is not going to be for  everyone, and arguably just slapping an ESG   label on the oil and gas company will probably not  satisfy a lot of potential investors. At the end   of the day, it is about if you are investing and  you are trying to generate return, and it is your   primary focus, then the valuation can become quite  compelling at some point. Obviously, if you are   driven by more value based approach, then it is  understandable why it might not fit for everyone.   Having said that, obviously, there is only certain  parts of the commodity market that would not be   ESG compliant. There are others like copper, there  are commodities linked to the battery revolution,   lithium, nickel, and some of these other ones,  or the rare earth metals, where, again, there   is going to be a similar dynamic potentially at  play. Obviously, what we found is that copper is  

potentially as an industry, actually quite capital  scarce versus some of the other ones. Obviously,   the sexier you are, the more linked to technology,  the more capital is generally being available.   Copper has been that funny, no mind sign in the  middle, where it is going to be a beneficiary,   but it is probably not seeing as much investor  interest as probably compared to the really   Green technology stuff. I think investors do not  like that something like copper still got a very   nice set up as we mentioned. Again, and even  in countries like China, there is potentially   a China wave behind it, where China consumed half  the world's copper. They only mine about 5%. As we  

go into this arms race in the future about US  versus China, who is going to get there first   in terms of transforming the economy, coming up  with new green technologies, electrification,   that everybody is going to be demanding more  of these commodities. This is like a potential   big arms race that then gets replicated  in urbanization projects across the world.   This could be a very similar big up shift in  demand that persists for decades. As you say,  

if ultimately, government policy starts to  back it and in particular, if governments put   funding available towards research in the area to  really ensure the technology starts being adopted   at a faster rate and more efficiently, then there  is potential for a really big supercycle in some   of these materials like copper that can benefit  from both a capital scarcity inflation point of   view, but also from the green technology point of  view. Simon, I guess, where do you think gold and   silver would fit in that spectrum of benefiting  from inflation versus ESG? SIMON WHITE: Well,   they have their own ESG problems. Obviously, gold  mining, and silver mining, they do environmental   damage, they have problems with their workers in  certain poorer countries. Again, it sounds like  

they are trying to move down the route of becoming  more ESG compliant and getting funding to do so.   Some of the mining companies are more ahead  of the curve like Newmont and other ones,   but everyone gets the message now, and they are  heading in that direction. As we have said, it   is about price versus expectations. As  expectations improve, you are probably still   getting a decent price for a lot of gold miners  right now. We have looked at some gold miners,  

remember the gold mining, it is the old them  Mark Twain quote, a gold mine is just a hole   in the ground with a layer at the top. Often,  it is about trying to avoid the most egregious   gold mining companies. The previous  cycle, we saw a lot of huge overspend,   their margins were very poor. They seem  to have tighten their belt significantly.   They are a lot better run. There has been a  lot of consolidation in the sector as well.   A lot of the companies that are buying now are  better run, better managed, better margins.  

On top of that, like the other sectors we have  been discussing, there has been a huge amount of   capital that has come out the gold mining sector.  The result of annual production peaked about a   year or two ago, and it is basically plateauing  and now, it is starting to come off more steeply,   partly because of obviously the pandemic and  restrictions on production. That certainly   looks like it has peaked. Exploration budgets  have been rock bottom, so there had been no new  

major gold discoveries for two or three years.  There always seems to be rumors of some, but I   have not seen any confirmed lately. It is ticking  on all those boxes and as I say, if you just avoid   the worst ones and what we have done in our work  is try to use a screening methodology to find   what we consider to be the worst gold miners,  focus on the ones that are better quality, and   they should do very well. They are very cheap to  the price of gold and have been for quite a while.   You know you are taking on extra risk to the  gold price, but you also potentially got a lot of   extra return. I think a hundred percent, you  want to have gold, maybe a little bit silver   as part of your real asset allocation. You want to  have things like gold miners, obviously the other  

industry as we have discussed as well. Then I  think as well, what is getting obviously more and   more interesting is things like Bitcoin. Bitcoin  has been outperforming gold lately, the amount   of money into standard Bitcoin assets. You got  this well-known ETF that went from they only had   3 billion of assets back in May, it is now over 6  billion. Obviously, the overall Bitcoin market is   massive now. When you hear like serious investors,  people like Paul Tudor Jones came out earlier this   year, he thinks it is one of the best inflation  hedges out there. On top of that, of course, it is  

not just a hedge, he thinks it is going to be  something that is going to perform extremely well.   Again, you need to be looking at having an  allocation to adding things like Bitcoin to   that as well, because it is something that is  very seriously worth considering. TIAN YANG:   Simon, I think today, we have had a whirlwind tour  through the commodity landscape. We talked about   inflation and fiscal dominance, supply/demand  mismatches, oil and gas, copper, gold, Bitcoin,   coal. Should we try and summarize now  a bit? For our listeners and viewers,   what do you think is the key takeaway from today?  SIMON WHITE: Very succinctly, the best trades are   when you get a number of disparate factors lining  up. They are the most compelling ideas. They do  

not come up that often, but when they do, you got  to seize them with both hands. Today, I would say   you got four different things. You got the macro,  the micro, you got price, you got positioning. You   got the macro, this background of inflationary  environment is going to become very supportive   for inflationary conditions, probably the riskiest  deflation condition since the 1960s. You have the   micro you have some of the most capital starved  industries in the world, are commodity industries.  

You have the price, you have basically real  assets, specifically commodities at 50-year   low to financial assets. You have the positioning.  You have an investment community that is extremely   underweight real assets and when the situation  changes and the realization of the risks have   changed, this is going to ultimately create a bit  of a stampede towards reallocating more towards   real assets and things like commodities.  As they say, when you have all the things   lining up like that, it becomes an extremely  compelling idea and one that difficult to   avoid. TIAN YANG: Great. That is  a wonderful summary. Thank you,   Simon. SIMON WHITE: Thank you. NICK CORREA: I hope  you enjoyed this special episode of the Interview,   the premier business and finance series in  the world. However, this is just the tip of  

the iceberg. For more in-depth content and  expert analysis, visit the membership link   in the description to unlock a week’s access for  only one dollar. This dollar can change your life.

2021-01-18 01:27

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