Inflationary Pressure & The Incoming Commodity Supercycle (w/ Simon White and Tian Yang)
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 realvision.com and see the 20 or so videos a week that we produce
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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
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