The Contrarian Quartet (Part II)

“You never bet on the end of the world, that only happens once, and the odds of something that happens once in an eternity are pretty long.” – Art Cashin

“A thing long expected takes the form of the unexpected when at last it comes.” – Mark Twain

This week’s piece is a follow up to last week’s Contrarian Quartet (Part I). We outline the remaining two out of the four opportunities where we find the risk-to-return profile in being contrarian is far more attractive than in following the herd.

Rather fortuitously we decided to delay writing about Italy, the first of the two opportunities we discuss below, to this week as the deterioration in sentiment towards the sustainability of the European Union has accelerated.

Italy

“In investing, what is comfortable is rarely profitable.” – Robert Arnott, chairman and chief executive officer of Research Affiliates

As recently as three weeks ago, investors were disregarding the risks of political turmoil in Italy and lifting the Italian stock market higher. From the start of the year to market close on 7 May, 2018, the FTSE MIB Index generated a total return of 12.2 per cent in US dollar terms versus a measly return of 41 basis points for the MSCI All Cap World Index. Starting 8 May Italian outperformance started to unwind and the year-to-date return for the market, based on live prices as at the time of writing, is now negative. As the cliché goes, stocks take an escalator up and an elevator down.

FTSE MIB IndexFTSE MIB.pngSource: Bloomberg

Investors were first spooked by the two leading populist parties in Italy – the Five Star Movement and the League – moving to form a coalition to run the country. And then by President Sergio Mattarella’s decision to block the formation of a eurosceptic government and selecting Carlo Cottarelli, an International Monetary Fund alumnus, as prime minister-designate, to try to form a new government.

The selection of Mr Cottarelli, who has consistently defended Italy’s membership in the euro and became known as “Mr Scissors” for making cuts to public spending in Italy during Enrico Letta’s brief period as prime minister, has antagonised the populist coalition.  The populists see the selection as a deliberate attempt by President Mattarella to undermine the Italian people’s will as expressed by them in the recent election. Moreover, choosing Mr Cottarelli flies in the face of the coalition’s desire to put eurosceptics in key cabinet positions – as they tried to do by choosing Paolo Savona, the 81-year-old Eurosceptic economist, as their economy minister.

Given the antagonist nature of the President’s selection, Mr Cottarelli is highly unlikely to win a vote of confidence in parliament. Italy, in all likelihood, will have to hold a new set of elections in the autumn. And the next election has inextricably become about Italy’s membership in the euro. The worry is that the populists will use the bitterness from President Mattarella’s actions to rally their voters and emerge even stronger after the new elections.

Investors have been selling-off all things Italy in apprehension. Most drastically, the yield spreads between Italian and German government debt has blown out.

Italian vs. German 10 Year Government Bond Yield SpreadYield SpreadSource: Bloomberg

This is not the reaction President Mattarella was expecting, we suspect.

While we acknowledge that political risk in Europe is back in vogue, we consider the probability of an Italian exit to be low and with the caveat that Señor Draghi keeps the monetary spigots up and running we see even less risk of financial contagion spreading through Europe.

Consider the state of Italian sovereign debt today versus that at the height of the Euro Crisis. Foreign-ownership of Italian sovereign debt is down from 41 per cent in 2010 to 32 per cent today, with non-European investors holding a paltry 5 per cent. At the same time, Italy’s debt servicing costs as a percentage of GDP are at their lowest level since the euro was instituted – this of course is largely down to the ECB’s benevolence.

The Italian economy has been humming along quite nicely with first quarter GDP year-over-year growth of 1.4 per cent. Italy is also running a primary fiscal surplus and the fiscal deficit for 2017 was just 2.3 per cent of GDP and is likely to fall below 2.0 per cent in 2018.

The possibility of a fiscal blow-out due to extortionate spending by the populist coalition, if it is elected in the next elections, is also highly improbable. Since 2012, the Italian constitution mandates the balanced budget law and the president has the power to veto any decision that is not in adherence with this law. We are almost certain that a Europhile like President Mattarella will not hesitate in exercising the veto should the need arise.

Lastly, there are clear ideological differences between the two coalition parties and it is likely that such differences will be severely tested in the run up to the elections and, if they are elected, by the highly bureaucratic legislative system in Italy.  We suspect that the differing ideologies will impair the populist coalition’s ability to implement policies, which in turn will severely test its survival.

For these reasons we consider the drastic widening of the yield spread in Italian debt relative to German debt to be somewhat unwarranted. Despite this and given where absolute yields are in Europe, we do not think investors should have any sovereign or corporate bond exposure in Europe.

We also think it might still be a bit early to add broad based exposure to Italian stocks. Although selectively we are starting to see opportunities in high quality Italian companies, which we will be monitoring closely for potential entry points.

Where we see the greatest opportunity is to go long the euro relative to the US dollar. We think the current sell-off in the euro is sowing the seeds for the next down leg in the US dollar. The political uncertainty has facilitated the unwinding of bullish euro and bearish US dollar positioning. We suspect positioning will quickly become, if it has not already, very bearish in the euro and bullish in the US dollar. Overly bearish positioning is in our minds a necessary condition for the euro to re-assert its bullish trend.


US Long Dated Treasuries

GS US Financial Conditions Index versus US 30 Year Treasury YieldsGS US FCI vs 30YSource: Bloomberg

In The Convergence of US and Chinese Bond Markets we wrote:

“The shifting secular trend does not, however, warrant shorting US treasuries. The last secular US bond bear market lasted thirty-five years and can be sub-divided into thirteen parts: seven major price declines and six bear market rallies. Moreover, even though short-term interest rates bottomed around 1941, long-term bond yields continued to decline till 1946. We would not be overly surprised if a similar dynamic played out once again, with short-term rates bottoming in 2015 and long-term bond yields bottoming several years after.”

While we remain secular bears on US government bonds, we think long dated US treasuries currently offer a tactical opportunity on the long-side. US financial conditions have started to tighten after the easing induced by the enactment of the Trump tax plan – for instance US companies pre-funded their pension schemes to benefit from the higher tax rate in 2017 and contributed to the easing in financial conditions – is beginning to wear off and the reality of higher rates and higher oil prices squeezes system-wide liquidity. As demonstrated in the above chart, as financial conditions tighten, long-term bond yields tend to decline shortly after. Add to this the near record levels of short positioning in long-dated treasuries by non-commercials and you have a recipe for sharp rally in long-dated US treasuries.

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein   

The Contrarian Quartet (Part I)

“If all the economists were laid end to end, they’d never reach a conclusion.” – George Bernard Shaw

“Twenty years from now you will be more disappointed by the things that you didn’t do than by the ones you did do.” – Mark Twain

 “Studies have shown that most rational people, including people that fit that profile, that their decision making breaks down in an environment of negative reinforcement. The ultimate example of which would be interrogation, where your ability to withhold information is broken down by various physical or mental techniques.” – Jim Chanos

 

  

Is there any population cohort exposed to a more rigid daily routine than school going children and teenagers?

The constant ringing of bells, schedule of classes, lunchtime, homework, each a daily fixture throughout the academic year. It is no wonder then that most people tend to be conformists – the rigidness of school stamps out individualism in favour of conformity.

The irony of it all is that we celebrate the individuals who have managed to resist the rigidness and maintain their non-conformist streaks. Our heroes are Steve Jobs not Jeffrey Immelt, Muhammad Ali not Floyd Mayweather, The Beatles not Coldplay.

Capital markets too have on occasion handsomely rewarded the contrarians, like Dr Michael Bury during the Global Financial Crisis, Paul Tudor Jones in 1987, and Jesse Livermore in 1929. Markets do not, however, look kindly upon the reflexive contrarian – the investor that cannot help but go against the trend. Markets can be conformists for extended periods of time and hence why momentum following strategies can be so rewarding.

We like to consider ourselves independent investors – investors that scour the market for signals that may provide us with opportunities to generate outsized returns. Our aim is neither to be contrarian nor momentum driven. Today, however, we see four areas of the market where the risk-to-return profile in being contrarian is far more attractive than in following the herd. We outline two out of the four areas of opportunity below and will outline the remaining contrarian opportunities in a follow-up next week.

Turkey

“Bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria.” – Sir John Templeton

  

In Turkey today we see many reminisces of what occurred in Brazil in 2015, with the caveat that with Turkey embroiled in a geopolitical storm as compared to the internal political strife in Brazil in 2015 makes Turkey potentially far more volatile.

Consider Brazil at the height of its crisis in 2015:

  • The premium on Brazil’s three-year credit default swaps surged by 189 per cent over a period of four and half months
  • The Brazilian real declined by 43 per cent versus the US dollar in a period of four and half months
  • Using the twenty-five year average, Brazil’s real effective exchange rate was one standard deviation below its average

Brazil Real Effective Exchange Rate (25 Years)Brazil REER 25Y

Source: Bank for International Settlements

  • Using the five year average, Brazil’s real effective exchange rate was two standard deviations below its average. As the political turmoil subsided and the real effective exchange rate reverted towards the mean, the Brazilian equity market rallied and foreign investors enjoyed the leveraged effect of a rising equity market coupled with the strengthening real

Brazil Real Effective Exchange Rate (5 Years) vs. MSCI Brazil IndexBrazil REER 5YSources: Bank for International Settlements, Bloomberg

  • Brazil’s rating was downgraded from Baa2 to Baa3 by Moody’s and from BBB-minus to BB-plus by Standard & Poor’s

Now consider Turkey in 2018:

  • The premium on Turkey’s three-year credit default swaps has increased by 152 per cent in less than three months
  • The Turkish Lira has declined by 26 per cent versus the US dollar in a period of less than three months
  • Using the twenty-five year average, Turkey’s real effective exchange rate is almost one standard deviation below its average

Turkey Real Effective Exchange Rate (25 Years)Turkey REER 25Y

Source: Bank for International Settlements

  • Using the five year average, Turkey’s real effective exchange rate is two standard deviations below its average

 

Brazil Real Effective Exchange Rate (5 Years) Turkey REER 5Y Sources: Bank for International Settlements, Bloomberg

 

  • Turkey’s rating has been downgraded from Ba1 to Ba2 by Moody’s and from BB to BB-minus by Standard & Poor’s

The bad news is that Turkey runs a current account deficit of around US dollar 40 billion a year and has external debt stock of approximately US dollar 450 billion. The net amount of outstanding external debt is around US dollars 290 billion, representing 34 per cent of its GDP.

The good news is that the vast majority of Turkey’s foreign currency denominated debt is held by local banks. We do not expect Turkey to default on the debt it owes to foreign investors. This view is founded on the assumption that while President Recep Tayyip Erdoğan can afford to antagonise the US and Europe on the political front given Turkey’s geopolitical significance, he cannot afford to antagonise foreign investors as Turkey relies on international capital markets to fund its economy.

We think the time is coming to scale into Turkish assets. The sequence of scaling in being the Turkish lira first, foreign currency bonds second, local currency bonds next and the equity market last.


Swiss Franc

“You can’t do the same things others do and expect to outperform.” – The Most Important Thing by Howard Marks

Hedge funds and speculators are holding the biggest net short Swiss franc position in more than ten years at a time when the Swiss franc is close to being undervalued relative to the US dollar – a first since the start of the new millennium.

CFTC CME Swiss Franc Net Non-Commercial PositionCHF CFTC

Source: Bloomberg

Over the last decade, Switzerland has run an average current account surplus of 9.3 per cent of GDP. The Swiss franc should not be undervalued. If anything, given that Switzerland has consistently run current account surpluses and enjoys the so called global safe haven status, the Swiss franc should be overvalued.  We all know the reason why the currency is not overvalued: the non-stop printing and selling of its currency by the Swiss National Bank.

At the end of last year, the State Secretariat for Economic Affairs revised its economic growth forecasts for Switzerland upwards, forecasting GDP to grow by 2.3 per cent in 2018 after growth of 1 per cent in 2017. The revision was driven by industrial orders rising by a fifth in the fourth quarter last year and a booming tourism industry that is benefiting from the artificial suppression of the Swiss franc.

In the face of such strong economic growth we doubt that the Swiss National Bank can sustain the suppression of its currency. We suspect the Swiss National Bank, not for the first time, is going to cause a lot of pain to those unwisely betting against its currency.

We will gradually look to get long the Swiss franc once we see the broader short interest against the US dollar unwinding – we expect such an opportunity to be presented imminently.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein  

AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market

“The icon of modern conservatism, Ronald Reagan, imposed quotas on imported steel, protected Harley-Davidson from Japanese competition, restrained import of semiconductors and automobiles, and took myriad similar steps to keep American industry strong. How does allowing China to constantly rig trade in its favour advance the core conservative goal of making markets more efficient? Markets do not run better when manufacturing shifts to China largely because of the actions of its government.” – Robert E. Lighthizer

“Patience is essential. We should step back, take a deep breath and examine carefully the ties that bind us together.” Maurice “Hank” Greenberg, former CEO of American International Group, at the congressional hearing on US-China economic ties in May 1996

American International Group (AIG), the once venerable multinational insurance group, was founded in 1919 in Shanghai, where it prospered until the communists forced it to leave in 1950. AIG had to wait over four decades to re-enter the Chinese market. In 1992, AIG became the first foreign insurance company licensed to operate in China and established its first office on the Mainland in Shanghai.

We doubt it was sentiment that led China to grant AIG the license. After all, there is little room for sentiment in the high-stakes game of global trade.

In 1990, Maurice “Hank” Greenberg, then chief executive of AIG, had been appointed as the first chairman of the International Business Leaders’ Advisory Council for the Mayor of Shanghai. In 1994, Mr Greenberg was appointed as senior economic advisor to the Beijing Municipal Government. In 1996, at the time when China’s status as Most Favoured Nation (MFN)[1] was under threat due to a resolution put forth to the House of Representatives in the US, he was appointed as the Chairman of the US-China Business Council.

While all of above mentioned appointments may have raised an eyebrow or two, they do not amount to much in and of themselves. When we throw in the fact that Mr Greenberg had been part of the President’s Advisory Committee for Trade Policy and Negotiations since the 1970s – the official private-sector advisory committee to the Office of the US Trade Representative – we begin to realise the possible reason why the Chinese leadership took a liking to Mr Greenberg and afforded his company the luxury of becoming the first foreign insurer to operate in China.

In May 1996, Mr Greenberg, during a key congressional hearing on US-Sino economic ties, testified in favour of not only renewing China’s MFN status but also making it permanent.

There we have it: quid pro quo.

In June 1996, the House of Representatives endorsed China’s MFN status by a vote of 286 to 141. At the time of vote AIG had eleven lobbyists representing its interests in Washington. One of those lobbyists was Skadden, Arps, Slate, Meagher & Flom, where AIG’s affairs were handled by one Robert E. Lighthizer – the current United States Trade Representative.


Senior American and Chinese officials concluded two days of negotiations on trade and technology related grievances the Trump Administration has with China. As many may have suspected, the talks appear to have achieved little despite the US sending a team comprised of top-level officials including Treasury Secretary Steven Mnuchin, Trade Representative Robert Lighthizer, White House trade advisor Peter Navarro, Secretary of Commerce Wilbur Ross, and National Economic Advisor Larry Kudlow.

As part of the talks the US representatives have submitted an extensive list of trade and technology related demands. In our opinion, the demands represent a hodgepodge of objectives as opposed to one or two key strategic objectives the Trump Administration may have – symptomatic of the differing views held by the various members of the US team. We expect US Trade Representative Robert E. Lighthizer to slowly take control of proceedings and to set the agenda for US-China trade relations – after all he is the only senior member of the team with meaningful experience in negotiating bilateral international agreements.

Mr Lighthizer’s primary objectives with respect to US-Sino trade relations are (1) for China to open up its economy – by removing tariffs and ownership limits – for the benefit of Corporate America and (2) to put an end to Chinese practices that erode the competitive advantages enjoyed by US corporations – practices such as forcing technology transfer as a condition for market access.

Mr Lighthizer’s goals are ambitious. They will require time and patience from everyone – including President Trump, Chinese officials, US allies, and investors. For that, he will need to focus Mr Trump’s attention on China. He will not want the President continuing his thus far ad hoc approach to US trade policy. If NAFTA and other trade deals under negotiations with allies such as South Korea are dealt with swiftly, we would take that as a clear signal that Mr Lighthizer is in control of driving US trade policy.


Unveiled in 2015, “Made in China 2025” is China’s broad-based industrial strategy for it to become a leader in the field of advanced manufacturing. The strategy calls for directed government subsidies, heavy investments in research and innovation, and targets for local manufacturing content.

To date, China’s industrial base is dominated by manufacturing of basic consumer products such as clothing, shoes and consumer electronics. The overwhelming majority of technologically advanced exports out of China have been made by multinational companies. The Made in China 2025 strategy identifies ten key areas – such as robotics, electric and fuel-cell vehicles, aerospace, semiconductors, agricultural machinery and biomedicine – where China aims to become a global leader. And it is these very industries that Mr Lighthizer aims to attack for the benefit of Corporate America.

One area where China is clearly at the cutting edge of global research is artificial intelligence. According to research published by the University of Toronto, 23 per cent of the authors of papers presented at the 2017 Advancement of Artificial Intelligence Conference were Chinese, compared to just 10 per cent in 2012. And we suspect, especially given the Chinese leadership’s dystopian leanings, China is going to be unwilling to relent on its progress in artificial intelligence regardless of the amount of pressure the Trump Administration applies.

Artificial intelligence requires immense amounts of computing power. Computers are powered by semiconductors. China cannot risk its AI ambitions by being hostage to semiconductor companies that fall under the US sphere of influence. China, we believe, will pull out all the stops over the next decade to develop its local semiconductor industry manufacturing capabilities with an aim to end its reliance on US-based manufacturers by 2030.

Investment Perspective

Investors often talk about the one dominant factor that drives a stock. While we consider capital markets to be more nuanced than that, if semiconductor stocks have a dominant factor it surely has to be supply – it certainly is not trailing price-to-earnings multiples as semiconductor stocks, such as Micron, have been known to crash when trading at very low trailing multiples. Chinese supply in semiconductors is coming.

While we expect the bull market in tech stocks to re-establish itself sometime this year, if there was one area we would avoid it would be semiconductors.

[1] From Wikipedia: MFN is a status or level of treatment accorded by one state to another in international trade. The term means the country which is the recipient of this treatment must nominally receive equal trade advantages as the “most favoured nation” by the country granting such treatment. (Trade advantages include low tariffs or high import quotas.) In effect, a country that has been accorded MFN status may not be treated less advantageously than any other country with MFN status by the promising country. There is a debate in legal circles whether MFN clauses in bilateral investment treaties include only substantive rules or also procedural protections.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein

Oil: Opportunities Arising from Infrastructure Bottlenecks

“Allow yourself to stand back to see the obvious before stepping forward to look beyond” – Adrian McGinn

“The fact is, America needs energy and new energy infrastructure, and the Keystone XL pipeline will help us achieve that with good stewardship.” – John Henry Hoeven III, is an American politician serving as the senior United States Senator from North Dakota

“Is it in our national interest to overheat the planet? That’s the question Obama faces in deciding whether to approve Keystone XL, a 2,000-mile-long pipeline that will bring 500,000 barrels of tar-sand oil from Canada to oil refineries on the Gulf of Mexico.” – Jeff Goodell, American author and contributing editor to Rolling Stone magazine

“When a measure becomes a target, it ceases to be a good measure” – Goodhart’s Law

A concept that frequently occurs in the study of thermodynamics – the branch of physics concerned with heat and temperature and their relation to other forms of energy – is that of irreversible processes.  An irreversible process is a process once initiated cannot return the system, within which it occurs, or its surroundings back to their original state without the expenditure of additional energy. For example, a car driven uphill does not give back the gasoline it burnt going uphill as it comes back down the hill. There are many factors that make processes irreversible – friction being the most common.

In the world of commerce when a supply- or demand-side shock occurs in a particular industry, it sets into motion a series of irreversible processes that have far reaching consequences not only within the industry which the shock occurs but for adjacent and related industries as well. The commodity complex, more so than most other industries, is typified by regular occurrences of supply- and demand-side shocks.

When a positive demand- or supply-side shock occurs for a certain commodity, the immediate impact is felt in the price of said commodity. As the price of said commodity re-rates, the net present values and prospective returns from investing in new production capacities for the commodity obviously improve. Once return prospects start to cross certain arbitrary thresholds – be it cost of capital, target internal rate of return, or a positive net present value – the investment case for the new production capacities strengthens. In response to the strengthening investment case a new capital formation cycle starts to take root and the amount of capital employed within the industry begins to increase, in turn impacting both supply-side dynamics within the industry and the demand-side dynamics within other supporting industries.

Conversely, when a negative demand- or supply-side shock occurs for a commodity, existing producers of the capacity start to feel the pain and suffer from declining earnings as the commodity’s price de-rates.  A sharp enough decline in the commodity’s price can lead to marginal producers selling at prices well below their cash cost i.e. cost of production excluding depreciation and amortisation. At this point the capital employed within the industry begins to decline – this can occur in a number of ways including shuttering of supply, bankruptcies, suppliers changing payment terms, or lenders recalling or withholding loans.

The capital cycle set in motion by either demand- or supply-side shocks are difficult to reverse. Once capital starts entering an industry, it continues to flow in until the vast majority of the planned capacity additions are delivered, even if the pricing assumptions that underpinned the original decision making have changed for the worse. The continued flow of capital despite the adverse change in return expectations is due to what Daniel Kahneman and Amos Tversky call the ‘The Sunk Cost Fallacy’. The sunk cost fallacy is a mistake in reasoning in which decision making is tainted by the investment of capital, effort, or time that has already been made as opposed to being based upon the prospective costs and benefits. It usually takes a shock of epic proportions to alter such a behavioural bias, such as oil falling below US dollar thirty per barrel in 2016 forced OPEC to switch from a strategy of market share maximisation to that of production rationalisation.

In the scenario where capital starts fleeing from an industry even though the sunk cost fallacy may not necessarily drive decision making – unless of course the decision makers have emotionally invested themselves in the negative prospects for the industry – reversing the tide of capital outflows can still be extremely difficult even in the face of improving prospects. This is partly explained by the lingering remnants of the emotional, psychological, or financial trauma that decision makers may have suffered through when the industry went through the negative shock. It often takes a sustained recovery either in terms of length of time or magnitude of price for the trauma to give way to rational decision making.

The turns at which behaviour begins to adjust towards more rational decision making often provide the most profitable trading opportunities.

Investment Perspective

Investing in commodities or equities of commodity producers is not for the fainthearted. Even the most sound investment thesis can be derailed by any number of factors, be it geopolitics, innovation, tax or subsidy reform, cartel-like behaviour, or simply futures markets positioning. Particularly in times of high levels of uncertainty, extreme investor positioning either long or short, or after a sustained move higher or lower in the price of the commodity, investors can be exposed to very high levels of risk. It is at such times that investing in companies that form part of the commodity’s supply chain can be a superior expression of one’s view as opposed to taking a direct exposure in the commodity or its producers.

We think that given the sustained move higher in oil, that has clearly wrong footed many, extreme positioning on the long side in futures markets and impressive revival in US shale oil production, one may be able to better express a medium-term bullish view on oil prices by investing in companies that service the oil and gas industry. Specifically, we consider, at this stage, being long equities of companies with products and services targeted towards oil and gas pipeline infrastructure to represent a more balanced risk-reward trade than simply being long oil or a generic energy ETF.

Brent Crude Oil and WTI Midland Price SpreadBrent WTI Midland Spread.pngSource: Bloomberg

To quote Bloomberg from its article Crude in West Texas Is Cheapest in Three Years Versus Europe:

Oil traders with access to pipelines out of West Texas to export terminals along the Gulf Coast are raking it in from the rapid supply growth in the Permian Basin. The 800,000 barrel-a-day output surge in the past year has outpaced pipeline construction and filled existing lines, pushing prices of the region’s crude to almost $13 a barrel below international benchmark Brent crude, the biggest discount in three years. That’s about double the cost to ship the oil via pipeline and tanker from Texas to Europe, signaling U.S. exports are likely to increase.

The infrastructure bottlenecks pushing down WTI Midland prices relative to Brent Crude prices are the direct consequence of underinvestment in pipeline infrastructure. This underinvestment is the result of either (1) the expectation that oil prices would remain lower for longer or (2) that shale production would not recover even if oil prices recovered. We think the reason is more likely to the former as opposed to the latter.

Oil prices have recovered both in terms of the magnitude and the duration of the recovery to such a degree that investors and decision makers are beginning to overcome the trauma caused by the sharp decline in oil prices between 2014 and 2016. And only now are they starting to invest in pipelines and other oil and gas infrastructure to benefit from the recovery in both oil prices and shale production.  Just as there was inertia in the change in investor attitudes towards oil and oil related investments, there is likely to be inertia – should there be a significant decline in oil prices from current levels – in stopping projects that have started and gone through the first or second rounds of investment.

Companies that manufacture components such as valves, flow management equipment, and industrial grade pumps, that are essential in the development of oil and gas pipeline infrastructure, we think, will be the primary beneficiaries of the recovery in oil and gas infrastructure investment. We also think companies specialising in providing engineering, procurement, construction, and maintenance services for the oil and gas services are also likely to benefit.

We are long Flowserve Corporation $FLS, SPX Flow $FLOW and Fluor Corporation $FLR.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.