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Olson’s Paradox and the Successful Collusion Amongst Oil Exporters

“What most of these doomsday scenarios have gotten wrong is the fundamental idea of economics: people respond to incentives. If the price of a good goes up, people demand less of it, the companies that make it figure out how to make more of it, and everyone tries to figure out how to produce substitutes for it. Add to that the march of technological innovation (like the green revolution, birth control, etc.). The end result: markets figure out how to deal with problems of supply and demand.” – Steven D. Levitt

“The only thing about sanctions is that, like a lot of drone strikes, there are countless unintended victims.” – Henry Rollins, American musician

“The English language has 112 words for deception, according to one count, each with a different shade of meaning: collusion, fakery, malingering, self-deception, confabulation, prevarication, exaggeration, denial.” – Robin Marantz Henig, contributing author to the New York Times

Mancur Olson in his seminal book The Logic of Collective Action: Public Goods and the Theory of Groups challenged the prevailing wisdom during his time and developed a theory of collective action, commonly referred to as Olson’s Paradox, to explain why the existence of a common interest among a group of people is not sufficient to induce cooperative behaviour amongst the members of the group.

Olson argued that “unless the number of individuals in a group is quite small, or unless there is coercion or some other special device to make individuals act in their common interest, rational, self-interested individuals will not act to achieve their common or group interests.” In a scenario where a change is being proposed and there are two rival groups contesting said change, and the number of members in one group vastly outnumbers those in the other group, the theory poses that the smaller group will have an organising advantage over the larger group and is thus far more likely to achieve a winning outcome.

Oil importing nations greatly outnumber oil exporting nations. And it almost goes without saying that rising oil prices richly benefit oil exporting nations while the gains of declining oil prices are more modestly divided amongst the oil importing nations. Oil exporters then have both (i) a greater incentive to push up the price of oil than do oil importers to push it down and (ii) an organising advantage. It is this combination of incentive and advantage that enabled OPEC and Russia et alia (NOPEC) to implement and maintain joint production cuts that stabilised and eventually propelled oil prices higher.

Oil prices have ripped higher this week, the price of Brent Crude has pushed through the US dollars 80 per barrel mark – a level previously unreached since the collapse in oil prices in late 2014; the level may have remained unreachable had it not been for the Trump Administration’s reinstatement of economic sanctions on the Islamic Republic of Iran in May this year.

The catalyst for this week’s push higher is seen to be the lack of response coming from the OPEC-NOPEC alliance to President Trump’s protestations for an increase in production to cool prices. Mr Trump, it seems, is asking for his vig as the bully who ejected Iranian oil from global markets.

Even though OPEC did indicate that it has the necessary capacity to replace Iranian supplies markets remain concerned about a supply deficit next year, especially with infrastructure bottlenecks limiting supply from shale.

The International Energy Agency (IEA) estimates oil demand growth to average 1.5 million barrels per day in 2019. Assuming that the moderate pace of global economic growth anticipated for 2019 is not derailed by the on-going trade conflict between China and the US, realised demand levels should not differ significantly from the estimate.

The supply side is where the challenge, we think, lies.

In the absence of renewed sanctions on Iran, the supply-demand dynamics would have remained evenly balanced. Shale production has continued to exceed expectations; US production has reached 11 million barrels per day – increasing by 1.6 million barrels per day over the course of the last 12 months. With oil prices as high as they are, shale producers are likely to continue pushing for increased output and US production may well continue to surprise to the upside.

The Trump Administration is likely to prove far less tolerant of importers breaching sanctions than the Obama Administration, which allowed China and other nations to continue exploiting legal loopholes to access Iranian oil

The impact of the Iranian sanctions on the oil supply-demand dynamic will come down to China and whether it chooses to comply with the US-led sanctions or not. We think China, at least in the near term, is far more likely to reduce (or completely halt) oil imports from Iran. Our thinking is led by the fact that the major Chinese oil corporations, such as SINOPEC, are listed on the New York Stock Exchange and have sprawling global operations that can easily be targeted by the US. Given the ZTE experience, the Chinese leadership, we believe, is unlikely to want one more of its national champions to get caught in the Trump Administration’s cross hairs.

If we our correct in our thinking on China, oil markets will end up losing a large chunk of the 1.5 million barrels per day of Iranian output starting November. Add this to curtailed Venezuelan output and the world could find itself in an oil supply deficit anywhere in the range of 2 to 4 million barrels per day in 2019, depending on how shale and OPEC production ramps up following the sanctions.

Investment Perspective

The figure of US dollars 100 per barrel of oil has been bandied in headlines recently. We think the three-figure market is largely symbolic and not one that concerns us much. Nonetheless, given the high likelihood of a supply deficit occurring next year, we expect oil prices to remain high (if not move higher) until we see a meaningful supply response or an unexpected drop in demand.

We have been long the SPDR Energy Select Sector ETF $XLE since late October last year and remain long.

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.

Too Much of a Good Thing

“Why then, can one desire too much of a good thing?” – William Shakespeare, As You Like It Act 4, scene 1

“Water is life’s matter and matrix, mother and medium. There is no life without water.” – Albert Szent-Gyorgyi (1893 – 1986), Hungarian biochemist who won the Nobel Prize in Physiology or Medicine in 1937

“Anyway, no drug, not even alcohol, causes the fundamental ills of society. If we’re looking for the source of our troubles, we shouldn’t test people for drugs, we should test them for stupidity, ignorance, greed and love of power.” – P. J. O’Rourke, American political satirist and journalist

According to the World Health Organisation (WHO), at least 2 billion people globally only have access to drinking water from sources contaminated with faeces. Contaminated water is known to transmit diseases such diarrhoea, cholera, dysentery, typhoid, and polio and is estimated to cause 502 000 diarrhoeal deaths each year.

The WHO estimates that by 2025 half of the world’s population will be living in water-stressed areas – that is, areas where the demand for water exceeds the available amount or when poor quality restricts its use.

Water is essential. There is no life on earth without water. All of us have known this from a very young age.

During our first year at university, we had a friend, let’s call him Zed. Zed was an odd fellow, eccentric even. Even his taste in music could be described as being unusual: Tom Waits and Chuck E. Weiss’ Do You Know What I Idi Amin could regularly be heard playing loudly from his room in the wee hours of the night. One evening, as a group of us gathered together for dinner at our dormitory’s dining hall, Zed joined us a little later and mentioned that he had not had anything to drink all day and that he was incredibly thirsty. Instead of a tray full food like the rest of us, Zed came to the dining table with a tray holding eight glasses of cold water. He needed to drink all the water to quench his thirst he claimed.

After quickly chugging down six of the eight glasses of water, Zed stood up, told us he was not feeling well and left. We did not see Zed for the next day and a half. When we did finally see him, he told us that he had been bed ridden ever since he downed all that water. Having so much water, so quickly had made him sick.

In 2007, David Rogers, a fitness instructor from Milton Keynes, died at the tender age of 22 died during the London Marathon. David did not die from exhaustion, nor did he die as a direct consequence of the sweltering temperatures – which reached their highest level in the event’s, at the time, 27-year history – during the race. No, he died from hyponatraemia, or water intoxication.

Water intoxication occurs when the amount of water in the body is so great that it dilutes vital minerals such as sodium down to dangerous levels. It can lead to confusion, headaches and a fatal swelling of the brain.

David Rogers drank too much water during the race without taking in the commensurate amount of minerals.

Do not let anyone ever tell you that “You can never have too much of a good thing”.

Investment Perspective

When AT&T announced its intention to buy Time Warner in late 2016, Netflix was valued at 18 per cent of the combined stock market value of AT&T and Time Warner.

By the time the courts cleared the way for AT&T to acquire Time Warner in June this year, Netflix’s value stood at a much heftier 60 per cent of the combined market capitalisation of AT&T and Time Warner.

The rationale for AT&T acquiring Time Warner was provided by CEO Stephan Randall at the time the intention to acquire the media company was revealed in late 2016:

Premium content always wins. It has been true on the big screen, the TV screen and now it’s proving true on the mobile screen. We’ll have the world’s best premium content with the networks to deliver it to every screen. A big customer pain point is paying for content once but not being able to access it on any device, anywhere. Our goal is to solve that. We intend to give customers unmatched choice, quality, value and experiences that will define the future of media and communications.

With great content, you can build truly differentiated video services, whether it’s traditional TV, OTT or mobile. Our TV, mobile and broadband distribution and direct customer relationships provide unique insights from which we can offer addressable advertising and better tailor content.

…

It’s an integrated approach and we believe it’s the model that wins over time.

Time Warner’s leadership, creative talent and content are second to none. Combine that with 100 million plus customers who subscribe to our TV, mobile and broadband services – and you have something really special.

…

It’s a great fit, and it creates immediate and long-term value for our shareholders.

What AT&T did not mention, however, is how they intend to treat Time-Warner content on their network post-acquisition. That is, will they give Time-Warner content consumer on AT&T’s network a zero-rating much the way they have done for DirecTV content or not?

According to Wikipedia, zero-rating is the practice of providing Internet access without financial cost under certain conditions, such as by only permitting access to certain websites or by subsidizing the service with advertising.

Simply put, if AT&T gives a zero-rating to all Time Warner content, any of this content consumed by AT&T customers will incur no charge (i.e. it will not count against their allotted data / download quotas).

Also in June this year, Disney received approval from the antitrust courts to acquire 21st Century Fox on the condition that Disney divest Fox’s regional sports networks, as they would create anti-competitive conflicts due to its ownership of ESPN.

Sporting rights aside, the combination of Disney and Fox will create a media behemoth. Disney and Fox’s combined domestic box office intake equalled US dollars 4.5 billion in 2017 – representing approximately 40 per cent market share, a figure no single major studio has ever hit. Even more staggering, however, is that with the acquisition of Fox, Disney will control the rights to two of the biggest back catalogues in entertainment, which includes full ownership of all Marvel Comic characters and the Star Wars, Simpsons, X-Files, Indiana Jones, Pixar, and Alien/Predator franchises.

To complement the huge catalogue of content, Disney plans to launch its proprietary streaming service during the second half of 2019. In preparation for the launch of streaming service, Disney has also announced that it will be pulling all of its content from Netflix in 2019.

Netflix is spending cash hand over fist to produce new content.

The US’s largest telecommunication network may well monetise the huge library of Time Warner content by zero rating it on their network. And just for good measure, it is also spending some of its cash pile on original content creation.

Disney, probably the largest media company in the world after it completes the acquisition of Fox, is likely to put a chunk of its vast amount of content on its proprietary streaming service in 2019.

Let’s not forget that Amazon, Alibaba, and Apple, are all throwing money at original content too.

We may soon reach a stage, if we have not already, where there is just too much content.

The bull and bear cases for and against Netflix are well known and we will not regurgitate them here. We will, however, say that given the tectonic shifts taking place in the online video streaming space, holding Netflix at current valuations does not make sense, to us at least.

Consumer: Long Stuff / Short the Experience Economy

“I think if you give in and accept society’s stereotypes, then you start thinking, ‘I cannot dance till late at night because I’m 70.’” – Yoko Ono

“Through most of human history, our ancestors had children shortly after puberty, just as the members of all nonhuman species do to this day. Whether we like the idea or not, our young ancestors must have been capable of providing for their offspring, defending their families from predators, cooperating with others, and in most other respects functioning fully as adults. If they couldn’t function as adults, their young could not have survived, which would have meant the swift demise of the human race. The fact that we’re still here suggests that most young people are probably far more capable than we think they are. Somewhere along the line, we lost sight of – and buried – the potential of our teens.” – Robert Epstein, American psychologist, professor, author, and journalist

“The theory of Economics must begin with a correct theory of consumption.” – The Theory of Political Economy (1871) by William Stanley Jevons

The human brain is predisposed to stereotyping. Stereotyping serves as a social heuristic that reduces the amount of thinking we have to do as it allows the brain to cluster people into groups with a whole range of expected characteristics and abilities. Scientific studies have gone as far as to show that that the brain responds more strongly to negative stereotypes – something the mainstream media has long understood with programming and messaging tilted towards negativity to exploit the human predisposition.

One population group that has become much maligned by negative stereotyping are the millennials – the generational cohort typically recognised as having birth years between the early eighties and the early 2000s. Stereotypes depict millennials as a generation of entitled, fame obsessed, narcissistic and lazy young adults that continue to live off of their parents with the aim of postponing the rites of passage to adulthood as long as possible.

Millennials also have a reputation for being over-indulgent spenders that do not save for retirement. A recent report issued by Bank of America Merrill Lynch in partnership with Khan Academy, however, discredits some of the widely held stereotypes about millennials, particularly those relating to financial matters. For starters, the report shows that almost half of millennials in the United States have managed to save at least US dollars 15,000, while one out of every six of them have US dollars 100,000 stashed away in a savings account, investments, individual retirement accounts, or pension plans. Millennials’ financially savvy – it appears from the report at least – is on par with or exceeds that of the baby boomers and Gen Xers.

Millenials are even driving home ownership higher in the United States – the cohort make up the largest segment of American home buyers today. Economic recovery is the simplest explanation for why more millennials are buying homes. Millennials started entering the workforce just as the Global Financial Crisis hit. A significant portion of the generation found itself unemployed, underemployed, or underpaid. And only now that the economic and psychological overhang of unemployment and underemployment has worn off meaningfully, has it become possible for the generation to step into home ownership at large.

A second reason is that marriage rates amongst millennials have also risen slightly as they have gotten older and achieved a degree of financially stability. Irrespective of the generation, marriage is widely accepted as being the number one indicator of whether people buy homes or not.

Beyond these obvious reasons we also believe that there is growing disillusionment amongst young adults today when it comes to the gig economy, big tech, and the echo bubbles that exist within Silicon Valley and popular social networks. This change can be seen with Peter Thiel ditching Silicon Valley for Los Angeles, increasing hostility towards Mark Zuckerberg and Facebook, and the gradual exodus of residents from San Francisco.

One cure to disillusionment is to lay down roots. And nothing establishes roots quite like buying a home.

Investment Perspective

Capital markets are not averse from stereotyping either. Markets in recent years have bought into at least one of the millennial stereotypes and put capital to work behind it. One such stereotype being that young adults today prefer experiences over goods. While this may indeed hold true, we believe that a larger change is afoot and that millennials are reaching a stage in their development where priorities will shift away from spending on experiences to accumulating assets and goods.

The rise of social media gave rise to the increasing trend toward experiential consumption. Conspicuous consumption amongst millennials as compared to Baby Boomers and Gen Xers was less about “stuff” and more about experiences. Social media both explicitly and implicitly rewarded the sharing of experiences – users receive positive feedback and increased network engagement from sharing photos, videos, and comments. The positive feedback incentivised users to share more and sharing more required engaging in more experiences – attending more concerts, going to more trips to far off places and trying out more restaurants. While we do not see a wholesale change is this behaviour to take place anytime soon, we do think that the marginal user is decreasing social media engagement, reversing the trend of the last decade of increasing marginal engagement.

Increasing social media disengagement – however small it may be – also means that the marginal dollar of conspicuous consumption will no longer be going toward experiences, it will be going elsewhere.

Millennials are stepping into homeownership and the wave of home buying is only getting started. With increasing homeownership comes increasing consumption, new homeowners have to fill up their houses with everything from furniture to lawnmowers. The marginal dollar of conspicuous consumption will be spent on stuff. For the homeowners this will be household goods. For the non-homeowners this will be on clothes, shoes, sports equipment, and health and beauty products.

In our recent trade ideas we added a long in Lululemon Athletica ($LULU). The idea was based on our thesis of increasing consumption of stuff. We consider the likes of Nike ($NKE), Ralph Lauren ($RL) and Under Armour ($UAA) as names that we see as beneficiaries of increasing conspicuous consumption by millennials both in the United States and overseas.

On the other hand, we consider restaurants and other experiential economy companies to be prime candidates to short. We certainly would avoid stocks of companies such as McDonald’s ($MCD), Starbucks ($SBUX), Darden Restaurants ($DRI) and cruise ship operators such as Carnival Corp ($CCL) and Royal Caribbean Cruises ($RCL).

We are getting long $UAA and $RL and short $CCL.

The Incumbent’s Challenge

“Washington is an incumbent protection machine. Technology is fundamentally disruptive.” – Eric Schmidt

“I ordered a soda – caffeine-free, low sodium, no artificial flavours. They brought me a glass of water.” – Robert E. Murray, Chief Executive Officer of Murray Energy Corporation, one of the largest independent operators of coal mines in the United States

“Here’s to the crazy ones. The misfits. The rebels. The troublemakers. The round pegs in the square holes. The ones who see things differently. They’re not fond of rules. And they have no respect for the status quo. You can quote them, disagree with them, glorify or vilify them. About the only thing you can’t do is ignore them. Because they change things. They push the human race forward. And while some may see them as the crazy ones, we see genius. Because the people who are crazy enough to think they can change the world, are the ones who do.” – Rob Siltanen, the creative genius behind the much celebrated commercial “To the Crazy Ones” that launched Apple’s Think Different campaign

When Mr. Warren Buffet decides to buy a stock it is a big deal. When he decides to sell a stock, however, it is a much, much bigger deal. We have just learnt that Mr. Buffet dumped most of his IBM’s shares during the fourth quarter last year. IBM is no ordinary company. It is a stalwart of the technology industry. It generates over sixty percent return on equity. Sixty per cent! Oh and by the way 2017 marks the twenty-fifth consecutive year of US patent leadership for IBM.

Unfortunately for IBM, invention does not always equal innovation. And it most certainly does not equal disruptive innovation.

IBM’s seemingly obsessive pursuit of patents, to us, is symptomatic of a zero-sum view of the world. That is, we think underlying IBM’s hunger for patents, is a convoluted assumption that by having a larger share of patents issued will somehow translate into them capturing an increasing share of the value generated by the technology sector. Value, however, is not finite. And technological progress is certainly not a zero-sum game.

A faltering technology company is not exactly news. Casualties in the technology sector are par for the course. IBM is not the first technology company to struggle and it is unlikely to be the last.

Disruption of long-standing and successful consumer staple businesses, however, is far more interesting. PepsiCo – the bluest of the blue chip consumer staple companies – is one company whose trajectory we are following with much intrigue especially after we outlined our bear case for household consumer brands last year.

When PepsiCo announced its USD 15 billion stock buyback plan, shortly after disclosing full year and fourth quarter 2017 earnings, our toes curled a little. PepsiCo is trading at 21x price to trailing earnings and 20x price to consensus 2018 earnings. Surely there are better ways to put the cash to work? It was only a few days prior to announcing the buyback plan that the company introduced Bubly, its new brand of sparkling water, which in and of itself is not a groundbreaking development but an encouraging sign of the company coming to terms with changing consumer preferences nonetheless. And it also signaled that the company was willing to invest in new markets.

The relatively small size of new or emerging markets is a well-documented hurdle for large companies. Investing in small markets just does not move the needle when it comes to meeting Wall Street’s quarterly earnings expectations; pursuing large-scale share buybacks does . Moreover, executives destined for the C-suite do not get there by slogging it out in risky, small-scale pursuits. As anyone who’s worked in an organisation of meaningful size will tell you, projects that do not have a strong sponsor get orphaned very quickly. The harsh reality, however, is that all great businesses start off small and it is therefore paramount that incumbents find ways to overcome their structural inability to enter small markets.

PepsiCo’s recent introduction of Bubly, while a relatively positive sign, is also yet another example of a large company playing catch-up due to their failure in either understanding or pursuing the potential of a small market. The company is entering the US sparkling water market only after LaCroix has proven that it is a big market and has established itself as a clear market leader.

An inability to timely enter high-growth potential markets is far from PepsiCo’s only challenge. The company is under attack on multiple fronts.

JAB, the investment vehicle backed by Germany’s Reimann family, bought Dr Pepper Snapple (DPS) for USD 19 billion last month. JAB plans to merge DPS with its coffee interests to create a giant distribution network to better compete against the likes of PepsiCo and Coca-Cola.

Consumer attitudes towards sugary sodas are also quickly shifting. Sugar is widely acknowledged as enemy number one when it comes to western dietary habits. We can see this PepsiCo’s soda sales in the US, which continue to decline despite a new marketing blitz to promote the company’s soft drink brands.

Investment Perspective

PepsiCo like other great consumer goods companies has leveraged its products’ strong brand identities in combination with far reaching distribution to make its products available to as many consumers as possible. Awareness and availability are perhaps the company’s widest and most effectively exploited moats. The company has proven to be a great investment for long-term, buy-and-hold type investors over the years.

The second-order effects of technological innovation, however, are such that we think the effectiveness of PepsiCo’s moats is eroding fast. People are watching far less television and spending less time reading newspapers and magazines. Instead, they are on YouTube, Facebook, Snap, or watching Netflix. Traditional mass media is great at creating awareness and shaping consumer preferences at a mass scale, which is exactly what consumer product companies needed to keep their their brands at the top of consumers’ minds. So much so that they came to monopolise advertising slots during peak programming. The sky-high prices paid for Superbowl half-time advertising slots just go to show the value of mass media to consumer products companies. It also demonstrative of the fact that traditional media advertising is deeply rooted in a zero-sum world.

The major strength of social media and digital advertising platforms, in contrast to traditional media, is targeting niche consumer groups based on precisely defined criterion. Such platforms are far better suited to products that have very high levels of appeal to a niche group – making them ill-suited as advertising platforms for large consumer product companies. The increasing popularity of social media and other non-traditional forms of media, in our opinion, will result in the increasing awareness of niche brands relative to the awareness of mass consumer brands. We see this as a secular trend that will have a profoundly disruptive impact on incumbent consumer product businesses like PepsiCo.

We do not, however, expect the incumbents to go down without a fight. Unfortunately, the following quotes from senior executives of PepsiCo suggest that, while they do realise they are in a fight, they are still stuck in a zero-sum world and do not yet understand the new rules of engagement:

“We have patents on the design, the cutter, the mouth experience. This is multiple layers of IP.” – Dr. Mehmood Khan, Vice Chairman and Chief Scientific Officer of PepsiCo

“The consumer has turned the definition [of healthy] upside down. If it is non-GMO, natural, or organic, but high in sodium and high in sugar and fat, it’s okay.” – Indra Nooyi, Chairwoman and Chief Executive Officer of PepsiCo

Active management, we think, is as much about avoiding losers as it is about picking winners. We think PepsiCo and other businesses like it are squarely in the loser camp.

Trade Ideas

Last updated: 04 Aug, 2020

Summary of Open Trade Ideas

Idea	Date Opened
LONG Uranium Participation Corp $URPTF	13 Sep. 17
LONG Salesforce.com $CRM	12 Jul. 19
LONG Snapchat $SNAP	18 Nov. 19
LONG Uber Technologies $UBER	19 Dec. 19
LONG The Coca Cola Company $KO	24 Mar. 20
LONG PepsiCo $PEP	24 Mar. 20
LONG 3D Systems Corp $DDD	04 Jun. 20
LONG Seattle Genetics $SGEN	19 Jun. 20
LONG Take Two Interactive Software $TTWO	19 Jun. 20
LONG Diode Inc. $DIOD	13 Jul. 20
LONG BHP Group Ltd $BHP	30 Jul. 20
LONG Nike $NKE	04 Aug. 20
LONG Nutanix $NTNX	04 Aug. 20

Trade Ideas 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.