$USO Archives - LXV Research

Clustered Volatility and the “Momentum Massacre”

“But, as with markets, in the ocean the interesting things happen not at the equilibrium sea level which is seldom realized, they happen on the surface where ever-present disturbances cause further disturbances. That, after all, is where the boats are.” ― W. Brian Arthur

Financial markets exhibit a temporal phenomenon known as clustered volatility. That is, the existence of periods of low volatility followed by periods of high volatility. Low volatility reigns supreme when the the outcome of the cumulative actions of market participants mutually benefits the majority. And, by extension, reaffirms the confidence the majority of market participants have in their forecast, “investment process”, algorithm or “analytical framework” ― or, more crudely, heuristics that they use in making their trading or investment decisions. The majority continue to follow their “process” and among the minority that did not benefit in the run up all but the most stubborn gradually adapt their processes to implicitly or explicitly chase momentum. Low volatility begets low volatility.

High volatility often occurs when an external agent, such as President Trump tweeting about tariffs or the People’s Bank of China excessively tightening or loosening financial conditions, disrupts the seeming equilibrium in the market. All else being equal, which it never is, the impact of external agents on market volatility, however, tends to be fleeting. For example, the declining half-life of President Trump’s trade war related tweets impact on the US equity market.

A structural change in volatility generally occurs when some participants or a group of market participants alter their algorithm ― such as shifting from selling at the money puts to deep out of the money puts ― or investment process or by the entry of entirely new participants with a novel agenda ― like the Bank of Japan buying up ETFs as part of its QE programme ― to the market.

The changing of algorithms or processes may, of course, be in response to the actions of external agents or the impact said actions had on the market. Regardless, this “updating” allows the first movers to front-run or anticipate the behaviour of the majority, which in turn causes other investors to re-adapt. This adaptive behavior, if it successfully percolates and propagates, moves the market away from its seeming equilibrium and into a state of ‘chaos’. It is this process of re-adapting that tends to precipitate longer lasting bouts of higher volatility.

Robert F. Engle, the winner of the Nobel Prize in Economics in 2003, formally defined this process of random periods of low volatility alternating with high volatility in financial markets as the the generalised autoregressive conditional heteroskedasticity (GARCH) process. (Heteroskedasticity is where observations do not conform to a linear pattern. Instead, they tend to cluster.)

Momentum Massacre

From the Financial Times on 12 September 2019 (emphasis added):

“The stock market may appear tranquil again after a rollercoaster summer, but many analysts and investors are unnerved by violent moves beneath the surface, reviving memories of the 2007 “quant quake” that shook the computer-driven investment industry.

The FTSE All-World equity index has rallied almost 3 per cent already this month, clawing back some of August’s losses. However, many highly popular stocks suffered a sudden and brutal sell-off this week, a reversal that analysts have already dubbed the “momentum crash”.

The blow was particularly strong in the US, where strong-momentum stocks — those with the best recent record — tumbled 4 per cent on Monday, in the worst one-day performance since 2009, according to Wolfe Research. Only once before, in 1999, has such a rout afflicted momentum-fuelled smaller company stocks, according to investment bank JPMorgan.”

This is massive,” said Yin Luo, head of quantitative strategy at Wolfe Research. “This is something that we haven’t seen for a long time. The question is why it’s happening, and what it means.”

The flipside has been a dramatic renaissance for so-called “value” stocks — out-of-favour, often unglamorous companies in more economically sensitive industries. The S&P value index has climbed about 4 per cent this week and, compared with momentum stocks, enjoyed one of its biggest daily gains in a decade on Monday.

The chart below is the ratio of the S&P Growth index to the S&P Value index. We are struggling to find the “dramatic renaissance”.

SGX Index (S&P 500 Growth Index) 2019-09-18 16-41-52.jpg

Of course we are being more than a bit flippant. Nonetheless, we do not think it is time to completely drop momentum or growth stocks and load up on value stocks. Rather we think the market is in a transient phase where participants are updating their algorithms and processes to go beyond momentum.

Our prescription from June remains valid:

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance regularly to avoid any lopsidedness in their portfolios.

The above has worked well in the recent “momentum massacre” and can continue to work well as long as uncertainty remains high and sentiment viciously waxes and wanes between optimism and pessimism. A slight adjustment to the above, however, is warranted as follows:

A barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and ~~precious metals~~ energy plays on the other.

Do Not Drop Momentum ― Not Completely Anyway

Dropping momentum or growth completely would be akin to calling the end of the transition away from actively managed portfolios to passively managed allocations that has accelerated since the Global Financial Crisis. Passive allocations are implicitly momentum seeking strategies. A strong secular trend is not upended by a 4 per cent move, it will take a crisis or a severe re-think of strategic asset allocation by the managers of the largest pools of capital to bring about an end to the trend.

The rise of passive investing, along with systematic volatility selling strategies, has contributed to the dampening of volatility since the Global Financial Crisis. A growing share of passive allocations, however, is somewhat like increasing leverage. As passive flows now make up the lion’s share of capital market flows, the actions of active investors are spread over a smaller segment of the investment universe. As the size of the active universe shrinks, in terms of what could be described as, in the case of stocks, free float market capitalisation minus passive allocations, the actions of active investors begin to have an exaggerated impact and give rise to higher volatility.

Simply put, the passive flows versus volatility curve is convex. Initially, increasing passive flows dampen volatility but beyond some hitherto unknown level increasing passive flows lead to higher volatility.

Why Energy Over Precious Metals?

Without delving into the geopolitics of it, the attacks on the Saudi Arabian oilfield should remind major oil consumers ― airlines, refiners, transportation companies and emerging economies such as India and China ― to review their energy security and hedging strategies. To balance future energy needs and to not become hostage to a rising geopolitical risk premium in the price of oil. This should lead to a rise in demand for oil at the margin; commodity prices are, of course, set at the margin.

The other angle is that if anything is going to take down the almighty bond bull market its going to be either: (1) fiscal spending by the G-7 governments of the like that we have never seen; or (2) a sharp and sustained increase in oil prices.

Lastly on energy, if Iran is, rightly or wrongly, shown to be the perpetrator of the attacks, China may have to reconsider it decision to purchase Iranian oil.

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.

Confusing the Cyclical with the Secular | The Iran-China Strategic Partnership

“The reason a lot of people do not recognize opportunity is because it usually goes around wearing overalls looking like hard work.” ― Thomas Edison

“The most important lesson I’ve learned is to understand and to trust abstractions. If you can learn both to see and to believe in life’s underlying patterns, you can make highly informed decisions every day.” ― Nathan Myhrvold, former Chief Technology Officer of Microsoft

Confusing the Cyclical with the Secular

We have, since late last year, been bullishly positioned in precious metals and have reiterated this view on several occasions over the course of this year. That being said, however, we are not of the view that precious metals have entered a new secular bull market and will be making a run for new highs, in US dollar terms, in the near term.

Similarly, in last week’s piece, we highlighted cyclical factors indicating that long-term US bond yields were likely to rise, in the near-term, as opposed to going even lower. Once again, this is a cyclical, not a secular, view.

Below we share two passages that provide a framework for understanding the conditions that would lead to a bond market rout and a new secular bull market in precious metals.

The following passage in an excerpt from The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money on the discussion between the author, Steven Drobny, and his (unrelated) colleague at Drobny Global Advisors, Dr. Andres Drobny (emphasis added):

Many people think there is a limit on public debt, but I am not so sure. Apart from a country constrained by a gold standard or fixed exchange rate, the only scenario where the government might bot be able to fund its debt is an inflationary scenario. However, the scenario only seems likely to emerge after the policies succeed in promoting growth. One of the reasons that a much-anticipated financing problem has never materialized in Japan is that reflationary policies failed to stimulate a sustained rebound and a return of inflation. Interest rates have remained low and fund the deficit has been surprisingly easy.

Consider what happens if the public debt and financing fears prove correct and bond markets start to tank. This is an issue that came up during a debate at our recent conference in London. Without inflation, rising nominal bond yields push up real yields and deflate the economy; bonds become more attractive again and buyers bring yields back down. Without inflation, it is hard to get a bond rout. It is only when inflation rises that government financing becomes a real and sustained problem for bond markets. That is when bonds no longer get cheaper as they sell off and nominal yields rise, which is when you get a real bond crisis.

The key takeaway from the above passage is that a secular turn in the bond market will only occur when rising nominal yields do not translate into rising real yields, that is when the rate of inflation outpaces the increase in nominal yields.

RR10CUS Index (Real 10 Year Yiel 2019-09-11 15-57-15.jpg

In the 1960’s and from the mid-1970’s through the early 1980’s, rising nominal yields in the US coincided with sharply declining real yields. Until such a disconnect begins to manifest, the secular bull market in bonds is intact.

The following passage in an excerpt from Peter Warburton’s essay The debasement of world currency: It’s inflation but not as we know it (emphasis added):

An excessive expansion of credit can create an environment where the factors of production — land, capital and labour services — appear to be in infinite supply. If sufficient (borrowed) financial resources are made available, then sterile, parched and polluted land can be fertilized, irrigated, cleaned up and turned to productive use. Similarly, more factories, kilns, assembly lines, steel mills, semiconductor plants and so on can be built using state-of-the-art technology. Idle and untrained workforces can be mobilized and organized into productive units. A rich country, with plenty of collateral assets against which to borrow, can indeed face a supply curve that is seemingly infinitely elastic. I can assure you that consumer price inflation will not be a problem for such an economy.

The United States still has plenty of collateral assets to borrow against. The US dollar hegemony may be on its last legs but there is no credible alternative making it still too early to bet against it.

BBDXY Index (Bloomberg Dollar Sp 2019-09-11 17-08-03.jpg

In the chart above, the magenta line is a custom index tracking the relative performance of US liquid assets (equities and investment grade bonds) to that of global liquid assets ex-US. The orange line is the Bloomberg Dollar Index ― the index is broader than $DXY, which is just a proxy for the EURUSD cross.

The continued out performance of US capital markets relative to the capital markets of the rest of the world is supportive of the US dollar and indicative of the superiority of US collateral relative to ex-US collateral.

The Iran-China Comprehensive Strategic Partnership

Speaking of the end of the US dollar hegemony, it was reported last week that Iran’s foreign minister Mohammad Zarif paid a visit to his Chinese counterpart Wang Li at the end of August to present a road map for the China-Iran comprehensive strategic partnership, signed in 2016.

As part of the deal, China will invest US dollars 280 billion in developing Iran’s oil, gas and petrochemicals sectors. There will be a further US dollars 120 billion of investments made by China in upgrading Iran’s transport and manufacturing infrastructure. Notably, the deal also includes “5,000 Chinese security personnel on the ground in Iran to protect Chinese projects, and […] additional personnel and material available to protect the eventual transit of oil, gas and petchems supply from Iran to China, where necessary, including through the Persian Gulf,” according to Iranian sources.

According to reports, the deal also includes a long-term commitment by China to buy Iranian oil. Based on these reports, Iran has agreed to sell its oil and gas to China at a guaranteed discount to prevailing market prices of at least 12 per cent, plus a further discount of up to 8 per cent to account for the risk ― presumably of a backlash from the US. China, of course, will pay for the oil in renminbi.

The benefits of the deal for Iran are obvious. It receives much-needed foreign direct investment. It secures a market for its hydrocarbon output. And secures a deterrent against possible military strikes by Israel or Saudi Arabia and its allies. Iran, though, does not simply want to be China’s discount oil dealer. It wants more, it wants a strategic alliance. Iranian foreign minister Mohammad Zarif penned an op-ed in the Global Times clearly articulating what Iran wants. It is unclear, however, if they will get it by “looking east”.

The benefits to China are somewhat mixed. Cheaper energy imports paid for not in US dollars but in local currency eases China’s dependence on the greenback and furthers its ambitions to form an independent monetary bloc. Buying Iranian oil and defying of US sanctions, on the other, is only likely to infuriate President Trump and further complicate ongoing trade negotiations.We see China’s willingness to defy US sanctions as a signal that its leadership is unwilling to do a deal with President Trump that it does not deem to be fair. By agreeing to buy Iranian oil, China is either hedging itself and preparing for a new economic reality or it is posturing to show strength in its negotiations with the US.

Aside from trade, the most interesting near term takeaway from China’s agreement to buy Iranian oil is that it did not lead to sharp pullback in the price of oil. Rather oil has moved higher, suggesting oil could move higher still.

Safe Haven Bid: Ahead of Itself?

Marilyn: Thank you for coming over, Mr. Baer. Welcome back and forgive me if I wade right in, but forgetting for a second your bureaucratic checklist, I’m trying to get undigested information, so if you could give me a reading of the temperature over there?

India is now our ally. Russia is our ally. Even China will be an ally. Everybody between Morocco and Pakistan is the problem. Failed states and failed economies, but Iran is a natural cultural ally of the U.S. The Persians do not want to roll back the clock to the 8th century.

I see students marching in the streets. I hear Khatami making the right sounds. And what I’d like to know is if we keep embargoing them on energy, then someday soon are we going to get a nice, secular, pro-Western, pro-business government?

Bob: It’s possible. It’s complicated.

Marilyn: Of course it is, Mr. Baer. Thank you for your time.

Intelligence is the misnomer of the century.

Bob: They let young people march in the street and then the next day shut down fifty newspapers. They have a few satellite dishes up on roofs, let ’em have My Two Dads, but that doesn’t mean the Ayatollahs have relinquished one iota of control over that nation.

Distinguished Gentlemen: Mr. Baer, the reform movement in Iran is one of the President’s great hopes for the region and crucial to the petroleum security of the United States.

Terry George: These gentlemen are with the CLI.

Distinguished Gentlemen: The Committee for the Liberation of Iran, Mr. Baer

Bob: We’ve had Iran in embargo for almost thirty years, we backed their neighbor, a neighbor we invaded twice, in a ten year war against them, we’re hanging on by a thread with a massive occupation force, so I got news for you… Thomas Jefferson just ain’t that popular over there right now.

― Syriana (2005)

Iranian foreign minister, Javad Zarif, made a surprise visit Sunday to the the Group of Seven summit, meeting with a delegation including French President, Emmanuel Macron, as leaders grappled with how to defuse tensions and salvage the landmark nuclear deal after a US pullout.

Mr Javad Zarif did not meet with the US delegation in Biarritz, France, although President Trump has indicated that he is open to meeting Iranian officials without preconditions.

The narrative in the noughties when oil was rallying and the spectre of peak oil (supply not demand) was of popular concern ― the BBC even produced a film titled The Crude Awakening: The Oil Crash in 2007 to warn of the end of life as we know it because the world was running out of oil ― was that of the US’s need to ensure hydrocarbon security. Today, the narrative is that the world is awash with oil and the US is energy independent, affording President Trump the luxury to scrap the deal with Iran and to re-impose economic sanctions.

As it relates to oil, the truth lies somewhere in between the fears over peak demand and peak supply but almost never, barring a energy paradigm changing supply- or demand-shock, at the extremes.

As it relates to geopolitics, should oil prices rise sufficiently, driven by a flurry of bankruptcies in the US shale patch or US shale production plateauing, it would be of no surprise to see the US either return to the negotiating table with Iran or to ease sanctions.

The overarching consensus for oil appears to be that of lower oil prices. With some even calling for a crash to below the US dollars 30 per barrel level, that would lead to global deflationary bust. In our opinion, these calls seem premature. Rather, if anything, we see the greater risk being to the upside.

We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average, albeit just barely. Given the proximity of the current price to the moving average, the best course of action may be to be on the sidelines. That being said, as long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices climbing the ‘Wall of Worry’ over the next 6 to 12 months.

USCRWTIC Index (US Crude Oil WTI 2019-08-26.png

Has the Safe Haven Bid Got Ahead of Itself?

In the below chart, the magenta line is the ratio of the price of gold to the Merrill Lynch 10-year Treasury Total Return Index. The orange line is that of core price index.

XAU Curncy (Gold Spot $_Oz) GL 2019-08-26 11-47-07

The US dollar price of gold, loosely an inflation hedge, rising relative to the 10-year Treasury index generally coincides with rising core inflation. There, of course, are periods that the ratio over- or under-shoots core inflation but over time the roughly coincident movement of core inflation and the gold-to-ten-year Treasury index tends to reassert itself.

In recent months we have seen safe haven assets, government bonds and precious metals, get bid up. Notably, gold has outperformed 10-year Treasury bonds in 2019 even as core inflation has witnessed a sharp drop. Between early 2017 and early 2018 we saw a similar dynamic play out, when long-term bond yields rallied (long bonds sold off) and gold remained steady while at the same time core inflation moved sharply lower.

In 2018, core inflation eventually moved higher and caught up with the gold-to-Treasuries ratio. Suggesting that markets had correctly anticipated the move higher in core inflation.

We will know in time if the markets have got it right again or not. If core inflation does not move higher, it is likely that the safe haven bid, specifically in gold and other precious metals, has gotten ahead of itself and investors are better off owning government bonds over precious metals.

With long-term bond yields near all-time lows, it is difficult to make a strong case for bonds, however.

The below chart is that of WTI crude (magenta) and gold (orange). The two commodity prices tend to, over the long-term, have the same directional move. Oil does not have the safe haven characteristics of gold and therefore has stronger moves than gold both to the up and down sides.

USCRWTIC Index XAU (US Crude Oil WTI 2019-08-26.png

Much like the relation between the gold-to-Treasuries ratio and core inflation, a gap has opened up between the price of gold and that of oil, much like it did in 2017. In 2018, the gap was closed with oil moving higher. Will that also be the case this time around?

Finally, the last chart in this week’s piece. This one compares the price of oil to core inflation.

USCRWTIC Index PCE.png

The price of oil is one of the primary drivers of core inflation, albeit with a lag. Should oil prices move higher from here, core inflation will be higher 6 to 12 months down-the-line; justifying the move higher in gold and likely proving the current rally in government bonds to be a bull trap.

On the other hand, if oil prices make new lows, gold should be sold in favour of government bonds.

The price of oil is probably the most important price in capital markets today. The next move in oil will drive many of key tactical decisions for asset allocators.

If oil moves higher, portfolios will be found to be lacking allocations to assets that do well in periods of rising inflation ― resource and mining companies, resource rich emerging markets, high yield credit and precious metals ―and over exposed to high duration assets such as loss-making technology companies as well as utilities and long-terms bonds.

If oil moves lower, the stampede into developed market government bonds, technology stocks and utilities is likely to continue unabated.

We will be following the oil price ever so closely hereon out.

Notes on Russia and Oil & Gas

“My problem is that my imagination won’t turn off. I wake up so excited I can’t eat breakfast. I’ve never run out of energy. It’s not like OPEC oil; I don’t worry about a premium going on my energy. It’s just always been there. I got it from my mom.” — Steven Spielberg

“Russia is tough. The history, the land, the people — brutal.” — Henry Rollins

We recently met with the management team at Rosneft — the third largest company in Russia and one of the top 25 oil & gas exploration companies in the world by revenue — for a wide ranging discussion on oil & gas, Russian macro, the deal with Saudi Arabia and OPEC, shale oil and geopolitics. In this week’s piece we share our notes from the meeting.

On Russian macro:

Russian budget balances at an oil price of around US dollar 47 per barrel.

Government and corporate external debt has declined from around US dollars 730 billion in 2014 to approximately US dollars 450 billion by the end of 2018.

50 per cent of crude oil production is exported unrefined, 50 per cent of production is utilised for refined products of which 50 per cent are exported. Directly and indirectly, approximately 75 per cent of oil produced is exported.

The government is actively running a weak ruble policy, which is benefiting exporters at the cost of lower domestic economic growth and lower purchasing power for the Russian consumer. This is translating into Russian economic growth being investment-led as opposed to consumption-led.

Moreover, the policy is resulting in weaker than potential economic growth. Real GDP growth is around 2 per cent while the economy has the potential to grow between 3 to 5 per cent annually.

To counter the below potential growth, the government is trying to attract foreign direct investment into the economy — Russia moved up to 31st in the World’ Bank’s ‘Doing Business’ rankings in 2018, up from 120th in 2011. The spectre of further economic sanctions, however, has thus far deterred foreign capital.

To implement the weak ruble policy, the Central Bank of Russia sterilises all oil revenues above US dollars 40 per barrel. At current oil prices, the central bank purchases between US dollars 200 to 300 million from the open market on a daily basis

Russia is able to implement its weak ruble policy as the majority of costs, even for oil & gas exploration companies, are priced in rubles. For example, Schlumberger and Haliburton price onshore oil rigs lease rates in rubles, not US dollars. Oil & gas companies are only impacted if they are engaged in offshore drilling as offshore drills are not available in Russia. At present none of the Russian oil & gas majors are engaged in offshore drilling.

Pension reforms implemented in 2018 raised the retirement age from 60 to 65 years for men and 55 to 60 years for women. The reforms were deeply unpopular amongst the populace and instigated protests across the former Soviet Union. Eventually only a watered down version of the originally proposed reforms were implemented.

On the deal with OPEC / Saudi Arabia:

The production quotas / deal between Russia and OPEC holds far greater significance for Saudi Arabia than for Russia given Russia’s lower budget break even price, free floating currency and ruble based cost structure.

Russian oil production peaked in October 2018 at 11.4 million barrels per day. It has been cutting daily production levels by 65,000 barrels each month starting January 2019 and will reach the agreed upon production level in May 2019, which should be between 220,000 to 230,000 barrels per day lower than levels recorded in October.

Saudi Arabia has already cut production by more than the levels they had committed to as part of the deal with Russia and they expect the Kingdom to enact further cuts in the coming months.

Subsequent to our meeting, Bloomberg reported that “Saudi Arabia will supply its clients with significantly less oil than they requested in April, extending deeper-than-agreed production cuts into a second month”.

Although Rosneft is opposed to the production quotas, they expect the deal between Russia and OPEC to be extended beyond June 2019.

Rosneft, which accounts for 41 per cent of Russian oil production, could have increased its output by 5 per cent in 2019 but will limit growth to 2 per cent. In return, they have submitted a request for tax breaks to the Russian Ministry of Finance to compensate for the lost revenue.

One of the unintended consequences of the production cuts has been heavy, high-sulphur (or “sour”) crude trading at a premium to Brent crude in parts of North West Europe and the United States despite its lower grade. This has occurred as the majority of OPEC producers, predominantly Saudi Arabia, have focused their production cuts on high-sulphur crude and at the same time sanctions have been enacted on Venezuela, a major producer of high-sulphur crude. Demand from US refiners, which are configured to operate only with high-sulphur crude, and China’s preference for it as well — a byproduct of refining heavy crude is bitumen, which is used in the construction of roads — has caused the squeeze.

On demand:

Demand erosion from electric vehicles has not been evident and it will take a much higher adoption rate for it to have a meaningful impact. Whatever adoption that is taking place is being more than compensated for by first time automobile buyers in emerging markets, particularly India and China.

Global demand is robust and should remain so as long as the US can avoid a recession in 2019.

On shale oil:

Full cycle, operating and capital expenditures cash break even for the Permian basin is between US dollar 40 to 50 per barrel versus the widely touted US dollars 35 to 40 dollars. This excludes the cost of land, which can push break even levels to as high as US dollars 55 to 60 per barrel.

There are signs of high cost inflation in the shale patch, particularly in the Permian, which may push up break even levels.

Listed shale oil companies returning capital to shareholders are being rewarded and those increasing capital expenditures have been punished. This suggests that the capital expenditure cycle for US shale may have peaked and that an increasing number of companies will choose to return capital as opposed to increasing production. If this happens, US production growth is likely to disappoint to the downside.

On natural gas and geopolitics:

Nord Stream is an offshore natural gas pipeline between Russia and Germany that is owned and operated by Nord Stream AG, whose majority shareholder is the Russian state company Gazprom. It has an annual capacity of 55 billion cubic metres.

Gazprom has a monopoly on all Russian natural gas exports.

Nord Stream 2 is a project to lay two additional lines and double annual capacity to 110 billion cubic metres and due for completion in 2019 . The project was backed by Chancellor Angela Merkel and the German government despite objections from some EU and NATO member states and from the European Commission

Since November 25, 2015, Ukraine has no longer imported Russian gas; instead, all supplies that enter Ukraine’s gas network from Russia are transferred to Europe. The gas transit agreement with Ukraine expires in December 2019. Nord Stream 2 is incidentally due for completion in December 2019. The completion of the project would allow all Russian gas to flow directly into Germany without transiting through Ukraine.

The cost of liquefaction, transportation and gasification of natural gas from alternate sources means that Russian gas remains the most economically viable source for Europe. Given Germany’s reliance on natural gas, especially after Chancellor Merkel outlawed nuclear power in Germany, it is difficult to see Europe turning away from Russian gas. German dependence on Russian gas has, however, caused a rift between France and Germany in the recent past.

Russia is confident that it can find alternative buyers for its supplies should Europe decide to stop buying from them.

In 2017, Rosneft sold a 20 per cent stake in Verkhnechonskneftegaz — one of the largest-producing fields in eastern Siberia that connects Russia with China, Japan and South Korea — to Beijing Gas. This is a sign of growing collaboration between the two states and a possible step towards de-dollarization. With the added benefit for Rosneft and Beijing Gas of undermining the domestic monopolies of Gazprom and China National Petroleum Corporation.

Some data points:

Organic reserve replacement costs in Russia are approximately US dollar 0.20 per barrel of oil equivalent vs. US dollars 1.10 for BP, 1.00 for Chevron, 2.90 for Royal Dutch Shell and 5.70 for PetroChina

Lifting costs (the cost of producing oil and gas after drilling is complete) is US dollar 2.50 in Saudi Arabia and US dollars 3.10 in Russia vs. US dollars 5.60 for Total, 7.30 for BP, 10.60 for Royal Dutch Shell, 11.40 for Chevron, 11.50 for PetroChina and 12.30 for ExxonMobil.

The Hawks Have Not Left the Building

“Difficulties are meant to rouse, not discourage. The human spirit is to grow strong by conflict.” – William Ellery Channing

“Very few negotiations are begun and concluded in the same sitting. It’s really rare. In fact, if you sit down and actually complete your negotiation in one sitting, you left stuff on the table.” – Christopher Voss

The Hawks Have Not Left the Building

A “typical feature of conflicts is that […] the intergroup conflict tends to be exacerbated and perpetuated by intragroup conflicts: by internal conflicts within each of the two contending parties. Even when there is growing interest on both sides in finding a way out of the conflict, movement toward negotiations is hampered by conflicts between the “doves” and the “hawks” –or the “moderates” and “extremists” –within each community”. So wrote Herbert C. Kelman, the Richard Clarke Professor of Social Ethics, Emeritus at Harvard University, in Coalitions Across Conflict Lines: The Interplay of Conflicts and Between the Israeli and Palestinian Communities.

Kelman – renowned for his work in the Middle East and efforts to bring Israel and Palestine closer towards the goal of achieving peace in the Middle East – identifies, in the paper he authored in 1993, the “relationship between intergroup and intragroup conflict” as a key hurdle towards building coalitions across conflict lines. According to Kelman, “doves on the two sides and hawks on the two sides have common interests”. The hawks, unlike the doves, can pursue their interests without the need to coordinate with their counterparts on the opposing side. The hawks simply “by engaging in provocative actions or making threatening statements” reaffirm the enemy’s worst fears and embolden the hawks on the opposing side. The doves, on the other hand, “tend to be preoccupied with how their words will sound, and how their actions will look, at home, and with the immediate political consequences of what they say and do.” Therefore, the doves tend to take a more measured approach in communicating their views and underplay their side’s willingness to negotiate – the kind of behaviour that plays right into the hands of the hawks and reduces the effectiveness of the doves

Kelman’s recommendation to increase the chances of resolving a conflict by means of negotiation is to facilitate greater coordination between the doves on the opposing sides and minimise the involvement of the hawks.

The lessons from Professor Kelman’s work, we think, are highly relevant today. His insights provide a framework for determining the possibility of success in each round of negotiations between the US and China in resolving the on-going trade dispute.

Subsequent to the working dinner between President Trump and President Xi in Buenos Aires following the G20 summit, the headlines have focused on the temporary ceasefire in the trade dispute. President Trump has pledged to suspend the increase in tariffs on US dollars 200 billion of Chinese imports that was to go into effect on 1 January 2019 for a period of up to 90 days. In return President Xi has pledged that China will buy more US goods, ban exports of the opioid drug, and offered to reconsider the Qualcomm-NXP merger that failed to receive regulatory approval in China earlier in the year.

The three-month period, before the suspension of the tariff increase lapses, provides the two-sides a window of opportunity to initiate a new round of talks to tackle some of the more sensitive issues surrounding the trade dispute, including ownership and access to technology and intellectual property.

Despite the announcements lacking details, capital markets have reacted positively to the news of the temporary ceasefire and the Chinese yuan, on Monday, posted its largest single day gain since February 2016.

We are not surprised by the bare bones nature of the agreement following the meeting between President Trump and President Xi. The last minute inclusion of Peter Navarro, White House trade policy adviser and prominent China hawk, to the list of guests attending the working dinner was, at least to us, a clear signal that meaningful progress on trade relations during the meeting was unlikely. After all, Mr Navarro’s role in the Trump Administration, as The Atlantic puts it, is “to shepherd Trump’s more extreme ideas into reality, ensuring that the president’s convictions are not weakened as officials translate them from bully-pulpit shouts to negotiated legalese. He is the madman behind Trump’s “madman theory” approach to trade policy, there to make enemies and allies alike believe that the president can and will do anything to make America great again.”

Moreover, we do not expect a breakthrough in negotiations to materialise during the next round of talks between Washington and Beijing before the suspension of the increase in tariffs lapses. As long as hawks such as Peter Navarro and Robert E. Lighthizer continue to have President Trump’s ear our view is unlikely to change. If, however, the dovish members of the Trump Administration, such as Treasury Secretary Steve Mnuchin and Director of the National Economic Council Lawrence Kudlow, begin to take control of proceedings we would become much more hopeful of a positive resolution to the trade dispute.

For now, we see the temporary agreement between the two sides as providing much needed short-term respite for China. More importantly, we see President Trump’s offer of a temporary ceasefire without President Xi offering any concessions on sensitive issues, such as industrial policy, state funded subsidies and intellectual property rights, to be a symptom of the short-termism that seemingly besets democratically elected leaders without exception. Had the US equity capital markets not faltered recently and / or the Republicans not lost control of the House of Representatives, it is unlikely, we think, that President Trump would have been as acquiescent.

Liquidity Relief

In June in The Great Unwind and the Two Most Important Prices in the World we wrote:

“In the 362 months between end of May 1988 and today there have only been 81 months during which both the US 10-year treasury yield and the oil price have been above their respective 48-month moving averages – that is less than a quarter of the time.

Over the course of the last thirty years, the longest duration the two prices have concurrently been above their respective 48-month moving averages is the 25 month period between September 2005 and October 2007. Since May 1988, the two prices have only been above their respective 48-month moving averages for 5 or more consecutive months on only four other occasions: between (1) April and October 1996; (2) January and May 1995; (3) October 1999 and August 2000; and (4) July 2013 and August 2014.

Notably, annual global GDP growth has been negative on exactly five occasions since 1988 as well: 1997, 1998, 2001, 2009, and 2015. The squeeze due to sustainably high US interest rates and oil prices on the global economy is very real.”

We have updated the charts we presented alongside the above remarks and provide them below. (The periods during which both the US 10-year treasury yield and the oil price have been above their respective 48-month moving averages are shaded in grey in the two charts below.)

US 10-Year Treasury YieldSource: Bloomberg

West Texas Intermediate Crude (US dollars per barrel) WTI Source: Bloomberg

The sharp drop in oil prices in recent weeks ended the 10 month streak of the 10-year Treasury yields and oil prices concurrently trading above their respective 48-month moving averages.

The recent drop in oil prices has coincided with the Fed weighing up the possibility of changing its policy guidance language. Several members of the Fed have suggested, according to the minutes of the FOMC’s November policy meeting, a “transition to statement language that [places] greater emphasis on the evaluation of incoming data in assessing the economic and policy outlook”. If the drop in oil prices sustains the data is likely soften and compel the Fed to dial back its hawkishness. With the base effects from the Trump Tax Cut also likely to recede in 2019, there is a distinct possibility that the Fed’s policy will be far less hawkish in 2019 than it has been over the course of 2018.

Lower (or range bound oil prices) and a more dovish Fed (even at the margin) are the conditions under which oil importing emerging markets tend to thrive. Although it is still too early to be sure, if oil prices fail to recover in the coming few months and the Fed is forced into a more dovish stance due to softer data, 2019 might just be the year to once again be long emerging markets.

Oil Market Misery | Amazon Ups Its Advertising Game

“This is a frightening statistic. More people vote in ‘American Idol’ than in any US election.” – Rush Limbaugh, American radio talk show host

“When luck plays a part in determining the consequences of your actions, you don’t want to study success to learn what strategy was used but rather study strategy to see whether it consistently led to success.” – The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing by Michael J. Mauboussin

“Sometimes it is the people no one can imagine anything of who do the things no one can imagine.” – Alan Turing

Oil Market Misery

Since late September, when oil prices hit four year highs, Brent and WTI prices have slumped by more than 20 and 23 per cent, respectively. With economic sanctions fully re-imposed on Iran starting 5 November, the price action of oil market makes one wonder if it is yet another case of buying the rumour and selling news.

The drawdown in oil prices coming at a time when Chinese oil imports have surged to record levels makes it all the more glaring.

The sharp drop in oil prices over the last six weeks has attributed to a number of factors, including:

The growing conviction that the Trump Administration’s will take a soft-touch approach in policing adherence of the economic sanctions on Iran;

Rising US oil production;

Expected growth in production from OPEC member states after the easing of production quotas;

Global economic growth expectations for next year being revised downwards, in turn implying weaker oil demand growth next year; and

Higher than anticipated levels of crude inventory builds in the US.

On Monday, when the US administration announced granting waivers to eight of the largest importers of Iranian oil including China, India and Turkey, it was seen as confirmation that US’s enforcement of sanctions on Iran will be lukewarm at best. We do not agree with this view and see no reason for the Trump Administration to take anything except the most hard line approach towards Iran.

The waivers granted by the US have been on the cards ever since the Trump Administration first announced it would re-impose sanctions on Iran back in May. They are a means to avoid disruption in the oil market and to give importers ample time to shift away from Iranian oil. The waivers have little to no impact on Iranian oil exports expectations for 2019 and beyond. Iranian oil exports are expected to drop from a peak of 2.5 million barrels per day in 2018 to less than 1 million barrels per day during the grace period afforded to the eight importers and drop off sharply once the waivers lapse.

We expect the Trump Administration to tighten the noose around the Iranian economy in 2019. We see no political or economic incentive for President Trump to act otherwise. Trump’s Middle Eastern allies – Saudi Arabia and Israel – are passionately in support of the sanctions and with mid-terms elections now out of the way Mr Trump is unlikely to agitate over a moderate rise in domestic gas prices at the cost of appearing to go easy on Iran.

Moreover, Mr Trump’s band of trade warriors and security hawks, with one eye on the on-going trade negotiations with China, are likely to be partial to higher oil prices and unlikely to want to see the Administration come across as being soft. Higher oil prices put a squeeze on the Chinese economy and increase its need for US dollars – factors that are likely to give the US an upper hand in trade related negotiations with China.

As it relates to rising US production capacity, nothing has changed since oil prices peaked in September to alleviate capacity constraints and infrastructure bottlenecks that would allow for an uninterrupted rise in US production. If anything, the recent drop in prices is bound to have a negative impact on future production growth.

We also think that worries about rising output from OPEC and Russia are misplaced. Although OPEC member states and Russia agreed in June to raise production by a combined 1 million barrels per day from May levels in order to offset expected losses from Iran and Venezuela, the Saudis and Russians are reportedly already contemplating production cuts for 2019 in response to the reason drop in prices. Our view is that oil exporting nations have little to no incentive to release their stronghold over the oil market.

High oil prices, a strong US dollar, rising interest rates and a slowing China certainly raise cause for concern for global economic prospects in 2019. Despite the concerns, OPEC still expects world oil demand to grow by 1.36 million barrels per day in 2019. Moreover, Chinese demand should continue to increase with at least two major refineries scheduled to start operations during the first half of 2019.

We consider the recent sell-off in oil to be largely sentiment driven and an unwinding of exceedingly bullish positioning by speculative accounts. Total net long exposure has declined by around 40 per cent in the last six weeks – representing almost 400 million barrels of crude.

Given that oil market supply-demand dynamics point to a probable supply deficit in 2019 and waivers for Iranian sanctions set to expire in six months, we expect oil prices to consolidate and move higher from current levels in the coming weeks and months – potentially even making a new cyclical high in the process.

Amazon Ups Its Advertising Game

Just a quick update on Amazon and another step the company has taken to increase its share of the advertising pie.

Amazon is shipping its first-ever printed holiday toy catalogue, titled “A Holiday of Play”, to millions of customers starting this month. Toys featured in the catalogue come with a QR code, allowing readers to instantly scan and shop for the products. Readers can also scan the product images in the catalogue with their Amazon App to get more information.

This is quite an interesting development in our view. We have a hunch that Amazon’s efforts have been heavily subsidised by advertising dollars from brands eager to feature their products and logos in the catalogue.

If Amazon’s efforts to blur the boundaries between offline and online prove successful in increasing consumer spending on its website, we can certainly envision a scenario where Amazon, the combination of the website and catalogues, becomes the go to destination for consumer brand advertising. Which half of the advertising pie Amazon gets its share from is likely to have far reaching implications for both digital incumbents (Google and Facebook) and traditional media.

Oil: Fighting the Myth

“This one will really take you back,” said the Great Winfield. “Sheldon’s Western Oil Shale has gone from three to thirty.”

“Sir!” said Sheldon the Kid. “The Western United States is sitting on a pool of oil five times as big as all the known reserves in the world – shale oil. Technology is coming along fast. When it comes, Equity Oil can earn seven hundred and fifty dollars a share. It’s selling at twenty-four dollars. The first commercial underground nuclear test is coming up. The possibilities are so big no one can comprehend them.”

“Shale oil! Shale oil!” said the Great Winfield. “Takes you way back, doesn’t it? I bet you can barely remember it.”

“The shale oil play,” I said dreaming. “My old MG TC. A blond girl, tan from the summer sun, in the Hamptons, beer on the beach, ‘Unchained Melody,’ the little bar in the Village…”

“See? See?” said the Great Winfield. “The flow of the seasons! Life begins again! It’s marvellous! It’s like having a son! My boys! My kids!”

The Great Winfield had made his point. Memory can get in the way of such a jolly market, that malaise that comes with the instantly gone, flickering feeling of déjà vu: We have all been here before.”

– Excerpt from The Money Game (1976) by Adam Smith (aka George Goodman)

Muscle Memory: Misnomer

Complicated skills that humans can overtime perform without much thought, almost automatically, such as riding a bike, playing the guitar, or knitting a sweater, are often thought of as being held in muscle memory. Think back to Karate Kid and Mr Miyagi’s ‘wax on, wax off’ training regime – popular culture fed us the idea of muscle memory and we gobbled it up.

While it is true that certain skills may require the strengthening of various muscle groups, the reality is that learning and retention of new skills occurs in the brain, not in muscles. The process of acquiring new skills causes changes to the structure of the brain. Magnetic resonance imaging (MRI) scans reveal that there is a visible increase in the number of the connections between the different areas of the brain that are required for the skill being acquired. This structural change alters the information the brain transmits to the muscles, thereby altering the movements produced by the muscles.

Ideas: Power

The ability to imagine a reality that neither exists today nor has existed in the past, to give birth to an idea, is one of the truly remarkable gifts endowed to humanity.

Ideas are the seeds of progress. It is ideas that enable large scale human cooperation that transcends self-interest, race, and borders.

Simple ideas: Highly contagious

Ideas are powerful. Simple ideas that are fully formed and easily understood are also highly contagious. Once a simple idea has taken hold, it is difficult, almost impossible, to eradicate.

Peak oil was a simple idea and it was easy to understand, making it both powerful and contagious. It was so contagious in fact that it bordered on belief; it was hardly ever questioned. And the parabolic rise in the price of oil during the last decade was taken by many as confirmation of that belief.

So when the price of oil crashed during the second half of 2014, the immediate reaction of the global investment community was not that peak oil was a myth but rather that OPEC (read: Saudi Arabia) had been greedy. That the cartel had artificially kept supply constrained to maximise its earnings and that the greed had comeback in the form of shale to bite the cartel in their proverbial behind.

The resilience of the peak oil concept is the very reason we think that oil prices recovered sharply during the first half of 2015 and that dedicated energy focused private equity funds were able to raise so much capital in a relatively short amount of time. As market participants witnessed the sharp drop-off in rigs across shale oilfields, it reminded them that cheap oil would eventually run out and higher prices would be needed to satisfy global oil demand – muscle memory or not, investors proceeded to bid up the price of oil.

Ideas that have taken hold in people’s minds are difficult to eradicate. And this is precisely the reason why an even sharper drop in the price of oil was needed to debunk peak oil as a myth. As oil prices tanked during the fourth quarter of 2015 and January 2016, a new idea took hold: the existence of shale placing a cap on the price of oil, i.e. if oil prices were to move above an arbitrary price, usually quoted to be between US dollar 65 to 80 per barrel, for a prolonged period of time, shale producers would ramp up production and flood the market with excess oil.

As oil prices recovered during 2017 so too did US oil production – US output has climbed by approximately 1.2 million barrels per day since January 2017. This surge in production is being seen by many as confirmation of both the responsiveness of shale oil producers and the existence of a cap on the price of oil. We beg to differ.

Investment Perspective

While the surge in US shale production has been impressive and may well continue for the remainder of 2018, we consider the supply and demand dynamics of oil to be decidedly in favour of steady or higher oil prices over the medium term:

The cyclical upturn in the global economy has supported oil demand, which grew by around 1.6 million barrels per day in 2017 and based on OPEC estimates is going to grow by a similar amount in 2018 and reach almost 100 million barrels per day.

Even though US shale oil production is increasing, it is not overwhelming the market. Suggesting that shale production is not exactly like a tap and that there may even be infrastructure related bottlenecks that constrain supply growth.

The anticipated phasing out of the combustion engine by electric powered vehicles, we think, will take far longer than oil bears expect. Beyond the intangible benefit – at least at an individual consumer level – of doing what is good for the environment, consumers receive very few, if any, tangible benefits in switching to electric vehicles. (We accept that there are some notable exceptions in countries where governments have incentivised electrical vehicle adoption through tax breaks, subsidies, etc.)

There simply are not enough electric vehicle charging stations across any automotive market of meaningful size. Any large scale roll out of electric vehicle charging stations would, in our opinion, have to be subsidised, directly or indirectly, by governments as any such roll out does not, at this stage, make commercial sense, even as an industry-wide joint effort.

China has been a strong proponent of electric vehicle adoption over the years.

China’s recent pollution crackdown, at face value, also appears to be a continuation of its policy of promoting electric vehicle adoption. The reality, however, is that the crackdown has placed immense pressure on China’s already limited natural gas supplies, fuelled discontent amongst its citizen and driven China to import record amounts of LNG.China simply cannot afford for the adoption rate of electrical vehicles to accelerate. We, therefore, think that China is likely to gradually phase out any remaining incentives for electric vehicle adoption as opposed introducing further incentives promoting adoption.

In addition to the above we do not think the market is fully pricing in the potential disruptions to supply from:

A collapse in Venezuelan crude production;

The increasing probability of the Trump Administration pushing through reinstatement of economic sanctions on Iran;

Sustained cooperation between Saudi Arabia and Russian in managing supply; and

Slashed exploration and production budgets across the non-state owned oil majors.

Positioning in futures markets remains stretched, making the price of oil susceptible to a sharp correction, especially if trade war rhetoric continues to ramp-up between the US and China. We would see any such correction as an opportunity to build a position in our most favoured oil plays.