Weekly Energy Update (July 27, 2023)

Posted on July 27, 2023July 26, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Oil prices have moved into the upper end of the trading range.

(Source: Barchart.com)

Commercial crude oil inventories fell 0.6 mb, less than the 2.0 mb draw forecast. The SPR was unchanged.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.2 mbpd. Exports rose 0.8 mbpd, while imports declined 0.8 mbpd. Refining activity fell 0.9% to 93.4% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. Current inventories are falling but at a slower-than-normal pace. If we follow the seasonal pattern, stockpiles should continue to fall into mid-September.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $60.14. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002. Using total stocks since 2015, fair value is $93.10.

Market News:

The Biden administration is projecting it will make a modest purchase of SPR oil this year, around 12 mb. Obviously, this amount pales in comparison to the sales over the past 18 months. Part of the reason for the slow injection is that the infrastructure may not be able to handle aggressive injections, but the bigger reason is that there is simply a lack of urgency to refill the reserve. Some of the reluctance is due to cost; like dieting, saving isn’t fun. Another reason is that the shale revolution means there is less vulnerability to world events, and if the world reduces its use of oil, the SPR could become stranded. Still, the SPR does act as a supply buffer, not just for the U.S. but the world. China has been doing the opposite of the U.S., which is building its reserve. Of course, cheap Russian oil has created this opportunity for Beijing.
As India industrializes, its energy demand is rising. The country is becoming an important source of incremental oil demand.
Argentina is expanding its natural gas exports.
Due to falling water levels, Kyrgyzstan has declared an energy emergency.

Geopolitical News:

Although U.S. foreign policy has clearly signaled a desire to reduce its focus on the Middle East, Washington has decided to expand its military capability in the region in response to ship seizures by Iran. Iran’s behavior is clearly an irritant and distraction, but it also shows that no other military is able to fill this stabilizing role in the near term.
- The U.S. is considering placing air defense systems in Iraqi Kurdistan due to threats from Iran.
- Iran is equipping its navy with long-range cruise missiles.
- In recent reports, we have been documenting this summer’s heat across the Northern Hemisphere. Iran is dealing with extreme levels of heat this year, which is leading to water problems.
Iran has become closely allied with Russia and China, but apparently there are limits to that alliance. Iran announced that its deal to buy Su-35 fighters from Russia has fallen through. Although no official reason was given, it appears that Russia was uncomfortable giving Iran its best military technology. Iran is also suggesting it has an indigenous substitute.
The net effect of the Western sanctions against Russia has not been a reduction in oil supplies, but rather a massive restructuring of the global oil market. One way the market has changed is that the former dominant oil trading firms have shied away from Russian trade, opening up opportunities for smaller firms to fill the gap created by sanctions.
- We are also seeing new buyers for U.S. crude oil as shipping patterns adjust. Asian buyers are purchasing U.S. crude oil in the face of rising Middle Eastern prices.
- Iraq has been a conduit for Iran to evade sanctions. The U.S. has taken steps to crack down on the illicit dollar trade between Iraq and Iran by banning 14 Iraqi banks from the dollar network.
China is taking steps to reduce its dependence on foreign energy supplies. Recently, it has been drilling ultra-deep onshore wells in search of natural gas. Given the costs, this investment is probably only justifiable on national security concerns. China is currently the fourth largest producer of natural gas. Although official data is lacking, there is a high likelihood that China is boosting imports to fill its SPR.
Afghanistan has struggled since the early part of the century. It harbored al Qaeda after 9/11, leading the U.S. to invade the country to oust the Taliban. The U.S. occupation continued until 2021, when the Biden administration engineered a chaotic exit. The Taliban returned to power, but to some extent, it was a Pyrrhic victory. Few nations wanted to deal with the regime, and it has faced its own internal unrest. However, one bright spot for the Taliban is that Afghanistan holds rich lithium deposits. China is making inroads into Afghanistan, hoping to exploit this resource.
The Kingdom of Saudi Arabia and China continue to deepen their economic ties. Saudi Aramco (2222, SAR, 32.25) recently completed a deal to take a 10% stake in China’s petrochemical industry.
In Sweden, demonstrators have allegedly been burning Qurans; in response, the Swedish embassy in Baghdad was stormed by protestors.
Oil and gas deposits in the eastern Mediterranean are becoming an important source of hydrocarbons for the Middle East and Europe. The West is dominating this development, acting as a counterweight to other Middle Eastern producers.

Alternative Energy/Policy News:

When China restricted Japan’s access to rare earth minerals in 2010, it highlighted China’s dominance in this market. In reality, rare earths are not all that rare. What allowed China to dominate the market was that the mining and processing of these minerals tend to be disruptive. China was simply willing to suffer the environmental costs. But as other nations realized the vulnerability they faced from Beijing’s whims, we have seen a concerted effort to build mining capacity outside of China. This report on Sweden’s mining activity is an example.
The Inflation Reduction Act (IRA) provides subsidies to firms building clean energy facilities in the U.S. Foreign firms have been aggressively taking advantage of the opportunity. This outcome suggests foreign firms are participating in the reindustrialization of the U.S.
- The IRA is also fostering the EV battery recycling industry. As EVs become more prevalent, scrapping the vehicles after their useful life expires creates new problems. Recycling the batteries reduces the problems of dealing with old EVs.
- In fact, recycling may be part of the solution in meeting the demand for EV metals.
- The U.K. is also subsidizing battery production.
One of the favorable factors of markets is that prices signal to both consumers and producers to adjust their behavior. The decentralized characteristic of markets creates efficiencies that central planning, to date, hasn’t been able to duplicate. The EV revolution will increase demand for copper, and as copper prices have increased, producers are looking for ways to use less copper. Most of the adjustments, so far, have been in modest engineering changes. We still expect copper demand to be strong in the coming years, but the simple extrapolation of demand from current use is probably overestimating future consumption.
- Another example of the evolution of the EV industry is the solid state battery. Toyota (TM, $165.40) claims to have a battery with a 745 mile range.
The Greens in Germany are part of the currency ruling coalition. Ostensibly an environmental party, it has moderated its positions over the years to increase its political power. However, true to its roots, it has supported an aggressive policy stance of replacing boilers in German homes with heat pumps. The plan has turned out to be very unpopular and may undermine the current coalition.
EVs are fair weather vehicles, as it turns out. It’s well known that extreme cold weather reduces battery range. Evidently, hot weather has an even greater negative effect.
The environmental movement is plagued by a purity constraint as virtually every technical solution to an environmental problem will create an adverse impact on some part of the ecosystem. A recent lawsuit against the EPA argues that biofuels likely violate the endangered species act.

View PDF

Bi-Weekly Geopolitical Report – China’s Collapsing Population (July 24, 2023)

Posted on July 24, 2023July 24, 2023 by Amanda Ahne

Patrick Fearon-Hernandez, CFA | PDF

In early 2020, we published a detailed, multi-part analysis of global demographic trends (see our Weekly Geopolitical Report from February 10, 2020). That report showed how falling birth rates and rising life expectancies have led to slower population growth, population aging, and weaker economic activity in countries ranging from China and India to the United States and Japan. These demographic trends will have big implications for economic growth, price inflation, interest rates, and relative military power in future years.

In this report, we take a deep dive into China’s worsening demographics, based on the UN Population Division’s updated projections from late last year and other recent revelations. As we show, China is now facing what could be considered an outright demographic collapse. We also discuss the many negative implications of this demographic collapse for the Chinese people and for global investors.

Read the full report

Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify | Google

The podcast episode for this particular edition is posted under the Confluence of Ideas series.

Asset Allocation Quarterly (Third Quarter 2023)

Posted on July 20, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

Our three-year forecast still includes a relatively mild recession followed by a recovery and the potential for an economic expansion.
We expect inflation to moderate in the near-term but modestly re-accelerate in the back half of the forecast period given underlying structural influences.
The Fed’s monetary policy is likely to ease as economic conditions slow. Additionally, we expect a measured and careful approach by the FOMC as the presidential elections draw nearer.
The duration posture remains short-term. We anticipate the yield curve will begin flattening from its current inverted state.
In domestic equities, we maintain our value bias as well as large cap cyclical sectors and quality factors within lower market capitalizations.
International developed markets include an overweight to Japan. We maintain emerging markets exposure in the most risk-accepting portfolio but exclude China.
Gold exposure is maintained for its benefits as a low-correlation asset along with its potential to act as a haven during economic turmoil and as a hedge against geopolitical risk.

ECONOMIC VIEWPOINTS

The economy has generally remained resilient despite the Fed’s tightening actions and a widely anticipated recession. While fiscal spending has supported the economy, consumer spending has carried the expansion on the back of strong household balance sheets. However, we are seeing the first signs of slowdown in consumer sentiment. As this chart indicates, household non-mortgage debt-to-cash ratios have crept higher recently, indicating weakening balance sheets which could negatively affect spending. Savings that were bolstered by stimulus payments have now been depleted by strong discretionary spending and inflationary pressures on the overall consumer basket. Early signs of slowing consumer spending are emerging from the Consumer Staples and Discretionary categories, which we believe are due to price elasticities of demand in response to higher inflation. It is significant to note that we are seeing household balance sheets deteriorate even before the resumption of student debt payments. An estimated 37 million borrowers had a three-year reprieve in student debt payments and reports indicate this primarily supported consumption and did not accrue into savings. We expect these debt payments to further suppress spending.

At the same time, labor markets have remained strong with unemployment near cycle lows. The unemployment rate may be artificially understated as employers are hoarding labor in fear of labor shortages even when consumer demand is slowing. Here, again, we are seeing early signs of a slowdown in hours worked and falling rates of wage growth.

Macro headwinds combined with monetary policy tightening reinforce our forecast for a mild recession, which is likely to be uneven among different segments of the economy. For example, the increased cost of capital is likely to weigh more heavily upon more highly leveraged companies and those embarking on new projects or expansionary efforts. The overall recession is not expected to be severe since it has been widely anticipated and elevated levels of liquidity on the sidelines should provide support to risk markets. As this chart shows, we continue to see historically high levels of money market and ultra-short bond fund assets. These levels are high for two main reasons. First, the inverted yield curve is offering attractive yields in the short end of the curve with low levels of risk. Second, accruing this yield is attractive for investors waiting on the sidelines for a dip in the market, providing support to risk markets.

Inflation is already showing signs of slowing. We believe this is primarily in response to the short-term smoothing of the supply-chain problems and is only secondarily affected by slower demand caused by tightening monetary policy. Our expectation is that inflation will return toward the end of the forecast period due to underlying structural issues, such as deglobalization and aging demographics. We also expect the new inflation regime to be higher than during the ZIRP epoch but lower than it has been since the pandemic.

One of the mega-trends supporting domestic economic activity longer-term is the re-shoring of manufacturing capacity and generally shortening supply-chains. Geopolitical tensions are likely to remain elevated and further support international polarization into regional blocs. Reliability of supply is now prioritized over the absolute lowest cost of manufacturing. Capacity buildouts are multi-year endeavors, which will place increasing demands on construction labor and materials initially and skilled labor to operate in the long-term. We believe these pressures, alongside general supply-chain complications, will further reveal inflationary bottlenecks in the economy and could lead to the resurgence of inflation.

We expect the path of monetary policy to be measured and careful over the forecast period, especially as we head into the 2024 presidential elections. Fed fund rates are likely to settle higher following the recession as the FOMC attempts to control a systemically higher inflationary regime.

STOCK MARKET OUTLOOK

A mild recession is generally discounted into current equity fundamentals, especially lower capitalization stocks. Domestic large cap stock valuations remain near cycle highs, with the expansionary cycle extended by excitement around AI and machine learning. We remain cautious regarding large cap exposure as concentration remains at historic highs. For example, the top 10 names in the S&P 500 accounted for roughly 30% of that index at quarter end. To guard against concentration risk, we lean our style tilt toward value over growth. Additionally, we retain our Aerospace & Defense position and cyclical sector overweights as we project that deglobalization and re-militarization of foreign countries is a sustainable long-term trend. We maintain our sector overweights to Mining, Energy, and Industrials in most strategies. The Mining and Energy sectors are likely to benefit from electrification/green energy policies as electrification is metals heavy.

We believe small and mid-capitalization stock valuations remain attractive, while fundamental earnings power remains healthy. Mid-cap stocks, specifically, remain at historically wide valuation discounts to large cap stocks. Last quarter, we introduced a quality factor in our mid-cap exposure. Similarly, we remain in a quality-screening vehicle on the small cap side. The quality factor screens for profitability, leverage, and cash flows, which should support the group through economic volatility.

We continue leaning into the value bias across all market capitalizations. We view the sustainability of earnings growth as more attractive in equities categorized as value and the fundamental valuation multiples are modest compared to historical data. In addition, value style has a lower exposure to sectors that we view as overpriced. Although growth has vastly outperformed value year-to-date, we anticipate that we are in the early stages of a value outperformance cycle.

International developed equities remain attractively valued, while their earnings potential remains healthy. This quarter, we added a country-specific overweight to Japan as shareholder-friendly reforms are starting to take hold in the country and as capital flows are moving out of the rest of Asia and into Japan, which could potentially lead to earnings multiple expansion. We also forecast positive returns from emerging market stocks on the back of U.S. dollar weakness, although exposure to this asset class is limited to only the most risk-accepting strategy. Given the potential economic slowdown and geopolitical risks stemming from China, we have directed our exposure to an emerging market ex-China investment vehicle.

BOND MARKET OUTLOOK

With the anticipated decline in the fed funds rate (the Fed’s reaction to the recession) and a more docile near-term level of inflation, the most attractive segment of the Treasury curve is in short duration. While our base case is for a flat yield curve to reign by the end of the three-year forecast period, we harbor concerns regarding intermediate-term bonds and especially long-duration bonds. Should inflation reassert itself within the forecast period, yields on long-term debt could rise, exerting downward pressure on prices and resulting in a traditionally shaped yield curve. Consequently, the duration posture of the strategies with income as a component remain short-duration with a concentration in one-year Treasuries.

Among investment-grade corporate bonds, it is notable that spreads have not compressed beyond historic averages, underscoring the absence of investor concern even in the face of the much-anticipated recession. Moreover, corporate debt issuance has been subdued over the past few years and has not led to excessive debt levels on most corporate balance sheets. Nevertheless, it would be consistent with our thesis for spreads to widen modestly as the recession takes hold and the maturing of low coupon debt to be refinanced with bonds reflecting higher rates than what prevailed during the years prior to 2022. As a result, corporate bond exposure in the strategies represents a lower proportion than popular market indices.

In the speculative-grade corporate bond category, we find caution is warranted due to the sizable increase over the past 15 months in the cost of capital for highly leveraged companies that are refinancing debt. As with investment-grade corporates, spreads have been relatively contained. However, an uneven recession is likely to cause spreads on lesser rated corporates rated B or lower, especially those in the distressed category, to widen markedly. Accordingly, all exposures to speculative-grade bonds in the strategies are exclusively in BB-rated debt.

OTHER MARKETS

Allocations to REITs are absent as our forecast for the sector over the near-term calls for continued headwinds and low levels of demand for office and retail space, compounded by the difficulty in arranging financing. Although the strategies similarly avoid broad-based commodities owing to recession-induced pressure on prices, we maintain the allocation to gold across the strategies. We favor the continued gold exposure as it can act as a haven during economic contractions and as a hedge against geopolitical risk. Furthermore, gold can be beneficial due to the potential strength it offers during periods of U.S. dollar weakness and its use as a reserve asset for global central banks.

Read the full report

Asset Allocation Fact Sheet

Weekly Energy Update (July 20, 2023)

Posted on July 20, 2023July 19, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

On Monday, oil prices spiked on reports that the Kingdom of Saudi Arabia (KSA) was going to extend its voluntary production cuts until year’s end. The report was incorrect but does show the power that the news has on the oil markets.

(Source: Barchart.com)

Commercial crude oil inventories fell 0.7 mb, less than the 2.5 mb draw forecast. The SPR was unchanged.

In the details, U.S. crude oil production was steady at 12.3 mbpd. Exports rose 1.7 mbpd, while imports increased 1.3 mbpd. Refining activity rose 0.6% to 94.3% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace in the first quarter, stockpiles have moved into a pattern consistent with the seasonal. Current inventories are in line with seasonal levels.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $59.94. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002. Using total stocks since 2015, fair value is $92.96.

About the Heat: We have been commenting on the unusually warm temperatures currently in the Northern hemisphere. Europe, unaccustomed to such heat, is having a very difficult time adjusting. In the U.S. the southern tier of states has experienced extreme heat, especially in the Southwest. China is seeing hot weather as well. Temperature reporting is now front and center in the media. Although climate change is being blamed for much of it, our experience with climate is that it’s complicated. There are two complications that are important to mention:

Sunspot cycles: The sun plays a major role in the earth’s climate. Sunspots are the result of magnetic activity on the sun that causes flares and ejections from the sun’s surface. The scientific community is divided on the impact of sunspots on climate. Some argue that it is an important factor, others dismiss the activity as negligible. We are not climate scientists but interested observers. Our take is that the cycles likely amplify the normal variation. That means that sunspot cycles probably don’t drive climate by themselves but do play a role.
- Sunspot cycles run 22 years, from trough to trough. The current cycle will peak in 2025. In general, increased activity tends to lead to higher temperatures. Thus, we are in the part of the cycle that should lift global temperatures. The current cycle isn’t unusually amplified, but its current readings exceed the peaks observed in the last cycle.

(Source: NOAA)

ENSO cycles: The ENSO cycle has three phases—El Niño, La Niña, and neutral. In recent years, we had experienced a set of La Niña events. We are currently in an El Niño event, and current projections suggest it will be moderate to strong. El Niño events often lead to hot North American summers, especially across the south. It has also coincided with mild winters.

The combination of elevated sunspot activity and an El Niño ENSO cycle indicates that hot weather will continue. In the developed world, this climate condition tends to be bullish for summertime natural gas prices, as it boosts air conditioning demand and consequently, electricity consumption. So far, U.S. natural gas production has been robust enough to keep injections on par with seasonal norms. This factor has kept natural gas prices low. If winters are mild, it could be bearish for natural gas prices going forward. There have been other effects as well:

Hot, dry weather in parts of Europe have caused the water levels of the Rhine River to decline, forcing shippers to lighten barges by shipping less product. Mississippi River water levels are also low.

High river temperatures are limiting nuclear power production in France.
Hot weather in Spain has sent (olive) oil prices soaring.
Temperature and rainfall changes have created situations where it is hard to find any part of the U.S. that is unaffected.

Market News:

The IEA’s oil market report increased oil demand by 2.4 mbpd to 102.3 mbpd, a new record. Most of the demand will be met by non-OPEC+ suppliers. Meanwhile, we note that the KSA is losing its spot as top oil producer within OPEC+. In the early 1980s, something similar occurred which led the Saudis to aggressively retake market share, tanking oil prices in the mid-1980s.
- As the KSA reduces output, Kuwait is aggressively lifting productive capacity. We doubt that the Saudis will tolerate this absorption of market share indefinitely.
The global natural gas market is experiencing a generational adjustment in the wake of the war in Ukraine. The IEA’s recent global natural gas report details how the world market for gas has changed.
The recovery in oil prices has lifted the Russian Urals price to the G-7 cap of $60 per barrel. The breach will begin triggering financial sanctions for traders and the financiers of these oil purchases. We will be watching to see if Russian oil sales are affected.
The Biden administration is planning modest injections into the SPR, but in no way is this going to replace all the oil that was sold.
California, once a major oil producer and still the 7^th largest oil producing state, has essentially stopped new oil well approvals.
Turkey has suspended oil flows from Iraq over a dispute over payments. So far, there has been little progress in freeing up these flows.
One of the surprises of the past year has been the rather modest increase in U.S. oil production despite elevated prices. As we have noted in the past few months, higher costs for drilling and financing issues have stifled output. Now, there are reports that drilling rig counts are fading, suggesting that production may decline in the coming months.

Geopolitical News:

India has been a major buyer of Russian crude oil, but the two nations have struggled to establish payments. India has been paying in INR, but the Russians have discovered that the usefulness of INR is limited due to the lack of deep Indian financial markets and capital controls. And so, to facilitate further sales and avoid USD transactions, Russia and India have agreed to transact in CNY. It’s unclear how much is being done in the Chinese currency and what India’s CNY reserve status is at the moment. However, if this continues, then at some point India will need to run a trade surplus with China to acquire CNY. We doubt China will support that outcome.
Israel is working to improve relations with Azerbaijan. The Israeli defense minister has visited the country recently. At the same time, Azerbaijan is working to improve relations with Iran as well.
Russia recently suggested that the UAE had the rightful claim to the Greater and Lesser Tunbs and Abu Musa, three islands in the Persian Gulf that are controlled by Iran. The Iranians were not pleased. Although Iran and Russia have seen relations improve recently, there have been notable differences over the years that still affect the relationship.
As part of the thaw in Saudi/Iranian relations, the KSA, Kuwait, and Iran may be working to jointly develop offshore natural gas in the Persian Gulf.
In response to Iran’s interdiction of Persian Gulf shipping, the U.S. is increasing its deployment of F-16s to the region. The U.S. has also moved F-35s and a destroyer to protect shipping. There is also talk of boosting air defense systems in Iraqi Kurdistan as Iran has also been threatening that region.
The morality police in Iran were sidelined during last year’s headscarf protests. The police have apparently returned, along with a crackdown on women not wearing the hijab.
Although sanctions on Russian energy sales have affected global oil supply, they haven’t really prevented Russian oil from entering the market. The sanctions have reduced the Russian revenues from oil sales (evading sanctions costs money), but the Russian economy continues to muddle through, although there is increasing evidence that economic conditions are deteriorating. Essentially, Western nations really didn’t want to shut off the flow of Russian oil, but they just didn’t want to pay high prices due to sanctions. The real goal was to reduce Russian revenue, and in those terms, sanctions have been generally effective.
- Saudi Arabia is increasing its imports of Russian petroleum products. We suspect these are for reexport. Exporting product to friendly nations is one way Russia is evading sanctions.
- Sanctions on Russian oil have benefited Venezuela and Iran, who have both seen sanctions on their respective nations ease. Dubai has benefited by becoming the place where Russian oil deals are consummated. The role of busting sanctions used to belong to Switzerland; that has changed.
- Interestingly enough, the U.S. has also benefited from sanctions. The shift from coal to oil disadvantaged Europe, which had plenty of coal but lacked oil. The U.S. has attempted to use oil as a diplomatic tool to gain European compliance to American policy goals. Europe, obviously wanting to avoid this pressure, and against American opposition, bought Russian oil. The U.S. was open to Europe buying oil from the Middle East as well, but Europe’s goal was diversity of sources. The war in Ukraine has exposed the risks of being dependent on Russia, which has led to a boom in U.S. oil and gas sales to Europe.
Schlumberger (SLB, $56.41) has finally ended sales to Russia.
Relations between the UAE and the KSA leaders have deteriorated recently. Mostly, it appears to be driven by the goal of both leaders to project power in the region.

Alternative Energy/Policy News:

Solid state EV batteries could be the technology that moves transportation to electricity. The batteries promise not only to recharge in a time frame similar to filling a car with gasoline, but also to have a range that may exceed 700 miles per charge. Nio (NIO, $10.48) announced it will start using these batteries. The current technology is still emerging, but the more the industry moves to solid state, the quicker the transition is likely to be.
- We continue to monitor the progress in not just solid state batteries, but cheaper materials to make batteries. Lithium prices have soared as EV production rises, so replacing such metals with cheaper alternatives would be another form of progress.
The European heatwave, noted above, is boosting solar power output.
The EU is trying to use trade policy to secure critical EV metals. Mercosur and the EU have been in trade negotiations for some time, but now the EV buildout is increasing European’s interest in getting a deal done. However, for the Mercosur nations, the echoes of colonialism continue, prompting resource nationalism.
- The U.S. Senate has approved a tax treaty with Chile, which could support lithium imports.
- The Economist magazine notes that the process of energy conversion may not be possible without buying such products from China.
Chinese GDP data was disappointing, but two bright spots are EVs and solar panels. China is aggressively building out battery storage which is critical to the expansion of solar power.
According to reports, China is aggressively hacking the U.S. energy grid and could use cyberattacks on the grid in case of a war.
One of the paradoxes of the energy transition is that environmental concerns about mining key metals is hampering the expansion of supplies needed to replace fossil fuels.
- As the world scrambles for critical EV minerals, mining the deep sea is being considered. Concerns about environmental damage are being raised.
- Maine has deposits of lithium, but the state prohibits commercial mining of the resource.
Clean hydrogen offers the promise of clean energy using the existing infrastructure. However, it isn’t clear if that promise will ever materialize.
A new deal to build and deploy small modular nuclear reactors in the Northwest shows the steady growth and interest in this new technology.
The CFTC is drafting guidance for the eventual creation of a carbon market. Economists hold that the fastest way to address carbon reduction is to properly price it. Having this trading done on exchanges is one way to create a market for carbon credits.

View PDF

Asset Allocation Bi-Weekly – Are Higher Interest Rates Bearish for Risk Assets? (July 17, 2023)

Posted on July 17, 2023July 13, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

Orthodox finance and economics rests on the idea that higher interest rates reduce economic activity and lower the attractiveness of risk assets. We have no real quarrel with the part about reducing economic activity as higher borrowing costs will tend to slow investment and consumer durable spending. The effect on risk assets seems rather straightforward as well. Higher rates should divert funds to fixed income and away from equities and commodities.

However, when debt levels are elevated, rising interest rates could increase interest income. Current debt levels are high.

This chart shows private sector debt (household plus non-financial business sector) scaled to GDP along with general government debt. Although the total is down from the pandemic peak of 304.1%, it is still 262.0% of GDP. Combine that debt level with rapid policy tightening, and interest income would be expected to rise. In fact, in raw terms, it is.

Interest income is about 8% of total personal income, which is lower than the peak of 18% in 1984. Thus, in looking at the overall data, there isn’t a strong case that interest income is all that significant yet.

However, there is a distributional factor that may affect risk assets.

In this chart, we estimate the flows of interest income by wealth distribution. As the chart shows, over the past 18 months, interest income to the top 10% of households has increased significantly. The middle 40% has seen modest gains, while the bottom 50% has seen small increases.

In terms of asset allocation, the top 10% hold around 50% to 60% of their wealth in equities. Increased income flows to this wealth bracket, paradoxically, means that more liquidity is available for other purchases. As long as interest rates stay elevated, we would expect fixed income and cash balances to remain high. Although once policy starts to ease, this additional income will likely look for other alternatives; put another way, the bounce to stocks from policy easing could be higher than expected.

View PDF

Weekly Energy Update (July 13, 2023)

Posted on July 13, 2023July 13, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Falling U.S. inflation is raising hopes that the Fed’s tightening cycle is coming to an end. That has lifted oil prices, triggering a breakout above the recent trading range.

(Source: Barchart.com)

Commercial crude oil inventories rose 5.9 mb, well above the 0.1 mb draw forecast. The SPR fell 0.4 mb, putting the total build at 5.5 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.3 mbpd. Exports fell 1.8 mbpd, while imports fell 1.4 mbpd. Refining activity rose 2.6% to 93.7% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace into mid-February, injections first slowed and then declined. This week’s build is contraseasonal; current inventories are in line with seasonal levels.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $59.77. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories. With another round of SPR sales set to happen, the combined storage data will again be important.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002. Using total stocks since 2015, fair value is $94.27.

Market News:

China has made a concerted effort to improve energy security. Increasing its imports from Russia and making aggressive diplomatic and investment actions in the Middle East are all part of this goal. It should be noted that domestic production is also increasing.
- China has increased residential natural gas prices in a bid to reduce demand.
Hot weather continues. In the U.S., 6 million Americans are in areas of extreme heat. Phoenix is threatening to break its previous record of 18 days with 110+ F temperatures. Miami has also seen temperatures near that level and has suffered through 30 consecutive days of heat indexes over 100 F.

Geopolitical News:

As sanctions erode on Iran, Tehran is boosting exports, thwarting the Kingdom of Saudi Arabia’s efforts to lift prices.
- Iraq is becoming increasingly important in Tehran’s sanction busting.
Venezuela has seen sanctions gradually erode as the world adjusts to the war in Ukraine. The country is using expanding oil exports to pay down debt.
Russia tends to view Central Asia as its near abroad. We have noted that recently China has been challenging Russia for this region. Reports suggest that the Prigozhin mutiny has led the “stans” to further distance themselves from Moscow.
Rob Malley is a long-time diplomat that specializes in Iran. He was the Iranian envoy (the U.S. doesn’t have formal relations with Iran) for the Biden administration and was involved in the JCPOA talks. He has been relieved of his duties as the FBI investigates his handling of classified materials. However, there is growing speculation he may be a spy for Iran.
Last week, we noted that the U.S. Navy had thwarted efforts by Iran to seize vessels. Apparently, this action wasn’t enough to keep Iran from trying again as the IRGC has now seized a tanker in the Persian Gulf. Meanwhile, Indonesia has seized an Iranian tanker thought to be engaged in an illegal oil transfer.
Iran is said to be increasing cyberattacks against Western targets.
There is increasing evidence that Iran is trying to attack Israel directly via Hezbollah.

Alternative Energy/Policy News:

Although car dealers are tending to hold less inventories these days, reports suggest that EV inventories are becoming rather bloated. Current inventories are at about a 92-day supply, twice the industry average. Sales have picked up, but supply is outpacing demand with probably the biggest issue being price. Also interesting is that hybrid inventories are only 44 days.
Chinese automakers are targeting the U.S. Chinese EVs are a threat to the U.S. market due to their lower costs.
Mercedes-Benz (MBGYY, $19.86) is the latest automaker to adopt the Tesla standard for charging connectors. The company joins five other firms, including General Motors (GM, $39.77) and Ford (F, $15.10), in adopting this standard.
The IEA has released its first report on minerals critical to the energy transition. There is an expanded race to secure key metals involving governments, commodity firms, and automakers.
The energy transition can’t occur without mining and smelting. Although such activities are generally acceptable in the abstract, they become problematic when they occur close to home.
The IEA has published an update on the progress made toward zero emissions.
The seabed is a controversial region for gathering these critical minerals. Island nations and China are keen to develop this source, while European nations are trying to restrict the effort. Meetings on this issue are underway in Jamaica.
Climate problems are becoming a challenge for insurers. The U.S. system of state regulation may not be suited to respond.
Biofuel makers are starting to consider bamboo as a source. The plant grows rapidly and could become a reliable source for ethanol. We note that on the West Coast biofuels are displacing distillate fuels.

View PDF

Asset Allocation Bi-Weekly – The Green Shoots of Re-Industrialization (July 3, 2023)

Posted on July 3, 2023June 23, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

In a little-noticed report last month, total construction spending in April was up a modest 6.1% from one year earlier, but private nonresidential construction spending was up a whopping 30.2%. That marked the fourth straight month in which private, nonresidential construction, a proxy for commercial construction, was up more than 20.0% year-over-year. In contrast, outlays on public works (such as roads, bridges, and sewer systems) rose 15.1% in the year to April, while private residential construction spending fell 9.7%. We believe these figures confirm an important new trend in the U.S. economy that will have big implications for certain asset returns going forward.

The strength in commercial construction may seem surprising, given today’s high vacancies and the pessimism regarding properties such as office buildings and shopping malls. Those sectors continue to face major headwinds, and they certainly were not responsible for this recent rise in commercial construction. The jump in commercial building has primarily come from new factory construction, especially manufacturing facilities for electronics and information-processing goods. Total outlays on factory construction in April were more than double their level in the previous April, with a year-over-year rise of 104.4%. Expenditures on just the subsector of electronics and information-processing factories nearly quadrupled, showing an astounding increase of 271.8% on the year. Of course, some of this increased spending simply reflects the high inflation in prices for construction inputs ranging from labor to cement. Nevertheless, the spending increases far exceed any reasonable estimates of inflation for construction inputs. The spending figures, therefore, confirm a huge rise in real factory construction.

The frenzy in building new electronics factories provides some of the first statistical evidence of U.S. re-industrialization, i.e., the rebuilding of the nation’s manufacturing, construction, and mining sectors as companies shift production back home from Asia or elsewhere abroad. We suspect that a lot of the new factory construction reflects the recently announced, high-profile projects for electric-vehicle batteries, semiconductors, and other green-energy or info-technology goods. However, we doubt that the recent spending uptick includes much of the hundreds of billions of dollars in subsidies provided by last year’s Inflation Reduction Act or the CHIPS Act. Slow bureaucratic and administrative procedures would suggest that most of those subsidies will only kick in later. In addition, higher military budgets have not yet had their full impact on the defense industrial base. The recent increase in factory construction, therefore, is probably only the beginning of a much larger, longer-lasting uptrend.

As geopolitical tensions between China and the West worsen, and as Chinese economic growth slows, we think the U.S. will be a key beneficiary of companies “near shoring” or bringing production back home. New data suggests even Europe will see some re-industrialization. The data shows that global businesses acquired or leased 9.6 million square feet of industrial space in the European Union during 2022, marking a 29% increase over the previous year. The uptake of factory buildings comes even as weak consumer demand in the region pushes down contracts for retail and warehousing space. Re-industrialization in the EU could accelerate even further if its member states adopt U.S.-style subsidies or if their defense spending increases spur an expansion in their defense industrial bases.

As the world fractures into relatively separate geopolitical and economic blocs, we have been arguing that re-industrialization will take root in the U.S. and, to a lesser extent, in Europe. The data discussed here shows re-industrialization has indeed started to take root and is now pushing up green shoots that are likely to grow further. Over the long term, this re-industrialization will be a mixed bag for Western societies. It will likely make the West more resilient to external supply shocks and provide more opportunities for workers without a four-year college degree, but these new facilities and the shortened supply chains they represent will be less efficient than under the extreme globalization of the last few decades. The result will likely be persistently higher inflation and interest rates.

Fortunately, shorter-term prospects are more positive. The building boom will likely support demand even as the overall economy slips into recession. The new, highly modern factories being built could also quickly boost worker productivity when they come on line. Finally, since rebuilding the nation’s factory sector will require repairing and expanding roads and other infrastructure, it could also help reverse the recent fall in state and local government investment that we recently wrote about. For these reasons, we believe this re-industrialization will provide a short-to-medium term boost to several different stock sectors, such as broad industrials, construction companies and the service providers that serve them, providers of construction materials and equipment, and perhaps even real estate investment trusts (REITs) that focus on industrial properties.

View PDF

Bi-Weekly Geopolitical Report – Distinguishing My Wife From a Hat, an AI Story (June 26, 2023)

Posted on June 26, 2023June 26, 2023 by Amanda Ahne

Thomas Wash | PDF

In his book, The Man Who Mistook His Wife for a Hat and Other Clinical Tales, Oliver Sacks, a neurologist, details his experience with patients suffering from varying neurological disorders. In one such case, he dealt with a man who had lost the ability to recognize faces. The patient was a university music teacher who had always been known for his calm and collected demeanor but had suddenly began behaving strangely. He would sometimes fail to recognize his students and was often seen patting the top of water fountains and parking meters as if they were small children. His antics were widely regarded to be jokes since he didn’t have trouble communicating, and his musical ability was as good as it had ever been.

It wasn’t until the patient was diagnosed with diabetes that he sought professional help. Aware of the disease’s impact on his eyesight, he visited an ophthalmologist, who reassured him that his vision was fine but referred him to see Dr. Oliver Sacks for a neurological exam.

During the visit, Dr. Sacks noticed something was off about the patient. The man seemed to be having trouble perceiving Dr. Sacks fully. Instead of looking directly at Dr. Sacks’ face, the patient fixated on certain parts. He gazed at Dr. Sacks’ nose, chin, right ear, and right eye, but never his face as a whole. After telling the patient the exam was over, the man attempted to find his hat but instead reached for his wife’s head and tried to lift it as if he were about to put it on. To Dr. Sacks’ surprise, the patient’s wife treated this as if it were an everyday event.

The case of the man who mistook his wife for a hat is a great illustration of how artificial intelligence (AI) neural networks process information. Like the patient, neural networks do not have the ability to look at an entire image to judge what it is. Instead, they break down images into parts, specifically into an array of numbers called pixels. AI models (neural networks) see images by recognizing patterns in the numbers that represent the image. They can make distinctions between different objects through training which then teaches them to associate certain patterns with specific objects. Just like the patient who needed to see an eye, nose, and mouth to know that he was looking at a face, AI models need numbers to achieve the same task.

This report provides a beginner-friendly introduction on how AI learns and processes information. We will begin by discussing the similarities between AI and our brains. Next, we will explain how AI works and explore some of its most important applications. We will then discuss some of the challenges and limitations of AI. We end the report with market ramifications. While this is not intended to be an exhaustive summary of AI, readers should come away with a stronger understanding of the technology and why it is such a big deal.

Read the full report

Don’t miss the accompanying Geopolitical Podcast, available on our website and most podcast platforms: Apple | Spotify | Google

Weekly Energy Update (June 22, 2023)

Posted on June 22, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Oil prices may be establishing a new trading range between $67 and $75 per barrel.

(Source: Barchart.com)

Commercial crude oil inventories fell 3.8 mb when compared to the forecast build of 0.5 mb. The SPR fell 1.7 mb, putting the total draw at 5.6 mb.

In the details, U.S. crude oil production fell 0.2 mbpd to 12.2 mbpd. Exports rose 1.3 mbpd, while imports declined 0.2 mbpd. Refining activity declined 0.6% to 93.1% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace into mid-February, injections first slowed and then declined. This week’s draw is consistent with seasonal norms. The seasonal pattern would suggest that stocks should fall in the coming weeks, but this pattern has become less reliable due to export flows.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $58.21. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002. Using total stocks since 2015, fair value is $93.15.

Market News:

The Netherlands is closing Europe’s biggest natural gas fields due to local concerns about earthquakes. Often oil and gas extraction can lead to earthquakes; Oklahoma has experienced similar issues. This decision, though, will put the EU at risk of supply shortages.
The war in Ukraine has led to a massive restructuring of the global energy market. LNG has become an important fuel, and there has been a clear expansion of its use. This expansion has led to a rapid increase in the infrastructure for the fuel, including gasification plants in the Middle East, Australia, Canada, and the U.S.
- China has embarked on long-term contracts with suppliers, which establish the funding for investment. The EU, likely because of expectations of renewable growth, is less open to long-term contracts. If natural gas usage continues, Europe could find itself isolated.
- Russia’s oil refineries hit new highs in utilization, which may mean that Russia intends to meet its OPEC+ obligations by replacing oil exports with product exports. Russian oil exports have been affected by the war.
- Russia’s oil flows to India have been at deep discounts, helping to improve India’s economy.
- Russian natural gas is still flowing through Ukraine, but the current agreement ends next year, and Kyiv expects Russian gas flows to stop.
There are some unusual actions being taken by the Kingdom of Saudi Arabia (KSA) regarding oil flows. For example, consistent with its decision to reduce oil flows, Saudi oil exports fell to a five-month low in April. However, there are numerous reports that the KSA is storing 20 mb of oil on 10 tankers in the Red Sea. We also note a spike in supertanker rates, which may be tied to the KSA’s decision to float oil storage.
- The Permian Basin is now producing more oil than the KSA’s giant Ghawar field.
- So far, the KSA’s bid to boost prices has failed to work.
The summer solstice came this week, marking the onset of astrological summer (meteorological summer began on June 1). We are seeing a strong heatwave in the South, especially in Texas. Hot weather boosts electricity demand and usually is bullish for natural gas prices. We note Texas degree days are running well above normal.

(Source: Reuters)

- Texas isn’t alone in its drought; Iran is facing a crisis as well.

Mexico has joined several firms in a deep-water oil and gas project.
Guyana is delaying offshore oil-block auctions in a bid to increase the number of participants in its oil exploration.
Ship channel dredging will allow larger oil tankers to directly load oil and products from the Texas coast.
The DOE suffered a data breach tied to Russian hackers.
- DOE Secretary Granholm failed to disclose stock holdings; it is unclear if this fact will lead to her ouster.

Geopolitical News:

The U.S. is still buying uranium from Russia for American power plants. Although nuclear power is an attractive alternative energy, the lack of a non-Russian supplier is a risk.
One of Russia’s long-term geopolitical goals is a warm water port. Although the warming of the Arctic may give Moscow the sea access it wants, it has eyed the Middle East as a possible path to the ocean. As Iranian and Russian relations improve, Russia is looking to build access to the Indian Ocean through Iran. A risk to this path is that the Arab states in the Persian Gulf have tended to side with the U.S. However, as relations fray between Washington and these Arab states, the risks in using Iran for sea access decline. Thus, the recent thaw between Riyadh and Tehran is a benefit to Moscow.
We are seeing a concerted effort by China to secure energy sources. China appears to be deploying an “all of the above” strategy, including both alternatives and fossil fuels. What is important here is that China is most interested in energy security, with less regard for the source.
Central Asia isn’t just the focus of China and Russia. Germany is also looking to secure energy from the region and held talks with Kazakhstan
As we noted last week, we were mostly wrong about an Iran nuclear deal. What we got right was that the JCPOA was dead. What we didn’t expect was that the U.S. would opt for a limited deal in what looks like a bid to reduce regional tensions. We doubt this will increase global oil supplies much since Iranian sanctions are far from tight, but easing tensions will likely make more oil available to the West. We suspect the White House is fully focusing on November 2024, and although there will be a political cost to a thaw, the chances of lower oil prices are probably seen as a greater benefit.
- It isn’t clear what will actually be agreed to in the deal. The U.S. appears willing to accept Iranian uranium enrichment to around 60%, which is less than weapons-grade but still shows that the country can reach the 98% required for bombs. Particles enriched to nearly 84% have already been reported.
- Iran will receive some funds that are currently frozen, and the U.S. will get prisoners freed.
The KSA has invited Iran’s president to Riyadh for an official visit.
China has agreed to build a nuclear power plant in Pakistan.
Here is a cool map of China’s energy infrastructure.

Alternative Energy/Policy News:

One of the emerging themes for the next few years will be the choice Western nations face on EVs. If the goal is extensive adoption, the most effective way of achieving this is to allow Chinese imports. China’s EV industry has improved rapidly and is now producing world-class cars at reasonable prices. On the other hand, if the goal for Western nations is re-industrialization, Chinese cars should be restricted. So far, we have generally expected Europe to be much more open to Chinese EVs compared to the U.S. However, there is evidence that the EU is rethinking that position.
- Tesla (TSLA, $268.75) is rapidly becoming the connection standard for the EV industry as more EV makers adopt its standard. Doing so gives car owners access to Tesla’s charging stations.
In fact, meeting climate goals is often in direct conflict with meeting geopolitical goals. There are serious doubts as to whether the West can move toward carbon neutrality without China.
Solid state EV batteries have the potential to revolutionize the industry. Toyota (TM, $157.40) has a test vehicle it claims has a range of 932 miles with a 10-minute charge. If high range/short charging becomes the norm, ICE vehicles will be much less attractive.
The U.S. is leading a critical minerals partnership in a bid to create a strong supply chain for metals needed for the energy transition. Presently, China holds a commanding position in these metals, but the U.S. and its allies want to build a supply network that prevents China’s dominance.
- It should be remembered that part of the reason for China’s dominance is that it was willing to accept the environmental costs of mining and processing these metals.
- The U.S. is facing calls from nations with key minerals but without free trade agreements with the U.S. to join this partnership. So far, Washington has restricted the subsidies, but if the U.S. doesn’t expand the list, China might become an alternative funder.
- Minnesota may become an important source of nickel, but the permitting process could be daunting.
Chinese regulators approved a thorium reactor. Thorium reactors have some major advantages over uranium reactors. They didn’t get used in the early days of nuclear power because nations wanted the dual option of being able to make nuclear weapons, and thorium can’t be weaponized. In addition, this reactor will use molten salt, which is another significant benefit.
Hydrogen is a fuel that offers promise in providing clean power but tends to fail at gaining traction due to costs. The U.K. is looking to use the fuel for home heating but is struggling with the details. In the EU, there is a program to expand the pipeline network to move hydrogen.
The U.K. has opened its first deep geothermal project in 37 years.
Although there is great hope for fusion power, the reality is that we are a long way from commercial fusion power.
The Biden administration announced an increase in biofuel use, but surprisingly, the ethanol mandate was less than expected. Even with other biofuels, the mandates were less than expected. Biofuels replace fossil fuels to some extent, but also still require fossil fuels in production. In general, biofuels are more about reducing U.S. dependence on foreign oil and are an aid to farmers. Corn ethanol, for example, reduces greenhouse gas emissions by 19% compared to gasoline. The best benefit comes from biomass and cellulosic ethanol. But because neither comes from a cash crop, support for these fuels is lacking.

View PDF