Author: Rebekah Stovall

Weekly Energy Update (August 13, 2020)

Posted on by Rebekah Stovall

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

Here is an updated crude oil price chart.  The oil market has stabilized at higher levels after April’s historic collapse.

(Source: Barchart.com)

Crude oil inventories fell more than anticipated, declining 4.5 mb compared to forecasts of a 3.7 mb decline.  The SPR declined 2.2 mb as oil that was placed in the SPR for temporary storage is now being put back into the commercial system.

In the details, U.S. crude oil production fell 0.3 mbpd to 10.7 mbpd.  Exports rose 0.3 mbpd, while imports fell 0.4 mbpd.  Refining activity rose 1.4% but most of that was due to declining East Coast capacity.

Unaccounted-for crude oil is a balancing item in the weekly energy balance sheet.  To make the data balance, this line item is a plug figure, but that doesn’t mean it doesn’t matter.  This week’s number is +515 kbpd.  Although the volatility of this number is elevated, the trend is slowly stabilizing.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data showed another decline in crude oil stockpiles.  We are approaching the end of the seasonal withdrawal period.  Although the declines of the last few weeks are supportive, stockpiles remain well above seasonal norms and remain a bearish factor.

Based on our oil inventory/price model, fair value is $35.95; using the euro/price model, fair value is $63.51.  The combined model, a broader analysis of the oil price, generates a fair value of $49.85.  The wide divergence continues between the EUR and oil inventory models.  As the trend in the dollar rolls over, it is bullish for crude oil.  Any supportive news on reducing the inventory overhang could be very bullish for crude oil.

As we have noted recently, gasoline consumption has stalled.  However, we are seeing some good news on the distillate front—demand is clearly recovering.

In oil news, OPEC has revised its demand outlook for 2020 lower, calling for a 9.1 mbpd decline in demand this year.  If VP Biden wins in November, it may be a bearish event for oil.  Not because of any new “green” legislation but more because he would likely return to the Iran nuclear deal that was implemented by President Obama.  If he does, it is likely that Iranian oil exports would resume, adding around 2.0 mbpd to the oil markets.  That would be difficult for OPEC+ to manage.

We have seen a surprising jump in natural gas prices.

(Source: Barchart.com)

As the chart shows, there was a huge rally in early August and prices have been consolidating since.  The jump in prices occurred despite the persistent inventory overhang.

The rise in prices is probably due to expectations that falling crude oil output will reduce natural gas supplies.  It is not unusual for oil drillers to discover natural gas (so-called “associated gas”), so when oil production is elevated, natural gas supplies increase almost as a byproduct.

Some of the suddenness of the price action was likely due to rising coastal temperatures, but the sustainability will really come down to winter weather.  Current outlooks are bearish for prices.

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Weekly Geopolitical Report – The Evolving U.S. Policy Toward China and Its Impact on Investors (August 10, 2020)

Posted on by Rebekah Stovall

by Patrick Fearon-Hernandez, CFA | PDF

Looking forward to the coming years and decades, today’s long-term investors face a stark question: will they be investing in a China-dominated world molded by authoritarian leaders in Beijing?  Or, will they be investing in a more familiar, Western-dominated environment reflecting the historic leadership of the U.S. and incorporating the values of freedom, private property, and justice, as handed down from British common law?  Here at Confluence, we have long discussed the global public goods of security and a reserve currency that the U.S. has provided in its traditional role as global hegemon, and we’ve shown that U.S. citizens have become tired of providing those goods.  We’ve argued that the most likely future is one in which the U.S. relinquishes its global dominance, producing an unstable and dangerous transition period from which some new hegemon—perhaps China—will eventually arise.

But the end of U.S. hegemony and its replacement by China are not yet set in stone.  High-level “China hawks” in the Trump administration have launched an audacious effort to convince the American people and America’s foreign allies that they must push back against China and its effort to assume the throne of global leadership.  At the dawn of the Cold War, the architects of U.S. “containment policy” faced a similar challenge as they built the case for thwarting Soviet expansionism.  The question now is whether the new tough-on-China argument will resonate to the same extent.

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Asset Allocation Weekly (August 7, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

Investors often fall into the habit of sloppy thinking about government spending and its relation to the economy.  For example, it’s easy to focus only on total government-sector expenditures.  According to the White House Office for Management and Budget, total government outlays in the U.S. averaged 32.3% of nominal gross domestic product (GDP) over the two decades ended in 2019 (one of the lowest ratios among advanced countries).  However, that figure overstates the government’s contribution to GDP because it includes a lot of “transfer payments,” i.e., funds that are simply redistributed from one set of economic actors to another.  Social Security retirement checks, Medicare payments, and unemployment benefits are all examples of such transfers.  Counting transfers as a component of GDP would result in double-counting because the funds would also be captured in the calculation when they are spent.  Instead, economists strip out transfers from total government outlays and focus only on government consumption and investment expenditures.  Over the last two decades, government consumption and investment averaged just 18.8% of GDP.

Government consumption expenditures (on items like wages, fuel, and office supplies) averaged about 15.0% of GDP over the last two decades.  Government investment (spending on long-lasting goods like vehicles, buildings, and roads) was much less important for the economy, averaging 3.8% of GDP.  The public sector data can also be broken down into the federal government’s share and the portion spent by state and local agencies.  Over the last two decades, total federal consumption and investment (both defense and nondefense) averaged 7.2% of GDP, while state and local spending accounted for a full 11.6%.  Showing all these subcomponents together, the heat table below makes clear that consumption spending by state and local agencies is by far the public sector’s most important contributor to national economic activity, at 9.5% of GDP.

These figures help explain why a key risk for the economy going forward is whether state and local governments, facing a sharp decline in revenues because of the coronavirus crisis, will be forced to cut their spending so much that they offset the stimulatory effect of loose fiscal and monetary policy at the federal level.  That’s exactly what happened after the Great Financial Crisis of 2008-2009.  Corporate and personal income taxes, sales taxes, property taxes, and fees all plunged with the collapse in the housing market and the deep recession that followed, but the impact was especially severe on state and local governments since they are usually bound by law to balance their budgets.  Their consumption and investment spending fell far more sharply than the federal government’s spending from 2008 to 2013.  State and local spending declines in those years initially offset the federal government’s increased stimulus spending and later exacerbated the federal spending cuts associated with the “sequester” law.  That can be seen most clearly in the chart below, which shows the contribution to GDP from each level of government and the particularly negative contribution from state and local spending in 2010 through 2012.

Going forward, we remain optimistic that the economy will eventually recover from the disruptions of the coronavirus pandemic.  With the plethora of potential virus vaccines and treatments in development and the extraordinary amount of monetary and fiscal stimulus being provided, we think many sectors and businesses are likely to regain their footing and start growing again, which would be positive for corporate profits and stocks.  However, as the administration and Congress continue to negotiate over the latest coronavirus relief bill, we see a significant risk.  If insufficient aid is provided to state and local governments to make up for the pandemic’s hit to their revenues, spending in that big chunk of the economy could be cut enough to drag down overall economic activity and weigh on the equity market.

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Weekly Energy Update (August 6, 2020)

Posted on by Rebekah Stovall

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

Here is an updated crude oil price chart.  The oil market has stabilized at higher levels after April’s historic collapse.

(Source: Barchart.com)

Crude oil inventories fell more than anticipated, declining 7.4 mb compared to forecasts of a 3.5 mb decline.  The SPR was unchanged this week.

In the details, U.S. crude oil production fell 0.1 mbpd to 11.0 mbpd.  Exports fell 0.4 mbpd, while imports rose 0.9 mbpd.  Refining activity rose 0.1%, close to expectations.  The recovery of imports is consistent with the passing of recent tropical storm activity.

Unaccounted-for crude oil is a balancing item in the weekly energy balance sheet.  To make the data balance, this line item is a plug figure, but that doesn’t mean it doesn’t matter.  This week’s number is -609 kbpd.  It is possible that production fell more than the DOE estimate.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data showed a decline in crude oil stockpiles.  We are approaching the end of the seasonal withdrawal period.  Although the declines of the last few weeks are supportive, stockpiles remain well above seasonal norms and remain a bearish factor.

Based on our oil inventory/price model, fair value is $34.29; using the euro/price model, fair value is $57.11.  The combined model, a broader analysis of the oil price, generates a fair value of $45.81.  The wide divergence continues between the EUR and oil inventory models.  As the trend in the dollar rolls over, it is bullish for crude oil.  Any supportive news on reducing the inventory overhang could be very bullish for crude oil.

After a steady recovery since the trough in late April, gasoline consumption has stalled.  We suspect this is related to the surge in COVID-19 infections; if it continues, it is a bearish factor for crude oil prices.

In energy news, the U.S. has expanded economic sanctions on Iran, specifying a series of industrial metals thought to contribute to Iran’s missile program.  A total of 22 metals were listed; any nation trading these with Iran could be subject to sanction.

Saudi Arabia, with the help of the Chinese, constructed a facility to make “yellowcake” from uranium ore.  This is an important step in the nuclear process and suggests the kingdom has decided to at least create the infrastructure for a nuclear program.  This news follows on the heels of reports that the UAE opened a nuclear power plant.  The U.S. has tried to prevent Middle East nations from going nuclear.  It failed to stop Pakistan and it is thought that Israel has a nuclear weapon.  But, Iran’s drive to be a nuclear threshold state and America’s steady withdrawal from hegemony appears to be leading Arab states to at least start the process for their own nuclear programs.

Turkey has been involved in Libya, supporting Islamist factions against secular forces operating in the eastern part of the country.  The secular forces have been aided by Russia, the UAE, and Egypt.  To reduce Turkey’s influence in Libya, Egypt has allegedly sent troops to Syria to bolster Assad’s military aligned against Ankara.

As the pandemic affects global trade flows, the Gulf States are increasingly concerned over food security.  These nations are mostly desert and are thus dependent on imports for much of their food supply.  They have been taking increasingly aggressive steps to manage this issue.

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Weekly Geopolitical Report – Rethinking China: Part II (August 3, 2020)

Posted on by Rebekah Stovall

by Bill O’Grady | PDF

In Part I, we described China’s situation using Japan as a historical analog.  This week, we will complete the analogy and examine in some detail the potential motivations of Chinese and U.S. policymakers. As always, we will conclude the discussion with potential market ramifications.

China’s Situation
Similar to Japan in the 1930s, China has become a large economy showing geopolitical power that is threatening the established order.  Similar to Japan in the 1980s, it has an economy overly reliant on investment, trade and debt.  And, like Japan, it is dependent on sea lanes it does not control.  Finally, as was the case with Japan during both the 1930s and 1980s, China has reached a point where the U.S. is refusing to accommodate its rise.  However, unlike Japan, China is not as dependent on the U.S. for its security (although it is quite vulnerable to a blockade).

It is arguable that Deng realized China would eventually reach this state and thus encouraged Chinese leaders to bide their time.  Simply put, Deng wanted to extend China’s ability to stay “under the radar” for as long as possible before it would inevitably trigger a response from the U.S.

It is important to realize China is not acting in a vacuum.  The U.S. has a clear role in how this situation evolves.  The American response to China’s rise appeared to be guided by two principles.  The first is that eventually China would accept U.S. hegemony and the trading system America had created after WWII.  The second was that communism was fundamentally flawed and China would eventually develop into a capitalist democracy.

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Asset Allocation Weekly (July 31, 2020)

Posted on by Rebekah Stovall

by Asset Allocation Committee | PDF

The pandemic has clearly affected the economy.  The decline in economic activity in Q2 will be historic.  However, it is still unclear what effects will be temporary and what will be long-lasting.  A recent paper suggests that one permanent change may be a reduction in older workers.  COVID-19 has a disproportionately negative impact on older people; studies have shown that nearly 75% of fatalities have occurred among those over the age of 65.  That age falls roughly in the middle of the baby boom generation.  Anyone born in 1955 or earlier falls into this high-risk category.

Americans working past 65 years old, at least as a percentage of the total labor force, was common after WWII.  Social Security was still relatively new.  But, from 1947 to 1985, the participation rate for Americans over the age of 65 fell from the 28.6% peak in October 1949 to a low of 10.4% in June 1984.  The number of Americans in the labor force over the age of 65 peaked at 10.8 MM in February.  It has fallen sharply since.

This chart shows both the actual number of civilians employed over the age of 65 and the percentage of these workers compared to the labor force of 65-year-olds and older.  Participation has been rising since the early 1990s.  Some of this rise is simply due to a rising population of Americans aged 65 years and older relative to the total population.

This chart shows the actual and projected level of 65-year-olds and older compared to the total population.  The percentage has been rising since 2003 and is forecast to plateau in 2040.  The entire baby boom generation will be 65 years or older by the end of the decade.

It is possible that the tendency for COVID-19 to be a greater risk to older workers may mean that the drop in employment for adults 65 and over will be lasting.  These workers have the option of taking Social Security and don’t necessarily need to take the risk of returning to work.  If they do leave the workforce for an extended period, perhaps 18 to 24 months for a widely available vaccine, employers may be less open to hiring this age of worker when a younger one can be found.

What impact would a decline in workers aged 65 and older have?  Since older workers are often paid more due to their years of service, losing these workers will, at least initially, improve margins.  It will almost certainly lead to some increased hiring of younger workers and may accelerate lowering the age of the workforce.  It may also lead these older households to lower the risk in their portfolios by reducing equity positioning.  Of course, given current paltry interest rates on low-risk fixed income, investors striving for yield will be forced to take on equity-like risk at times.  It is still unclear whether the pandemic will lead to a permanent shift, but there is a good chance it will.  Thus, we will continue to monitor this development.

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