Centre Street Cambridge Corporation - October 2021 - cscc96 meta name="keywords" content="Commentary October 2021

all Street offers frequent and unique opportunities to examine human decision-making in the face of great uncertainty, a process that fascinates students of the financial markets, inspiring renewed reflection on investment challenges and methods. This year’s most noteworthy lessons have come from an unlikely source: the energy sector. Given up for dead last year, energy has produced strong returns for investors and commodity speculators in the intervening months.

Call it the revenge of the unloved and unwanted. While much attention has lately been focused on global warming and the need to transition to more sustainable sources of energy, the world has quietly stumbled into a new energy crisis. Recent price action in the markets for traditional fossil fuels tells a remarkable story. Following their collapse in early 2020 during the pandemic’s initial surge, when petroleum futures prices briefly fell below $0, oil’s price per barrel gradually rose, until, in early October 2021, the world benchmark Brent crude contract changed hands at $83 per barrel, the highest since 2018. On October 5, European natural gas prices gained 23% (multiplying nearly seven times in six months), while those in the U.S. rose 10%. U.S. crude oil reached a seven-year high. Even coal, the most vilified of fossil fuels, has reached thirteen-year highs in Asia, where the price has doubled this year. Lack of investment in new coal production capacity is crimping supply at a time when demand has increased due to high natural gas prices. In Europe and the UK, record prices and shortages of coal and natural gas threaten their economies and have already caused other problems, from electricity generation to more obscure activities such as ice cream delivery. An unusually cold winter could complicate matters more. In countries with weak currencies, such as Turkey and Argentina, prices for oil have reached historic levels due to the pricing of oil in U.S. dollars. Fears of inflation brought on by rising energy costs have also lifted some sovereign bond yields to the highest in two years.

Demand accounts for much of this dramatic price action, as economies have reopened with unexpected rapidity following pandemic curtailments and shutdowns. Demand for coal has increased in some areas due to shortages of natural gas, as utilities turn to the traditional resource to produce electric power, in contrast to other regions that have increased gas usage in order to reduce their dependence on coal-fired plants. China, on the other hand, is building more coal-fired electricity generating plants, and even the U.S. has seen an increase in coal demand for power generation. A fierce competition has erupted for available supply of both coal and natural gas; the Chinese government, for example, has directed its energy companies to secure, “at any cost,” the supplies necessary to maintain the country’s economic growth.

Supply has been playing its necessary role in determining prices as well. Looking at the big picture, it’s important to note that hydrocarbons still represent 85% of the world’s primary energy supply. Given the prevailing negative attitude towards the fuel, it may also surprise and dismay some to know that coal still accounts for about 28%, mostly used in Asia. Expansions and contractions of demand for fossil fuels will, therefore, have a big impact on pricing at the margin, and combined with a dearth of investment in productive capacity across the sector spanning several years, pricing will probably become more volatile in the future.

Specific factors are also at work in the current price surge; for example, OPEC has managed to maintain their production cooperation since the price collapse last year and has only gradually increased crude output as the world economy recovers. The imperatives of capitalism have also played a part; U.S. shale producers, once a hot growth sector in the industry, have demonstrated unusual restraint in increasing their production even in a higher price environment (shale drilling, or “fracking,” requires a relatively high commodity price to make a profit). In their heyday in 2014-2015, shale companies consumed more capital than they produced, but Wall Street now refuses to finance such profligacy, requiring less attention to growing production rates and more to returning cash to shareholders in the form of dividends. Regional supply pressures, such as Europe’s natural gas shortage, have been attributed to politics, with some fearing that Russia, a major supplier, has been using gas exports as a tool of diplomacy in an attempt to pressure the EU into removing sanctions. Shut-in gas wells in the Netherlands and lack of storage capacity have also wreaked havoc in European gas markets.

These supply/demand developments in the energy sector are a wake-up call, providing important lessons, both for investors and for those who believe in the importance of laying the groundwork for a less carbon-intensive future (which should be all of us). It should be clear that any attempt to rapidly move away from dependence on hydrocarbons will be extremely difficult — despite all the talk and rancor, the use of fossil fuels continues to rise and will probably exceed pre-pandemic consumption rates within a couple of years. We suspect that much of the talk about carbon neutrality — especially in the corporate world — contains more than a hint of hype and “greenwashing.” Like it or not, from the beginning of their use in industry over two centuries ago, fossil resources have been an abundant, easily accessible, and cheap source of energy and raw materials that have infused themselves into every aspect of modern life, from fuels to pharmaceuticals. Fully replacing them would be unfeasible without upending economies, and doing so carelessly, without preparation of alternatives, would impose substantial, perhaps unbearable costs, especially on less-developed, poorer countries, and vulnerable populations in wealthier ones. The upheavals brought on by the pandemic might well seem tame compared with to social stresses that would be caused by a botched energy transition.

To compound the problem, some of the more significant and popular of the proposed solutions to limit greenhouse gases are of doubtful merit. For example, when viewed over the entire cycle from production to scrapping, it is unclear if electric vehicles are more advantageous than small gasoline-powered automobiles. Much depends on the source of the electricity powering them, but the production process itself is energy-intensive, and the sourcing of some materials, such as lithium and cobalt for batteries, poses serious environmental threats. Lithium production, for example, in addition to using large amounts of water often in arid regions, risks releasing poisonous materials. Often called an ideal “green” solution, nuclear power presents well-known environmental dangers, as well as tremendous cost. Other efforts to reduce greenhouse gas emissions in air travel and transport seem at their earliest stages at best. Realistically speaking, global warming will not be easily stopped, and sacrifices will not be avoided. Technological advances could change the calculus but cannot be counted on. Fossil fuels, and the need to produce them, will very likely be with us for quite a while to come.

We will close this topic by pointing out that for the last fifty years or so there is one tool that has already succeeded in greatly reducing the rate of greenhouse gas creation, and that is the price mechanism. The radical increase in oil prices after 1972 altered the trajectory of hydrocarbon consumption and reduced the economy’s energy intensity. This change alone prevented the release of billions of tons of greenhouse gases that would otherwise have made it into the earth’s atmosphere. Changes in the relative costs of different energy sources could be a powerful factor in moving away from fossil fuels. This has already taken place to some extent; solar power has become less expensive to the point where it is a competitive source of electricity in some regions. However, the resistance to imposing a cost for carbon (which would make the cost of “externalities” clear) is not encouraging.

The Future is not Knowable, but it is Important

— Howard Marks

The bust/boom trajectory in the energy markets since early 2020 is a perfect, if extreme, example of the chief challenge that investors face: how to deal with uncertainty. The future is, in fact, unknowable, yet upon it the success of all investment, whether in one’s education or in financial instruments, depends. In March of 2020, in the midst of an economic crisis and market panic, oil consumption dropped 10% and prices collapsed. Investment in production halted, and many energy companies went under. For all we knew at the time, weak economic conditions and depressed stock markets could have lasted for years. Few anticipated that economies would reopen, haltingly, within months, after successful pandemic control measures were put in place. Even fewer expected potent vaccines to be developed in record time. When business activity began to recover, and, in the case of petroleum, demand started to revive, prices embarked on their remarkable ascent. Investors in depressed stocks, especially those in the energy group, and those willing to place bets on commodity prices, did well.

The great paradox of successful investing is that it actually requires uncertainty. Certitude about the future — were it to exist — would demand no return. It is when the future is unknowable that we require compensation for the risk of unexpected outcomes. Those investors who successfully navigated the market panic in 2020 recognized that the returns being offered by a market in turmoil would more than compensate for an uncertain future that, as they correctly surmised, would not look so very different from the pre-pandemic past. Doing so demonstrated they had learned the lesson of past crises, when staying calm and acting opportunistically proved a wise choice.

Due to the challenges facing the world as a result of global warming and the changes that will be required to check its progress, the assumption at the heart of our investment thesis, that the world will continue much as before, may be called into question. Nevertheless, given the uncertainties now surrounding the future, it is, paradoxically, certain that investment opportunities will appear.

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