Q2'21: Financial Repression
By: Jack Schibli
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Inflation: All part of the plan?🎈
A two-year suspension of the U.S. debt ceiling passed in 2019 expired on July 31st. In a letter to Congress, Janet Yellen warned the Treasury will need to take "extraordinary measures" in order to prevent the U.S. government from defaulting on its obligations, and that these measures would be exhausted by early October[0]. Although lawmakers seem to be taking this to the wire, it's likely just a playing card for the GOP. As the U.S. Treasury's very own website points out "Congress has always acted when called upon to raise the debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit"[i]. Given this is like having a 5-year old decide how much Halloween candy they can eat, it's unlikely this trend will ever change. Yet, a 127% debt-to-GDP ratio puts the U.S. at risk of a market-induced default rather than budget-inflicted[ii]. Market actors might someday decide that record low-interest rates on U.S. Treasuries do not accurately reflect the risk of default should the debt-to-GDP ratio continue to rise. The increased interest expense associated with such a rise in rates would all but ensure default. If we've learned anything over the last decade, it's not to bet against the government's agenda, and today that agenda is financial repression.
There are several ways for a country to reduce its debt burden: 1) grow its way out in real terms (GDP growth > nominal debt service cost) 2) exercise fiscal austerity (increase taxes, decrease spending) 3) default and restructure (everyone takes a haircut) 4) inflate away the debt. Through low rates, the Federal Reserve tried to promote option 1 over the last decade to little effect. Option 2 will not happen in this administration and is unrealistic given the size of the debt load. Option 3, default and restructure may happen in emerging markets, such as Argentina, but is not realistic for the world reserve currency. This leaves option 4, which comes with a few caveats. As discussed above, financial markets will eventually require higher interest rates if inflation is well above Treasury yields, which would negate any progress generated through inflation for the government, given the associated interest expense costs. Enter financial repression, broadly defined as the use of policy to indirectly have private industry dollars pay down public debts.
To combat rising nominal interest rates, the Federal Reserve is likely to employ yield curve control (YCC). This would entail the Fed using quantitative easing to set an upper bound for interest rates, most likely on the long end of the curve, which effectively means it would provide unlimited demand for Treasuries above a stated level. YCC can be effective but at a certain point, the amount of QE required may be overwhelming, in which case the Fed could use their regulatory powers to create a captive buyer of Treasuries: commercial banks. The mechanism to implement such macro-prudential policies already exists. Following the 2008 Financial Crisis, the Bank for International Settlements created banking sector reforms, known as Basel III, to mitigate the risks of a repeat banking crisis. Among these regulatory frameworks is the introduction of the Liquidity Coverage Ratio (LCR), which stipulates banks must hold enough High-Quality Liquid Assets (HQLA) to fund 30-days of net cash flows[iii]. Adjusting the LCR or increasing reserve requirements are both avenues for the Fed to forcefully increase the banking sector's appetite for Treasuries.
If financial repression is the playbook, the result is deeper negative real rates. This is the transfer of real value from creditors to borrowers through the loss of purchasing power, hence why inflation is often referred to as the "silent thief". It's effectively a tax on savers, and one that does not require politicians to explicitly acknowledge, which is yet another incentive for the government to choose this debt reduction strategy.
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Even high yield bonds cannot provide a real yield in this regime.
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In the 1980s UK sitcom, Yes Minister, a particular scene shows two advisors to the Prime Minister discussing the four stages of the "Standard Foreign Office Response" to crises: "In stage one, we say nothing is going to happen. In stage two, we say something may be about to happen, but we should do nothing about it. In stage three, we say that maybe we should do something about it, but there's nothing we can do. Stage four, we say maybe there was something we could have done, but it's too late now". By the looks of it, we are somewhere between stage 1 and stage 2, as Jerome Powell and Janet Yellen have begun the process of extending their definition of "transitory".
"Inflation has increased notably and will likely remain elevated in coming months before moderating" / "The incoming inflation data have been higher than expected and hoped for" - Jerome Powell, Congress Testimony 7/14/21
"We will have several more months of rapid inflation.... but I think over the medium term, we'll see inflation decline" - Janet Yellen, CNBC Closing Bell Interview 7/15/21
Oil to the Moon? 🚀
Environmental, Social, and Governance (ESG) standards have taken the world by storm. Governments and investors alike are demanding companies make decisions based not solely on their contributions to shareholder value. The Milton Friedman doctrine "there is one and only one social responsibility of business--to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud" has been uprooted to include ethical considerations of a companies stakeholders and the environmental and societal costs of their externalities[iv]. The effect of investor demand for ESG principles has led many companies to make changes or promises that position them for better access to that capital. ESG, and its impact on the investing landscape, deserves its own piece, but for our purposes, we are concerned with the ramifications for the "dirty" oil and gas industry.
First, we must understand the role oil and gas play in the global energy complex. The global demand for energy is primarily a function of GDP growth, and presently the emerging markets are the primary drivers of GDP growth as their economies progress towards a more developed state. As you might expect, the wealthier and more developed a country is, the more energy it consumes per capita.
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As the chart details, the average American consumes more than 5x as much oil as their Chinese counterparts, and 15x the average Indian. Shockingly, these statistics do not account for developed worlds' reliance on outsourced manufacturing, through which it exports energy consumption and imports finished goods, thus these differences are actually understated. Should China and India consume an equivalent number of barrels per capita to Germany and Japan, global oil consumption would jump over 60%[v]. It is clear the demand for energy will continue to grow, the question then becomes how is that energy sourced. Renewable energy sources, such as solar, wind, and hydropower, have been taking share from traditional sources.
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However, this does not account for the growth in aggregate energy demand described above. So rather than replacing fossil fuels, renewable energy sources are additive, helping to soak up some of the demand growth.
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Oil and gas consumption continues to grow on an absolute basis, which is primarily a result of renewable sources failing to be a competitive alternative in terms of energy density and energy return on investment (energy on energy return). [As a side note - nuclear power remains the most promising carbon-free, scalable energy on Earth, carrying the highest energy density per land footprint and highest energy ROI[vi].] Barring any spectacular engineering breakthroughs, oil and gas will remain the world's largest energy source by a wide margin.
Commodities are inherently cyclical. An unexpected increase in demand relative to supply results in a period of rising prices, which lures companies into increasing production. New supply eventually manifests into excess supply, leading to lower prices, which disincentivizes any further investment in supply. A key dynamic in cycles is the lag time for new projects to reach the production stage, which is typically several years for oil.
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For Illustrative Purposes OnlyThe above charts tell the story of the last decade: the United States shale industry has been the world's swing producer of oil. Fracking is a highly capital-intensive form of extraction because wells are rapidly depleted and therefore, new funds are constantly needed to finance new drill sites. An extended period of low-interest rates allowed U.S. shale to fund their operations through debt and equity issuance rather than cash flows. Over the period January 2016 to March 2020, the average close price of WTI crude was $54.07, whereas the breakeven price of producers based on Dallas Fed Surveys over the same period was roughly $52. Large U.S. banks have been the primary financiers of U.S. shale[vii]. Of the nearly $225 billion in lending and underwriting from banks to U.S. frackers since the 2016 Paris Agreement, 60% have come from the top 5 U.S. banks: Wells Fargo, JPMorgan Chase, Citi, Bank of America, and Goldman Sachs[viii].
The era of easy money for U.S. oil is over. Many previous investors in the sector have already been harmed beyond repair, given over 250 North American E&P companies have filed for Chapter 11 since 2015[ix]. With investor demand waning and ESG mandates circulating throughout the investment and banking community, future financing for U.S. fracking will have to rely more heavily on cash flow. In the Q2 2021 Dallas Fed Energy survey, one E&P respondent commented:
"We have relationships with approximately 400 institutional investors and close relationships with 100. Approximately one is willing to give new capital to oil and gas investment. The story is the same for public companies and international exploration. This underinvestment coupled with steep shale declines will cause prices to rocket in the next two to three years. I don’t think anyone is really prepared for it, but U.S. producers cannot increase capital expenditures[.]"[x]
The current U.S. rig count has recovered to 491, still well below the pre-Covid level of nearly 800, despite rising prices[xi]. Therefore, the U.S. is currently producing about 2M barrels per day less than February 2020, and given the reopening demand forces, this has resulted in total crude inventories declining over 1.2M barrels per day over the last 4 weeks, the largest 4-week stock draw in 40 years[xii].
ESG policies focused on limiting the growth of oil and gas, and restrained access to capital are shaping a future of undersupply, while demand is growing in tandem with the global reopening, and potentially accelerated by any further government infrastructure spending. In this light, we believe oil prices will remain high and are subject to rapid increases following any demand-side surprises. This would continue to pressure inflation measurements, given oil is a key input cost to global manufacturing activity.
If inflation is the quarterback of the government's debt reduction playbook, is ESG its star receiver?
Disclosures
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status, or investment horizon. You should consult your attorney or tax advisor.
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Sources:
[0] Janet Yellen Letter to Congress. July 23, 2021.
[i] US Department of the Treasury. Policy Issues - Debt Limit. 2021
[ii] FRED Economic Data. Federal Debt: Total Public Debt as Percent of Gross Domestic Product. 2021
[iii] Bank of International Settlements. Liquidity Coverage Ratio Executive Summary. April 2018.
[iv] Friedman, Milton. The Social Responsibility of Business is to Increase its Profits. The New York Times Magazine. September 1970.
[v] Lane Generational Calculation based on data from BP Statistical Review of World Energy. 2020 & Worldbank Population Data. 2021
[vi] D. Weißbach, G. Ruprecht, A. Huke, K. Czerski, S. Gottlieb, A. Hussein. Energy intensities, EROIs (energy returned on invested), and energy payback times of electricity generating power plants. 2013
[vii] Market Pricing Data from Refinitiv. WTI Crude Breakeven Data from Federal Reserve Bank of Dallas. M. Plante, K. Patel. Breakeven Oil Prices Underscore Shale's Impact on the Market. May 2019.
[viii] OilChange International / Rainforest Action Network. Fracking Fiasco: The Banks that Fueled the U.S. Shale Bust. September 2020.
[ix] Haynes and Boone, LLP. Oil Patch Bankruptcy Monitor. March 2021.
[x] Federal Reserve Bank of Dallas. Q2 2021 Energy Survey. Comments from Survey Respondents. June 2021.
[xi] Baker Hughes Rig Count. June 2021.
[xii] U.S. Energy Information Administration Data & Bison Interests White Paper. Oil Demand is Outweighing Supply: Inventory Analysis. July 2021.
Figures:
1 - Longtermtrends.com. Real Interest Rates. Data compiled by Lane Generational Research 2021.
2- Koyfin Data. ICE BofA US High Yield Index vs. Consumer Price Index. 2021. Generated in Koyfin by Lane Generational Research.
3 - BP Statistical Review of World Energy & WorldBank Data (2019) compiled by Lane Generational Research.
4/5 - Our World in Data. Energy. Energy Mix. 2019
6 - Bank of Canada. Commodity Price Supercycles: What Are They and What Lies Ahead? August 2016.
7 - Federal Reserve Bank of Dallas. M. Plante, K. Patel. Breakeven Oil Prices Underscore Shale's Impact on the Market. May 2019.
