The alert trader holds a particular maxim in high regard. It is to never underestimate the influence of one’s present condition in infecting the mind as it looks to the future. It is the thought process of the contrarian.
It is striking how many mainstream commentators seem to be content to promulgate forward today’s fearful state when engaging in the future guessing game. Yet time, they say, is a great healer and history shows that we do forget the unusual times. Astute traders know that when everything is all out of kilter and upside down, at some point, normality will return. Dynamic disequilibrium will settle down to a state of more stable equilibrium. There will be a reversion to the mean and the conditions of the interregnum will be soon forgotten.
The macro level, longer term manifestation of mean reversion is the tendency for markets, especially in commodities, to display cyclicality.
Cycles in commodity markets are not accidental, nor are they to be observed as infrequently (or for the reasons) espoused by Kondratieff. In fact, they are based on the sound economic underpinning of supply and demand…time lags and overreactions. It is known as the “cobweb” theory – developed in the 1930’s through observing the market for Hogs in the US Mid-West – and translated into economics textbooks for generations of students (who remembers Richard Lipsey’s text “Economics” now in its 12th edition, which sets out this theory for budding undergraduate economists!).
Thinking beyond what is (invisibly) all around us at present (yet causing so much social, medical and economic pain) and, thinking in terms of cyclicality, is especially relevant for intelligent forward planning as we struggle through the present demand shock of COVID-19 and the oversupply conditions in the oil markets. We may struggle to see 5 minutes, 5 days or even 5 months ahead, but maybe 5 years – a decent planning timeframe – is more visible. Maybe there is not (and hold your nose at the irritating expression), a “new normal” on the horizon.
It increasingly appears that there will not be a quick answer to our current woes via vaccine or immunity, but is it not reasonable to assume that in a 3 to 5 year time period COVID-19 will be behind us, the most disruptive ergonomic adjustments to our way of life will have outlived their usefulness, demand will have recovered and energy prices reverted to a reasonable level consistent with the consequences of lower production and drilling levels borne of the present panic? Demand may not fully recover to pre-COVID levels as some new habits evolve, but the supply side will also bear scars where the highest cost, least economic (and possibly filthiest) reserves will be stranded underground. There will, of course, be pain for individuals and corporations as there has been through other crises – Gulf wars, stock market crashes etc…. even if this round is especially extreme for the traditional fossil fuel industry.
Perhaps, then, the new normal is the same as the old normal when seen in hindsight through the cycle, even if the mean reversion resettles to a different absolute level on the secular trend – one where the benefits of technological advance justify a downward sloping absolute price trend in order to preserve financial returns.
Except…. what if this time around there is also a secular force of heroic proportions at work that will actually lead to things being different. Could the Energy Transition (ET) agenda be such a force? Will the momentum of this agenda pre-COVID-19 be resilient enough to survive through the panic or will the agenda be set aside as the fiscal and monetary consequences work their way through the economic system and individuals and corporations stick tightly close to home?
A recent study from BCG – reported in the Financial Times on 9th May – offered interesting food for thought. It found that “92% of professional investors polled would prioritise key business capabilities over commitment to environmental, social and governance objectives (ESG)”!! It is hard to imagine such an opinion prevailing in the pre-COVID-19 world. The present condition is clearly having a negative effect on what was the strategic imperative of many, other than just the politically correct, to address with a seriousness of purpose: the push to counter climate change and to press towards zero net carbon. Is the ET agenda being unfrocked to reveal itself at the top of the pyramid in Maslow’s hierarchy of needs-merely a ”luxurious” concern while other more basic immediate needs take priority? Perhaps oil demand will only be truly threatened fundamentally by poverty and economic stagnation. Have professional investors simply been wallowing in a conscience salve while times are good?
Furthermore, might the growing suspicion of “models” such as those predicting the speed and incidence of climate change, be tarred with Professor Neil Ferguson’s brush and be manna for naysayers? If this thought process is pervasive, then the agenda is on hold. So many questions……
Yet there is a compelling counter argument, at the very least for those who possess a “Western” gaze on the world. A recent report from the American bank, Goldman Sachs, reported that the “UN’s Principles of Responsible Investing (PRI) has set the requirement for signatories to have ESG criteria integrated into 50% of their assets under management (AUM)”. This will impact $45 trillion of AUM in 2020 with non-compliance risking de-listing. This, they said, “will act as a drag on capex in carbon intensive industries”.
Furthermore, there is a strong argument that the ESG/ET agenda has gone too far for the momentum to be more than, at worst, temporarily interrupted. Arguably, the collective psyche of the Western world has been imbued with an agenda of ethical behaviour towards the environment.
A belief in cyclicality strongly suggests a return to health of the energy market that will again offer producers a return consistent with the risks inherent in their business. After all, it is the internal rate of return (IRR) metric and not absolute price level that matters. The interim pressures to control costs will only reinforce the return to improved performance. Surely the good news about this has to be that price levels consequent on this process should be sufficient to sustain and indeed reinforce the ET agenda, even if the colossal cost of technological change that this agenda requires will also need governmental contribution through continued subsidy and intelligent carbon taxation. This will enable governments, corporations and individuals who are charged by society as a whole with the task of transforming themselves into environmentally sustainable entities to continue to meet the challenge.
There is a co-dependency. Perversely the net zero carbon agenda needs there to be a cyclical recovery in the fossil fuel business to continue to impact climate change!!
Maybe, in fact, we can see forward better than we think we can, if only we were to look more closely at the lessons of the past. Maybe we need neither guess nor fear!!
Or maybe you think differently!!!???