The Long Shadow of the Commodity Bust

Falling oil prices don’t make growth impossible

Originally published in the January 2015 issue

I’ll kick off where we left off, with the big surprises of last year. Obviously, one of them was the collapse in yield. The other, let’s face it, was the dramatic drop in oil prices. I suspect that few owned oil puts at $55 for the end of 2014, and that by the start of 2015, few expected WTI to reach $45. On a large scale, to illustrate the magnitude of the recent move, such a collapse in a period of six months is obviously a multi-standard deviation event. It’s a very rare occurrence.

When we look at a move of this magnitude, I think there are two possible responses. One of them would be to say there is a lot of information in this price move: it tells us that the world economy is doing a lot worse than people expected; we’re facing a global recession, perhaps because of a slowdown in China, or a slowdown in other emerging markets, etc. This is one possible conclusion. The other possible conclusion when you look at a collapse of this magnitude is to say oil prices were in a bubble and the bubble has burst, and we have thus had a massive adjustment.

Let’s look at the first possibility. Are we facing, today, a global recession? Now, the interesting thing, of course, is that when you look at the economic data, broadly you find a US economy that’s finding its feet, a Chinese economy that is slowing down but not imploding, and a European economy which, after two or three very, very poor years, is also recuperating (at least in the north).

But, more importantly for me, the struggle I have with the idea that the collapse in oil prices reflects an absolute economic meltdown such as the one in 2008 is that equity prices are not at all behaving as if we were in 2008. There has been lately a massive dichotomy between Chinese equities that basically tells you the Chinese economy is finding its footing, and of course, the collapse in oil prices.

Which brings me to the second possibility: the possibility that oil was in a bubble, and that this bubble burst. As to why it burst now, I think you can find many possible explanations. The first, of course, is that the Fed has stopped injecting excess liquidity into the system. The other is that China, for the past 18 months, has been in the grips of a very strict and rigid anti-corruption crackdown. If you look at commodities, it’s no secret that, for the past 10 years, China has been the marginal buyer, and here, I would quote Charlie Munger, Warren Buffett’s right hand man. Munger often says, “Show me the incentives, and I’ll tell you the outcome.”

For 10 years, if you were a middle-ranking manager at a Chinese state-owned enterprise linked to commodities, you were basically told, “Go out and do a commodity deal, and we won’t look too closely at the prices you pay.” Lo and behold, as the anti-corruption crackdown unfolds, what do you find? You find that most people who’ve been put in jail were either related to the police, related to the army, or related somehow to PetroChina and the Chinese overall oil complex, because if you tell me you’ve got a blank cheque to go buy assets abroad, it’s pretty easy to go to places like Indonesia, Angola, or wherever else and say, “All right, I’ll pay a billion for this asset, and you send $50 million to my account.”

This is potentially the second reason for the commodity bust: the fact that now that the incentive for Chinese middle managers to pay the wrong price for commodity deals has disappeared, now that you’ve had no commodity deals done by China over the past, really, 18 months, commodity prices start to collapse. But, for me, the real catalyst for the collapse in the oil price was Putin’s visit to Beijing this summer, when Putin was on the ropes. Here, I’ll quote another famous American investor, T. Boone Pickens. T. Boone Pickens always says, “If you want a deal real bad, you get a real bad deal.”

This is exactly what occurred to Putin. Putin arrived in Beijing, on the ropes, sanctions from the EU, sanctions from the US, and he needed a deal real bad, and he needed a friend. Xi Jinping took him by the hand, treated him royally, said, “We can be Russia’s friend.” But, what deal, fundamentally, did Xi Jinping give Putin? He said, “I’ll buy your natural gas from you, but I’ll buy it at 40% below the price I pay today, and I’ll pay for it in Renminbi, so whatever money I give you, you’ve got to come back and spendhere”, and Putin took the deal.

Now, this matters tremendously. It matters tremendously, if you think of the world as having two marginal energy producers, and these marginal energy producers being Saudi Arabia and Russia, and one marginal energy consumer, being China, the guy who’s constantly in the market saying, “I need more, I need more.” If a marginal supplier and a marginal producer get together and do a deal off the market, at 40% below market, then, guess what? That’s the new market price.

Of course, since that deal was done, energy prices have looked one way, and that’s been down, because what happened this summer – and this is, I think, a very important change in the world – is that China managed to transform itself from a price-taker in the energy market, to a price-setter. This transformation alone means that the dynamics in the energy market have been radically transformed. Today, when we look at the energy market and all of us want to pick a bottom, most of us think that this comes down to second guessing what the Saudis are going to do.

Forget it. It’s not about whether the Saudis are going to cut or not. The bottom will be formed by China, and specifically, the question we should be asking ourselves is, when will China decide the oil price is now low enough that I want to load up and import massively? If you want to figure out when oil makes a bottom, don’t look at Saudi politics, because the odds there of figuring out what happens are slim to none; instead, look at VLCC (very large crude carrier) rates. This will tell you whether China is importing oil at today’s low prices, which is what China did in 2008, and whether China is filling up to benefit from the current low prices. Until China does that, energy prices will remain low.

But it still leaves us with a very distinctively different investment environment. The first acknowledgement we need to make when we look at the low oil price is that a bubble has just burst, and bursting bubbles are, in and of themselves, profoundly deflationary. When bubbles burst, it means that capital has to move from weak hands to strong hands at lower prices. It also means that capital, and potentially a lot of capital, needs to be written off. Of course, this burst of the commodity bubble, I believe, explains why bond yields have been collapsing over the past six months.

Each burst bubble that we’ve had over the past 20 years has led to lower and lower bond yields, and to a six to nine-month precipitous decline in yields, pretty much all over the world. We’ve just had the six to nine-month precipitous decline in bond yields that comes, typically, with the burst bubble.

Having said that, we must also acknowledge that there are different kinds of bubbles. You have what we’ve called in our research good bubbles and bad bubbles. Bad bubbles occur on unproductive assets – think houses in Florida, or condos in Tokyo. Good bubbles occur on productive assets – think oil wells, or telecom lines, etc. Good bubbles and bad bubbles also distinguish themselves by the way they are financed. A good bubble is financed by capital markets directly, junk bonds, equities. A bad bubble is financed by commercial bankers, and when a bad bubble bursts, if the banks are the ones having to take the capital loss, you get a dramatic multiplier effect on the economy, contraction in bank loans, a collapse in the velocity of money, and the kind of outcome that we saw in 2008.

So when we look at the implosion of the commodity bubble, the first question we should ask ourselves is, “Who financed this? Who’s going to take the write-off?” Is it going to be the commercial banks, or is it going to be junk bond and equity investors? This is where the good news comes in: when you look at most countries in the US, in Europe, most countries in Asia, banks’ exposure to the overall commodity sector remains moderate. In all mining industries, including oil and exploration in the US over the past decade or so, what you find is, you have had an increase in debt over the past decade, but most of the increase in debt has really come from the issuance of bonds, much more than the issuance of bank loans. I think you see that in the market, with the high-yield market taking a bath on the back of the commodity sell-off.

Another way, I think, to monitor whether your burst bubble is affecting banks or not, is simply to look at the relative performance of bank shares. When a bubble bursts, interest rates collapse, and falling interest rates, logically, should be decent news for banks. So, in a falling interest rate environment, you would expect banks to at least perform in line with the markets. If banks underperform the market when a bubble bursts, then that’s a sign that their exposure to the burst bubble could be problematic, that they’ve got impaired balance sheets, and that they’ll need to raise capital.

If you look, for example, at the US, or for that matter, at most Asian countries in the past six to nine months as the commodity bubble has burst, banks have not underperformed. Most markets have performed in line with the market, and in some markets, they have underperformed. Interestingly, this cannot be said everywhere. There probably are countries where the banks are exposed. Take Brazil, South Africa, Russia, and potentially even Australia. I find it interesting that Australia, which is really a market dominated by two sectors – commodities on the one hand, banks on the other – in 2014, in a year where the commodities were such dogs, Australian banks did not manage to outperform their domestic markets, begging the question of, in a market like Australia, what is the bank exposure? Begging, also, the question as to why today Australian government bond yields are the highest bond yields in the OECD, aside from New Zealand?

You have an economy that is highly commodity-dependent, with a banking sector that is decently leveraged, both potentially to the commodity sector, and to a fairly overvalued domestic real estate market, and an economy that will now be slowing hard on the back of the commodity bust. Now, if we go back to the years before the commodity boom, you find that Australian bond yields were roughly just marginally above those of Germany, or marginally above those of the US. Today, Australian bond yields are six times those of Germany.

I think, in a world where making money on bonds looks increasingly challenging, one of the best trades you can make is to be long-dated Australian bond yields, hedged back either in Swiss franc or in US dollar or euros, or whatever your reference currency can be. This is one of the few bond markets in the world where you can potentially hope to have significant capital gains in the year ahead, as interest rates will likely continue to collapse. But enough of the bad news. Enough of the bad news, because at the end of the day, the drop in commodity prices, while it does represent an imploding bubble, also represents tremendous news, not least of which, for the countries where I come from, for Asia. It represents tremendous news on many fronts. Falling commodity prices, for most Asian countries, but also, for most European countries, represent an immediate improvement in the current account balances. Very simply, we have to export less money to buy the commodities we need. That, right there, leaves more money at home, and generates, if nothing else, all else being equal, stronger GDP growth numbers.

For Asian countries, though, that’s not the only impact. In Asia, most governments still subsidise energy expenditures, so falling energy prices immediately mean not only improving current account balances, but also improving fiscal balances. If you take a country, for example, like India or Thailand or the Philippines, the lower commodity prices now mean that if you’re the local central bank, you don’t haveto worry about current account deficits any more, and you don’t have to worry about budget deficits any more, which means you don’t have to worry about your currency coming under attack, and you can follow a much easier monetary policy than you’ve done thus far.

To go back to India, loan rates in India today are at 8%; who thinks they will still be there in 12 months’ time? In 12 months’ time, loan rates in India will be six, five… Who knows? And between the improving current account balances, the improving fiscal balances, the easier monetary policies, all of a sudden, you have an environment where the cost of capital comes dramatically down, which allows governments to embark on higher infrastructure spending, which in a lot of Asian countries is still needed, which triggers, by itself, higher productivity gains, higher consumption growth, higher employment, which has a positive feedback loop on better fiscal balance. Very quickly, you’re in the kind of positive feedback loops, positive virtuous cycles that growth is all about. To make myself very clear, we should look at the drop in oil price, for most OECD countries and most Asian countries, as a tremendously positive exogenous shock towards higher consumption, higher infrastructure spending, and higher productivity gains.

Now, this lower oil price obviously invites all of us to look at our portfolios and reassess a lot of the analysis that we’d done over recent years, and the biases we have put in our portfolios. As we look through our portfolios, we should all ask ourselves, in a low oil price environment, is this particular investment still my best allocation of capital today?

I wrote a book a couple of years ago, a book called Too Different for Comfort (this is my plug – the book is available for free on our websites, But, unfortunately, this book is increasingly becoming obsolete. It’s becoming obsolete because one of the main theses of the book was that, when you’re an entrepreneur, you really have five factors that drive your investment. The first factor is the cost of labour. The second factor is the cost of land. The third factor is the cost of government. Fourth, the cost of energy, and fifth, the cost of capital.

Now, one of the theses of the book was that, for most of the late 1990s and most of the 2000s, what differentiated different countries was the cost of labour. We lived in a world where Asia had a massive comparative advantage because, following the Asian crisis, the cost of labour was down at the floor in Asia, and was up here in the western world. So, if you were building a new factory, basically, you put it in Asia. This was the 2000s.

One of the theses of the book was that the cost of labour, because of advancements in robotics, because of advancements in software, mattered increasingly less. Increasingly, either labour was thinking labour, high value-added, etc, and that was an international price, or if it was – excuse my French – dumb labour, basically two strong arms; this was increasingly being replaced by machine. Asia’s big comparative advantage was basically being taken away, and instead, what was appearing in the world was differences on the cost of energy.

What you had was that, all of a sudden, the US had a comparative advantage against everybody else, thanks to the shale gas revolution. The US had a cost of energy that was a fraction of everybody else’s, partly because other regions – most notably Germany and Japan – were following boneheaded energy policies, with cutting back on nuclear, which drove up their energy price. So, the conclusion was, the marginal dollar of investment will go to the US, since they have a comparative advantage that nobody else does. This called for a stronger dollar; this called for an outperformance of US equities, etc.

The question is, is this still the case today? Because, with the collapse in energy, the one big comparative advantage that the US had is now being taken away. Everybody’s got a cheap cost of energy now. So, the big comparative advantage, if it’s no longer the cost of labour, if it’s not the cost of capital (because everybody’s got free capital now), if it’s not the cost of energy, perhaps the way we should look at the next five to 10 years is through the question of the cost of government, and that this  is the one differentiating factor around the world. I would venture that, when it comes to the cost of government, the US doesn’t have a big comparative advantage, for several reasons. First, in the US, people don’t even agree on what the government is supposed to do, which ends up being costly, because you have big battles as to what you can do. The other big problem in the US is, you have a checks and balance system, and you’ve got different parts of government that have basically been taken over by lobbies. Given the checks and balance system, it’s very hard to remove the power of these lobbies that end up costing the system a lot of money.

When it comes to the cost of government, the countries with the comparative advantage today are in Asia, where the cost of government is very low, or probably in northern Europe, in Switzerland, in Germany, in Scandinavia and potentially in the UK.

Now, this isn’t to make a very bearish case for the US, and you read a lot of things in the press as to how the collapse in capital spending in the US will now lead to potentially a recession in the US. If you look at total capital spending in the US on oil and gas, it represents just 7% or 8% of total capital spending. Even if we go back to the depths of the 1990s, the hit on the overall economy will remain modest.

More important, I think, is the impact that lower oil prices will have on US domestic consumption. With the price at the pump having fallen from just below $4, to somewhere around $2, the average US family will now save $800 a year in gasoline spending. The beauty of the US consumer is that we know that if he saves $800, he is going to spend $900. So, the consumption in the US – and let’s not forget that consumption remains 70% of the US GDP – will be very strong going forward. Now, this is tremendous news. It’s tremendous news for Europe, that needs the US to consume strongly to get out of its slump, and it’s frankly tremendous news for Asia, which remains the US’s number one trading partner.

Whenever we at GaveKal look at a country, we like to answer, basically, five questions. The first question we always ask ourselves is the question of growth. Is growth accelerating, decelerating, moving in negative territory? And, more importantly, what do I know about growth today that perhaps is not reflected in the overall consensus, in the overall view of the market? On this question of growth, it’s obvious that the biggest shark to the system we have now just had is oil. Some countries’ growth will be very negatively impacted by the drop in oil; some countries’ growth will be very positively impacted in the short term, perhaps less in the long term. I think that’s the case of the US. In the short term and the long term very positively impacted, I think that’s the case of Asia, or frankly, Europe, but we have to review, all of us, our assumptions on growth, given the very different commodity environment.

The next question is, is the momentum of the market positive or negative? We all know that trend is our friend, and we typically want to invest in markets where the trend is moving in a positive direction. Now, when it comes to momentum, obviously in 2014 the US was very impressive, but the other big movement in 2014 was that Asia (which for all intents and purposes had been underperforming between 2011 to the end of the first half of 2014) started to outperform in the second half of 2014. Europe, which had done very well in 2013 and the first half of 2014, started to underperform, so we’ve had a passing of the baton between Europe and Asia in the second half of 2014, and for now, the momentum is with Asia.

Now, the third question is a simple question on liquidity: when you look at a market, let’s say Hong Kong, trading at 11 times earnings, the question is, how do you make that market move from 11 times earnings to 13, to 15, to 19? You need excess money to come from somewhere. The money can come from central banks that print more aggressively; it can come from domestic commercial banks that expand their balance sheets; or it can come from foreign fund flows. Today, in Asia, I believe you have all three. You’ve got the Bank of Japan, the Bank of Korea, now the Bank of China, very soon the RBI in India, all easing monetary policies. You’ve got commercial banks that are expanding their loans, and you get foreign fund flows that are very positive.

Asia is now the one place in the world where you’ve got all three legs of the liquidity stool. In Europe, we have a central bank that talks a great game, but for a long time didn’t do anything. We’ve got commercial banks that are still flat on their backs, and probably still need to recapitalise. And, we have foreign fund flows that, in Europe, remain very, very negative.

The fourth question is whether the market is acting rationally or not, and finally, the last question is the question of valuation. On the question of valuation, I think, very simply, that we have a quandary very similar to the one that we had in the late ‘90s where, on the one hand we have a US market that is extremely expensive, and Asian markets that are extremely, extremely cheap. The question is, where do you go? Do you go with the momentum and the high valuation, or now, with the momentum and the lower valuation?

For me, it’s a no-brainer. If I put it all together, the green dots are mostly in Asia, and therefore, having an overweight position in a falling oil environment in Asia is where you want to be.

After receiving his bachelor’s degree from Duke University and studying Mandarin at Nanjing University, Louis-Vincent Gave joined the French Army where he served as a second lieutenant in a mountain infantry battalion. After a couple of years, he left the army and joined Paribas Capital Markets where he worked as a financial analyst first in Paris, then in Hong Kong. He left Paribas in 1999 to launch GaveKal Research. He is CEO of Gavekal and MW GaveKal and frequently contributes to the research.

This article was extracted from a presentation at the Notz Stucki Investment Conference held in Geneva on 13 January 2015.