Divestor

When you get into an investment, you should always have some sort of view and pathway that will guide you to your valuation assumptions.

Clearly in the past month, a commodity-heavy investor has gotten punched very hard in the face. What we have seen is a February/March 2020-style of trading in the commodity complex – indiscriminate amounts of selling. Back in February/March 2020, it took me about a month to get my act together during Covid (when I realized that people were truly losing their minds over it) before I was able to adapt.

This again is one of those situations that is forcing an adaptation.

The previous underlying thesis, at least as far as late 2020 went, was that there was a significant under-investment in capital expenditures (who wants to invest in oil fields when WTI is at -40?), coupled with demand increasing, especially as a function of money printing by governments.

The party went on for about 18 months and now we are on the flip side of the story, starting June 7th. The past has seen inflation, everybody is worried about it, but markets do not value they past – they value the future.

Today, the August crude oil contract is down 10%, and is down about 20% from its recent peak on June 14th, where it traded at US$121.

While letting the market be your sole guidance is always dangerous, when there is a significant breakage to expectations beyond white noise, one should always re-examine your thesis.

Now that the Federal Reserve and the Bank of Canada are drilling the stake deeper into the heart of the inflation zombie, we’re witnessing the results of the convulsions, and this guarantees in 2023 we will be seeing significantly lower levels of inflation.

I especially note what has happened to copper in the past month. If demand is high and world GDPs are high, then the price action we have seen makes no sense whatsoever in an inflationary and expansionary environment.

My crystal ball is telling me that it is probable the rest of the commodity market is going to experience what happened to the lumber industry, except in slower motion.

Dusting off my dis-inflationary playbook, it means that fixed income is your friend. In Canada, already we have seen the yield curve drop roughly 25bps across the board to roughly 300bps for long dated tenors. Fixed income markets have already priced in July 13th’s rate increase (I suspect it will be 50bps just given what’s going on in the markets), but in 2023 things will stabilize, if not head lower again when the economy starts to depress.

The playbook also suggests that the Canadian dollar will drop with a commodity price drop – perhaps on the way to 70 cents/USD??

What happened? I think there were a confluence of factors, but one obvious data point is that industrial production in Europe is going to get slaughtered due to high energy price inputs. This is going to significantly slow down consumption of industrial commodities. Given the energy starvation strategy that Russia is currently employing, this one is already in the bag.

There is also the issue of China, which has partially shut down its economy in the name of Zero Covid, but in reality there was probably a political component to this concerning the default of their major real estate developers (Evergrande and the others). The halting of construction in the country would have a massive impact on global demand, including that for metallurgical coal and copper.

Domestically, real estate construction is going to come to a halt – with 5yr fixed mortgage rates at 5% and construction financing costs equally high, this will continue to suppress activity in the sector.

It just doesn’t look good all around and the market has woken up to it.

The dis-inflationary playbook also suggests that entities with significant amounts of debt will struggle. Conversely, those that took the actions to right-size their balance sheets during the previous boom will not do as worse going forward. We’re now going to go back to the grind of low cost producers being able to out-last the transient high-cost players.

Economically this is not looking good – with margins compressing, the “E” in a typical P/E ratio will be dropping and this suggests further broad equity price compression. There will likely be some sharp rallies here and there, but the trend is now clearly down.

There are a couple ways to have your dividend yields rise, at least as a function of market price.

One is that the underlying company raises the dividend.

The second, and what has clearly gone on in the past two weeks, is that market values crater.

I have not seen this volatility in commodity equity pricing since the Covid crisis began. The peak-to-troughs since two short weeks ago has been about 25 to 30% across the board.

There is likely a confluence of events going on which results in the sell-side pressure in these stocks. One is that the momentum trade is obviously broken and funds that have bought these types of stocks on momentum are likely triggering their stops and bailing out. The second is that the fundamental metrics aren’t nearly as good at US$104 oil than it was at US$120 – all things being equal a 15% haircut in oil price will result in a higher percentage drop of cash flows for most oil equities. The third is from cost of capital concerns – money is getting tighter by the day and the easy gains to be harvested are from energy equities. The fourth is the narrative – namely demand destruction via monetary policy-induced recession and a slowdown in spending and consumption.

You add all of this up together, and when everybody decides to hit the sell button at the same time, you get a very sharp price drop as there is not enough bidding to sustain prices.

The cash flow generation currently for all of these companies is still very positive. Most have stated policies of a mix between debt reduction and buybacks/dividends, and as long as the commodity price environment continues it will continue being highly beneficial for shareholders – but never in a straight line up!

Just as an example, Canadian Natural Resources (TSX: CNQ) is slated to generate about $20 billion in free cash flow for the year (about $18/share with a current market price of $65/share) with oil at US$104. Half is slated for debt reduction and half is for dividends and buybacks. Between Q2 to Q4, they should be able to get their debt down to around $7-8 billion by years’ end and buy back another 5% of their own stock or so, along with paying their $0.75/quarterly dividend. Even if oil traded down another 25% of its present price, the buyback wouldn’t be as large but it would still be around another 2-3% of the shares outstanding. Lower prices increase the long-term impact of share buyback programs – assuming the underlying cash generation of the companies are intact, this is a positive for existing shareholders.

Needless to say, however, the last two weeks have felt like the financial equivalent of getting punched in the face! It was bound to happen, but I wasn’t expecting it to be as sharp as it was.

Apparently the German government (one of the coalition parties is ironically the Green party) is now clearing the way to fire up the coal power plants again in order to save natural gas for the winter.

For whatever reason, they cannot seem to get their nuclear power plants up again, so barring that option, coal is a reasonable policy option. Apparently opening up more solar and wind farms wasn’t on the docket.

However, there are considerable logistical issues to solve. Perhaps the internet has caused most people to think that you can start and stop things with a switch. Physical markets take a much longer time to start and stop than most think.

Let’s take some basic facts from the EIA and run some simple math.

It takes 1.12 pounds of coal to generate a kilowatt-hour of energy. This is the energy equivalent of one kilowatt of power during an hour. Most standard microwaves, when running, consume 1.2 kilowatts. Most hot water kettles use 1.5 kilowatts.

If you wanted that kilowatt of power for an entire day, you need 26.88 pounds of coal.

If you wanted that kilowatt of power for an entire year, you need 9,811 pounds of coal. To give some perspective of what 9,811 pounds is, think of three Toyota Corollas with a couple average-sized passengers each.

A kilowatt is not a large amount of power in the grand scheme of things. Power plants run into the hundreds of megawatts of capacity. Viewing the coal power map of Germany, say they wanted to re-start a 800 megawatt plant. This would replace 52 billion cubic feet (yearly) of natural gas. How much is 52 billion cubic feet? It is about the amount of natural gas that can be carried by 10 large LNG tankers.

An 800 megawatt coal plant would require the daily consumption of 21,500,000 pounds of coal and yearly consumption of 7,840,000,000 pounds of coal. These numbers, when written out wholly, are a bit ridiculous, so we say 10,700 tons and 3.92 million tons, respectively.

Over land, coal is typically shipped by rail. A coal rail car carries 116 tons of coal. Thus, your typical 800 megawatt coal plant needs approximately 92 rail cars of coal to operate, daily.

Needless to say, this is a gigantic amount of mass for one coal power plant. You need specialized machinery and the people with the appropriate training to haul it out of the ground, transport it, and get it into a boiler furnace.

When you tell an entire industry for over a decade that they are no longer needed, competent managers will operate the business on a run-down mode. Capital investment is minimal, and worker training programs are halted. Unions tend to prefer seniority, so younger people in the business go elsewhere. Know-how gets lost and things start to atrophy.

Now the message is “get started, but after you’re done bridging the gap while we solve the problem with our LNG capacity issues we’re going to shut you down again after a few years”, it is hardly confidence-inspiring. Nobody will want to invest time and energy into the industry unless if there is a huge financial incentive to compensate for the blade that is still over the necks of the coal mining industry.

There will still be a huge lack of capital, both monetary and knowledge, to ramp up an operation to produce 7,840,000,000 pounds of coal yearly in the name of saving natural gas. An entire industry cannot be turned on and off like a light switch.

The result is that the domestic price of coal will skyrocket.