West of the Hudson
We spent 2021 obsessing over the apocalypse of disappearing workers, a creaky supply chain, rising costs, and a constantly evolving pandemic. The pandemic triggered a supply chain and energy crisis, labor shortages and, ultimately, inflation, disrupting economic and social life, and exacerbating inequality within and between countries. The pandemic’s aftermath also genuinely strained the delicate construct of globalization, at a time when political and social cooperation are more important than ever. As participants in the wide world of finance, we spend our days shepherding client assets, absorbing data, and debating what’s next. While we all have personal opinions about how the world turns, we try to “stay in our lane” as best we can when it comes to current events and capital markets.
As such, we will try our best to describe the impact of the latest global gut punch only as it impacts our thesis and outlook. So, setting aside the ongoing horrors on eastern Europe’s doorstep, the fact is that Russia represents a big chunk of global energy and agricultural supplies, much of which is suddenly unavailable to the west, or soon will be. And there’s not a whole lot anyone can do to quickly replace it. Even if the U.S. oil and gas industry wanted to crank up production (they don’t), adding enough new output to matter will take the rest of this year, and maybe many more. Renewable energy won’t come to the rescue. Worse, Russia and Ukraine are major exporters of grains and vegetable oils, and agriculture is an energy-intensive industry, so global food supply is threatened, too. The result is higher prices — as you’ve no doubt noticed if you’ve bought gasoline or shopped for groceries.
Gasoline and food prices were already high before the attack on Ukraine, in large part because demand continues to outstrip supply. Now the war has delivered an additional shock: significant supply disruptions and fears that these disruptions will become protracted, driving the price of food staples sharply higher. For an extraordinary number of humans and their wobbly governments, this is an existential threat. Russia and Ukraine are key sources of oil, natural gas, essential crops, and a host of industrial metals. Ukraine alone accounts for a staggering 25% of global wheat production and is the “breadbasket” for over one billion people across Europe, the Middle East, and Africa. Loss of access and mounting sanctions have sent prices for these vital, non-discretionary commodities parabolic, pushing inflation to multi-decade highs, and exacerbating the negative supply shocks that were already in place. We highlighted the precarious circumstances in the global fertilizer markets and the knock-on effects these would have on global agriculture prices in our last quarterly letter, so we were already watching what supply chain issues would mean for agriculture. This is another accelerant on an already-raging commodity price inferno.
While the U.S. has some exposure to Ukraine and Russia, there is nothing we trade with those countries that cannot be substituted internationally or, quite frankly, domestically (we export an excess of energy and wheat). But our economy has a significant, 88% correlation with the European GDP, so there is no avoidance or decoupling — and in that respect, globalization is alive and well. And the E.U. is in a tight spot: Russia is a top importer of European goods and services, while the E.U. depends on Russia for 40% of its natural gas and 27% of its oil. Russian energy exports, especially natural gas, are too big to be substituted, so there is a lot to monitor. In the near term, we expect European economic growth will take a severe hit from the effects of this war, and throw up new obstacles to growth, including considerable inflation, for consumers, businesses, and investors.
As we have seen with many issues during the past two years, large problems create peripheral problems that in turn create more unexpected problems. And it is here that we jump off for this, our first letter West of the Hudson TM in 2022.
We pick this thought up where we left it in our most recent year-end letter, months prior to Russia’s invasion, when mounting energy costs and transportation disruptions were well-documented drivers of inflation. Like other current supply-demand imbalances, rising energy prices are the result of several idiosyncratic inputs, including the snap-back from pandemic demand running straight into the sea-borne supply chain disruption. But mostly, today’s oil reserve anxieties are a direct result of today’s capital market investor. Capital markets have financed exploration and production (E&P) for decades but received no freecashflow (FCF) in return as energy companies have historically reinvested their profits back into developing future production. Eventually, the capital markets balked, and the rate of reinvestment has fallen considerably since 2018. These investor preferences (demands) — buybacks and dividends (comically labeled “capital discipline”) — have meant much less capital for E&P.
And this means less investment in energy supplies even as reserves dwindle, driving the ratio of proven reserves to production (a measure of how much extractable oil remains in the ground relative to annual production) to its lowest level in decades. The bicep-flexing narrative promoted by some (fracking is a patriotic duty, slash regulations and drill) is not grounded in reality. Setting aside the foundations of our capitalist economy, the fact is modern oil economics and national priorities no longer line up. The U.S. currently produces 11.6 million barrels of oil a day, 12% of global consumption, which is ahead of both Saudi Arabia and Russia. But it remains 8% lower than in 2019. The taps are already running at full strength, and there is little that can be done to immediately grow that metric.
The U.S. Energy Information Administration has forecast that U.S. operators might be able to add 760,000 daily barrels this year. And most of that will come from private operators, who don’t have to answer to penny-pinching shareholders. While they account for 30% production, they make up more than half of the growth in shale as the large operators stand idle. Another significant constraint is the loss of thousands of ready-to-go wells, known as “drilled but uncompleted” (DUCs), many of which were un-sealed and depleted during the pandemic. At its 2019 peak (8,800) wells, the DUC backlog is now fewer than 4,400 wells — similar to the industry backlog, circa 2013. But many of the wells left behind will likely never be put into production because some were likely less prolific to begin with or were impacted by the drilling of other wells nearby, as some companies pursued tight spacing plans that proved overly optimistic.
While corporate incentives are a leading cause of this predicament, the post-pandemic environment rears its head here too, with the result that the industry is running up against physical limits. Most energy companies report shortages of workers, and bottlenecks in acquiring drilling equipment, parts, chemicals, and sand (used in the process of fracturing shale). A lack of truckers is the common denominator across all these supply constraints. Finally, it should be noted that energy exploration is highly cyclical, and firms are hesitant to rush into investing in more production because of fears that prices could fall in the future. Despite the positive optics surrounding energy independence, the fact is that investing in new wells has been a losing bet for a decade because of overproduction. The U.S. imported a de minimis ~50,000 barrels per day of oil from Russia in 2020, but Europe imported substantially more (2.4 million barrels per day). The U.S. and Europe cannot match Russian production barrel for barrel. According to industry analysts, capital budgets would have to quadruple by the end of 2024 for shale to entirely replace Russian oil, and no analyst sees a conceivable scenario where that happens. As the CEO of leading E&P producer, Diamondback Energy, commented, “if Russia’s oil production and exports are curtailed to the tune of two million to three million barrels a day, shale’s response is a garden hose trying to fill up an Olympic swimming pool.”
Oil and gas alone clearly won’t protect Americans from swings in the global oil market. We are technically energy independent, but consumers are still vulnerable to price shocks because oil trades on global markets. In Europe, replacing Russia in the longer term won’t be easy. Its pipelines send more than 13 billion cubic feet of gas to Europe every day. That is about equal to the total U.S. liquified natural gas capacity, and much of that U.S. gas is bound for Asia. These are tense times for the world’s oil consumers.
Of all the worrying headlines that crossed our desk in recent months, this one from Bloomberg stood out: “wheat futures surge to highest level this century”. In combination with the pandemic’s supply disruption, the invasion of Ukraine has pushed the United Nations Food and Agriculture Organization (FAO) price index up 72% over the last two years, with fertilizer prices up 100%, and oil prices up by 200%, rising prices for essentials have sparked unrest and instability across a range of developing economies.
With the tight link between gas supplies and industrial agriculture, we have fretted about the impact of global fertilizer shortages on agricultural production in recent communiqué. A recent analysis confirmed that “with wheat already in the ground, and only a few weeks left to plant corn, farmers in Ukraine can’t get needed fertilizers and chemicals; they are low on fuel for tractors and other farm equipment; workers are quitting to join the fight or to leave the country, leaving farms short-handed.”
According to the U.S. Department of Agriculture (USDA), Russia and Ukraine account for 29% of global wheat exports, 19% of corn exports, 30% of barley exports, and ~80% of sunflower oil exports. 85% of these exports travel by sea and Black Sea ports are closed, while train tracks are gridlocked, and trucking is stymied. Understandably, Ukraine has also banned exports of rye, barley, buckwheat, millet, sugar, and salt for the rest of the year to ensure that it has enough food to feed itself.
As with energy, the war in Ukraine is exacerbating pre-existing problems with global supplies and prices. Although higher prices will be felt by all, North African and Middle Eastern countries along the Mediterranean will be more directly and severely affected. Sudden spikes in food prices – especially staples of the human diet — are directly linked to increased social unrest and conflict.
Farmland covers 70% of Ukraine and it is all at risk the longer the invasion and its aftermath persists. As of now, the crop that remains in warehouses will not make it to the market in 2022. We remain vigilant that the spring crop is planted and fertilized, or this will be a topic we return to again, as the crop for 2023 is at risk. The world seems broken even as it continues to function. We have already noted that, while the U.S. has some exposure to the unrest, there is nothing we trade with those countries that cannot be sourced elsewhere. For our purposes, it’s the intersection of supply, demand, and excessive price spikes that has our attention, for it is here that reality meets the investment thesis.
As investors, we, face a rising number of daunting challenges in portfolio construction. These include the aforementioned price shocks, fraying global supply chains, the menace of political volatility, and an inflation-spooked Fed, running headlong into tightening fiscal policy (but other than that, Mrs. Lincoln, how was the play?). Prices have gone parabolic over the past year, driving inflation to a four-decade high, and leading the consumer price index (CPI) to increase a whopping 7.5% year/year. But it is not so remarkable as to be unexpected. As evidenced with China, Covid variants continue to throw kinks into the supply chain, and the challenge of getting goods and materials where they need to be continues to mount. Ukraine sent a spike into the rawest of raw materials. By now, everyone knows that companies have been raising prices to cope with surging costs. The key is to find the firms with the leeway to lift them the most.
On recent earnings calls, the largest companies have posted huge profits and promised continued price increases, even as inflation continues to rise to rates not seen in decades. For example, a certain coffee company recently reported a 31% increase in profits — but still plans to hike prices this year; while a softdrink duopoly raised prices within days of each other, and subsequently posted record margin growth. The largest protein processor raised prices 20% in less than one year — it’s still just a GDP+ net margin business, and there is very little to get excited about on the productivity-enhancing front, but such pricing power helped drive its stock price to an all-time high. But nowhere is pricing as steep as pandemic casualties — 4 especially travel and entertainment (airlines, hotels, restaurants), and current supply chain casualties (furniture, apparel, appliances) and their delivery services.
While the sample size is admittedly not that large (a few months), U.S. consumers have thus far proven willing to pay higher prices and, at its core, those are the necessary ingredients for inflation — demand outstripping supply. But this rapid rise is putting companies in a precarious position as they boost prices enough to account for higher input costs, meet investor expectations, and do so without driving customers away. Higher sales don’t mean much if your profits don’t also increase at least proportionately. From our perch, for the first time since indexing eclipsed active investing, it pays to invest in companies with strong moats, robust cashflows, and resilient margins.
Some argue that businesses are using inflation as an excuse to jack up prices beyond what’s necessary to account for their increased costs. More than just passing those costs onto consumers, it is argued, corporations are taking advantage of the unprecedented global economic circumstances to increase their profits, simply because they can. Again, for a capitalist system, this is a feeble accusation — companies are always trying to maximize their profits! Why should the current environment be any different? And certainly now, more than ever, higher prices are to be expected, and reflect the increasing costs to supplies, transportation, and labor. If anything, we consumers don’t have a way of knowing how those increased costs factor into prices — and that’s something we’ll likely never figure out.
This is especially so in consumer staple brands that line supermarket shelves, which are overwhelmingly produced by a small handful of multinationals. The market power of these giants means they are better placed to pass on price increases. And here critics are closer to the truth: because these conglomerates hold so much of the market share, they are able to raise prices out of step with the actual price increases they’re incurring — essentially, that they’re using the current inflationary environment as an excuse to raise prices more than necessary because they don’t have competitors to drive them to keep prices down which, in turn, contributes further to the problem of inflation.
As with energy, we are a free-market society and consumers are free to consume as they like. And for now, in corporate earnings call after corporate earnings call, executives are using inflation as a cover for price hikes to boost profits, and these price hikes aren’t going anywhere so long as people are still willing to pay. And it will sustain so long as prices doesn’t weigh on demand.
But all good things must come to an end and for those companies that only push up prices, there will be a point when consumers balk and seek substitutes. The bottom line is that if there are any “winners” in this period, it is those companies that find a balance which successfully marries investments in marginenhancing productivity, and higher prices at the check-out line. Those that just raise prices will find themselves in a pinch when they outprice their customers, while those who have remained focused on investment will continue to take share and grow larger.
The markets and the economy are facing three shocks that will be hard to overcome: an energy shock that has taken gasoline prices up 45% from year-ago levels; a food shock that has taken agricultural prices up 32% from a year ago; and an interest rate shock that has taken the 10YR government bond yield up 75 basis points in just thirty days.
Fuel and food inflation, supply-chain bottlenecks and labor shortages are mainly symptoms of the same underlying problem: the unprecedented tug-of-war between a demand surge and a global break in the supply of inputs, as repeated Covid lockdowns devastated the intricate coordination required for just-in-time production. Russia’s invasion of Ukraine delays the healing process indefinitely.
In the big picture, we mentioned in a mid-quarter note to clients that, while war brings about human suffering on a massive scale, such events historically haven’t been that meaningful to the fundamentals that 5 drive financials markets, and the immediate reaction to conflict tends not to affect equity valuations over the long term, These horrific events exact a terrible human toll of course, but the immediate reaction to dangerous mass conflicts tends not to affect equity valuations over the long term. What drives equity prices are growing corporate revenues and profits, and a geopolitical event — however unforeseen — typically doesn’t meaningfully impact either revenues or profits in the aggregate. This is especially true in the U.S., where vast oceans separate us from international conflict and investors remain fixated on monetary policy.
As for this energy crisis, there is no quick fix, and all solutions are long-term in nature. The food crisis is severe, and this has emerged more than ever into a whole theme around security of supply. It has to be understood that even after this situation in Ukraine is “resolved”, Russia will be a pariah for many years to come. From energy to wheat to metals (especially those required in electrical vehicle batteries, semiconductors, and cell phones), Russia is a key global producer, so we have to come to grips with a completely different shape to the world commodity cost curve — which, of course, will keep global prices elevated and since these resources are essential and not just discretionary.
Nobody can predict with confidence when supply and demand will come back into equilibrium, but historical experience shows that market mechanisms are remarkably effective in eventually finding that balance. Nonetheless, a commodity price spike on gasoline and food staples is a huge tax on discretionary spending which will impact entire economies, shifting spending from what people want to what they need.
We look forward to seeing you and discussing these themes in the near future. In the meantime, from our families to yours, we wish you all peace, prosperity, and good health.
Hirschel B. Abelson
Adam S. Abelson
Chief Investment Officer
This information is intended for the recipient’s information only. It may not be reproduced or redistributed without the prior written consent of Stralem & Company Incorporated. This commentary reflects our current views and opinions. These views are subject to change at any time based upon market or other conditions. Past performance is not indicative of future results. Sources: U.S. Energy Information Administration, Wells Fargo, Energy Information Administration, United Nations Food and Agriculture Organization, Wall Street Journal, Bloomberg
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