Good morning

I hope this finds everyone safe and well. I've been working from home for over five weeks now and in addition to discovering how many gardeners work in my neighborhood, I reverted to a skill from high school and gave myself a haircut last weekend.  Video available upon request.

This morning's note is entitled "We've Never Seen…" because I am sure I have heard that phrase used to describe at least twenty different economic or market scenarios evolving during the past two months. This week we added another to the list as oil prices collapsed and went NEGATIVE!.  What does that mean?  On Monday, as the price of oil (WTI) collapsed to -$40 per barrel, as oil producers pulled a barrel of oil out of the ground, they had to pay someone else $40 to haul it away.  While that's a simplification as I expect a large speculator probably blew up, it shows the absolute carnage in the energy sector so far this year.  The chart below shows oil prices, adjusted for inflation, going back to 1870, 150 years. When we say "We've never seen..", this one takes the cake. 
 

As with any other asset class, this is not simply  a case of "price down, asset bad."  (Sorry that sounded like a GEICO Caveman commercial-bad tone comes with three hours of sleep). Energy, specifically oil, is a tough sector to make money because the overall economics for energy are bad. When you analyze the sector across an entire energy cycle, from glut to shortage and back, you have one of the few industries which does not earn its cost of capital.  What does that mean?  It means that for every dollar invested to develop a unit of energy, the return on that investment is negative. As an example, Exxon can arguably be considered the best operator among the major oil companies. Their cost of capital is 8%, which means they pay 8% to investors for every dollar they invest into the business. Their long term return on invested capital is 2%, which means for every dollar they invest, they earn 2%.  It doesn't take a math wizard to recognize that if Exxon's capital cost is 8% and their return on that capital is 2%, Exxon is losing 6% on every dollar they invest in their business.

How does the industry keep attracting capital with poor long term returns? Tax incentives are one enticement. The other is the overconfidence of investors, who are certain that 1) they can time the energy market, and 2) they can find the company in the space that will outperform. Item one, timing the market, is tough because the cycles are so long. The last great opportunity to invest in oil was 1998, when oil touched $10 per barrel (note that was the last time I was bullish on the space). The cycle was strong for roughly nine years, but has been in a morass since the GFC.  Item two, picking the best company, is truly folly in the energy sector. Long term analysis shows the correlation among energy stocks at 0.9, which effectively means you could throw a dart at the names in the sector and have a 90% probability of performing in line with market. In other words, stock picking in energy doesn't matter!

The question is what to do now that oil is in turmoil?  My short answer is stay away for now. I am going to speculate that oil won't touch -$40 again (note it's $17 today), however, the fundamentals today are worse than when the last big collapse started in the mid-1980's, a cycle that took 13 years to find its bottom, in October 1998. Demand destruction is occurring because of the Covid-19 situation, however, even prior to this crisis oil prices were collapsing. Note in the chart below that the price of crude in December 2019 was $61, and began falling well in advance of the shutdown. Global production was running ahead of demand, a situation that was exacerbated by a series of political events. President Trump sanctioned Russian oil company Rosneft for evading sanctions on Venezuela. OPEC plus, effectively OPEC members plus Russia, could not come to agreement on production cuts and Saudi Arabia and Russia entered a production war. While demand was collapsing, the 2nd and 3rd largest producers in the world ramped production. Saudi Arabia, Russia, and the United States now all produce roughly 11 million barrels of oil per day.

One of the three large producers is going to blink. Russia and Saudi Arabia do not get along and are happy to hurt each other, however, the United States energy sector is taking hard hits as a result. Because the other two are effectively government run and owned, they can be coordinated in their actions. In the United States, our energy market consists of scores of private energy companies and thus do not act in unison. Layoffs have begun in the sector, rig counts are declining. It would appear that, at least initially, the US energy sector will be the first to have capacity cutbacks.

Is this the type of cycle where a long term bottom is established and a resulting investment cycle will develop. I believe so, however, it will take a couple of years for the production destruction to occur and supply-demand to come back in balance.  Oil prices will continue to fluctuate, dependent upon market sentiment and announcements regarding production levels and demand. The long term supply/demand most likely will not come back into balance until sometime in late 2021 or 2022. This means that while we may have seen a bottom in oil prices, there are many bankruptcies, production shutdowns, and acquisitions coming to rationalize the production  capacity.

The upshot is gas prices should remain low for some time, hopefully we will all be back in our cars soon to benefit. I haven't filled my car since March 7th but am looking forward to paying $2 for a gallon of gas. 

Have a great day

Ned

We Have No Clue

"To date we have no clue how many people have been infected. This could be an extraordinarily important piece of how we're going to get over this epidemic." Eran Bendavid, infectious disease physician, Stanford University

While the world is full of unknowns and the future is unpredictable, hearing these words uttered from a leading infectious disease specialist certainly makes you question our chosen course of response to Covid-19. Have we taken appropriate steps by shutting down 50% of the economy? Did we go overboard in our response? Is the recent CDC estimate of 60,000 US deaths, down from 240,000-2,000,000 just two weeks ago, a signal that our extreme efforts are working or that the panic was overblown? I will repeat the comment from the Stanford physician "we have no clue."

Regardless of my opinion on the necessity of the extreme shutdown of the economy, there is no disputing that the impact is unprecedented and enormous. Except during war, shutting down the economy by government fiat in a free society has never been attempted before. Making these types of decisions without sufficient data to appropriately understand the risk of not acting, and without any way to objectively measure the success or failure of the policy, is fraught with risk. The biggest risk has been the excessive insertion of opinion versus fact in the decision-making process, the politicization of the situation, the reckless abandon of the press to fuel the panic, and the decision to implode the economy without a true understanding of the risk of a more limited response.

The chart below, courtesy of Blackrock, shows their estimated trajectory of the economic impact compared to the Great Financial Crisis (GFC) of 2008.  Note the severity of the initial downturn today versus 2008. Also, it is important to note the size and speed of the policy response. In 2008 the response from the Fed and the government was measured, haphazard (think Cars for Clunkers as an example), and slow. The response from the Fed has been significant in size, speed and breadth. My best estimate is that Fed programs could ultimately total $10 trillion. Recall in the GFC the Fed balance sheets expanded by just over $4 trillion. Adding some perspective, the US economy is $22 trillion annually. These are BIG programs.

The chart below, from the Federal Reserve of St. Louis (FRED), demonstrates how quickly the Fed has expanded their balance sheet, with more programs on the horizon.

The response from the federal government has also been swift, comprehensive and sizable. In addition to responding to the healthcare issues resulting from the crisis and the normal today to day operations of the government, the federal government is also creating processes on the fly to deliver the promised funding to those in need.  This is a daunting task and will test the patience of recipients who want their money yesterday, but also will test the organization and systems of a government which is not known for its efficiency.
Some have posited this will lead to another depression. While the possibility cannot be completely eliminated, the probability is very small based upon what we know. The fiscal and monetary response from the Fed and the government during the Depression exacerbated and extended the downturn, turning a liquidity crisis and recession into a solvency crisis and depression. The policy responses during this crisis stand in stark contrast to those of the Great Depression and minimizes the possibility of depression.

How far will GDP fall?  I have seen estimates as high as 50% declines for the second quarter and 10% for the entirety of 2020. The chart below, courtesy BoA and the BEA, shows the declines in GDP during previous recessions dating back to 1953. Note that the worst case scenario of 2020 is estimated to be the largest we have seen in that time period, however, the policy responses combined with consumer balance sheets that were strong heading into the crisis, should help reverse this downturn through the course of 2020, assuming we do not experience a significant second wave of Covid in the fall. My estimate for 2020 GDP is in the -4-5% range.



Always the question becomes, what does this mean for markets? The markets have rallied from the most recent bottom as the government programs have been approved, but also as estimates for the severity of Covid-19 have subsided-the now proverbial "flattening of the curve." Have we seen the bottom in markets?  My hope is yes, but history and logic say probably not. In addition to the 16 million new unemployment filings over the past three weeks, with more to come, there is a slew of bad economic data coming over the next couple of months which could add downward pressure on the market. The horrific set of earnings reports coming soon, the bankruptcies of well-known companies, ongoing bad economic data, a negative turn in the Covid battle, bad news from foreign markets, and history could all signal a bottom is still coming. Some of that is already priced into the markets, but it is questionable whether markets have truly priced in the full extent of the damage being done to the economy. Some factors that could support the market include a quicker economic recovery, effectiveness of the government programs being implemented, size of the Fed response, and progress on the virus front (better testing, lower mortality rates than initial estimates, a vaccine, effective anti-virals, etc).

I have had multiple conversations with virtually all of our managers over the past eight weeks, with a focus on identifying any trouble spots as well as where opportunities exist. Fortunately, we have had minimal surprises in the portfolio. Opportunities in the credit space abound and we are fortunate to be involved with some very skilled managers in this area who successfully navigated the GFC and are well-positioned to excel in this crisis as well.

This is a holy week with Passover and Easter. Take time to enjoy your blessings and family.  Happy holiday to all.
Cheers

Ned