Commodity prices are booming. And in theory the way it’s supposed to work is that higher prices incentivize more mining and production. And then the increased supply brings the prices down. But according to Goldman’s top commodity strategist Jeff Currie, that investment isn’t materializing yet. On this episode of the Odd Lots podcast, he characterizes the current environment as a “vol trap” that will keep the supercycle going for a long time to come. The below transcript has been lightly edited for clarity.
Key moments in the pod:
What is the volatility trap? (3:43)
Similarities between now and the 70s (4:57)
What banks have to do with it (10:00)
Why finding commodity financing is so challenging (14:57)
The economics of natural gas (26:30)
Can changing commodity trade patterns undermine the dollar (38:54)
Why the copper market is so crucial to watch (45:04)
Joe Weisenthal: (01:11)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy: (01:16)
And I'm Tracy Alloway.
Joe: (01:18)
Tracy, we got the latest inflation data this morning — we're recording this on April 12th — and it was interesting. I mean, it showed there's some easing perhaps — core goods, core inflation — on that side. But the headline, which of course includes energy and food, is continuing to move higher, at least as of March.
Tracy: (01:41)
And last month would have captured the worst of the energy spike so a lot of commodities prices have come down ever so slightly, but it does feel like there's just generally a lot of angst and concern about what's happening with commodity prices at the moment. And I have to say, I just realized the last time we spoke to our guest, it was also CPI day. And we started out the discussion basically in exactly the same way.
Joe: (02:06)
Okay. So in a year from now, it’s gonna be ‘there’s some good news here but oil is at $300.’ No, but yes, oil and other food-related commodities, energy, natural gas is very expensive. There is, of course, I think two dimensions. One is pure price. And then the other is availability because as we've been talking about with some recent guests, including Pierre Andurand, those have become two separate things. Also there's this fracturing of global commodities supply chains we're seeing.
Tracy: (02:32)
Absolutely right. And even with financial exposure to commodities, you might make a lot of money at the moment, but you're not necessarily guaranteed to take delivery. There seems to be a chasm opening up between financial commodities exposure versus the physical.
Joe: (02:47)
And we saw that very dramatically with nickel and some of the dislocations there. Well, no more intro. I want to get right into our guest because we've had him on twice before. And I would say of all the people we’ve talked to, he's probably called this commodity cycle — maybe it’s a supercycle — better than anyone. We are going to be speaking with Jeff Currie. He's at Goldman. He's the global head of commodities research. We had him last on in middle of October and he said there was more pain ahead in this commodity supercycle. And that has proven clearly to be true. Jeff, thank you so much for coming back on Odd Lots.
Jeff Currie: (03:24)
Great. It's a pleasure to be here and I didn't realize it was CPI week last time.
Joe: (03:28)
So, well, let's just start it off like really simple. You know, in the middle of October, you said there was still more pain ahead — that clearly proved to be true — let’s start really general — is there more pain ahead?
Jeff: (03:43)
It's a different kind of pain. We like to argue we're entering a ‘volatility trap’ where higher vol discourages investment, which then reinforces higher vol. And to think about what ends a super cycle, there's only one thing that can end a supercycle: investment. You’ve got to grow supply and de-bottleneck the system so that you can accommodate more demand growth on a forward-going basis.
And that's how you ended the 70s. It’s how you ended the 2000s. And that's how we're going to end this one. But at this point right now, investment — whether it's investment through capital markets, through banking, you know, in the commodity markets themselves — it's all declining right now in an environment in which it needs capital more than ever. I like to say we're in the early innings still. Maybe it's the second or third inning of the supercycle, but we're just getting going now.
Tracy: (04:36)
Well, why don't we just jump into that point then, because this is something that has come up quite a lot on recent episodes, this capital investment point. What is it in your opinion, that's holding back that investment and when would we perhaps expect that to change as higher prices start to incentivize more producers?
Jeff: (04:57)
Well, this one is a little bit different than the other cycles, but why don't we start with the other cycles and then talk about how this one is different. And the way this one is different is through ESG and banking regulation following the financial crisis in ‘08 ‘09. So let's go back to the 1960s. You had the Nifty Fifty, that was your new economy booming along, absorbing much of the capital from the old economy and starving the old economy of the capital it needed to grow the supply base, which set you up for a very tight supply environment when you got the big uptick in demand off the Great Society in the late 60s and the early 70s. [A] similar dynamic happened in the 2000s as well as today. You think about in the 2000s, you had the Dotcom boom. And in the 2010s you had the FAANG boom.
So it was a very similar dynamic. And you saw that, you know, basically it was this whole idea, the revenge of the old economy is, investors preferred growthy names like Netflix to old economy names like Exxon. That created the capital deficit that led you into this environment. Now why is this one so much more extreme than ones that we've seen in the past? One, you have ESG policies overlaid on top of that. I'm not gonna belabor those points much further, because we've talked about them in the past, but it's important to remember that ESG is not a substitute for a carbon tax. It's a blunt instrument that is reducing capital flows into a very critical sector. So if you had a carbon tax, you'd put the carbon price into that energy company model, look at its carbon emissions and think, ‘Hey, is this a good investment or a bad investment?’
What we're seeing is entire sectors being shunned and that's made this one much tighter and it's not just the oil and gas guys. It's the metals and mining as well as the agriculture sectors,. But banking regulation — and that's the one that I've really began to focus on over the last, let's say two to three months — and it really boils down to leverage ratios. And those were put in place back in, you know, Dodd-Frank back after following ‘08, ‘09. And let's think about what that leverage ratio is. It's tier one capital on the top, and the total assets of the bank on the bottom. If you think about what are tier one capital? It's bonds. Wat are all the assets that go into the economy, all that lending? It’s based off commodities. So it's things in the real world. And so let me ask you, if you have, and most policy makers are gonna tell you it's inflation proof because it's the price level times the bonds on the numerator, and then the price level times the overall assets on the denominator. So the price level drops out. It's, you know, inflation proof.
The reality it is not. And why? Because bond prices are negatively impacted by commodity prices. So essentially what is that ratio? It is bonds on the top and commodities on the bottom. And what we're seeing is that these leverage ratios are starting to become really binding. You think about how much more capital the market needs today than it did, let's say, you know, a year ago. We have oil prices at two X what they were a year ago. You're gonna need two times the amount of working capital out there. And it's in an environment where you were already bumping up against those constraints and banking. You think about banking, banking's old economy too. It's, you know, anything that is capital heavy. The world was focused on asset-light, capital-light, everything of that investing. But we've now focused on a need for having capital heavy investments, particularly in commodities, at a time it was already under invested and at a time that you have ESG constraints.
So I think you get the idea that the capital deficit in this market is extreme. And now it's kicking off this volatility trap where the underinvestment leads to declining inventories to raise cash, liquidation of financial positions to raise cash. All of that accentuates the volatility and then scares off further investment. So you now are entering this volatility trap. You know, we've made the point and I've testified in Congress on this point before, is the only way out of this is you need somebody to stop that vicious cycle and create some type of stability. The saying I like to say is spot prices solve surpluses, long-term contracts solve shortages.
Tracy: (09:33)
Hmm. Can I just ask, because I know we'll have people who listen to this and they'll hear someone from Goldman Sachs, you know, a big bank, a sell-side analyst, they'll go, oh wait, it's someone from Goldman complaining about bank leverage ratios and ESG and regulatory capital requirements. Can you flesh that argument out a little bit, or what would you say to the critics who are immediately going to go, well, this is just, you know, a bank talking its own book. Obviously a bank would like to lend more to the energy sector.
Jeff: (10:10)
Well, one is that the banks, you know, all of them are, are very much much behind the ESG push. And I want to emphasize, I am very, very much pro-climate change and really believe it's a problem that needs to be solved. What I'm arguing is ESG is probably not the best way to go at it
You know, I really believe a carbon tax is the right way to approach this, and most economists would agree with me on that. And the way I could think about ESG is an effective carbon tax on the consumers in places like the United States and Europe and [a] particularly high carbon tax in places like Europe, where the tax revenues do not go to the local governments. It’s going to places like Russia. As I like to point up, you know, the quarter over quarter growth in oil revenues for Russia funded it $62 billion military budget last year.
So you know, the impact of ESG and the fact that you're not collecting that tax revenue is significant, but more importantly, it’s creating big distortions and investment. So I want to really emphasize I'm very much pro-climate change. It's a problem we need to deal with, decarbonization. It's just ESG is not effective tool in approaching this. Or there's a more effective tool to do it.
In terms of the question about bank regulation there. I'm just gonna point out that the energy companies and the trade houses in Europe, they went to the regulators asking for more funding. So clearly there's not enough funding. And whether it's coming from the likes of banks, the point is that you're bumping up at these constraints.
The whole industry was focused on being capital light, and it goes back to this whole revenge of the old economy, becausebanks are old economy too. In fact, you look at banks’ share prices, and you look at them to metals prices, where you are in the capex cycle. They're very much correlated because ultimately the banks are the conduit of that capex cycle.
So they're all really old economy and pretty much more broadly since ‘08, ‘09, old economy was bad. If I could just show you pictures of the equity prices of anything that was capital light, it went straight up. Anything that was capital heavy, you know, like the big oil companies, went down or sideways over the course of the last 10 years. And it's not just, you know, so I'm not gonna blame it all on ESG, and listen I'm gonna be very careful here so it doesn't sound like I'm so anti-ESG. This industry had really bad returns, right? Investors were not interested in it.
And if we go back and we look at the previous super cycles, let's say the one in 2000s, prices started to move up ‘03 and it wasn't until ‘06 that that capital came in. Why? Tthey wanna see a track record of good returns. That still holds today. So I don’t want to blame it all on ESG, all on banking regulations. I say it's just a combination of many different factors that's created a huge capital deficit, and I wanna point out it wasn't just all Volcker that solved the seventies. There was a huge amount of investment that went into North Sea, Alaska north slope, Gulf of Mexico, Mexican production, Brazilian, Norwegian. I can keep on going down the list. That investment that came to fruition did a lot to ease the inflationary pressures as you went into the 80s, so you just can't contribute it all to the rate hikes by the Fed because there was a lot of that investments and that investment was critical. And we're at a junction right now with 8.5% inflation, but we still haven't seen the underlying investment that was already there., let’s say in the 70s, that is not here today. We need that investment because the only way out of this is investment in the appropriate ability to that supply.
Joe: (13:56)
You know, you hear from say the CEOs of independent oil companies and they talk about the demand among investors for returning cash. And that's totally understandable because after a decade of the industry having lost half a trillion or whatever the numbers are, you can understand investors want to optimize for cash flow.
And you can also understand as you've been pointing out, the reluctance of banks to bump up against their capital requirements by lending further, why not though more opportunities on the private side? Me and Tracy could just start a private oil company and forget about the public market. Forget about borrowing from banks and, you know, borrow money in the bond market and return money to our investors privately without some of these outside financing considerations. Why aren't more players taking advantage of seeming like, you know, with oil where it is at roughly a hundred dollars, opportunities around that.
Jeff: (14:57)
Scale. The scale of these industries are unlike anything else on the planet earth. You take a Kashagan in the Caspian. It’s nickname was ‘Cash all gone.’ Why? You know, it was somewhere around a $60 billion project. I mean the magnitude and the scale of these investments are unlike anything. And take a company like BP with that Deepwater Horizon spill. It had to write over a check for fines that were something like $38 billion. Tell me another company on the planet earth who could write over a check for $38 billion? So the first and most important issue is the scale. And then the access issue is really critical. I like to point out things like copper are very narrowly geographically distributed. So you need to have the scale to be able to get into these places, but you have to have the ability to know how, the technological know how, the political know how, to go in there and do it.
So I think that is one of the real key reasons here, but by the way, I wanna point out, why are the oil stocks going up? It's because private investors are going around the institutional players and making these investments in these companies. So where it can go around , it is, which is why, you know, ultimately if you're gonna solve that change, you know, I don't wanna sound dismissive here, but when the Russian army is coming barreling down, you can't have Germany turning back on the coal plants.
You know, historically when you deal with these problems, you have to have policy create rules. These rules need to be enforced. And those rules that they've violated there has to be punishments. And there has to be a price associated. Which is why trying to go down this ESG type path to deal with this is gonna miss a lot of these really critical points that are gonna be required to solve this problem.
So, you know, looking at this on a longer-term basis, we need to have policy put in place that is creating a framework that's gonna be conducive to getting these capital flows coming to the right places, because even if the private investor tries to do it, he still needs to do this in a way that is environmentally friendly. And I think that, again, you need to have this scale, the policies put in place, in such a framework that it addresses the need for investment in a very environment friendly way.
Tracy: (17:14)
So you're talking about this volatility trap, and I think you briefly mentioned this earlier, but there has been talk of maybe there is a role for either governments or central banks to play in this space, to make things smoother, maybe smooth out price volatility, or provide financing or funding for energy firms or energy traders that need it. First of all, is that required in your view? And secondly, what is the best way to try to smooth out volatility to give players in the commodity space confidence to actually invest and produce?
Jeff: (17:48)
Well, it goes back to that saying I made before, you know, spot prices solve surpluses, long-term contracts solve shortages. Why is that the case? It's because if you can take out that volatility and lock in that return through a long-term contract, that investor feels that he is safe to be able to make that investment because there's a minimal rate of return. Because remember these things are not like tech. Tech is, you have a low chance of getting in it, but you have a big return that lasts over maybe 12 to 18 months. You know, something like an iPhone. It’s vvery short cycle and it's high returning. These are low return, very long cycle type of investments. So locking in that rate of return throughout that volatility is really critical. And so when we think about, you know, what you need to do to get that, you need to create an environment that's conducive to creating that type of long term contract structure.
You know, and actually, if you look at what happened in the 70s, that was when we created many of these long-term contracts around LNG and gas so forth, but there was also conglomerates that were put together to be able to shield the upstream/downstream type of volatility. So there’s lots of ways. And then we moved the 2000s to a market-based and this will bring you to the nickel story. Why was this nickel story? Because in the 70s we did this with conglomerates in long-term contracts. If somebody failed a long-term contract, this thing would be resolved in a court of law. So then in the 2000s, the banks got inbetween these conglomerates, let's say between like a GM and an Alcoa, could squeeze in there provide lower cost of capital and you had the financial market squeeze in there and then create that new kind of long-term contract that was financially-based.
Now the problem with that is that when you go through periods like we are right now and that price of that long-term contract goes up because it's traded on the market, you get a huge capital call, you know, margin call, which is what was happening with that case in nickel. Then you need the cash to fund that margin call. You didn't have that back in the 70s. You have it today. So that's, the question is, are we gonna gravitate something closer to the 70s to deal with this problem? Or are we gonna try to fix the structure that was created in the 2000s, which means you're gonna need different type of lending agreements and people have to be more comfortable in that risk and how much capital these sectors needs. You know, I would say I think the easiest way to solve this is create a regulatory framework. And you know, Tracy, as you talked about, that would be able to address these issues, take out that volatility, make banks, investors and so forth, comfortable with that kind of risk. Otherwise we will go back to of the period of the 70s, which is vertical integration, conglomerates and these longer-term contracts that end up in court of laws, not in financial institutions.
Joe: (20:42)
Is there more, so one proposal that’s floating out there would be to be more creative — this is with oil specifically — with the SPR. And so we know that the administration has authorized daily sale of oil. Could it solve the long-term contracts problem or the challenge by pairing that with more robust commitments to buy back at a certain price, we have seen this sort of it's flattened a little bit, but this heavy backwardated oil futures curve, essentially putting a floor underneath the longer-term prices. And could it use the SPR to create more domestic supply and investment right now?
Jeff: (21:23)
I mean, you can do it. What you're describing are the farm subsidy programs that the U.S. has with, you know, its Farm Bill with the farmers in terms of giving farmers a kind of put on soybeans, you know, in case some bad weather shock or something like that occurs. You don't need the SPR to create that type of dynamic. But what we're talking about is a physical version. The Farm Bill really is, these are ones that are more like a financial put, but what you're describing is more like an in-kind physical put. Both are ways to think about solving it. But the one thing I will say about dealing with higher oil prices with an SPR release, like what we're seeing right now, that's crowding out private investment, which doesn't help solve that longer term problem of getting investment into the right place. So these policies need to be thought through in such a way that they're conducive to creating incentives in place to make these longer-term investments.
Tracy: (22:17)
I wondered if I can ask something I've been wondering about when it comes to the SPR release and I'm sure a lot of people have been asking this as well, but, you know, it's a pretty big release and we saw a very immediate impact on prices. And I think Goldman also cut its price target on oil because of the release. What happens after this? Like how does that actually get topped up in the future and how does the U.S. source that oil and at what pace would you expect it to replenish that stockpile?
Jeff: (22:48)
I mean, the details on the replenishment rates are not that clear at this point, but you know, it'd be at least a year or two before you'd expect them to come back and buy it. And I think the plan right now is that they would go back and buy it. But let's talk about the impact that it has had on prices. There's two factors that have created the recent downdraft in oil prices and commodities more broadly, is the SPR announcement, which was a million barrel per day — throw in the Europeans, it gets up to around 1.2 million barrels per day — release for about six months. And then, you know, it's meant to bridge the gap until you get the investment that brings on new supply that can be used to refill the SPR. So you can see it's a temporary patch.
And then you have the Covid situation in China, which is another 2 million barrel per day demand hit. So you've had a big hit through the situation more near term. Now I want to emphasize though that, you know, these are all transient events, a loss in demand once you normalize China, you get the problems back again. Once you have to buy back those barrels of oil that go into the SPR, the problems come back again. You know, so we're in a downdraft right now, which is part of this whole idea of higher volatility, but it doesn't mean that any of this is signaling into the longer term problem. I'd like to point out policy right now is a temporal solution to a structural problem that needs to be readdressed.
Joe: (24:19)
I wanted to pivot actually. So with a lot of commodity conversations, the focus is on oil. But natural gas is also really at the forefront of mind. We see prices, they were already surging in Europe, even prior to the invasion. Obviously the politics of Germany and other countries cutting such a big check to Russia every month is incredibly uncomfortable. And we've seen prices rising here in the U.S., I think it’s like a multi-decade high with prices at the Henry Hub. Do prices there have a lot further to run?
Jeff: (26:30)
In the U.S., yes. In Europe, you're at the demand-rationing phase. We're gonna have more severe shortages. You need more upper price hikes, maybe you have periods of less tightness, but you're at that — you can think about a commodity cycle that's going, you know, from you draw your inventories down when the price begins to trend up, once you exhaust your inventories and have to go into a demand rationing phase because you don't have enough supply, that's when you know, you get the high volatility. Europe is at that phase right now, the U.S. on the other hand is not. One, it has the shale production that can be brought online. You can't continuously export it because there's constraints around LNG liquefaction capacity in the U.S., which means the U.S. is much more immune to this than the rest of the world.
I like to say it's east of Rocky, U.S. California has a problem similar to the rest of the world. But east of Rockies U.S. is a relatively well supplied market, but it won't be forever, particularly as you continue to build more LNG terminals and the policy more recently in response to the situation in Russia, Ukraine is, you know, to build more LNG terminals to supply Europe, which will ultimately exhaust that cushion and then push Europe into a much more higher vol regime. But I don't think we're gonna get there anytime in the next year.
Joe: (27:50)
So this is something that's I'm curious about with expanding LNG export capacity. How should we think about it from the perspective of U.S. national interest? Because it does seem like a more globalized LNG market would cause prices to go up. On the other hand, we would have more export revenue. So how should we think about it?
Jeff: (28:17)
You know, if you do it with all the permitting it’s somewhere around four years, you take out the permitting, you could get it down to 23 months. You do a Defense Act, Production Act type [thing], maybe you can squeeze it down to 12 to 18 months. I don't know what you could get it down to, but you get the idea. It's a pretty long drawn out process to create one of these liquefaction terminals.
And you know, that's definitely one of the goals in terms of dealing with this geopolitical situation, right? But I want to emphasize the following. You know, I've talked to many German industrials that have made this point. The German industrial manufacturing base can't operate off LNG. Move the BMW plant to the U.S. and build the BMWs on top of the gas plant and then export the BMWs or build the BMWs in Qatar. Don’t move the gas. Move the gas to heat people, but you can't run an industrial base off of liquified gas.
You know, I've never been a fan of that. You know, think about what this thing is, it's a $300 million floating thermos that is frozen and you pump a bunch of gas into it and you move it around the world. It's a lot easier to move manufactured goods on bulk cheap containers than it is in LNG tankers. So I'm not a fan of using LNG to run a manufacturing economy, but it does work for heating and things like that. But, you know, the question is this the most viable solution to this thinking about it on a longer-term basis? It's probably not.
Tracy: (29:50)
So this actually leads into my next question quite well, which is how should we think about the fungibility of commodities in this situation? Because it seems like one thing we are learning over the past couple of years is that if there's a crunch on coal in China, it's not that easy to source alternates. If Russian gas is suddenly taken out of Europe, it's difficult to source replacement supplies as well. So how are you thinking about that? And how does that inform your overall supercycle commodity thesis?
Jeff: (30:23)
It's critical here. And, you know, as I like to say, there's BTU conversions across all these commodities. We saw it in the 70s. We saw it in the, in the 2000s, and we're beginning to see it happening again. And meaning that if you think about commodities and you rank order them, we chose all these commodities is to do what they do for us, by their cost basis. And, you know, actually I come to the point, there's four things we use commodities for — obviously transportation. And we figured out oil is the best, the lowest cost way to create that transportation. You can do it with electricity. You know, with, let's say nuclear, but it's got a different cost basis and actually it's higher. If you just look at the density of oil and you put it into the car, it's pretty much the lowest cost way to do that. In fact, Ford and Edison had this debate well over a hundred years ago about which one was better. And we determined at that point in time that oil was.
Then the other one is we need to build things. And, you know, copper is for things like plumbing, conducting electricity. Then you have, we gotta feed ourselves. And we figured out using corn, wheat, soybeans, which are your workhorse grains, were the cheapest to do that. And then you have to cool yourself, heat yourself, which then, you know, you look at natural gas and nuclear and those other types. So we chose all these things for that reason, but let me point this out. And this is fairly obvious. We could do all of that with corn. We can drive our cars on corn. You can make plastics out ofcorn. You can build your house out of corn. You obviously can feed yourself with corn and you can use corn to generate electricity, heating, cooling, and all those things. So we only need one commodity to do that, which is corn, but we don't do it because it's too expensive.
And so what you're asking now is, okay, we look at some of these other commodities, like oil and gas. They have these emissions that we don't like. Let's figure out how to replace them. And the best way to do it, I'm gonna go back to my carbon price — put the carbon price out there. This is how much it's gonna cost to do it. Then let's sit and let's figure out, is nuclear the best way to do it? Is hydrogen the best way to do it? That would be the appropriate way to do this. Create a market based solution to find the answer to this.
wanna go back and talk about, you know, the 70s because it was very similar to today about the war on acid rain and how we solve the war on acid rain. In fact, the same three big themes we talk about the supercycle — about redistribution of policies, environmental policies, and de-globalization — they're all the same ones. You had redistribution, which was the Great Society or the war on poverty. The environmental was the war on acid rain. And let's talk about how that war on acid rain was solved in the 70s. There was the Soviets and the Americans wrapped up in a nuclear treaty that was enforceable the rules around desulfurization. And in doing that, you had enforceable rules that then was imposed on Nato countries and Warsaw Pack countries, which is, you know, why they were able to enforce them, but you got a functioning sulfur market out of it.
Once you have the functioning sulfur market, you were able to let you know venture capitalists come in there and create the solutions to it. By the way, you ended up solving the sulfur problem was much cheaper than what we had ever envisioned. We're now focused with a very similar part, by the way, the other lesson to learn from the acid rain? When did the Americans get serious about dealing with the acid rain? When places like Lake Eerie were on fire. They had to see it. And once they saw it, they passed. The other thing too, it was Nixon who passed the Clean Air Act. And you know, actually somebody pointed this out to me that, you know, conservation, conservatives and conservation, historically have gone hand in hand. But I think the key point here, it was a sulfur market with a price signal and it was enforceable policy that led to that solution. And we need something similar to that around carbon to deal with this current problem that we're dealing with, call it the war on climate change.
Joe: (34:25)
So just to put it all together, you know, ESG in your view discourages investment, what we need is a price on carbon, some sort of tax, but then that would in theory, create the encouragement of investment because okay, you know, the rules. You know, the cost that any given entity is going to bear. And then the challenge is out there to do better, to find a way to make it profit.
Jeff: (34:50)
Absolutely. And then you would look at some oil companies and you would put their total emissions, you'd know what that number is, you'd put a cost on it. And then the equity analyst would go, ‘Hey, this is a good company. This is a bad company.’ And I did it by looking at the economics that they're imposing on society. And then we wouldn't have this blanket under investment that's creating many of the problems we're witnessing today.
Joe: (35:10)
Can I ask, you know, how do you see like these various shortages and tightnesses in markets affecting all the other ones? Because it's interesting, you know, one of the reasons cited for the slow ramp up of U.S. production is shortages in metal pipes and shortagees in labor as well and other commodities, sand as well, that are needed to expand domestic production. How much is essentially the shortage and the tightness of every commodity at the same time contributing to slowness in the ramp-up of new production and new investment?
Jeff: (35:46)
It's the revenge of the old economy. Like my point. Banks are old economy too. It's why they're not providing the capital. They don't have the capacity to, we didn't invest in everything you just mentioned plus, you know, old economy banking. I can just give you a list of all the things that were underinvested, you know, warehouses in the U.S. Port facilities, trucking chassis, the list goes on and on. And then all of a sudden we ‘ve got a pull in demand that stressed the system. And then we find out where all these shortages are. Part of the reason why, you know, you go back to, you know, the 70s and the 2000s. What made it very similar was you had that same dynamic. You know, revenge of the old economy. I mean the new economy, the Nifty Fifty, sucked all the capital away.
The Dotcom boom did it again in the 2000s, the FAANGs again this time, that's why you have this, you know, it's a very broad-based shortage, you get this persistency in transitory shocks, meaning that one shock in one market then leads to another shock in another market, which then makes it feel like, you know, the transitory becomes much more persistent. That's what we've seen. But the core reason is everything you just listed were poor-returning industries that also were very much impacted by decarbonization, which as a result, we underinvested.
Tracy: (38:20)
Can I ask another question on a topic that has been coming up quite a lot recently, which is this idea of the demise of the dollar or the long-term decline of the dollar. And maybe that starts with certain commodities producers asking to be paid in something other than U.S. currency. So we've seen Russia talk about getting natgas payments and rubles for instance, and there've long been rumors and speculation about China taking yuan payments and things like that, how do you see that playing out in the commodity space?
Jeff: (38:54)
To make a one of these reserve currencies work, you need to have a current account deficit and a very large bond market, of which China does not have. But I think, you know, let's go to another point about all this, you know, talking about the demise of the dollar is, you know, everybody's focused on the demand of the dollar.
Let's talk about the supply of the dollars. And you look at the commodity bull markets in the 70s or in the 2000s, what was associated with both of those was a savings glut. And the reason why everybody thinks that higher commodity prices and oil prices is bad to the economy is because when you think about, if you just took a closed economy, raised oil prices, let's say the U.S. Let's take the U.S., produce enough oil, you raise the oil price. All it is is a transfer from Chicago to Houston. It should have no impact on the broader U.S. environment. Maybe they'll spend, you know, the wage increases in Houston may take time. You get the exercise I went through. If everybody had the same consumption and savings, it'd have no impact. The reason why the 70s and the 2000s had such an impact, was that savings glut. You had a transfer from groups in the U.S. that would consume something, you know, like 92%, to groups that were consuming somewhere around 50% to 60%. And then you created that savings glut. You know what, this time around, they're gonna spend it. You're not gonna get that savings glut off the higher commodity prices, which is gonna reduce the availability of dollars on the global market.
In fact, the reason why you had that sharp oil-dollar correlation in the 70s as well as in the 2000s, let's think about this. And this was, you know, you know, Ben Bernanke was the one who coined the term “savings glut,” is as oil prices went up, the dollars would go to Saudi Arabia, Saudi Arabia takes those excess dollars and then buy U.S. Treasuries.
In fact, when they were hiking rates between June of ‘04 and June of ‘06, the front of that curve was going up and the back end was going down because you had such higher commodity prices going in and buying U.S. Treasuries on the back end. That was the recycling. You know why they had to do that? They didn't have anything else to do with those dollars. I remember one time I was in China in ‘05 and was talking to SAFE. They were spending a hundred billion dollars. They needed to place a hundred billion dollars per month. That's a huge amount. One of the key reasons, you couldn't spend a hundred billion dollars inside China in 2005. Guess what? Today you could, you could easily. Same thing with Saudi Arabia. And so you have these entities that are developing in places like Saudi Arabia — take PIF.
The only market that had enough liquidity to absorb that kind of potential investment were U.S. Treasuries, which is why we saw that savings glut and saw the capital move into places like U.S. Treasuries. And you can think about that period between June of ‘04 and June of ‘06 when the Fed was hiking rates, the back end was coming down. Why was the back end coming down? It's because you had all of that capital going into those emerging markets that was being recycled back into U.S. Treasuries, hence the term the savings glut. Now the difference between today and the 70s, is you can place hundred billion into some place like China immediately. You cam place billion into some place like Saudi Arabia immediately. So if you can think about if we had a savings glut in the 1970s and in the 2000s, today what we're teeing ourselves up for is a spending spree.
And I'm gonna say teeing up, you look at an entity like PIF in Saudi Arabia, ot was the intention of that investment vehicle is to go out and invest in Saudi Arabia. There's similar entities in places like Abu Dhabi. They're gonna invest in power, gas, logistics, transportation, healthcare, all of these things in their own economy. And this is part of this whole idea of deglobalization, is that you're gonna get a lot of this investment locally. So if the savings was able to, you know, create a slow down in growth from higher oil prices, a spending spree is gonna do the exact opposite. And if anything, it's gonna reduce the available supply of dollars that was being recycled back into the U.S., run up funding costs in places like the U.S., but also create more commodity inflation out of spending in places like Saudi Arabia, Neom city, or in China, like One Belt One Road.
Tracy: (43:36)
Can I just ask, where is the production response from OPEC? Because again, you know, traditionally in a situation like this, you would expect OPEC to start ramping up production, but it hasn't really happened, or at least not to the scale that people have anticipated. And one of the things that comes up is that some of the smaller OPEC members actually have trouble increasing production. They have underinvestment in their own oil sectors. And so they can't, you know, immediately press a button and satisfy the world's energy needs.
Jeff: (44:06)
So you gotta ask yourself, who's gonna put money into a $15-20 billion deep water offshore project that’s gonna be producing oil 20 years from now? The answer is not very many people, hence why you don't have capital going to places like Nigeria or Angola and why production is starting to decline.
Joe: (44:26)
Obviously gasoline prices have people talking about upping EV production. And so, you know, that does seem to be happening. Demand for electric vehicles seems to be growing pretty rapidly in the U.S. and elsewhere. I guess I have two questions. When, in your view, do we see the peak of petroleum demand as a result of this shift? But then related to that, what kind of deficit do you think we are facing for the other commodities that go into EVs, such as all the different metals and chemicals that go into batteries? How are you thinking about that?
Jeff: (45:01)
Yeah, you can think about the hydrocarbon commodities, like oil and gas and coal. They face underinvestment and supply constraints that you're referring to, while most of the other non-energy and metal commodities and copper and aluminum in particular are gonna see significant increases in their demand.
In fact, I would argue copper is likely to be the tightest commodity we'll have ever seen. You know, it's much tighter than what oil was during the 2000s. Let me remind you, oil went up 7X in the 2000s, you know, our forecast is $15,000 a ton on copper, but no matter what technology you use, you're gonna be using electricity. And the only thing that can conduct electricity, given the rules around the periodic table and the rules of chemistry, is copper at the rate we need to conduct it, which means that the demand for copper is gonna be there.
So I think the upside around our $15,000 target, which by the way, if you started this cycle at $5,000 copper, 15 is a 3X. And oil was 7X over that time period, the upside potential in copper, I think is significant. But I think there’s a big disconnect here, I think is why, people are going well, how is this happening? Can't we just invest in green EVs more to solve this problem? Is the scale of EVs. There's maybe 10 million of them on the road today. There's 1.25 billion internal combustion engine cars on the road today. You're gonna have to grow those EVs at a very rapid to overtake the combustion engines. To get to that point you're asking, “when is the, you know, peak oil demand?”
You know, I'll take our base case, which has been generated off of, you know, announcements and investments and everything , which would say that, you know, we start to slow demand growth — and this was pre-Russia, Ukraine invasion — you start to slow demand growth somewhere around 2025, 2026. You hit a peak in the early 2030s, and then you begin to roll over. That's probably optimistic thinking. You're probably gonna overshoot to the upside near term. Let's not forget. There's also the constraint about the damage we're doing to the environment. Eventually there's gonna be a point, remember the 70s? We started dealing with the war on acid rain when people started to see, you know, fires on Lake Erie. Are we gonna see a similar dynamic where people start to see enough of the damage that's being done by carbon emissions? They go, Hey, enough’s enough? And we're gonna do an about face and start to deal with this thing in a much more efficient way to try to get results.
More likely just watching things historically, you don't deal with the problem until it's knocking on your back door. Think about what did we learn from Covid? If that's the case, oil demand probably goes well above those projections near term, then we hit a wall and we go, Hey, time to deal with this. And then it starts to drop precipitously. We showed during Covid that, you know,ingenuity was able to come up with a vaccine in six months. You know, if you have to remove the stuff from the sky and figure out how to, you know, store it and do removal or capture something like this, to do it on that very rapid basis, that could potentially be a solution here. But I think the key point here is you need investment, technology, people, everything directed at solving this problem. Like I say, don't ever bet against an engineer. You give 'em enough time and money, they will solve the problem. The problem with decarbonization is we just haven’t given them enough time and money to solve the problem?
Tracy: (48:32)
So if you're an investor and you're bullish on the commodity cycle, how do you actually go out and play that at the moment? Because I feel like we talk conceptually about, for instance, the copper price going up, but as we've seen over the past six weeks or so, there can be a difference between financial exposure to commodities and the physical. So had you just bought a wheat ETF, for instance, you might have experienced problems in the past couple of weeks or so. So how would you recommend people actually get commodities exposure at the moment?
Jeff: (49:07)
By the way, you know, the thing that I've really learned in the last six months is nobody has to buy a financial product, but somebody has to buy a commodity. Somebody has to buy oil and somebody has to buy wheat. I could say commodities have a captive consumer and a captive producer who can do nothing about their position in the very near-term. In contrast nobody has to buy an oil equity. We've now learned that. Oil prices can keep going up. The fundamentals of the company can get better and better, but nobody has to buy it. And that's why you have that huge disconnect between commodity prices and the commodity-related financial instrument. So to answer that question, what do you wanna own? You wanna get as close as to that person who actually has to buy this thing as possible, and these things like the BCOM, you know, the Bloomberg commodity index, that rolling front month — and I'm not pitching Bloomberg here — but the index is an excellent product that does this.
It's rolling the front month of these commodities that gets you right up, as close as you can, to that consumer who actually has to buy this commodity, because that's where the returns are gonna be generated. And given this pullback that we've seen more recently now with oil down below a hundred dollars a barrel yesterday, you're in an environment in which that entry point I'd argue is relatively good, particularly if you're gonna have volatility going forward. That rolling front month strategy, it's just another way to say your long commodity vol. And if you believe our view, that commodity vol is gonna be rising over time, being long that kind of product is gonna be your best bet here. So, you know, you don't even really have to think about trying to choose which sector to own, just go out and the overall BCOM index that gives you a nice weighting across energy metals, agriculture, and the rest of the commodity complex. If you wanna be more weighted towards energy, the old Goldman Sachs Commodity Index, which is now S&P one, the GSCI, is more energy-weighted. The BCOM is more, you know, a broad commodity index. And then you can pick the sub, but, you know, the thing that you're capturing here is you're as close to that consumer who has to buy it as possible.
Joe: (51:15)
I just want to ask a quick question about copper again. And you talked about $15,000 a ton being plausible where it's I think roughly 10,000 [now], but you also said the tightness that we're seeing in and copper rivals, or perhaps exceeds, even what we saw with oil in the sort of earlier 2000s during that cycle, what are the numbers like?What's the potential deficit we're looking at, given where demand is going and how much new production needs to come online? Like quantify the tightness beyond just the sort of where the price is at.
Jeff: (51:46)
Okay. Good question. So if, if you go back to 2002, 2003, when we first started getting really bullish on oil, and you looked out, you would say peak oil, you know, somewhere around oh ‘05, ‘06, by the way, it rolled over on conventional oil late ‘04. And then demand with China was going, you know, you would get a episode of somewhere around 5% of the market. The numbers we're coming up with copper are like 15% of the market. Three times as tight as than what you would've seen with oil in the 2000s. And, you know, part of it, you know, at this point right now, oil is not, or copper’s not responding is because you have the inventories are going down, but investor’s very concerned about China. So, you know, despite the fact that fundamentals are getting tighter and tighter, you don't have investors and consumers worried about copper because they're focused on the China property market, but this is the big gear which you see the passing of the baton from Chinese property market to the green capex story. And by 2023, green capex becomes a dominant force there.
Joe: (52:55)
You talked about, we need to create sort of a regulatory structure that encourages long-term investment. And that's really the only thing that's gonna solve this. So the White House calls you up and says, “Jeff, we need to craft a plan. And anything you say will get implemented.” What are the basic ideas of what the ideal policy response, at least just let's just say in the U.S., what does the ideal policy response look like to induce that increase in investment? What are the components of it?
Jeff: (53:24)
First and foremost, you need a policy around how we're going to do decarbonization, right now there's a focus on the demand side, but it's a very asymmetric response in terms of there's no policy around how you're gonna wind down the side. So first and foremost is create a policy framework around how we're going to actually decarbonize and then create it in such a way that it can be rolled out in U.S., Europe and China. Because that's two thirds of the world emissions right there. The second thing is then create, once you have the rules in place that are enforceable by punishment, and that's the key — they gotta be punish. You know, we saw with Volkswagen, the catalytic converters, they got punished for cheating. If you cheat on this, you gotta get punished. Once you have that, then you can now create a cap and trade model or a tax carbon price.
And once you have that carbon price put in place, then solving a lot of these problems and getting the investment to flow becomes much more, more easy. The other thing that, you know, I advocate is creating, you know, Tracy came up with a few ideas or so around the SPR or whatever, it might be to create that idea of a long-term contract to take out the volatility that investors would potentially be focused on. So, I mean, those are the two ways I think. First and foremost is we need a see around decarbonization. And if you go back to the 70s, an example, that didn't happen until you saw Lake Erie on fire. I don't know what it's gonna take in the 2020s to get that, but that's first and foremost. We need that policy around decarbonization and a carbon price.
Joe: (55:03)
Well, Jeff always fantastic to talk to you, this question of how we're going to finance increased extraction of commodities is the question and fantastic perspective. So thank you for coming back on Odd Lots.
Jeff: (55:16)
Thanks for having me.
Tracy: (55:18)
Thanks so much. Yeah, that was really good,
Joe: (55:35)
Tracy. I obviously, I love talking to Jeff. I mean, that really does seem to be the fundamental challenge that we face right now really, it does seem to be on the investments side. However you wanna slice it. Like, what do you want to talk about moving away from fossil fuels and the, uh, the copper deficit? What they're talking about, just what do we need to bring balance to the oil market right now solving this sort of like long term, it's kinda like a game theory problem. How do you get people to commit to investment? Seems like a huge is the huge challenge at the moment.
Tracy: (56:05)
It is weird to think, I mean, if you think about what human beings need on a day to day basis, it's basically food and energy. And you could argue that the entire role of the state is basically to ensure those two things — maybe as well as social order and security and things like that — but clearly two vital things. And yet it seems like structurally there have been years and years of underinvestment now, and this is something that's come up both from Jeff, as we just heard, but also Zolton Pozsar idea that A) you have previous underinvestment, but now you have the cycle of volatility, increased transport costs, things like that, that just means you need even more capital to support commodities trading and production.
Joe: (56:52)
I love Jeff's use that term volatility trap. It speaks to, obviously look, the job of guess of the capitalist is to take risks and including price volatility. But if you have this sort of like volatility that feeds volatility overall, you could create this situation, which you have this dearth of investment. And it's interesting too, because so Jeff talked about obviously bank capital requirements and the discouragement there, and then the ESG overlay on top of that, and then also this extraordinary tech boom that we saw. And so the rise of like the Netflixes in our life and the rise of the iPhone and the rise of Facebook and social media, you just like you're in an environment like that. You could just see like, who wants to invest in digging up, you know, fossils, you know, dead, dead animal holes that turn to liquid, uh, out of the ground. It's just in, in that, in that period, you can just see why there had been such a dearth of interest in this/
Tracy: (57:52)
Right? Well, this is also just, I guess the sort of headspace that a lot of investors tend to be i , which is you're always looking for the next big thing. And oil has never been, or, you know, for a very, very long time has not been considered the next big thing. And so it just doesn't have a good story behind it.
Joe: (58:10)
Well, and I, I think there's another thing, you know, we talk about normalization all the time. And so normalization, I think of the very sort of crude sense, all the restrictions from COVID slowly getting lifted and we go back to services. But I think like implied is just the idea that like, yeah, and then oil prices are gonna go back down and then everyone's gonna invest in tech and web3 and crypto, etc. But I feel like as long as we have that mentality or as long as everyone sort of has this feeling like, well, yeah, we're having this like temporary surge, cuz it's weird. Like you're not gonna actually get there. It's almost like in order to get, you know, in order to get prices down, people have to believe the prices will never come down.
Tracy: (58:51)
Yeah. Which is very tricky. Yeah. From a narrative perspective.
Joe: (58:56)
I mean, I think like if you, you know, you think like back to like 2004, 2005, we thought that prices were, that was the exact opposite. I think people thought there was this big oil boom that's happening. China's usually got an infinite amount of oil will never catch up and that then you get the investment. Well
Tracy: (59:13)
You have the peak oil narrative...
Joe: (59:15)
The whole peak oil narrative. Exactly. Right. And so now it's like, well, we are still in the opposite where these sort of conditions seem temporary and we're gonna move to EVs and we're gonna normalize and everything will bring back into balance. And that's not a sort of a, it's not a great head space. We're actually bringing stuff into balance.
Tracy: (59:31)
We need to think of a good story for like wheat.
Joe: (59:35)
Right? What is, but in all, in all seriousness though, like the copper thing, I think really interesting mm-hmm and I hadn't thought about that, that people maybe associate copper as largely a Chinese construction, Chinese real estate story. But if we're going to electrify everything in the world that creates a lot of copper demand. And so then it's just a matter of like, well, what's the cycle for building that out?
Tracy: (59:58)
Well, this is another thing that we are discover on these episodes, which is that you actually need a lot of these old economy metals or dirty fuels or whatever in order to, to
Joe: (01:00:10)
Get off the other dirty fuels.
Tracy: (01:00:11)
Yeah, exactly. Alright shall we leave it there?
Joe: (01:00:22)
Let's leave it there.