This week, we welcome Greg Sharenow into the SmarterMarkets™ studio. Greg is the Managing Director and Portfolio Manager for Commodities and Real Assets at PIMCO. SmarterMarkets™ host David Greely sits down with Greg to discuss the European energy crisis, commodity markets, inflation, and what it all means for investors.
The following Q&A is created using slightly edited excerpts from the episode transcript, optimized for readability. Download full transcript.
GS: I think it’s the FED versus OPEC that has been a very challenging dynamic when you’re formulating a view because it is hard to look at the actions of the FED and not notice that this will lead to a slowdown of economic activity. You’re already seeing it in some of the data that’s regarding housing, and you would expect to see the actions of higher Central Bank rates, not just in the US but globally, having a negative impact on real spending capability ultimately over time. Ironically, higher rates also increase the cost of capital to the energy space, reducing potential investment.
GS: So there is a bullish aspect to the FED policy that will be more impactful over a longer term horizon than a short term because investors now have more places to put their money. To places where they’re earning some risk-adjusted return. After many years of interest rates being so close to zero, which was made to facilitate more money going to more places and is now working in the other direction. I think that points to one of the challenges we’re facing right now, that this cycle that we’ve been in higher commodity prices hasn’t been a demand-side cycle. If you look at the last super cycle, the emerging market growth rate, particularly centered in China, really strained global supplies; demand for many of these commodities isn’t much different than where they were in 2019, and if anything, they’re not on the trend where they would’ve been, but we’re seeing extreme tightness and very strong markets in part because of the constraints on the supply side.
GS: If the FED were to move rates much higher, reducing capital availability further to upstream investment and investment in the power sector, it could have a positive long-term impact. Regarding OPEC’s action, they had some concerns about short-term demand, and there is an interest in supporting prices long term. And if you’re OPEC and you’re producing at near max capacity, if you look at Saudi, they were producing 11 million barrels per day recently. From a consumer standpoint, if you believe we need to get that CapEx invested, that we have been shy to do up to now, but I don’t think that’s the only reason. Another part of their view was that if you think about driving your car and you have your pedal down to the metal, you will start getting vibrations.
GS: They’ve never sustained that for two consecutive months. Sure, their surge capacity is still higher, but we haven’t proven that they’ve had meaningfully higher sustainable capacity. So seeing a reduction in output from OPEC also probably has a lot to do with creating flexibility in the system and reducing that vibration. Now the one other piece that has happened since then is also some guidepost from SPR, which has the same sort of guidelines as what you were saying that OPEC Plus was trying to do, which is creating price stability, which over the long term is arguably going to facilitate more investment if the SPR now can commit to forward buying oil around $70. OPEC is willing to adjust its output, at least for right now. Policies have changed a lot in OPEC over the last 20 years.
GS: Their response function today is not necessarily what the response function will be tomorrow, but as of right now, SPR, as well as OPEC, are working to put a floor under our backend oil prices. That leads us to have a constructive view on oil over the next 6 or 12 months or certainly that the market is discounting a lot of demand weakness that could come potentially from the FED tightening, particularly if the FED tightening leads to lower CapEx. Now about China, what’s remarkable about these commodity markets, and in the last cycle up in commodities was very much led by China, and it used to be that if the US sneezes – the world caught a cold. The response function of global growth that changes in China’s growth is becoming like a three-month lag, and it is not just the US now; it is also China’s impulse function.
GS: And that’s even more true for commodities, given their large share of not only growth but also their large share of absolute demand, given how much they’ve grown over the last 15-20 years. Almost all commodities are in a state of backwardation, consistent with low inventories and tight fundamentals where people are willing to pay a premium for prompt delivery. So we’ve had incredibly tight commodity markets across the whole chain. You’ve managed to have this, with China being a negative impulse. Next year, I would love to know what exactly China will grow; they will still grow at a slower rate than they have been and probably decelerating, but if they’re growing. They started changing their COVID policies, which could be a positive catalyst. But up until they make that decision, there are headwinds to commodities, and that’s the challenge for prices, and if not, I don’t know where prices would’ve been. It would’ve been a lot higher and a lot more painful.
GS: For sure. We had the Twitter wars also for four years before, and we’ve had COVID, so there have been many policy shifts and challenges. When you and I were working together, we were trying to get supply and demand down to a couple hundred thousand barrels daily. Now all the inputs could be half a million to a million barrels a day – easily! With China’s demand, if they reaccelerate, that could be $more demand for 500,000 barrels per day next year. The uncertainty bands are wide, and I think that’s part of what is also contributing to a lot of the constructive nature of the market because it challenges CapEx if you’re sitting there looking at this environment. You’re looking at policy uncertainty, demand uncertainty, and the policy being China’s COVID as well as fiscal policy, which is a huge deal in Europe right now. And it has had a big outsize impact on the market, the political future of some European leaders, and the rising concerns leading to protests in the street.
GS: Like there’s a lot of uncertainty. It makes one have to be more nimble, but it also makes the CapEx decisions to solve some of the supply-side challenges even more difficult because of all these uncertainties.
GS: Well, I can also widen that and say the ripple effects across the economies in the politics because Europe is the epicenter, but the echo has been global. And in the real wage contraction, you’re seeing that is very sharp in Europe, in particular, but elsewhere, the European energy crisis has many impacts on other commodities; for example, high natural gas prices are leading to higher coal prices, higher power prices, which has the implications for creating higher coal prices elsewhere as well, which has the feed through to higher power prices. It has a substitution effect on oil. Now I’m a little less alarmist than others on the outlook for winter in Europe. There’s been a bit of migration to that view recently because cash prices in Europe are trading down from €350 per megawatt hour.
GS: This weekend, it traded for $50 or $60. That’s a pretty big change now. The forward curves are still pricing a big premium. We all have the challenge of figuring out the demand response functions when we’ve never seen prices in this neighborhood. And if you look in the past, you’ve seen price spikes, and you kind of get a sense of how the demand responded on a short-term basis, but in almost all those cases, the forward curve was largely unmoved. It was viewed as a transient effect, and today it is the full forward curve at a huge premium to what anything would’ve been expected historically. So I’ve been a little less alarmist because we have so much excess consumption in our energy systems, and there are a lot of actions people can do to save.
GS: One of the ironic things we’ve seen this year is how weak gasoline demand may have been in the United States. It’s been much better in Europe, but it’s been weakish in the United States. Part of that concerns when your real wages are contracting; you start looking at ways of saving energy. Now, if you’re a European energy consumer, you cannot heat your whole home, but you can move back in with your parents, work from the office more, and let your firms pay your heating bills. Like there are a lot of actions, the awareness can lead to a material change. For instance, changing your thermostats by one or two degrees has a huge implication for energy consumption as well as, and curtailing peak power demand has a material impact on thermal generation because thermal is your marginal generation.
GS: What’s going to happen in Europe, it’ll have meaningful implications on the fiscal stress in Europe and their ability to manage through the needed subsidies that they’re planning or the planned subsidies. Whether or not that’s a good idea and if it’s needed, as Europe consumers go, a lot will go in the global market. Suppose we end up getting the 15% consumption out of the consumers. In that case, that’ll be a meaningfully lowered tax on industrial output and lower energy prices that you could expect in Europe, Asia, and elsewhere, big energy importers competing with Europe. Oil could have independent issues because of Russian sanctions and OPEC’s decisions. There’s a variety of things that can make that market different, but certainly, when it comes to gas and coal, it’s Europe that controls and holds a lot of the outcomes cause we’ve seen weaknesses in other places from the high prices that are causing real strains for Asian importers in some of the lower income countries. If Europe can figure out how to contain its demand, that will be very helpful in relieving some of the pressure elsewhere.
GS: We spend a lot of time with the corporates trying to understand their decision functions, trying to get a handle on what dollars are going back in, and at one point, they were spending 120% of free cash flow and now spending 40% or 50%. You look at the changes in oil production relative to what you would’ve expected at similar prices, and you look at changes in investment in terms of rigs; it’s meaningfully lower, and if you look at the international energy agencies’ investment outlook that was published a few months ago, they were also commenting that 50% of your increase in global energy expenditures this year is all cost. So when you look at an inflation-related company, they are more concerned about their cost and cost management because of how investors view and treat their equities when they increase CapEx and have higher costs associated with it. It’s very negative.
GS: When you look at the oil and gas side, we’re investing about 15% below where we were in 2018 and 2019, despite prices about 30% higher. On a real basis, it’s like 25% below. Meaning companies are just being more disciplined now. I think it’s a function of a few things. One, investors demand it after a very long period of subpar returns, and they want to be paid for the risk they’re taking. The second part, think about anything long-term CapEx-related. You don’t just have the demand uncertainty associated with the energy transition; you have liabilities that the environmental policies will change. What is your carbon exposure? What is your remediation exposure? Have you started expanding your time? The uncertainty bounds around these policies, and the demand outlook gets wider.
GS: And that’s very challenging for companies to justify and operate in that environment, and that’s why you see a lot of investments more likely to be green-lighted in renewable diesel, which with LCFS markets down here, it has to be challenged, but at least they can make a justification that in the long term it’s aligned where the puck may be going. The problem’s a long skate between now and then in the energy markets, and that’s not just true in oil and gas exchange but also in power. And while in the long term, more growth in renewables and more growth in storage for renewable, associated renewables are the grid that will lead to lower prices. The problem is we’ve done such damage to the base load generation that we’ve added intermittent sources that aren’t able to meet the full spectrum of our needs.
GS: I think we’re going to end up in a situation where the next three to five years, there will be higher and more volatile energy prices because of the CapEx decisions and the challenges of making incremental CapEx improvements on base load capacity whether it’s thermal related or even nuclear in many places. Even though nuclear is having a bit of a renaissance, it’s still a two-track system where some are going in the opposite direction. It will be very challenging to meet the energy needs when the economy begins to grow again meaningfully.
GS: I think the policy uncertainty is what you’re referencing there. If you look at clean diesel, for example, it relies on policy incentives, and if you look at some of the other investments, it’s all about policy, and if the policy is going to change with different political wins, it does make the challenges harder. Certainly, consumers and governments are willing to look at the next 3-5 years and make that decision, but it’s harder to make that decision over a 20-30 year period. Now we’re moving into a peer with higher LNG FIDs going to be made. Even if it’s the lesser of all the evils, it’s one that markets are paying for. So I think you’ll see more LNG projects, but when you start looking at other projects that would otherwise go, you can easily say that some of the challenges are real.
GS: My concern about LNG is that everyone might want to build an LNG import terminal, and many US builders want to be LNG export terminals. We have to accompany that with upstream. Now, if you’re in East Africa, they are paired, and there are some other areas of the world where they’re going to be paired, like in Qatar, but in places like the US, we have to be able to invest to keep up with the LNG export capacity that could come down the line and permit is a big portion of the challenges in doing so.
GS: I would expect that you’ll see compression in the ERBS because the incentives are there, just like dollars will flow through the highest margin over time. It’s not a grand philosophical statement of insight. Investors go for returns, LNG arbitrages are high, and we should invest in rectifying that.
GS: Yes, but it’s fairly nuanced. Suppose you look at the 60/40 portfolio. In that case, there’s a time with a large historical sample where the correlations between fixed income and equities aren’t negative. Usually, that environment tends to be associated with inflationary environments. You’ve seen that in the past year, inflation has picked up, growth rates are coming down, and nominal rates are going up, creating a problematic time for investors. So owning inflation assets are more important than maybe other periods where growth is a dominant factor when inflation’s dominant, inflation-related assets are in higher demand for portfolio diversification. So there are a lot of clients who are interested in hedging their inflation risk in their portfolios. The thing is that there are a lot of scars, particularly in the United States, from long periods of poor commodity returns and low inflation where it wasn’t the best use of the dollar.
GS: Now the problem is when we have the regime shifts, and you have had the investment, and while
there’s some regret from a lot of the US investor base who weren’t actively engaged like they may have been 10 or 15 years ago. The challenge many are debating now is whether you can buy commodities today if the forward economic ALEC is lower? So there’s a tug of war between those who can get over that hump and view it from a portfolio diversification standpoint versus those who think with a bad economic outlook. Do you want to own commodities in a dire situation? They’re at a higher nominal price than they’ve been, so they think they shouldn’t be interested. It’s a two-way conversation; the other part is for those who were invested because your 60-40 went down so much, and commodities are up; if you had a 3% allocation now, you might be at 4.5% or 5% today.
GS: Portfolio rebalancing, take the cash from here to finance other ills in your portfolio, but the interesting part is that the global investor, particularly in Asia, and Latin America, these are places that historically have had high leverage to EM growth and, as a result, would’ve felt more insulated in an inflationary cycle, a commodity cycle than they have been this time. All of a sudden, they’re finding themselves very subject to changes in inflation globally and changes in the US FED policy. They have found themself on the tail end of the inflation cycle and have become increasingly interested in hedging their inflation. I never had that EM virtual demand growth and never had the EM growth story, I mentioned before about China. You never had the growth, but you still got the commodity, inflation, because of the supply exchange.
GS: So while the US, what our perception is, the US investors are very much split, and some are reducing for various reasons or some have just missed it, and they’re now concerned because of demand. The global investor has been much more interested than they have been in past cycles in part because of the nature of this, rise in prices has been much more on the supply rather than the virtuous economic boom EM-led cycle that we had before. So everyone has a different experience regarding how, or rather everyone has a shared understanding and has different wrong conclusions on how to manage it. There’s no rock you can hide under that’s big enough.
GS: The part of the commodity complex with the best medium-term outlook is the oil space, partly because of the real limitations on the growth and production sides. When I look at other commodities such as agriculture, while the environment is very tight at the moment and we’ve had two years of some fairly unfavorable weather conditions, ultimately, every year, this volatility on the supply side is meaningfully higher than the volatility on the demand side. So if you have good growing conditions, you can start seeing a rebuilding of stock. So it’s hard to strongly believe these prices are sustainable in agriculture without knowing the weather. There have been higher inflationary pressures that will likely limit the ability to bring in additional marginal acreage.
GS: We’ve seen some plateauing or definite slowing of the ability of places like Brazil to bring in additional acreage. There is inflationary potential in the AG space, but I would describe it more as we have much like power and gas and a much more brittle system. If you believe the climate is becoming less stable and more volatile, AG will have a higher likelihood of seeing price spikes than you would’ve seen maybe 10 or 15 years ago if you think this is a fundamental structural change. We had a speaker from Nassau who talked to us about this, and what I concluded from that is you would expect higher average prices but higher volume than you would’ve expected before.
GS: The starting point on the AG market, in the near term, is on the constructive side because of where inventories are and where the harvest has been, but at least the worst has been avoided in the US for corn and soya, but still it wasn’t a great year. When I look at metals, a lot of it has to do with as China goes – the metals markets will go; we see some reductions in CapEx on the metal side as prices have come down, and they’re doing it at higher price levels than you would have expected in the past, but again, related to inflationary pressures. However, still, China is the biggest mover. The energy transition has positives for the metal space, but it’s hard to offset the size and scale of China’s growth to their implications for the metals markets.
GS: Yes, that will ultimately drive much of what happens in other commodities. For example, suppose the oil has the investment. In that case, the cost of investing in other upstream production, whether in metals or agriculture, becomes less challenging, and high fertilizer and ammonia prices result from what’s happening in Europe. If that reverses, that certainly reduces some of the pressures in the system. But I do think oil is the one that has the greatest constraints. Certainly, natural gas has been very tight, but Russia’s ability to shock Europe has now gone; there were 400 million cubic meters a day, and now 40% into Northwest Europe. There’s always zero, and that wouldn’t be an easy adjustment, but in the oil market, their potential drop in exports alone can dramatically keep this market tight for a very long time. So we think oil health’s a better outlook right now.
GS: We’re not going to see a phase-out or retirement of trading and investing opportunities in traditional energy because we have yet to prove that the world can move off of any. We’ve seen lower shares over time for different commodities, but we’re always adding our wood, coal consumption, and so on because of the high demand in the global energy market. So I think we expect that in five years, the investment in space will still be very similar to today with additional opportunities. Carbon, for example, is an area of growing interest. Let’s talk about a market that has big policy-driven views. Europe going for a 50-55% reduction had a meaningful impact on the forward supply of European emissions allowances. US California policy is another market that is potentially going to change, given the new carbon neutrality goal by 2045.
GS: That was just brought into law, but these markets are going to be very interesting because one of how the globe is going to try to make that transition is through bringing in carbon prices, and carbon is almost like a way for the market try to solve the way hopefully forward, but some places will be more command and control, and some other places will be carbon taxed and assume that they know the right place to get the outcome they want, but it’s going to be an area where you’ll have greater opportunities for investing. Now, suppose I think more broadly across asset classes. In that case, it argues for a very flexible approach because you are going to have periods where different areas are going to have higher rates of return, and just being in the energy transition sector and not investing in the old-line energy markets could leave pretty big gaps in one’s portfolio.
GS: Particularly if you’re considering this area as part of your inflation hedging basket. It’s not just a return center, but a return and inflation that needs to have what drives inflation. Core inflation has had its year and a half right now, where volatility is certainly picked up, but if you want to hedge and have your view about that as inflation related, you can’t ignore old-line commodities. Oil and food in emerging markets and elsewhere are still the biggest contributors to the volatility of inflation. In terms of being investible, the capital markets are ignoring some of the challenges with the higher rates, reduced ability for the market IPO, and new technology sector’s kind of the epicenter of some of those challenges; it’s going to continue to grow, and there are opportunities in companies that will take advantage of some of the growth industries.
GS: The challenge I have is if I want to invest in a company that’s going to build batteries; for example, for the grid, they’re all going to target the same hour or two or three a day. So you always have to be very careful with how much you expect current margins to sustain. So I think knowing the history of the challenges and investing in solar globally, investing in wind, investing in some of these technologies is going to be important for investors to take those lessons and learn them because you don’t want to put money behind an investment theme and you’re relying on something very challenging.
GS: I commented before about renewable diesel; look at the LCFS market, we looked at a bunch of projects two years ago, and we got called to sell puts to hedgers because they all needed to have $125 or $120 to generate a good return for their investment and we’re trading $65 or $70 now. It’s challenging because of the growth in projects that we’re looking at over $200; commodity markets are very volatile. I suggest having a very broad approach and a very flexible approach because you have to appreciate just how volatile they are.
GS: Policy, certainty, and clarity would all be very helpful, but I am optimistic we’ll get there. If you look at Europe and United States, the western world is struggling with that. China probably has slightly greater ease in imposing policy certainty, but even there, we’ve seen changes in how they approach their heavy-emitting industries. The big challenge is to deal with that. I think the other challenge is to deal with a lot of the efforts in deglobalization and some of the challenges that a lot of countries don’t want to rely on energy or mineral suppliers from other countries and view it as a zero-sum game. I think that also threatens to reduce the amount of money that will float to the upstream or energy supply. When I say upstream, I do not just mean oil and gas from that standpoint.
GS: The energy transition will require a massive amount of capital, and some of these hurdles are just a real challenge at the very least; one would say we can control policy a little bit better than we have and put some good policy in place. If you look at the political outcomes in Europe with people in the streets and the pressure of rising populism, you can see the imperative of doing so. I’m afraid these events cause bad outcomes as a short-term and political imperative, which reduces the incentive and ability to invest. The other thing is hedging is hard as you go into less liquid commodities, and many banks face different tiering on their capital. So if you trade something that’s highly ill liquid or something long-dated, they have to have higher capital charges and greater reserves against it, which is probably good for the overall financial stability of the system, but also makes hedging very challenging. So there’s a bit of a dearth of capital dedicated to helping facilitate that. I think that’s an opportunity for investors, but it’s an obstacle to the growth of that CapEx.