Macro-Economic Environment
A recent article in the FT has assured us all that while rate cuts may not be forthcoming, the Fed has our collective backs. The author commends the Fed on its masterful handling of the proverbial fires that have flared up via the creation of a number of special facilities. What the article is really touting is that the Fed has been uniquely successful in its ability to dampen volatility, and not only dampen it but squash it.
This reduction of volatility has not been lost on Wall Street where the amount of dollars devoted to selling “vol” has grown tenfold since 2018. Not coincidentally, this was the last time premium sellers got into real trouble. The addition of ODTE (zero days to expiration) options has only exacerbated the trend in premium selling. This begs the question: If everyone is selling, is anyone buying? Well, it’s not the institutions, which were once large buyers of tail risk protection, particularly since this has been such a losing proposition over the last five years.
At this point you might be asking: So what? Is there really anything wrong with the Fed trying to step in during periods of market turmoil? We don’t believe that there necessarily is, but to assume that this intervention is without a cost is naïve. The artificial manipulation of anything, including rates, volatility, and credit spreads has a cost. That cost might not be readily apparent or show up immediately, but there will be a cost to bear.
We believe that the manipulated stasis that we have seen over the last several years is manifesting itself primarily in two areas:
Tighter credit spreads than otherwise would be the case given actual fundamentals. When volatility is suppressed, that feeds into financing spreads, which theoretically should be reflective of the potential for default.
Equity valuations which have become completely divorced from reality in some areas. Wildly speculatively driven names like NVDA can only be sustained when the possibility of some external shock is seemingly neutralized.
In the broadest sense, when the entire marketplace is seemingly placing their bets that some tail risk event is not even remotely possible, that is often about the time such an event will occur. We believe that too much faith has been placed in the Fed, and their ability to micro-manage any event. We also would point out that one area where the Fed has not been tested is their skill at managing a number of disparate and simultaneously occurring financial “wildfires”.
Takeaways: “Black Swan” events, by their very definition, cannot be predicted with any degree of accuracy. However, one would not surmise this by looking at the dollars being directed at aggressively selling optionality on these three standard deviation type moves. Beware of markets that are making new highs while simultaneously pricing out the potential for any unforeseen set of circumstances.
Commodities/Energy
If one wasn’t convinced that energy “makes the world go round” by the sheer volumes of oil, natural gas, distillates, etc. consumed on a daily basis, perhaps observing what is geopolitically (militarily) focused on will. The targeting and sabotage of energy infrastructure isn’t new; however, it’s not being perpetrated by simple ragtag militias any longer, but increasingly by state actors.
It wasn’t all that long ago when Russia’s gas lines to Germany (Nord Stream and Nord Stream 2) were mysteriously blown up on the floor of the Baltic Sea. While many have strong opposing opinions on who is to blame, it is fair to say that only a few countries possess the sophistication to pull off something like that. Ukraine and Russia have been trading commodity blows ever since, with directives out of Kyiv to hit Russian refineries and those out of Moscow to take out power, grain storage/ports and other infrastructure. When Israel responded in Gaza, one of the first targets was their only operational electrical power plant. While the Yemeni Houthis may have taken a hiatus in targeting Saudi energy infrastructure, they’ve refocused their efforts on “wrong-flagged” tankers in the Red Sea.
What all of this means is much higher levels of volatility in energy and other commodities as supply disruptions will most likely persist. These price movements are often short-lived however. A stark example was European gas prices in winter 2022 vs. winter 2023. More recently, the cost of re-routing and insuring cargo between Europe and Asia has skyrocketed. This immediately lifted container/tanker firm shares despite the industry being plagued with overcapacity. The point here is that investors need an active and flexible strategy when managing their respective commodity allocation.
Another mega-Permian deal commenced last week, with Diamondback (“FANG”) taking out (private) Endeavor for $26Bn. The number of remaining targets available is literally fewer by the week. With the fervor in upstream consolidation of late, the prices paid on a few of the more recent transactions has some questioning the economics. This begs the question of when will those heavily-discounted (on a relative basis) producers in other geographic locations be taken out?
Well, it may have begun with the recent announcement that Chord is buying Enerplus ($3.7Bn) to create a synergistic Bakken-focused combination. We’ve previously talked at length about the opportunities surrounding Western Canadian Select crude trading at a >$21/barrel discount (currently) to WTI. North American refiners are always on the hunt for sour crude, and takeaway capacity in Canada is vastly improving. In 2021, Enbridge added ~370K barrels/day of pipeline capacity. This year, the Trans Mountain pipeline expansion is expected to add another ~600K barrels/day. Furthermore, with natural gas prices currently fetching near 28-year lows of ~$1.10/Mcf in the Bakken, values can be had on both sides of the U.S./Canadian border.
Takeaways: The numerous developing opportunities, combined with advantageous risk/reward valuations, within the commodities sector makes an allocation (in our view) absolutely essential. That said, this requires a “keeping your head on a swivel” type of active management.