Why Crude Oil Prices Will Recover Faster than You Think

Over the last six months, WTI crude oil prices declined from a peak of $107 to $60 a barrel, or a decline of 44%. Many analysts, including the Energy Information Administration (EIA), are forecasting even lower prices, and more glaringly, for prices to stay at these levels for at least the next 12-24 months. The EIA is forecasting WTI crude oil to average $63 a barrel in 2015 (down from its October forecast of $95 a barrel), while Andy Xie, a Chinese economist, is forecasting oil prices to stay at $60 over the next five years.

The oil market is now in a state of panic. We believe WTI crude oil prices will recover to the $75 to $85 range by the second half of 2015 as: 1) fear in the oil markets subsides, 2) shale production growth plateaus or even declines, and 3) global demand increases as a reaction to lower oil prices. Let’s examine these three reasons in more detail.

1) Oil markets are panicking and prices will bounce back after the fear subsides

At $60 a barrel, WTI is now more than two standard deviations below its 200-day moving average, its most oversold level since March 30, 2009. With the exception of the 6-month declines during: 1) late 1985/early 1986, and 2) summer 2008 to December 2008, the WTI crude oil price is now at a level which has previously marked a multi-year bottom. More importantly–from a technical standpoint–oil prices have always bounced faster than most analysts expected. E.g. After hitting $10.73 a barrel in December 1998, WTI rose by 80% to $19.28 a barrel over the next 6 months; similarly, after hitting $17.48 a barrel in November 2001, WTI rose by 68% to $29.38 over the next six months. Note that in the latter case, the rise in oil prices occurred despite the 9/11 attacks and the fact that the U.S. economy was in recession. Just like today, analysts were expecting oil prices to remain low during December 1998 and November 2001. In its December 2001 forecast, the EIA expected WTI to average $21.79 a barrel in 2002. WTI would average $26.17 in 2002, or 20% higher. We believe the current supply/demand dynamics today are even more conducive for a quick snap-back and a subsequent stabilization at higher crude oil prices.

oiltradingsystem12102014

2) Shale production growth will subside faster than expected

Our recent MarketWatch.com article discusses three reasons why the U.S. shale supply response in reaction to lower oil prices will be faster than expected. Those are: i) shale drilling is inherently capital intensive; many shale E&P firms have relied on GAAP and dubious accounting practices to mask the high, ongoing costs to sustain shale production, ii) unlike the major, multi-year projects undertaken by major, integrated oil companies, shale production growth is highly responsive to prices, and iii) shale depletion rates are much faster than those of conventional oil production.

These arguments for faster-than-expected shale production declines are stronger than ever. Firstly, shale drillers have only sustained the boom as long as there was ample financing, but this game is now about to end. The spread for high-yield energy debt has already jumped from less than 450 basis points in September to 942 basis points today. We expect financing to dry up for marginal drillers and fields; higher financing costs will also increase the costs of shale oil production, creating an overall higher hurdle for shale projects. Secondly, shale fields on average take about 6-9 months to come online, which is much faster than for most conventional projects. With such a quick response time, we expect shale production growth to slow down dramatically by April-May of 2015. Thirdly, higher efficiencies have meant faster depletion rates. Shale producers are looking for quick paybacks, and so are highly incentivized to begin and ramp up production as quickly as possible. As discussed by the EIA, the monthly decline in legacy shale oil production is about 300,000 barrels a day. We expect U.S. shale oil production to begin declining by April-May of 2015 unless prices rise back to the $75-$85 a barrel range.

3) Global oil demand to surprise on the upside

Our recent MarketWatch.com article discusses why U.S. gasoline consumption is already surprising on the upside, with the AAA estimating that Thanksgiving travel by car was up by 4.3% from last year, and the highest in the number of miles driven in seven years (versus EIA’s estimate of a 20,000 barrel decline in U.S. gasoline consumption in 2015). Higher demand is also now materializing in other parts of the world. For example, the Society of Indian Automobile Manufacturers reported a higher-than-expected 10% year-over-year rise in domestic passenger vehicle sales due to lower fuel prices. We expect Indian automobile growth to pick up even more next year as the Reserve Bank India (India’s central bank) will likely cut policy rates by early next year. This will reduce the cost of auto loan financing, thus increasing automobile affordability for the Indian middle class. In addition, Chinese car sales in November still increased by 4.7% year-over-year despite an economic slowdown and a broad government mandate to limit car ownership in major cities. We believe both Chinese and Indian oil demand growth will be resilient as both the country’s central banks have ample room to slash interest rates, thus countering any pressures of a further global economic slowdown.

Now, more than ever, we reiterate our bullish stance on oil prices. We expect WTI crude oil prices to bounce back soon and to stabilize and mostly trade in the $75-$85 range by the second half of 2015.

WTI Crude Oil – Blood in the Streets

Buy when there’s blood in the streets, even if the blood is your own.” – Nathan Mayer Rothschild, 1815

As we are writing this, WTI crude oil is trading at $69 a barrel, a fresh 4-year low, after OPEC refused to cut production as a response to the recent decline in oil prices. Prior to today’s OPEC meeting, Brent option time spreads indicated a 250,000 barrel/day cut by OPEC, while as much as 42% of analysts polled by Bloomberg expected a cut; therefore, today’s 6% decline in the WTI oil price as a response to a no-cut decision is not surprising. The following chart puts into perspective the ferocious decline of oil prices over the last five months (spot WTI traded as high as $107 a barrel in June).

oiltradingsystem11272014

The green line represents the WTI spot price (left axis); while the blue line shows the percentage deviation of the daily WTI spot price from its 200-day moving average (right axis). With today’s decline to $69 a barrel, the WTI spot price is now trading at 29% below its 200-day moving average. A further drop to $65 a barrel would put the WTI spot price at 2 standard deviations below its 200-day moving average. Should it hit that level, crude oil would be trading at its most oversold level since April 2009, and prior to that, November 2001 (when the U.S. entered a recession in the aftermath of the September 11th attacks on the World Trade Center).

We reiterate our conclusion from our November 19, 2014 commentary (“The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015“). Quoting our conclusion:

With U.S. shale oil drilling activity still near record highs, we believe WTI crude oil prices are still biased towards the downside in the short run. But we believe the recent decline in WTI crude oil prices is overblown. Beginning next year, we expect U.S. shale oil drilling activity to slow down as capex budgets are cut and financing for drilling budgets becomes less readily available. Combined with the strength in our latest CBGDI readings, as well as imminent easing by the ECB, we believe WTI crude oil prices will recover in 2015, averaging around $80 a barrel.

At the time of our November 19, 2014 commentary–while certain E&P companies were already cutting their 2015 capex budgets–we realize panic has not set in yet in the E&P industry. We believe this will now change as WTI crude oil prices definitively decline to below $70 a barrel. Our analysis suggests that around 18% of all global oil production will not be profitable with WTI/Brent below $70 a barrel. Even pricing in a 10% cost deflation (e.g. day rates for rigs have already declined substantially), many shale oil and Canadian heavy oil producers will still not realize a profit with WTI oil at $69 a barrel. While prices would continue to be volatile over the next several months, we believe crude oil prices are now close to a bottom. More importantly, we believe many U.S. E&P firms will not only cut capital spending in 2015 (debt financing costs for new shale oil projects have already risen by 200-300 bps across the board)–but will divest assets in order to stem cash flow issues. Clients who have cash on the sidelines will be presented with an excellent, once-in-a-decade buying opportunity as distressed assets come onto the market over the next 6 months.

Here’s why–with WTI at $69 a barrel–we are now long-term bullish on oil & gas assets:

1) E&P firms will be desperate for cash and will slash production at the same time

This is the primary reason why we are bullish with WTI crude oil at $69 a barrel; and more importantly, why we believe the 1st half of next year will present a once-in-a-decade buying opportunity for distressed assets, even if we factor in a 10% cut in the cost of production of U.S. independent E&P firms. Our analysis of 29 independent E&P firms suggests a funding gap of over $13 billion with WTI crude oil at $69 a barrel based on current capex budgets. Secondly, none of the key U.S. shale oil fields are profitable with WTI crude oil at $69 a barrel and Brent at $72 a barrel, even assuming a 10% across-the-board reduction in costs of production (see below exhibit).

Exhibit: Breakeven Brent Oil Prices at Key U.S. Shale Fields Assuming Base Case Well Costs
and a 10% Reduction in Costs of Production

e&pcostofproductionWith WTI crude oil at $69 a barrel, U.S. oil producers will be cutting capex and putting distressed assets on sale at the same time. Clients will thus be able to: 1) purchase oil & gas assets at distressed prices, 2) purchase oil & gas assets going into a declining production/rising oil price scenario. Clients who are more risk-averse can also purchase equity or debt at existing E&P firms at discounted prices. We would not be surprised if U.S. oil production actually decline next year (right now, U.S. oil production is expected to increase from 9 million barrels/day today to 9.5 million barrels/day by the end of 2015).

2) U.S. oil demand will surprise on the upside

The EIA currently estimates U.S. oil consumption to rise by only 160,000 barrels/day next year, based on a scenario of relatively slow economic growth, higher vehicle fuel efficiencies, and simply less driving as more baby boomers retire. But with WTI crude oil at $69 a barrel–and with U.S. employment growth still recovering–Americans will likely spend more time on the road next year than currently expected. The argument for an upside surprise is even more compelling since Americans are still driving less miles than at the peak in 2007–which is unprecedented in the history of the automobile–as seen in the below chart.

USmilesdriven12MA

3) The ECB’s one-trillion euro quantitative easing policy will buoy demand and support commodity prices

The European Central Bank’s Vice President and second-in-command, Vitor Constancio, is now on record for advocating a one-trillion euro quantitative easing policy to begin as early as the 1st quarter of 2015. The purchase would involve all of the Euro Zone’s sovereign bonds (including those of Greece), with the allocation to be determined by the relative size of each euro member’s economy. If implemented, this will not only lower the cost of sovereign borrowing across the Euro Zone, but would also act as a transmission mechanism for other forms of borrowing by improving the health of banks’ balance sheets, while increasing the region’s inflation outlook. All else equal, this should also provide a boost to commodity, and of course, oil prices as well.

Bottom line: WTI crude oil prices at $69 a barrel will provide once-in-a-decade, distressed buying opportunities for clients over the next 6 months, as well as excellent opportunities to purchase equity or debt of independent E&P companies.

The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015

We first introduced our CB Capital Global Diffusion Index (“CBGDI”) in our March 17, 2013 commentary (“The Message of the CB Capital Global Diffusion Index: A Bottom in WTI Crude Oil Prices“), when WTI crude oil traded at $93 a barrel. Based on the strength in the CBGDI at the time, we asserted that WTI crude oil prices have bottomed, and that WTI crude oil is a “buy” on any further price weakness. Over the next six months, the WTI crude oil spot price would rise to over $106 a barrel.

To recap, we have constructed a “Global Diffusion Index” by aggregating and equal-weighting (on a 3-month moving average basis) the leading indicators data for 30 major countries in the Organisation for Economic Co-operation and Development (OECD), along with China, Brazil, Turkey, India, Indonesia, and Russia. Termed the CBGDI, this indicator has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by about three months with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally, as stock prices actually make up one component of the OECD leading indicators).

Our logic rests on the fact that the vast majority of global economic growth in the 20th century was only possible because of an exponential increase in energy consumption and sources of supply. Since 1980, real global GDP has increased by approximately 180%; with global energy consumption almost doubling from 300 quadrillion Btu to 550 quadrillion Btu today. That is–for all the talk about energy efficiencies–the majority of our economic growth was predicated on the discovery and harnessing of new sources of energy (e.g. oil & gas shale fracking). Until we commercialize alternative, and cheaper sources of energy, global economic growth is still dependent on the consumption of fossil fuels, with crude oil being our main transportation fuel. As such, it is reasonable to conclude that–despite the ongoing increase in U.S. oil production–a rising global economy will lead to higher crude oil prices.

This is what the CBGDI is still showing today, i.e. WTI crude oil prices should rise from the current $74 spot as the CBGDI still suggests significant global economic growth in 2015. The following monthly chart shows the year-over-year % change in the CBGDI and the rate of change (the 2nd derivative) of the CBGDI, versus the year-over-year % change in WTI crude oil prices and the MSCI All-Country World Index from March 1990 to November 2014. All four indicators are smoothed on a three-month moving average basis:

CBGDI September 2014As noted, the rate of change (2nd derivative) in the CBGDI (red line) has historically led the YoY% change in WTI crude oil prices by about three months. The major exceptions have been: 1) the relentless rise in WTI crude oil prices earlier last decade (as supply issues and Chinese demand came to the forefront), and 2) the explosion of WTI crude oil prices during the summer of 2008, as commodity index funds became very popular and as balance sheet/funding constraints prevented many producers from hedging their production.

The second derivative of the CBGDI bottomed at the end of 2011, and is still very much in positive territory, implying strong global oil demand growth in 2015. Most recently, of course, the WTI crude oil prices have diverged from the CBGDI, and are now down 20% on a year-over-year basis. While we recognize there are still short-term headwinds (e.g. U.S. domestic oil production is still projected to rise from 9 million barrels/day today to 9.5 million barrels/day next year), we believe the current price decline is overblown. We project WTI crude oil prices to average $80 a barrel next year. In addition to our latest CBGDI readings, we believe the following will also affect WTI crude oil prices in 2015:

  1. An imminent, 1-trillion euro, quantitative easing policy by the ECB: The ECB has no choice. With the euro still arguably overvalued (especially against the US$ and the Japanese yen), many countries in the Euro Zone remain uncompetitive, including France. On a more immediate basis, inflation in the Euro Zone has continued to undershoot the ECB’s target. A quantitative easing policy by the ECB that involves purchasing sovereign and corporate bonds will lower funding costs for 330 million Europeans and generate more end-user demand ranging from heaving machinery to consumer goods. While such a policy will strengthen the value of the U.S. dollar, we believe the resultant increase in oil demand will drive up oil prices on a net basis.
  2. The growth in shale oil drilling by the independent producers are inherently unpredictable. Over the last several years, the U.S. EIA has consistently underestimated the growth in oil production from fracking. With WTI crude oil prices having declined by nearly 30% over the last four months, we would be surprised if there is no significant cutback in shale oil drilling next year. Again, the EIA has consistently underestimated production growth on the upside, so we would not be surprised if the agency overestimates production growth (or lack thereof) on the downside as well.
  3. Consensus suggests that OPEC will refrain from cutting production at the November 27 meeting in Vienna. With U.S. shale oil drilling activity still near record highs (the current oil rig count at 1,578 is only 31 rigs away from the all-time high set last month), any meaningful production cut (500,000 barrels/day or higher) by OPEC will only encourage more U.S. shale oil drilling activity. More importantly, Saudi Arabia has tried this before in the early 1980s (when it cut its production from 10 million barrels/day in 1980 to just 2.5 million barrels/day in 1985 in order to prop up prices), ultimately failing when other OPEC members did not follow suit, while encouraging the growth in North Sea oil production. Moreover, OPEC countries such as Venezuela and Iran cannot cut any production as their budgets are based on oil prices at $120 and $140 a barrel, respectively. As a result, it is highly unlikely that OPEC will implement any meaningful policy change at the November 27 meeting.

With U.S. shale oil drilling activity still near record highs, we believe WTI crude oil prices are still biased towards the downside in the short run. But we believe the recent decline in WTI crude oil prices is overblown. Beginning next year, we expect U.S. shale oil drilling activity to slow down as capex budgets are cut and financing for drilling budgets becomes less readily available. Combined with the strength in our latest CBGDI readings, as well as imminent easing by the ECB, we believe WTI crude oil prices will recover in 2015, averaging around $80 a barrel.

Why CB Capital’s Upcoming Trip to India is so Important

India is experiencing a resurgence as one of the world’s largest economies. According to the late Cambridge professor Angus Maddison, India’s share of the world’s income peaked at over 20% in 1700, about equal to all of Europe’s share at the time. By 1952, however, India’s share of the world’s income has shrunk to just 3.8%, despite its status as the world’s second most populous country. Many economic liberalization policies were implemented beginning in 1991  (most reforms were forced upon India in exchange for an IMF bailout in 1991)–beginning a period of economic growth acceleration. From 2003-2007, Indian real GDP growth averaged 9% a year–hitting double digits immediately after the 2007-2009 global financial crisis. Despite years of high growth, as well as a highly educated and young workforce, the Indian economy slowed down dramatically beginning in 2012, registering just 4.4% growth that year. Today, the size of India’s economy (in nominal terms) is only US$1.9 trillion, equivalent to 2.7% of world GDP.

Since then, Indian economic growth has regained ground. The IMF recently raised its 2015 GDP growth estimate from 6.0% to 6.4%. We expect Indian real GDP growth to hit 7% in the next several years–surpassing that of China–and for the size of the Indian economy to surpass US$5 trillion (in nominal terms) by the end of 2020. As we mentioned in two of our recent articles on MarketWatch (“Why Indian stocks are a buy right now” and “Top three Indian stocks to buy (and hold)“), much of this growth will be driven by business-friendly reforms implemented by the Modi government. These reforms include: 1) removing barriers to greater foreign investments, especially in the defense and insurance sectors, 2) a national policy to provide 150 million Indians a bank account by 2018, 3) a national plan to spend $1 trillion on infrastructure investments, 4) a more independent central banking policy with a new monetary policy framework of inflation targeting, and 5) a concerted crackdown on cronyism among the highest levels of government.

The recent 30% decline in global crude oil prices (India imports 70% of its energy needs)–as well as the just-announced deregulation in diesel prices–will also provide a significant tailwind to the Indian economy. We expect Brent crude to mostly trade within the US$75-US$95 a barrel range for the next several years, thus assisting India’s growth plans.

We believe U.S.-India cross-border financing activities and investment opportunities will grow significantly as the Indian economy generates unprecedented amounts of entrepreneurial talent and wealth over the next decade. CB Capital Partners is already engaged in U.S.-India cross-border corporate finance transactions. We will be in Mumbai, Hyderabad, and Pune to meet clients and research investment opportunities for two weeks during November 15-29. We believe there are many industries poised for substantial growth and thus represent attractive, long-term investment opportunities. Following are highlights of some industries that we like–and where our clients are actively doing business in.

Digital Media: Nearly 300 million Indians go online to listen to music, watch a film, a TV show, or cricket match through their cell phones, computers, or tablets. Today, Indian digital media garner over $4 billion in digital pay revenues annually, with digital advertisement revenues at nearly $400 million. Both are expected to grow at double digits for the foreseeable future. In February 2012, Disney paid almost $500 million for the remaining stake of UTV that it did not already own—a huge bet on the emerging Indian middle class. Within this industry, CB Capital Partners is heavily involved in providing financing in the Indian animation industry. The Indian animation industry has an 8.2% market share in Asia-Pacific, and is expected to grow by over 20% annually to $2.9 billion by 2015.

eCommerce: India is experiencing the most rapid growth of online buyers in history. Amazon recently announced that its Indian online business is on track to become the fastest country ever to reach $1 billion in sales. On July 29, Flipkart, a homegrown eCommerce company based in Bangalore, announced that it raised $1 billion from Tiger Global Management, Accel Partners, Morgan Stanley Investment Management, and Singapore’s GIC. Forrester estimates the number of Indian eCommerce customers will reach 39 million by the end of this year, and an astonishing 128 million by the end of 2018. By the end of 2020, the Indian middle class population (the target market for apparel, consumer electronics, and personal care products) will rise to over 300 million, or the equivalent to the size of the U.S. population. Amazon already announced on July 30 to invest an additional $2 billion into its Indian business.

Healthcare: CB Capital Partners has substantial financing and investment experience across the healthcare industry (30% of all our transactions have been in the healthcare industry), including pharmaceuticals, generics, biotechnology, stem cells, medical devices, medical IT, and hospitals. Another sub-industry we are tracking is the medical tourism industry in India. There will be many opportunities to invest in hospitals or hospital-related services (such as medical hotels) that specialize in this trend as the global population ages. It is estimated the Indian medical tourism industry is now worth $2 billion, with over 150,000 patients traveling to India each year for medical procedures.

Finance: The Modi government’s initiative to provide 150 million Indians a bank account by 2018 is significant, as only 60% of India’s population have access to financial services today. Financial services are essential to a modern, growing society. While many Indians had traditionally put their savings in physical assets such as gold, this option will no longer be attractive as inflation trends down (the Indian CPI declined to an all-time low of 6.4% in September). Banks in particular will also benefit from the government’s recent increase in the housing loan interest tax deduction from 150,000 to 200,000 rupees (or $2,450 to $3,300) a year as this policy will increase demand for residential mortgage loans.

CB Capital Partners is ready to assist both our U.S. and Indian clients who want to learn more or are already engaged in U.S.-Indian cross-border financing or fund-raising activities. Our strategy in India covers a full suite of traditional investment banking services such as equity & debt raises, M&A services, and fairness opinions.

Revising Our Price Target of Gold to $950-$1,100 an ounce

We first became bearish on gold prices in August 2011, when gold traded at $1,848 an ounce.  Even though we understand systemic risks in the Euro Zone were real, we thought gold was highly overbought at the time. We subsequently became even more bearish on gold prices in late 2012, when it became apparent to us that the year 2013 was shaping up to be an “anti-climatic” year as global and European systemic risks began to dissipate. We articulated our bearish views on gold in our January 25, 2013 global macroeconomic issue–when gold traded at $1,660 an ounce–sticking our neck out with a 12- to 18-month $1,100-$1,300 price target. Our call was made several weeks ahead of similar calls by Goldman Sachs and Credit Suisse.

Over the last 18 months, we have reiterated our bearish views on both gold prices and gold miners; in our July 7, 2013 commentary (“A Technological Revolution in the Making – The U.S. Giant Awakens“), we further lowered our price forecast to $1,000-$1,200 an ounce as gold production remained high despite the decline in gold prices. Recent developments suggest that deflation and increasing production efficiencies remain alive and well in the gold mining industry. As such, we are lowering our price target range for gold yet again to $950-$1,100 an ounce. We believe this target will be hit over the next six months. Figure 1 below shows our calls on the price of gold during and post the 2008-09 global financial crisis.

CBcapitalcallsongold

From a classic economic standpoint, gold production should be declining given the decline in gold prices over the last 18 months. But this has not happened in the gold mining industry, for two reasons: 1) almost all gold miners had a bloated cost structure going into the recent price decline; as such, many gold miners were able to cut production costs and stay marginally profitable even as gold prices declined, and 2) some gold miners–post production cost cuts–had to produce and sell more gold to stem cash flow problems.

As the cost of production declines, miners are able to produce more gold at lower prices. According to the World Gold Council, mine production hit 765 tonnes during Q2 2014, a 4% year-over-year increase from Q2 2013, despite an average market price of $1,288 an ounce, or a decline of $125 an ounce from Q2 2013. Figure 2 below shows that global supply of gold has remained steady despite the decline in gold prices in the last 18 months.

QuarterlygoldsupplyQ22014

Interestingly, at the September 15-17, 2014 Denver Gold Forum, some gold miners are indicating a higher allocation of capital for development projects, such as Goldcorp (Cerro Negro, Eleonore, and Cochenour), Newmont (Merian), New Gold (Rainy River), and Eldorado (Skouries). With the exception of the Eldorado project, all of these projects are expected to come online with an all-in-sustaining-costs (AISC) of $1,000 an ounce or below. This means almost of these projects will remain profitable (taking into account regular future capex and maintenance costs) even if gold falls below $1,000 an ounce in the long-run. At the same time, many gold miners indicated that cost-cutting remain their main objective. The combination of more ambitious expansion plans and ongoing cost-cutting initiatives suggest that mine production (i.e. gold supply) will continue to increase even if gold prices continue to fall. We thus do not believe gold miners will curb production significantly until gold falls to below $1,100 an ounce and stays there for at least several months.

Finally, we assert that from a sentiment and psychological standpoint, gold is oversold but still not sufficiently oversold for us to buy. In our July 7, 2013 commentary–when gold traded at $1,220 an ounce–we stated that the two most reliable indicators for at least a tradeable bottom were absent. Quoting our July 7, 2013 commentary:

The two most reliable psychological indicators for a tradeable bottom in any asset class are: 1) Panic, or 2) Indifference. The best time to invest in any asset class is after years of investors’ indifference. That–along with other screaming buy indicators–was the reason why I invested in physical gold and unhedged gold miners at under $275 an ounce in late 2000.

One sentiment indicator that we track is the change in the holdings of the gold ETF, GLD. Holdings in GLD are highly indicative of marginal/short-term demand given its daily liquidity and the types of speculators it attracts. As shown in Figure 3 below, GLD holdings peaked at 45 million ounces (orange line; right axis) in early January 2013, and have since declined to 25 million ounces, a drop of 44% over the last 18 months.

GLD 9-26-14

While a 44% drop in GLD gold holdings is dramatic, keep in mind that all of this drop occurred from January 2013 to December 2013. Since the beginning of 2014, GLD gold holdings has actually remained steady–suggesting that retail investors have neither capitulated nor panicked into selling their GLD just yet. We do not believe that gold prices will bottom until there is another selling panic similar to that in April 2013 (when the price of gold dropped by $200 an ounce in just two weeks).

The combination of steady/higher gold production and the lack of investor panic in GLD suggest that gold prices have more downside to go. Bottom line: We reiterate our bearish stance on gold. New evidence suggests that gold production is more resilient and less sensitive to lower gold prices than we believed as gold miners continue to cut costs to achieve higher efficiencies . This is leading us to revise our target range downwards to $950-$1,100 an ounce over the next six months. Stay short gold.

Why Investing in Consumer Brands is Still Attractive

We just got back from Las Vegas where MAGIC–the biggest apparel convention show in the world–was held last week. More than $200 million of orders were done on the trade show floor every day of the convention. The premier fashion event there was PROJECT, which hosted a variety of men’s and women’s advanced contemporary, premium denim, and designer collections.

ProjectVegas

20140820_091905

We also attended AGENDA–a more diverse and creative lifestyle convention and with a more “edgy” or “urban” tone to that of PROJECT.20140820_133906

Our recent funding transaction with Active Ride Shop demonstrates that there remains numerous opportunities for both small and large funds to invest in the consumer brands space. In fact, post the 2007-08 financial crisis, the consumer brands industry has been undergoing a transformation. This means certain brands (yes, this means PSUN, ARO, and ANF) will die; while others will survive or even thrive.

This also means that the playing field for consumer brands is now more even than ever. Smaller, upcoming brands who resonate with younger consumers (i.e. Millennials or Gen-Zs) now have a marketing edge over the traditional behemoths such as PSUN, ARO, and ANF–who, in our opinion, have turned into mere retail distributors only somewhat conveniently located in dying American suburban malls. Combined with the increasing adoption of social media as a marketing medium–as well as more efficient e-commerce and payment platforms–it is obvious to us and up-and-coming brands that the consumer brands industry is now wide open for smaller brands to gain market share.

In our March 4, 2014 commentary (“Building a Specialty Brand in the 21st Century“), we asserted that: 1) traditional segmentation and marketing methods based on socio-demographics no longer works, and 2) the 21st century consumer mentality is no longer based on the mentality of purchasing “expensive brands” (although this mentality still exists in China and India today, e.g. Abercrombie’s success in China) but on actively engaging with and subsequently purchasing premium brands based on the concepts of self-identification and a sense of belonging to a group of like-minded, but distinct individuals with similar life philosophies.

Our discussions with PROJECT’s organizers and participants suggest this trend is only accelerating; brands who have been losing resonance with their core customers will continue to lose market share.

Finally, we should keep in mind that most global consumer discretionary dollars today are still being spent on non-branded goods. In 1950, brands made up less than 10% of all global consumer spending (believe it or not, most handbags back then were unbranded and sold in department stores); today, brand spending still only accounts for around 30%. As such, brands who are able to maintain resonance with their core customers will enjoy a long runway of growth ahead of them. We thus advocate funds to seriously consider investing in the consumer apparel and the consumer brands industry in general.

How Fracking Saved the U.S. Economy

The modern economy is a function of cheap, easily-accessible energy sources. The modern transportation, technology, healthcare, and agricultural industries cannot function without a cheap and reliable source of energy–in fact, our survival depends upon it. Beginning with the Industrial Revolution, the vast majority of U.S. economic growth was predicated on an exponential increase in energy consumption. This demand was met by the growth in global energy supplies, the rise of natural gas as a fuel source during the 1970s, and now alternative energy sources such as solar, wind, and biofuels. Surprisingly, efficiency breakthroughs did little to counteract the insatiable demand for new sources of energy (e.g. each die shrink in the modern-day CPU created even more demand for computers and computing power). This means that future U.S. and global economic growth can only be guaranteed through new sources of energy–i.e. greater efficiency and recycling can only achieve so much.

Since 2012, we have argued for a “U.S. Energy Renaissance” through the advent of hydraulic fracturing (“fracking”), horizontal drilling, ultra deepwater drilling in the Gulf of Mexico, as well as the commercialization of alternative energy solutions and more efficient battery storage. Recent evidence suggests our thesis continues to be true. In fact, the latest energy (especially crude oil) production statistics show that tight oil production (through fracking in shale fields such as Eagle Ford (TX), the Bakken (MY & ND), Spraberry (TX & NM Permian), Bonespring (TX & NM Permian), Marcellus (PA & WV), etc.) is still hitting record highs, surpassing many analysts’ expectations.

Figure 1: The Exponential Increase in U.S. Shale Oil and Shale Gas Production (source: EIA)

shaleproductioneia

As recent as October 2012, the Energy Information Administration (EIA) projected U.S. crude oil production to rise from 6 million barrels/day to just 7 million barrels/day by 2020 in its base case. Only in its most optimistic scenario did the EIA project U.S. oil production to hit 8 million barrels/day by 2020. Shale oil production, however, has surpassed even the most optimistic projections from just 20 months ago. Today, U.S. crude oil production has already surpassed 8 million barrels/day (8.3 million barrels/day during May 2014), and is now projected to rise above 9 million barrels/day by the end of 2015–close to the record high of 9.6 million barrels/day production in 1970.

Figure 2: EIA’s U.S. Oil Production Forecast by Region (million barrels/day)

USoilproductioneiamay2014

We contend that the tremendous increase in U.S. oil and gas production over the last several years has single-handedly saved the U.S. economy and employment picture from a potentially catastrophic outcome. According to the EIA, the U.S. trade deficit resulting from oil imports reached a record high of $452 billion during the third quarter of 2008 as the spot price soared to nearly $150 a barrel. As recent as the second quarter of 2011, the U.S. oil trade deficit sat at $346 billion. As of the end of 2013, the oil trade deficit has shrunk to $203 billion and is projected to shrink to less than $170 billion by the end of this year. This shrinkage in the U.S. oil trade deficit added a full percentage point to U.S. GDP (as well as added a record number of jobs in Texas and North Dakota), but more important, helped secure U.S. energy and national security for years to come.

Figure 3: U.S. Oil Production Growth Has Slashed Our Trade Deficit by Nearly $200 Billion a Year…

USoiltradedeficit

The Important Knock-on Effect on Global Oil Supply from Shale Production Growth: Less Resource Protectionism

Paradoxically–as U.S. reliance on foreign oil supplies dwindles–we expect foreign oil production growth to exceed current expectations, Iraq’s geopolitical turmoil notwithstanding. As oil prices rose from <$40 a barrel over the last decade, many countries such as Russia and Mexico have resorted to a parasitic policy of resource protectionism to maintain national control over its oil supply/infrastructure. This has resulted in anemic global production growth at best, as many oil-exporting countries had no incentive to invest in future oil production growth given the rise in oil prices every year.

The decline in Petroleos Mexicanos’ (Pemex’s) production due to the lack of R&D and capital expenditure spending is a prime example. Just last week, Pemex lowered its 2014 production forecast from 2.5 million to 2.41 million barrels/day, its lowest in at least 24 years. As long as oil prices were rising, the Mexican government did not have much incentive to invest in future oil production growth. Now that global oil prices are expected to remain flat over the next 5-10 years (due to the ongoing shale revolution), the Mexican government has no choice but to execute a 180-degree turnaround to compete for global oil market share. For the first time since 1938, the Mexican government has invited foreign capital back into its oil industry; consensus expects this landmark law to bring in $50 billion of annual foreign private investment by 2020 (as a comparison, Pemex’s 2015 capital expenditure budget is estimated to be $29 billion, up from $27.7 billion this year).

Going forward, we expect global oil production growth to exceed expectations–thanks to the direct and knock-on effects of the U.S. fracking revolution.

Emerging Markets’ Desperate Need for Renewables

In our October 28, 2013 commentary (“An Early 21st Century Narrative: The Age of Renewables“), we asserted that–due to increasing domestic crude oil production and the ongoing adoption of renewable fuels–U.S. energy independence on a national level is a foregone conclusion. The Energy Information Administration (EIA) chronicles that last year, as much as 84% of total U.S. energy demand was fulfilled by domestic sources, the highest level in 30 years.

Exhibit 1: U.S. Energy Production at 30-year High Relative to Consumption

domesticproduction2013

Interestingly, 10% of our domestic energy production now comes from renewables (including hydro, solar, wind, biofuels, and thermal). We believe government agencies in general are too pessimistic regarding the trajectory of the increasing impact of renewables on U.S. and Developed Markets’ energy production. For example, Germany (a country not known for its sunshine) recently generated over half of its electricity from solar for the first time, while Great Britain’s installed solar capacity doubled over the last year–none of which anyone has foreseen. Because of the rapid adoption of renewables, as well as the ongoing shale revolution, we continue to believe that U.S. energy independence on the national level is a foregone conclusion.

What we are more interested in–as investors and global citizens–are two more ambitious goals: 1) energy independence at the community or household level through microgrids and a “smart,” decentralized distribution system, and 2) bringing electricity and heating to more undeveloped areas of the world. The International Energy Agency (IEA) estimates that 1.3 billion people today are still without access to electricity, while 2.6 billion people have no access to clean cooking facilities.

This is a glaring social problem not just in Sub-Saharan Africa but in other developing countries/regions, such as India, China, and Developing Asia. e.g. The IEA contends that as much as 25% of India’s population today have no access to electricity. A country where a vast segment of its population is disenfranchised is both a significant impediment for future economic growth and social harmony.

According to the IEA’s 2014 World Energy Investment Outlook, global policy makers and corporations are projected to invest $40.2 trillion into our energy production and transportation infrastructure from now till 2035. 59% of these funds will be used to maintain current production, while 41% will be for new development. Two interesting trends are expected to continue over the next 20 years:

  1. There is a decisive trend towards investing into renewables and efficiency programs in both developed and emerging market countries;
  2. The role of public policy makers in shaping global energy policy has been on the rise, and will continue to rise for the foreseeable future as governments set goals for renewables adoption (e.g. California’s 33% renewables goal by 2020) and new efficiency standards.

Within the developed world, these two trends are driven by environmental and domestic energy security concerns. Within Emerging Markets, however, these are driven by more fundamental concerns. For example, economic growth and the rising cost of energy has led to a significant deterioration of China’s and India’s trade accounts in recent years. The rising cost of energy (combined with significant gold imports) was instrumental in causing India’s financial crisis last summer.

Exhibit 2: Oil Import Bills of Net Importing Developing Countries on the Rise (source: IEA)

oilimportbillEMSince 2011 (the IEA’s last study on Emerging Markets’ energy imports), energy dependence in countries like China and India has continued to rise. In fact, China’s oil imports are projected to rise above that of the U.S. sometime this year. As such, investments in renewables in both China and India are not only necessary due to environmental concerns, but national security concerns as well.

Finally, as discussed above, there is also a dire need to empower those who currently have no access to electricity in many developing countries, including India. This is crucial to sustain high economic/productivity growth, as well as for long-term social cohesion (having electricity inherently increases access to education, knowledge, and healthier lifestyles). The IEA estimates that an additional $641 billion in investments is needed to achieve universal access to electricity by 2030, $135 billion of which is needed in India. In light of the $40.2 trillion of projected investments in the global energy sector over the next 20 years, $641 billion is achievable. However, the IEA also stresses that much of these investments would need to be made in rural areas with little or no access to any existing infrastructures (e.g. power lines or even paved roads). Since the costs of building a centralized grid (or expanding the current grid) to rural areas are prohibitively high, the only alternative is to install microgrids or roof-top solar in such undeveloped rural areas. The age of renewables will thus not only bring U.S. energy independence, but increased energy access to the rest of the world as well.

 Exhibit 3: Additional Investment Required for Universal Access to Electricity ($billion in year 2010 dollars; source: IEA)

energyaccessforpoor

The Education of the Millennials

Published in 1907, The Education of Henry Adams is a meditation of the immense shifts in the political, economic, social, and technological landscapes of 19th century America during the Second Industrial Revolution. While granted a first-class education, Henry Adams–the great-grandson of John Adams and grandson of John Quincy Adams–would lament throughout the book that his formal education in the classics and history never prepared him for the scientific and technological revolution of the late 19th century. Quoting the book (narrated in third-person):

At any other moment in human history, this education, including its political and literary bias, would have been not only good, but quite the best. Society had always welcomed and flattered men so endowed. Henry Adams had every reason to be well pleased with it, and not ill-pleased with himself … Only on looking back, fifty years later, at his own figure in 1854, and pondering on the needs of the twentieth century, he wondered whether, on the whole the boy of 1854 stood nearer to the thought of 1904, or to that of the year 1 … The calculation was clouded by the undetermined values of twentieth-century thought, but the story will show his reasons for thinking that, in essentials like religion, ethics, philosophy; in history, literature, art; in the concepts of all science, excepts perhaps mathematics, the American boy of 1854 stood nearer the year 1 than to the year 1900. The education he had received bore little relation to the education he needed. Speaking as an American of 1900, he had as yet no education. He knew not even where or how to begin. (emphasis mine).

A cursory review of U.S. history suggests that the Millennials (a demographic group typically defined as those born between 1980 and 2000) have already experienced profound political, social, and technological changes in their short lifetimes unmatched by previous generations, with the possible exception of those who: 1) fought the American Revolutionary War, 2) the American Civil War, 3) experienced the Gilded Age, or 4) experienced the Great Depression and fought in World War II. Many historical seismic shifts in the American cultural fabric were bloody; some not (e.g. the influx of more than 25 million European immigrants from 1850 to 1930).

Further review of these societal shifts suggests one common, and very important, attribute: With the exception of the various waves of immigration, none of these were uniquely American. However, all of these have ultimately made America stronger on the global stage, beginning with American independence in 1776.

Fast forward to today, and the Millennials (also known as the Gen-Ys) are struggling. We believe we could distill this into three major causes:

  1. The U.S. labor market is no longer protected: Relative to Europe and Asia, the U.S. has always had a chronic shortage of labor, resulting in relatively high wages and the subsequent creation of a middle class. Post Civil War and Slavery as an institution, the Gilded Age was a glaring exception, as waves of immigrants served to depress wages for manual labor. The creation of a U.S. middle class after WWII was enabled by a significant curb in immigration beginning in the late 1910s, as well as the democratization of higher education and a general shortage of labor after WWII. The fall of the Berlin Wall in 1989, and the subsequent commercialization of broadband internet and cellular networks, has resulted in an unprecedented shift in the old Labor vs. Capital debate. We believe the acceleration of automation in the U.S. economy will shift this debate further as more manual labor (including those who engage in complex, but repetitive tasks, e.g. fast-food workers or coffee baristas)  is replaced by machines over the next 5-10 years;
  2. The rapid pace of change in the U.S. labor market: Most of us fear change; however, we also secretly crave it, but only if implemented gradually. The rapidity of the shift in the labor market caught many Americans by surprise. In 1901, the Wall Street Journal summarized the immense consolidation of U.S. industry with the comment: “God made the world in 4004 B.C. and it was reorganized in 1901 by J.P. Morgan.” Carnegie Steel–which formed the basis of the $1.4 billion IPO of U.S. Steel in 1901–was founded only just 25 years before, while Standard Oil was founded as recent as 1870. With the exception of Google and Microsoft, many of today’s largest companies were founded more than 50 years ago. However, business practices have shifted immensely over the last 25 years. The mass adoption of outsourcing and automation by U.S. companies–along with an influx of college-educated Gen-Ys into the labor market–has depressed wage growth significantly. Defined benefits pension plans are no longer offered (or valued), and unemployment among young, college-educated workers are near record highs. Such experience by the Millennials is encapsulated by a recent NY Times article chronicling “the rise of the serial intern.”  The world has been reorganized and rearranged in a way such that today’s U.S. labor market bears no resemblance to that of 1989, when the Gen-Ys were still being educated on the wisdom of obtaining a college degree at all costs.
  3. The lack of a 21st century education and the rise of a highly educated global workforce: Year after year, the OECD PISA (Programme for International Student Assessment) shows that American kids are continuing to fall behind their global counterparts in terms of K-12 education. There are many reasons for this (lack of accountability by schools and teachers, lack of respect for the teaching progression, different cultural emphases for formal education, etc.); but more important, even kids who graduate with a four-year college degree have had little preparation to compete in today’s highly educated global workforce. I believe the main problem is this: The modern university system does not sufficiently prepare college graduates to compete in the 21st century global economy as it was engineered with the 20th century industrial economy in mind. Even the emergence of college entrepreneurship programs is a relatively recent phenomenon. e.g. The Arthur Rock Center for Entrepreneurship at Harvard Business School only opened in 2003, and the Polsky Center for Entrepreneurship and Innovation at University of Chicago opened in 1998. Furthermore, only a selected number of universities offer undergraduate courses or experiences in entrepreneurship (neither Harvard nor University of Chicago does). Moreover, most Americans remain U.S.-centric in nature; most U.S. college graduates have never resided or worked overseas. The challenge of working and collaborating with those from foreign cultures will be one of the main challenges for Gen-Y workers over the next 5-10 years.

The ongoing struggles by Millennials are exemplified by the following charts, courtesy of Goldman Sachs.

 Chart 1: A Sign of the Times… Today’s Millennials Are Less Employed

(16-24 Year Olds Labor Force Participation Rate)

 MillennialsLaborParticipation

Chart 2: And Millennials’ Average Income Have Been Declining Relative to that of the U.S. Labor Force

(15-34 Year Olds’ Average Income as a % of U.S. Labor Force Average Income)

 MillennialsAverageIncome

The struggles of the Millennials are real, and will have real implications for U.S. society and the global economy. In our last commentary (“Engaging with China as a Global Economic Superpower“), we addressed the need for U.S. leaders to engage with China as the latter rises to become the world’s biggest economy over the next 6-8 years. This is a job for the Millennials, as most baby boomers and Gen-Xers are too far entrenched in their attitudes and work habits to adapt to a globalizing workforce. Most important, U.S. consumer spending will be driven by Millennial spending growth over the next five years (3.4% annualized), easily crowding out the impact of the Gen-Xs (only 0.6% growth). In fact, total consumer spending by Millennials should surpass that of the Baby Boomers by 2020, making Millennials the largest spending cohort in U.S. history. Just as the Baby Boomers dictated every major societal and economic trend since the end of WWII (from the adoption of disposable diapers to the Civil Rights movement), the Gen-Ys will be driving similar trends for decades to come. The Education of the Millennials continues…

Chart 3: Projected U.S. Annualized Spending Power Growth by Generational Cohort

(2014-2019)

MillennialsSpendingPower

Engaging with China as a Global Economic Superpower

Last Wednesday, the World Bank declared China would overtake the U.S. as the world’s biggest economy on a PPP basis by the end of this year. The practice of utilizing PPP in comparing economic output across countries has become less useful as global trade and cross-border asset flows continues to grow as a percentage of the global economy. Yes, your US$ still gets you further in China than in the U.S. on average; and the median Chinese urban household still earns less than 20% of the median U.S. (both urban & non-urban) household. But this ignores the fact China is the world’s biggest importer of commodities such as copper, iron ore and precious metals–all of which are settled at world market prices which PPP has no bearing upon. Chinese economic output measured at PPP also ignores the fact that real estate prices in Tier-1 cities such as Beijing and Shanghai are now on par with those in New York and Los Angeles. Seen in this light, a Yuan actually goes further in a major U.S. city such as Houston or Dallas than in Shanghai or Beijing. Since Americans are generally much more mobile than the Chinese (which in theory allows a U.S. family to resettle to lower cost-of-living areas), a comparison between U.S. and Chinese economic output using PPP is highly misleading.

That is not to say it isn’t a worthwhile exercise. At the very least, the World Bank study has again put the Chinese economy, leadership, and corporations in the spotlight as the “Central Kingdom” re-asserts herself, first in the global economy, and second, in global geopolitics. Work done by the late British economist Angus Maddison suggests China’s share of global GDP was over 30% as recent as 1820. At their respective peaks, total economic output of China and India together made up approximately half of global GDP during most of the last two thousand years, with the exception of the last 200 years.

chinaindiaworldeconomyhistory

As students of Asian history, the above chart comports with our understanding of the history of the Chinese dynastic system, and its subsequent decline (note that pre-1368 A.D. data–i.e. pre-Ming Dynasty–is almost non-existent, e.g. the invasion of the Mongols and its impact on China during the early 1200s does not register in the above chart). The relative decline of China’s influence as the Ming Dynasty retreated from global trade–along with a costly war with Hideyoshi-led Japan–could be seen in the above chart. The decline in Chinese relative influence accelerated in the early 1600s as the Ming Dynasty weakened, with the dynasty eventually falling due to corruption, inept management, bad harvests, and the Manchu invasion during the early to mid-1600s.

Under the Manchu-led Qing Dynasty, however, the Middle Kingdom regained her former glory. The Qianlong Emperor (who ruled for 60 years and interestingly, would die in 1799–the same year that President George Washington died) ruled an empire unprecedented in size–encompassing both Mongolia and Tibet. By 1790, the population of the Qing Empire soared to over 300 million, or just under the U.S. population today. Chinese relative economic output would peak soon afterwards at nearly 35% of global GDP.

According to Professor Maddison and Professor Dwight Perkins of the Harvard Kennedy School, what was most impressive about China during most of her history was not its sheer population growth; nor the size of her empire. What was most impressive about the Chinese economy was her successful response to population growth–i.e. her ability to sustain per capita consumption over time even as population grew. The Chinese drove productivity growth in agriculture through increased use of fertilizers, irrigation, development of crop varieties, as well as published and distributed agricultural handbooks to spread “best practices” in farming. New crops from the Americas–which could be grown on inferior lands–were also introduced.

In other words, China has a rich history of innovation, adaptation, and engaging herself with the rest of the world. By the early 19th century, however, China’s 2,000 year-old dynastic system was no longer a suitable governing system for a fast-changing, industrializing world. As innovation and change swept the world, the Chinese ruling class hung on to outdated concepts and actively discouraged reforms–including the emphasis of science/math over the “classics” in the Imperial Examination. The rigidity of China’s ruling class and system during the 19th century made her vulnerable to foreign influence and invasion. The subsequent experimentation with Communist ideology in the early 20th century would prove disastrous. All in all, it took over 150 years for China to recover and to be recognized as a global economic power once again.

The latest World Bank study is thus timely, as both China and the rest of the world need to begin addressing the consequences of China rising to become the world’s #1 economy. Consensus suggests China will surpass the U.S. in nominal GDP by 2019 (as recent as 2003, Goldman Sachs believed China won’t surpass the U.S. until 2041). e.g. Chinese battery maker BYD experienced significant growing pains due to the company’s inexperience when it opened its North American HQ in Los Angeles. As Chinese influence continues to grow around the world, there will be inevitable clashes over business practices, cultural  misunderstandings, and increased competition (including those for real estate and college applications). As an investment bank who actively engage in U.S.-Chinese cross-border transactions, CB Capital has had first-hand experience in working with Chinese companies and cultures. We are also engaging with other U.S.-Chinese cross-border groups to cultivate closer relationships between local U.S. and Chinese/Hong Kong companies.

Sure, China is experiencing growth challenges, but this is to be expected. In particular, we are watching three issues very closely. As we have discussed, the Chinese “demographic dividend” is over. We expect Chinese real GDP growth to be in the range of 5%-8% over the next several years. China’s population growth has sunk to just 0.47%, ranking 159th in the world. By 2020, the Chinese demographic pyramid will be more inverted than that of the U.S. Another challenge is China’s unprecedented credit growth over the last five years, which was fueled by the country’s well-intended but poorly-executed US$586 billion fiscal stimulus package in 2008-09. A final challenge–which comes with the territory of being potentially the world’s #1 economy–is China’s dependence on foreign energy imports. China as we speak is making slow but steady progress on shale gas, but the country’s oil consumption growth remains unabated. In fact, the Energy Information Administration (EIA) expects Chinese oil imports to surpass those of the U.S. sometime this year. Energy security will thus become an increasing concern for China over the next several years.

Chart 2: China to Become World’s #1 Crude Oil Importer in 2014

globaloilimports

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