The Coming Breakthroughs in the Global Supercomputing Race

In our August 31, 2015 article (“The U.S. Needs to Rejuvenate the Global Supercomputing Race“), we expressed our concerns regarding the state of the global supercomputing industry; specifically, from a U.S. perspective, the sustainability of Moore’s Law, as well as increasing competition from the Chinese supercomputing industry. Below is a summary of the concerns that we expressed:

  • Technological innovation, along with increasing access to cheap, abundant energy, is the lifeblood of a growing, modern economy. As chronicled by Professor Robert Gordon in “The Rise and Fall of American Growth,” U.S. productivity growth (see Figure 1 below; sources: Professor Gordon & American Enterprise Institute)–with the exception of a brief spurt from 1997-2004–peaked during the period from the late 1920s to the early 1950s; by 1970, much of today’s everyday household conveniences, along with the most important innovations in transportation & medicine, have already been invented and diffused across the U.S. Since 1970, almost all of the U.S. productivity growth could be attributed to the adoption and advances in the PC, investments in our fiber optic and wireless networks, along with the accompanying growth of the U.S. software industry (other impactful technologies since the 1970s include: the advent of hydraulic fracturing in oil & gas shale, ultra deepwater drilling in the Gulf of Mexico, as well as the commercialization of alternative energy and more efficient battery storage systems, as we first discussed in our July 27, 2014 article “How Fracking Saved the U.S. Economy“). This means that a stagnation in the U.S. computing or communications industries would result in an invariable slowdown in U.S/global productivity growth;

americanproductivitygrowth

  • The progress of the U.S. supercomputing industry, as measured by the traditional FLOPS (floating-point operations per second) benchmark, had experienced a relative stagnation when we last wrote about the topic in August 2015. E.g. in 2011, both Intel and SGI seriously discussed the commercialization of an “exascale” supercomputer (i.e. a system capable of performing 1 x 10^18 calculations per second) by the 2019-2020 time frame. As of today, the U.S. supercomputing community has pushed back its target time frame of building an exascale supercomputer to 2023;
  • At the country-specific level, the U.S. share of global supercomputing systems has been declining. As recent as 2012, the U.S. housed 55% of the world’s top 500 supercomputing systems; Japan was second, with 12% of the world’s supercomputing systems, with China (8%) in third place. By the summer of 2015, the U.S. share of the world’s top 500 supercomputing systems has shrunk to 46%, although both Japan and China remained a distant second at 8%. Today, the Chinese supercomputing industry has led an unprecedented surge to claim parity with the U.S, as shown in Figure 2 below.

Figure 2: China – Reaching Parity with the U.S. in the # of Top 500 Supercomputerstop500

Since the invention of the transistor in the late 1940s and the advent of the supercomputing industry in the 1960s, the U.S. has always been the leader in the supercomputing industry in terms of innovation, sheer computing power, and building the customized software needed to take advantage of said supercomputing power (e.g. software designed for precision weather forecasting, gene sequencing, airplane and automobile design, protein folding, and now, artificial intelligence, etc.). With U.S. economic growth increasingly dependent on innovations in the U.S. computing industry and communications network–and with China now threatening to surpass the U.S. in terms of supercomputing power (caveat: China’s HPC software industry is probably still a decade behind)–it is imperative for both U.S. policymakers and corporations to encourage and provide more resources for the U.S. to stay ahead of the supercomputing race.

Unlike the tone of our August 31, 2015 article, however, we have grown more hopeful, primarily because of the following developments:

  • Moore’s Law is still alive and well: At CES 2017 in Las Vegas, Intel declared that Moore’s Law remains relevant, with a second-half target release date for its 10 nano-meter microprocessor chips.  At a subsequent nationally-televised meeting with President Trump earlier this month, Intel CEO Brian Krzanich announced the construction of its $7 billion Fab 42 in Arizona, a pilot plant for its new 7 nano-meter chips. Commercial production of the 7nm chips is schedule to occur in the 2020-2022 time frame, with most analysts expecting the new plant to incorporate more exotic technologies, such as gallium-nitride as a semiconductor material. The next iteration is 5nm chips; beyond 5 nano-meters, however, a more fundamental solution to extend Moore’s Law will need to occur, e.g. commercializing a graphene-based transistor;
  • GPU integration into supercomputing systems: The modern-day era of the GPU (graphics process unit) began in May 1995, when Nvidia commercialized its first graphics chip, the NV1, the first commercially-available GPU capable of 3D rendering and video acceleration. Unlike a CPU, the GPU is embedded with multiple threads of processing power, allowing it to perform many times more simultaneous calculations relative to a CPU. Historically, the supercomputing industry had been unable to take advantage of the sheer processing power of the GPU, given the lack of suitable programming languages specifically designed for GPUs. When the 1.75 petaflop Jaguar supercomputer was unveiled by Oak Ridge National Laboratory in 2009, it was notable as Jaguar was one of the first supercomputers to be outfitted with Nvidia GPUs. Its direct successor, the 17.59 petaflop Titan, was unveiled in 2012 with over 18,000 GPUs. At the time, this was a concern for two reasons: 1) hosting over 18,000 GPUs within a single system was unprecedented and would doom the project to endless failures and outages, and 2) there were too few programming codes to take advantage of the sheer processing power of the 18,000 GPUs. These concerns have proven to be unfounded; today, GPUs are turning home PCs into supercomputing systems while Google just rolled out a GPU cloud service focused on serving AI customers;
  • AI, machine-learning software commercialization: Perhaps one of the most surprising developments in recent years has been the advent of AI, machine-learning software, yielding results that were unthinkable just five years ago. These include: 1) Google DeepMind’s AlphaGo, which defeated three-time European Go champion Fan Hui by 5-0 in 2015, and finally, the world Go champion Ke Jie earlieir this year, 2) Carnegie Mellon’s Libratus, which defeated four of the world’s top poker players over 20 days of playing, and 3) the inevitable commercialization of Level 5 autonomous vehicles on the streets of the U.S., likely by the 2021-2025 time frame. Most recently, Microsoft and the University of Cambridge teamed up to develop a machine learning system capable of writing its own code. The advent of AI in the early 21st century is likely to be a seminal event in the history of supercomputing;
  • Ongoing research into quantum computing: The development of a viable, commercial quantum computer is gaining traction and is probably 10-20 years away from realization. A quantum computer is necessary for the processing of tasks that are regarded as computationally intractable on a classical computer. These include: 1) drug discovery and the ability to customize medical treatments based on the simulation of proteins and how they interact with certain drug combinations, 2) invention of new materials through simulations at the atomic level. This will allow us to build better conductors and denser battery systems, thus transforming the U.S. energy infrastructure almost overnight, and 3) the ability to run simulations of complex societal and economic systems. This will allow us to more efficiently forecast economic growth and design better public policies and urban planning tools.

Leading Indicators Suggest Further Upside in Global Risk Asset Prices

Note: I know many of you reading this are either overweight cash or net short U.S. equities. Please don’t shoot the messenger: I am not personally biased to the upside – I am merely channeling what my models are telling me, and they are telling me to stay bullish.

In my January 31, 2016 newsletter, I switched from a generally neutral to a bullish position on global risk assets. Specifically:

  • For U.S. equities, I switched from a “slightly bullish” to a “bullish” position (after switching from a “neutral” to a “slightly bullish” stance on the evening of January 7th);
  • For international developed equities, a shift from “neutral” to “bullish”;
  • For emerging market equities, a shift from “neutral” to “slightly bullish”; and
  • For global REITs, a shift from “neutral” to “bullish.”

My bullish tilt on global risk assets at the time was primarily based on the following reasons:

  1. A severely oversold condition in U.S. equities, with several of my technical indicators hitting oversold levels similar to where they were during the September 1981, October 1987, October 1990, and September 1998 bottoms;
  2. Significant support coming from both my primary and secondary domestic liquidity indicators, such as the relative steepness of the U.S. yield curve, the Fed’s renewed easing bias in the aftermath of the December 16, 2015 rate hike, and a sustained +7.5% to +8.0% growth in U.S. commercial bank lending;
  3. Tremendous bearish sentiment among second-tier and retail investors (which is bullish from a contrarian standpoint), including a spike in NYSE short interest, a spike in the AUM of Rydex’s bear funds, and several (second-tier) bank analysts making absurd price level predictions on oil and global risk assets (e.g. Standard Chartered’s call for $10 oil and RBS’ “advice” to clients to “sell everything”).

In a subsequent blog post on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“), I followed up on my bullish January 31st prognostications with one more bullish indicator; i.e. the strengthening readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”) indicator which “suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last two times I discussed the CBGDI in this blog was on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“) and on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“).

To recap, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD-constructed leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. Moreover, the CBGDI has historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%; and has led or correlated with the MSCI All-Country World Index, with an R-squared of over 40% (which is expected as local stock prices is typically a component of the OECD leading indicators).

The latest reading of the CBGDI has continued to improve upon the readings which we discussed several months ago (see Figure 1 below)–just 10 days after we turned bullish on global risk assets. Both the 1st and the 2nd derivatives of the CBGDI have continued to climb and are still in (slight) uptrends, suggesting a stabilization and in some cases, a re-acceleration (e.g. the economies of South Korea, New Zealand, Spain, and India) in global economic activity. So don’t shoot the messenger–but it appears that the rally in global risk assets coming out of the late-January-to-early-February bottom still has more room to run.

CBGDIMay2016

Leading Indicators Suggest a Stabilization in Global Risk Asset Prices

Even as the vast majority of analysts stayed bullish on the global economy and global risk assets early last year, I began to turn bearish for a variety of reasons, including: 1) global liquidity, as measured by the amount of US$ circulating freely in the global financial system, continued to weaken, 2) valuations in U.S. equities were at the 95th percentile of all readings dating back to the late 1970s, as measured on a P/B and P/E basis, 3) U.S. corporate profit margins were already at 50-year highs, while U.S. corporate profits as a percentage of U.S. GDP was at a high not seen since 1929, 4) U.S. corporate earnings growth, ex. energy, were beginning to decelerate, and 5) our proprietary leading indicator, the CB Capital Global Diffusion Index (“CBGDI”) was indicating a global economic slowdown, as well as a pullback in global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s latest readings in many of our weekly newsletters, and last discussed it in this blog on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“). Specifically, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. The CBGDI has also historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators).

In my May 15, 2015 blog entry, I also stated:

Our own studies suggest the global economy has been slowing down significantly since the 2nd half of last year [i.e. 2014]; more importantly, the negative momentum has not abated much … the 2nd derivative of the CBGDI has gotten weaker. It also extended its decline below the 1st derivative, which in the past has led to a slowdown or even a major downturn in the global economy, including a downturn in global asset prices.”

The rest is history, as they say.

Recent readings of the CBGDI, however, paint a much brighter picture. Firstly, both the 1st and 2nd derivatives of the CBGDI have stabilized and are now increasing. Secondly, both global equity prices (i.e. the MSCI All-Country World Index) and oil prices have declined to levels that are indicative of a more severe slowdown than the CBGDI readings imply (see Figure 1 below). To me, the latest readings of the CBGDI suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

CBGDIDecember2015

 

 

The U.S. Needs to Rejuvenate the Global Supercomputing Race

Technology, along with increasing access to cheap energy, is the lifeblood of a growing, modern economy. As we discussed in our December 2, 2012 article (“The Global Productivity Riddle and the Supercomputing Race“), fully 85% of productivity growth in the 20th century could be attributed to technological progress, as well as increasing accessibility/sharing of cheap energy sources due to innovations in oil and natural gas hydraulic fracturing, ultra-deep water drilling, solar panel productivity, and the commercialization of Generation III+ nuclear power plants and deployment of smart power grids.

Perhaps the most cited example where the combined effects of technological and human capital investments have had the most economic impact is the extreme decline in computing and communication costs. Moore’s Law, the ability of computer engineers to double the amount of computing power in any given space every 2 years, has been in effect since the invention of the transistor in the late 1940s. Parallel to this has been the rise of the supercomputing industry. Started by Seymour Cray at Control Data Corporation in the 1960s, the supercomputing industry has played a paramount role in advancing the sciences, most recently in computationally intensive fields such as weather forecasting, oil and gas exploration, human genome sequencing, molecular modeling, and physical simulations with the purpose of designing more aerodynamic aircrafts or better conducting materials. No doubt, breakthroughs in more efficient supercomputing technologies and processes is integral to the ongoing growth in our living standards in the 21st century.

Unfortunately, advances in both the U.S. and global supercomputing industry has lagged in the last several years. Every six months, a list of the world’s top 500 most powerful supercomputers is published. The latest list was compiled in June 2015; aside from providing the most up-to-date supercomputing statistics, the semi-annual list also publishes the historical progress of global supercomputing power, each country’s share of global supercomputing power, as well as a reasonable accurate projection of what lies ahead. Figure 1 below is a log chart summarizing the progression of the top 500 list from its inception in 1993.

Figure 1: Historical Performance of the World’s Top 500 Supercomputers

top500progressAs shown in Figure 1 above, both the sum of the world’s top 500 computing power, as well as the #1 ranked supercomputer, has remained relatively stagnant over the last several years. Just three years ago, there was serious discussion of the commercialization of an “exaflop” supercomputer (i.e. a supercomputer capable of 1 x 10^18 calculations per second) by the 2018-2019 time frame. Today, the world’s top computer scientists are targeting a more distant time frame of 2023.

From the U.S. perspective, the slowdown in the advent of the supercomputing industry is even more worrying. Not only has innovation slowed down at the global level, but the U.S. share of global supercomputing power has been declining as well. Three years ago, the U.S. housed 55% of the world’s top 500 supercomputing power; Japan was second, with 12% of the world’s supercomputing power. Rounding out the top five were China (8%), Germany (6%), and France (5%). Today, the U.S. houses only 46% of the world’s supercomputing power, with countries such as the UK, India, Korea, and Russia gaining ground.

Figure 2: Supercomputing Power Distributed by Country

top500countryshare

Bottom line: Since the invention of the transistor in the late 1940s and the advent of the supercomputing industry in the 1960s, the U.S. has always led the supercomputing industry in terms of innovation and sheer computing power. With countries such as China and India further industrializing and developing their computer science/engineering expertise (mostly with government funding), U.S. policymakers must encourage and provide more resources to stay ahead of the supercomputing race. To that end, President Obama’s most recent executive order calling for the creation of a National Strategic Computing Initiative–with the goal of building an “exascale” supercomputer–is a step in the right direction. At this point, however, whether the industry can deploy an energy-efficient exascale supercomputer by the less ambitious 2023 time frame is still an open question.

Our Leading Indicators Still Suggest Lower Asset Prices

In our March 12, 2015 commentary (“The Weakening of the CB Capital Global Diffusion Index Suggests Lower Asset Prices“), we discussed the shortcomings of Goldman Sachs’ Global Leading Indicator (GLI) based on its over-reliance on various components such as the Baltic Dry Index and commodity prices & currencies (specifically, the AU$ and the CA$). To Goldman’s credit, the firm has been highly transparent and vocal over the last several months about the distortions created by an oversupply of dry bulk shipping capacity and an impending wall of additional supply of industrial metals, such as copper and iron ore.

Goldman Sachs thus recognized that the GLI’s downturn in December last year (by that time, the bear market in oil and metals prices were well under way) was providing misleading cyclical signals of the global economy, with the exception of certain economies such as Australia, Canada, Brazil, and Russia. Indeed, our own studies suggest that global economic growth was still on par to hit 3.5% in 2015–with U.S. economic growth hitting 3.0%–while energy-importing countries such as India would actually experience an acceleration to 7%-8% GDP growth.

That being said, Goldman’s GLI remains highly instructive. Since December, other components of the GLI have begun to exhibit weakness that is consistent with a contraction of the global economy. Components exhibiting significant weakness include global industrial survey data (PMI), as well as new orders to inventory data (NOIN). Countries exhibiting significant weakness include the U.S., China, Norway, Japan, Turkey, and surprisingly, India. Meanwhile, Germany, France, and Italy are experiencing industrial production growth–likely due to the declining euro and record-low borrowing rates.

In a nutshell, our latest studies are now finally confirming Goldman’s GLI readings (a high probability of a global economic contraction). In our March 12 commentary, we asserted that global asset prices (especially equity prices) are poised to experience a +10% correction, given the weakness in the readings of the CB Capital Global Diffusion Index (the CBGDI).

The CBGDI is constructed differently in that we aggregate and equal-weight the OECD leading indicators for 30 major countries, including non-OECD (but globally significant) members such as China, Brazil, Turkey, India, Indonesia, and Russia. The OECD’s Composite Leading Indicators possess a better statistical track record as a leading indicator of global asset prices and economic growth. Instead of relying on the prices of commodities or commodity currencies, the OECD meticulously constructs a Composite Leading Indicator for each country that it monitors by quantifying country-specific components including: 1) housing permits issued, 2) orders & inventory turnover, 3) stock prices, 4) interest rates & interest rate spreads, 5) changes in manufacturing employment, 6) consumer confidence, 7) monetary aggregates, 8) retail sales, 9) industrial & manufacturing production, and 10) passenger car registrations, among others. Each of the OECD’s country-specific leading indicator is fully customized depending on the particular factors driving a country’s economic growth.

The CBGDI has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators). Since we last discussed the CBGDI on March 12, the 2nd derivative of the CBGDI has gotten weaker. It also extended its decline below the 1st derivative, which in the past has led to a slowdown or even a major downturn in the global economy, including a downturn in global asset prices. Figure 1 below is a monthly chart showing the year-over-year % change in the CBGDI, along with the rate of change (2nd derivative) of the CBGDI, versus the year-over-year % change in WTI crude oil prices and the MSCI All-Country World Index from January 1994 to April 2015. All four indicators are smoothed on a three-month moving average basis:

OECDleadingindicators

With the 2nd derivative of the CBGDI declining further from last month’s reading, we believe the global economy is very vulnerable to a major slowdown, especially given the threat of a Fed rate hike later this year. We believe two or more Fed rate hikes this year will be counter-productive, as it will reduce U.S. dollar/global liquidity even as many Emerging Markets economies are struggling with lower commodity prices and declining foreign exchange reserves. We also remain cautious on global asset prices; we will mostly sit on the sidelines (or selectively hedge our long positions with short positions on the market) until one of the following occurs: 1) global liquidity increases, 2) the 2nd derivative of the CBGDI begins to turn up again, or 3) global risk asset or equity prices decline by +10% from current levels.

We will look to selectively purchase energy-based (i.e. oil, natural gas and even coal) assets given the historical divergence of the CBGDI and WTI crude oil/natural gas prices. We continue to believe that U.S. shale oil production is topping out as we speak. Should the WTI crude oil spot price retest or penetrate its recent low of $44-$45 a barrel (or if the U.S. Henry Hub spot price declines below $2.50/MMBtu), there will be significant opportunities on the long side in oil-, gas-, and even coal-based assets.

The Weakening of the CB Capital Global Diffusion Index Suggests Lower Asset Prices

The Economist just published an article discussing the Baltic Dry Index (“BDI”) and its lack of usefulness as a global leading economic indicator. We know Goldman Sachs constructs its global leading economic indicator with the Baltic Dry Index as one of its components. To its credit, Goldman discloses this and quantifies the impact of the BDI (along with each of its other components) on a monthly basis. Over the last decade, the BDI has become increasingly volatile–first, due to the rapid industrialization of China; then the subsequent over-building of ships just as the 2008-2009 global financial crisis led to a drop in global trade.

Today, the BDI sits at an all-time low; it is down by 65% in the last 13 weeks alone. This is the major reason why we do not include the BDI as one of our leading indicators on the global economy; it is very difficult to strip out the BDI’s volatility due to fluctuations in shipping utilization, as well as idiosyncratic events such as port or iron ore mine disruptions. We prefer to utilize leading indicators that are less dependent on fluctuations in shipping utilization or commodity supply. This is why we like the OECD Composite Leading Indicators, which we incorporate into our CB Capital Global Diffusion Index (“CBGDI”).

The OECD’s Composite Leading Indicators, unlike those compiled by others, are much less dependent on commodity prices or exchanges rates of commodity currencies, i.e. the Australian dollar, the Brazilian real, the Canadian dollar, and the New Zealand dollar. Instead, the OECD meticulously constructs a Composite Leading Indicator for each country that it monitors by quantifying country-specific components including: 1) housing permits issued, 2) orders & inventory turnover, 3) stock prices, 4) interest rates & interest rate spreads, 5) changes in manufacturing employment, 6) consumer confidence, 7) monetary aggregates, 8) retail sales, 9) industrial & manufacturing production, and 10) passenger car registrations, among others. Each country-specific leading indicator is fully customized depending on the particular factors driving the country’s growth.

To recap, the CBGDI is constructed by aggregating and equal-weighting (on a 3-month moving average basis) the OECD leading indicators for 30 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. The CBGDI has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall in November 1989. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index sightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators).

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.

We last discussed the action of our CBGDI in our November 19, 2014 commentary (“The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015“). At the time, we mentioned that–due to the strength in the CBGDI–WTI crude oil prices will likely rise in 2015. We obviously were early on that call as: 1) OPEC subsequently refused to cut production leading to the “Valentine’s Day Massacre” in global oil prices, and 2) the supply of U.S. shale oil continued to rise despite lower prices (a trend that is now ending).

Even though both the 1st and 2nd derivatives of the CBGDI are still positive, they are beginning to flash ‘caution’ signals. For example, the 2nd derivative of the CBGDI just declined below its 1st derivative–which in the past has led to a slowdown or even a major downturn in the global economy (as well as global asset prices). Note 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 January 1994 to March 2015. All four indicators are smoothed on a three-month moving average basis:

OECDJanuary2015Despite the recent weakness of the CBGDI, however, the historic divergence between the CBGDI and WTI crude oil prices suggest that the latter is bottoming. The case for higher crude oil prices is compounded by the fact that U.S. shale oil production growth is now stagnating (which we discussed in our recent weekly newsletters, and just confirmed by the Energy Information Administration). Should the WTI crude oil spot price retest or penetrate its recent low of $44-$45 a barrel, there will be significant opportunities on the long side of the commodity.

With the CBGDI expected to weaken further this year, we also do not believe the Fed should hike rates anytime soon (even a one-time 25 basis point hike)–especially given the recent strength in the U.S. dollar. A Fed rate hike will be counter-productive as it will simply reduce U.S. dollar/global liquidity at a time of global risk-aversion and reduced economic activity. We thus remain cautious; we will mostly sit on the sidelines until one of the following occurs: 1) global liquidity increases, 2) the CBGDI begins to turn up again, or 3) global asset prices correct by more than 10% from current levels.

Why Commodities Will Rally Hard Over the Next 2-3 Weeks

The commodities complex is hugely oversold. US$ bullishness has not been this high since the depths of the financial crisis in early 2009. With the SNB eliminating the synthetic peg to the Euro–Euro bullishness will be revived over the next couple of weeks, as the 41% intraday decline of the Euro against the Swiss franc likely resulted in the short-term capitulation of all remaining Euro bulls. My sense is that the Euro will actually rise if the ECB chooses to adopt QE on January 22nd, as QE would mean the ECB will unconditionally try to keep the European Monetary Union together, which will be bullish for euro-denominated assets, as well as for assets leveraged to the global economy, such as commodities.

We also believe the latest 25 basis point easing by the Reserve Bank of India will be first of many rate cuts this year; China will also follow. With India now the world’s third largest oil importer, any economic acceleration in India will also be felt in the commodities complex.

As such, I believe the commodities space (oil, copper, silver, etc.) will rally hard over the next 2-3 weeks at the very least.

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.