An "Energy Crisis, Wrapped In A Banking Crisis, Engulfed In A Fiscal And Monetary Crisis" Is Coming
Harris Kupperman offers up his latest thoughts on markets in his Q1 letter to investors.
One of my favorite investors that I love reading and following, Harris Kupperman, has offered up his thoughts on the market for Q1 2023 - with a focus on commodities like oil and his largest positions - which I think are a great read.
Harris is the founder of Praetorian Capital, a hedge fund focused on using macro trends to guide stock selection. Mr. Kupperman is also the chief adventurer at Adventures in Capitalism, a website that details his investments and travels.
Harris is one of my favorite Twitter follows and I find his opinions - especially on macro and commodities - to be extremely resourceful. I’m certain my readers will find the same. I was excited when he offered up his latest thoughts to Fringe Finance, published below (bold emphasis is QTR’s).
Market Views
Many market pundits are currently fixated on interest rates and their expectation that the fastest rate cycle in recent memory will succeed in creating a recession. While I’m receptive to such a view, I don’t think that rates will be the kill-shot. Rather, I believe that the imminent arrival of an energy crisis, precipitated by dramatic increases in the price of oil, will supersede whatever impact rates may have on the economy.
Taking a step back, I’ve been speaking about oil for a while now. At first, the recovery from negative prices in 2020, made me look astute as a prognosticator. However, since peaking out following the Russian invasion of Ukraine, oil prices have drifted lower, losing almost half of their peak price. As a result, it would be disingenuous for me to tell you how oil is about to rapidly increase in price, if I didn’t first explain why oil prices took a breather, especially over the past 9 months.
In the end, it all comes down to math. Unfortunately, given the nature of oil, precise data is impossible to come by. Instead, I’m forced to use some back-of-the-envelope internal estimates that are likely to be directionally correct, if empirically incorrect. With that in mind, I believe that oil investors have now suffered through the following since the late summer of 2022:
China locking down over COVID for approximately 200 days with a demand loss of 2.5 million barrels per day (bbl/d) or 500 million barrels (bbl) throughout Asia
Global Strategic Petroleum Reserve releases in excess of 300 million bbl
Russia dumping approximately 150 million bbl of crude and refined products before sanctions took hold
A warm winter in Europe and North America which reduced heating oil and propane demand by approximately 100 million bbl
In total, we’re looking at a swing of approximately 1.05 billion barrels over a period of roughly 200 days, or 5.25 million bbl/d. With that in mind, the surprise shouldn’t be that oil prices declined under the weight of this massive swing. Rather, the surprise should be that global commercial inventories barely increased. Where did those barrels go? They got consumed. What’s more, they got consumed during a period where increasing interest rates incentivized many consumers to run down their existing inventory, inventory that is not tracked by the various acronym agencies tasked with tracking inventory, adding a further headwind to global imbalances.
Now, we find ourselves at a moment in time when the first three of the headwinds noted above are reversing, and no one can predict the weather. Meanwhile, global demand grows every year. If global commercial inventories could barely increase with these extreme factors in play, what happens now that they’ve reversed? What happens if there’s an accident on the supply side for a change?
In my year-end letter to you, I estimated that the year-end 2023 deficit would be between 4 and 6.5 million bbl/d. I remain convinced that this is a great baseline to use (adjusted for a smaller decline in Russian production offset by an increase in global consumption as the “Work from Home” trends reverse) and recent OPEC moves to reduce production by 1.15 million bbl/d will only accentuate the deficits.
Now, think about how ludicrous it sounds to say that we’ll draw inventory at 5.15 and 7.65 million bbl/d to account for the recent OPEC cuts? Of course, we will not draw at anything approaching that rate, but that’s only because oil prices will have to rise to a level that destroys roughly that much demand, balancing the market. Hence why I’m not worried about interest rates. Instead, I’m trying to envision the magnitude of the energy crisis necessary to destroy somewhere between 5% and 7% of global demand. For a point of reference, the GFC, which was the largest economic crisis since the Great Depression, destroyed less than 2% of global energy demand. Could a crisis, a few times worse be necessary and imminent?
Of course, in a highly dynamic market like oil, there are often countervailing forces at play—some positive and some negative for balances. Who could have predicted that a warm winter would save Europe from having to burn copious quantities of oil for power generation? Or that Libya would enter a rare period of relative political stability? These were both impossible to predict, yet positive for overall balances. Where were the inevitable and offsetting negative events?
In summary, it’s odd for a period of time to witness so many events that swing balances in one direction, without other offsetting adjustments in the other direction. I think the past 200 or so days were an unusual outlier, that is unlikely to repeat, and without the events noted above, the energy crisis would have already arrived. At the same time, I’m finely attuned to the fact that many of these events are out of my control, and I have positioned the portfolio so that if the thesis again gets postponed or adjusted in magnitude, we should not suffer too gravely. Ideally, we can profit handsomely, even if the events play out differently than I anticipate.
The fact that some prominent and successful energy investors use similar math, means that I am by no means an outlier in my thinking about oil balances. What makes me an outlier, is that I’m gravely attuned to what this means for other risk assets—while most market participants, having never contemplated an energy crisis, seem blissfully unaware of what is coming their way.
While all of this is happening on the energy front, we’re simultaneously witnessing an inflationary crisis, a slow-burning banking crisis, a pending commercial real estate crisis, multiple geopolitical crises, and likely a fiscal crisis intertwined with a monetary crisis. All of these will be accentuated by the coming energy crisis, especially as the Fed is increasingly powerless to react, as its tools are pressed to the limit for fear of breaking something else.
I believe that 2023 will be a year that tests many investors as tail events become commonplace and formerly reliable bastions of stability are forever shattered. I believe that many of the economic systems that we have taken for granted for most of our lives are about to be upended. Longer-term, I believe that this is healthy as the whole system desperately needs a reset. However, as this unfolds it will be downright terrifying.
To summarize, I’m unusually bearish on things and anticipate a period of chaos. However, unlike many doomsday prophets in the markets, I want to be clear that I will keep an open mind about the trajectory of things. For instance, I can very easily envision a world where the stock market crashes higher. I can imagine a world with a banking crisis along with raging inflation (who says banking crises are deflationary?). I can see a world where the Fed loses control of interest rates, and the fiscal side simply loses the narrative. Alliances can suddenly shift, and trade-flows become upended. Meanwhile, small regional conflicts can suddenly engulf the Great Powers. I believe that all kinds of demons that have festered are about to explode into the open, upon people who are unusually unprepared.
Anticipating chaos, I’ve kept our exposure at reduced levels for over a year. I had wanted to unleash our capital reserves and max out our positions on a market bottom, and I genuinely thought that I’d be deploying capital into GDP sensitive companies, as the Fed began to cut rates. Instead, I’m increasingly of the view that macro events may trump fundamentals. Instead, I am considering precious metals, which may be entering a new bull market, possibly even THE bull market that comes when the edifices around us collapse and the authorities lose control.
The Freedom to Lose Money
I’m sure that I’m going to regret this sub-header, but I’m going with it out of my belief in transparency.
You see, in the volatile world that we’re about to enter, wild swings in our P&L are going to be inevitable. Knowing the financial landscape, I also know that these swings will wreak havoc on other investors, especially given their copious use of leverage and desire to achieve a reduced quantum of volatility for their clients, by constantly adding and reducing exposure. These investors will inevitably exit at extremes and accentuate moves, in both directions. Short term, this volatility will be terrifying, but also an amazing source of opportunity for us. This is because I simply do not care about our short-term P&L. As far as I’m concerned, I have the freedom to lose money, sometimes surprisingly large sums of money as various assets swing around wildly. Otherwise, I’d be like every other investor, forced to de-risk and de-gross at extremes. In fact, I’d say that my willingness and ability to just ignore the volatility, is one of the Fund’s greatest competitive advantages.
As we enter an increasingly volatile world, it’s worth reminding you that my expectation is that roughly every 18 to 24 months, we’ll experience a 35% pullback in our returns. Of course, depending on the timing of the extremes of the move, you may only see some small portion of such a move, as much of it may be truncated intra-month. However, there will come times when the extremes are vividly portrayed on your statements. I want to stress again that this is a feature and not a flaw in my style.
There will also be times when temporary losses become permanent and realized. This should be self evident to all investors. While we could try and hide from this fact or even try and mitigate it, my approach is to accept it as part of the price we pay to target outperformance. Accepting this as simply part of the game, is tantamount to gaining an edge amongst those who think they can side-step such losses and volatility. Perpetually acting fearful seems foolish.
I believe the only way that you can reduce volatility, is to reduce the upside and that seems silly to me. The Fund is focused on outperformance over rolling three-year intervals. Anything shorter is simply noise to me.