Written by: Guild Investment Management
1. Limited effects from the attack on Saudi oil facilities. This past weekend, unknown actors launched a drone and missile strike on two Saudi oil production facilities, resulting in a temporary disruption. While oil prices spiked on Monday morning, they quickly retraced much of the move as it became apparent that Saudi production would probably rapidly recover, and that the U.S. administration would not respond impulsively with a military strike on Iran (widely considered to be responsible for the attacks, even though responsibility was claimed by Iranian proxies in Yemen). Although analysts have spent endless years considering the risks of regional conflict sparked by Iranian and Saudi rivalry, oil markets have been complacent about that risk. The weekend’s events are unlikely to spark a regional conflagration, and in fact, we believe regional tensions will be more likely to express themselves in the future through local, asymmetrical events such as drone strikes and cyberattacks, rather than in full-scale hot wars. The fresh realization that such modestly disruptive events can occur will probably lead to a gradual pricing-in of a $5+ per barrel risk premium for oil over the next few months. That may be a modest positive for some small and mid-sized oil producers who will be able to hedge future production at more attractive prices. It may also lead to modest inflation bumps in some oil-importing developing countries such as India and China — and that in turn could be a positive for the price of gold.
2. A market for regenerative agriculture. Although a majority of climatologists concur that climate change is afoot, and likely driven by human activity, many believe that some of the world’s biggest carbon emitters — such as India and China — will be unwilling to embrace mitigation solutions that would hamper economic growth and prevent their poorest citizens from being lifted into the global middle class. This has led some scientists and engineers to propose radical solutions such as geoengineering, which in our view could be a cure worse than the disease. However, one U.S. startup, Indigo Ag, is using $600 million in venture capital to encourage farmers to move to “regenerative agriculture” — a system of practices that can sequester large amounts of carbon, offsetting emissions while boosting yields and reducing chemical inputs. Their voluntary carbon offset market will allow big corporates to become “carbon neutral” in response to increasing public and consumer demand; Anheuser-Busch is their biggest catch so far. Previous attempts at such market-driven programs have failed in the past — but Indigo Ag is betting that this time, the critical mass of public opinion will be present. We like the prospect of climate-friendly solutions that are market-driven rather than bureaucratic, and that are friendly to the economy.
3. Market summary. Dislocations in the overnight interbank lending market earlier this week do not seem to be a harbinger of imminent stress in the broader financial system. As anticipated, on Wednesday, the Fed lowered short-term interest rates a further 0.25%. Contrary to some reporting, there was not mass dissent at the Fed — only two members of the ten members of the Fed’s Open Market Committee voted to leave rates unchanged. We do not view the attack on Saudi oil production as a game-changing event that would be highly disruptive to U.S. or global markets. We think that a modest additional risk premium will gradually get baked into the price of oil, but not that a major regional conflagration is suddenly on the table. Even the attack on Saudi did not result in a notable volatility spike or short-term market correction, which we read as a bullish sign. We remain bullish on U.S. stocks, particularly on the barbell of growth stocks, primarily tech-related, and solid, dividend-growing income stocks. A new modest risk premium for oil may help generate some inflation, which will be modestly beneficial for some commodities and some commodity-exporting emerging markets — but not enough for us to believe that these markets represent an opportunity superior to that of the U.S. market. We continue to be bullish on gold, for all the reasons mentioned in recent letters. The addition of a risk premium for oil, and the inflation it generates, should be somewhat beneficial for gold demand.
The Attack on Saudi Oil Production: Likely Consequences
Last Saturday, a missile and drone strike on Saudi Arabia took out about half the Kingdom’s daily production capacity — 5.7 million barrels per day (bpd), or about 5% of the global total. About a third of that lost capacity was restored rapidly, within 24 hours; on Tuesday, Reuters reported that normal production would be restored in two or three weeks. Although rebels in Yemen claimed responsibility for the attack, U.S. and global intelligence quickly determined that Iran was the more likely source — particularly since the attacks showed a sophistication far beyond what Yemen’s Houthi insurgents had ever previously demonstrated.
The price reaction for oil was sharp on Monday. Much of that move was quickly retraced on Tuesday as the limited nature of the damage and the likelihood of a rapid recovery became apparent.
A straightforward “mechanical” analysis of supply disruptions suggests that a one million bpd disruption that lasts for a year would cause the price of oil to rise by $15 per barrel. However, the current disruption will fall far short of that damage, with a total market impact of 40 to 70 million lost barrels — a small amount compared to global stockpiles, and well within the estimated 188 million barrels of crude stockpiled in the Kingdom itself. (Globally, an estimated 1.8 billion barrels are stockpiled, including 600 million in the United States.)
The objective damage of the attacks was slight. Their real significance is, of course, geopolitical.
The rise of fracking in the United States has dulled the sharp edge of American dependence on a region of the world that’s fraught with enduring conflicts. But much of the rest of the world is not fortunate enough to be blessed with the U.S.’ combination of geology, technology, robust capital markets, and the rule of law (the things that have unlocked vast new U.S. oil reserves). For the much of the rest of the world — including India and China — Saudi Arabia remains the “central bank of oil,” the swing producer of last resort with spare capacity that can make up for disruptions elsewhere.
The attacks may not have been highly damaging or disrupting, but they have highlighted risks that oil markets have evidently not fully priced in — not unknown risks, just currently unpriced ones.
- First, in spite of the rise of U.S. oil production, Saudi is still the world’s key swing producer — and Saudi production has significant bottlenecks, including the Abqaiq processing facility that was struck in the attack.
- Second, a war with Iran has been feared for so many decades that most observers have become complacent about the risk. Still, Iran maintains deep ties with regional asymmetrical militias that are capable of either conducting proxy attacks on Iran’s behalf, or of distracting attention from activity that covertly originated from Iran itself. (Intelligence seems to suggest that the latter is what happened on Saturday.) In short, while a regional war involving Iran remains unlikely, Iran can still have a significant and destabilizing regional influence.
- Third, technology (drones, cyber warfare, etc.) means that destructive asymmetrical attacks can more easily be launched by non-state actors (though often with covert state backing). Those attacks will increase in sophistication and efficacy as the technological means become cheaper and more accessible.
These risks may now start to be priced into oil more consistently. We foresee a somewhat durable risk premium of $5 or maybe $10 being added to a barrel of oil over the coming months — though with all the other drivers in place (particularly, the strength or weakness of overall global economic growth), that risk premium will not be decisive on its own to determine the path of the price of oil.
Investment implications: The recent attack on Saudi oil production is not a disaster from a geopolitical perspective, and a small positive from an economic and market perspective — particularly from a U.S. point of view. The oil price spike after the attack has afforded some small and mid-sized exploration and production companies the opportunity to hedge future production at higher prices, easing cash flow concerns and better ensuring cash return to shareholders. As a higher risk premium is priced into oil over coming months, that will lead to a modest bump in inflation — more in developing countries that are large energy producers (particularly India and China). That modest inflation effect will, in turn, be a further small positive for gold.
Regenerative Agriculture, Market Style
Although there is a wide range of opinion about the accuracy of the models and the severity of the changes that lie ahead, the consensus of climatologists agrees that climate change is real and that human activity is having a significant effect. Readers are certainly familiar with the various debates about the efficacy or practicality of controlling carbon emissions.
Some scientists and engineers believe the threat posed by climate change is real, but that it is unlikely that emerging economies such as China and India will be willing to sacrifice economic growth by curtailing emissions significantly. Therefore they have suggested a variety of outlandish ideas for geoengineering — for example, atmospheric aerosols, orbital solar shields, ocean fertilizing to encourage plankton growth, or covering deserts with reflective surfaces. For our part, we appreciate the realism which understands that carbon emissions cannot be radically curtailed without kneecapping the global economy — but the prospect of geoengineering seems to us at least as dangerous as unmitigated atmospheric carbon. Mad scientists tinkering with the atmosphere, when their climate models are woefully incomplete and inaccurate, may be a recipe for disaster.
However, if science-fiction geoengineering and Luddite decarbonization are both off the table, there are still steps that can be taken to remove carbon from the atmosphere and mitigate the warming that it might create. These solutions are low-tech and market-based — and so wouldn’t require massive new government bureaucracies or invasive regulations. They would simply incentivize farmers to farm in a way that sequesters carbon in the soil — potentially balancing out a significant part of the world’s carbon emissions.
No-Till Farming and Crop Rotation: Part of the Carbon Sequestering Arsenal of Regenerative Agriculture
“Regenerative agriculture” is a system of organic agriculture which dramatically increases the sequestration of carbon in the soil, after it is absorbed and bound into plant tissues during the process of photosynthesis. Although this agricultural system is rooted in pre-modern agricultural approaches, it has been refined and systematized over the past several decades by organic advocates such as the Pennsylvania-based Rodale Institute. It shies away from the use of agricultural chemicals but embraces low-impact aspects of high-tech farming. The practice of regenerative agriculture, according to its advocates, results not just in carbon sequestration, but in healthier soil, healthier food, reduced or eliminated fertilizer and pesticide input, and higher crop yields.
Why don’t more farmers adopt regenerative practices? Because the transition can be expensive, involving significant capital investment — for example, seed drills to replace traditional tillage equipment. Yields can often be lower during the transition period as healthier soil is created, and many farmers don’t have the financial cushion to endure the shift.
Boston-based startup Indigo Ag, which has received more than $600 million in venture capital funding, is offering farmers a full suite of regenerative ag training and consulting services — as well as seed (wheat, corn, soy, and rice) treated with organic microbial solutions to boost yield.
To assist farmers in the financial transition to regenerative practices, Indigo Ag is creating a voluntary carbon-offset market. Farmers participating in this program receive $15 per ton of sequestered carbon (as measured by Indigo Ag’s high tech methods) — giving them revenues of $30–$60 per acre. The offsets are bought by companies who want to be able to claim carbon neutrality for their products or services. Indigo Ag’s biggest corporate carbon market participant to date is Anheuser-Busch, which made a deal this year to source 2.2 million bushels of sustainable rice.
In the past, efforts such as the ill-fated Chicago Climate Exchange collapsed, leaving farmers holding the bag. While Indigo Ag is guaranteeing farmers $15 per ton for now, they intend ultimately to transition to pricing set by the market. It remains to be seen whether a sufficient critical mass of public demand for carbon neutrality will be reached to prevent this experiment from meeting the same fate as its predecessors.
Investment implications: Fueled by shifting public opinion, demand for carbon neutral products and services may help enable the emergence of market-based solutions to climate change and carbon sequestration. Extreme technological intervention, and bureaucratic overreach which hamstrings economic growth, may prove to be less attractive alternatives than simply incentivizing the world’s farmers to be leaders in mitigating the impact of carbon emissions.
This week brought another development in an obscure corner of the market — overnight lending, which banks rely on to meet funding needs. Observers had noted for some time that Fed tightening had been draining liquidity from the system; a confluence of funding needs created a shortfall and overnight rates spiked, causing the Fed to step in. Although the Fed has several tools at its disposal to ensure liquidity in this market, they will ultimately need to inject liquidity through permanent open-market operations (POMOs) to build a reserve buffer — a form of QE, likely at the very short end of the curve (i.e., Treasury bills). The long and the short is that this event does not seem to be a harbinger of imminent stress in the broader financial system. And as anticipated, on Wednesday, the Fed lowered short-term interest rates a further 0.25%. Contrary to some reporting, there was not mass dissent at the Fed — only two of the ten members of the Fed’s Open Market Committee voted to leave rates unchanged.
As we noted above, the media made much ado of the attack on Saudi oil production, but we do not view this as a game-changing event that would be highly disruptive to U.S. or global markets. We think that a modest additional risk premium will gradually get baked into the price of oil, but not that a major regional conflagration is suddenly on the table.
U.S. markets have been marking time and digesting improving macroeconomic data. Even the attack on Saudi did not result in a notable volatility spike or short-term market correction, which we read as a bullish sign. We remain bullish on U.S. stocks, particularly on the barbell of growth stocks, primarily tech-related, and solid, dividend-growing income stocks.
While anti-trust investigations into big tech may create some static, we think it is unlikely that they will show anti-competitive behavior. Other big techs may follow the lead of FB [NASDAQ: FB], and establish independent oversight boards that will handle some of the concerns that consumers and regulators have voiced about privacy and editorial overreach.
Europe and Emerging Markets
Nothing has occurred to change our view of Europe. Europe remains mired in low growth, which further easing from the European Central Bank is unlikely to remedy. The best remedy would be for Germany to do a little deficit spending — but political and culturally, that seems unlikely. The UK, as we have noted, could be attractive (stocks and currency) if they really succeed in leaving the EU on October 31 — though of course, after a period of volatility.
As we said above, a new modest risk premium for oil may help generate some inflation, which will be modestly beneficial for some commodities and some commodity-exporting emerging markets — but not enough for us to believe that these markets represent an opportunity superior to that of the U.S. market.
We continue to be bullish on gold, for all the reasons mentioned in recent letters. The addition of a risk premium for oil, and the inflation it generates, should be somewhat beneficial for gold demand.
Thanks for listening; we welcome your calls and questions.
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