Making The Jump to Twitterspace

 

Dear friends, family, and followers of Kaoboy Musings:

 

It's been almost 6 months since my last missive using this medium as I've come to realize that the Twitter platform is much better suited to my objectives: 1) to stimulate discussion, 2) to educate, 3) to learn, 4) to interact with smart folks with similar interests. Those were the 4 objectives I had in mind when I set up this site a little over a year ago: https://kaoboymusings.com/welcome-to-my-blog/.

For those of you who know me well, I tend to go deep when I get interested in something, so learning WordPress/CSS and setting up the site was fun.  However, after writing for about 6 months, I realized that I was missing the primary psychic gratification of being able to interact with you all in a community-based setting and that I was wasting a lot of time trying to recreate the wheel when such a platform already existed. Kinda reminds me of when I tried to set up an automated observatory dome on my hillside because of a casual interest in stargazing/astronomy -- before long, the process of setting up the infrastructure pretty much consumed all the time and joy from the underlying impetus for the project. Just like how my objective was to simply enjoy astronomy, my objective here is to have an interactive platform/conduit with smart folks like you.

The bottom-line here is that I've greatly enjoyed the one-on-one interactions from writing these musings and miss those interactions; therefore, after several months of experimenting on Twitter, I'm deciding to move all of my future musings to this platform and invite you to join the Kaoboy Musings forum on Twitter: @UrbanKaoboy. I will leave my existing content and past posts intact on this site for now.

I look forward to reconnecting with many of you and hopefully interacting more frequently!

  

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

The Good, The Bad & The Ugly — Coronavirus Edition

The Good, The Bad & The Ugly -- Coronavirus Edition

It’s been two months since my last Musing, but it feels like two years.  The world has dramatically changed for all of us in the last 60 days, and if you’re like me, you’ve been drinking from a firehose of information about the coronavirus daily – a lot of which is conflicting and some of which is downright bogus. 

In this Musing, I will attempt to distill my own thoughts and learnings from voracious readings on this topic and also include a compilation of what I deem to be the best papers, presentations, and books.  I am going to disclaim right off the bat that I won’t be sugarcoating anything and that some of my conclusions won’t be pleasant for some to hear, but my view is that it is better to sacrifice some near-term zen and be prepared than to be blissfully ignorant and woefully unprepared.

The Bad

Because I like to disclose bad news first, I’m going to violate the sanctity of my title and attack “the bad & the ugly” first before ending on “the good.”

Background/Timeline

The “novel coronavirus” known as COVID-19 or SARS-CoV-2 originated in December, 2019 in the city of Wuhan, in the province of Hubei in China; by some reports, China may have known about it as early as September.  Coronaviruses comprise a family of zoonotic viruses (animal-to-human) that include SARS, MERS, and now COVID-19.  Zoonotic viruses “spillover” from an animal “reservoir host” (in this case believed to be bats) often by way of an “intermediate host” (possibly pangolins) to humans.  China’s abundant “wet markets” which feature a myriad of animal species for sale in close proximity provide the ideal “petri dish” for these types of spillovers to occur, which is what happened with SARS in 2002.  A great, prescient book on this topic that I am currently reading is Spillover: Animal Infections And The Next Human Pandemic by David Quammen.

Dr. Lu Wenliang warned fellow doctors about this new SARS-like flu and was silenced in December.  The World Health Organization (WHO) didn’t learn about it until December 31.  By January 4, 44 infections were documented, with more than half traced to a “superspreader” – the Huanan Seafood Wholesale Market in Wuhan.  By January 23, 581 cases had been reported.  The cases exploded to 2800 by January 27, and WHO declared the outbreak to be a “public health emergency” on January 30.  Trump imposed travel restrictions related to the epidemic on January 31. 

By February 2, global cases hit 14,557 with 305 deaths; China claimed that cases in China peaked on that day.  February 6: 193 people from Wuhan landed in Auckland, New Zealand and were quarantined.  On February 8, 2 New Zealanders boarded the cruise ship Diamond Princess and wound up infecting 64 passengers. Cases reached 43k by February 11, and deaths exceeded 1000, achieving in 1 month of SARS claimed in 2 years.  February 17: cases jumped to 71k, and 60 million people were locked down in Hubei.  Iran got its first case on February 19, and by February 22, there were 634 cases onboard the Diamond Princess and 50k people were quarantined in Italy. 

Fast forward to March 9: global cases hit 109k with 3788 deaths for a case fatality rate of 3.47%.  By today, March 20, that number hit 275k with 11.4k deaths for a case fatality rate of 4.14%.  Italy deaths are now 4k vs. 3.1k in China.  As of today, the US stands at 19,624 cases with 260 deaths.

Why COVID-19 Is NOT “Just A Bad Flu”

Just two weeks ago, while I was waiting for my yoga class (which I now regret attending) to start, I was listening to the banter between several other attendees: “Can you believe the hype?”, “This is just a bad flu – big deal.”, “I think all these people stocking up on everything are crazy.”  I decided then and there to not come back to class for a while – little did I know that in just days, all gyms and studios would be shut down.  Similarly, in various financial conversations I’ve had over the last several weeks with people whom I greatly respect, I’ve heard comments like the following: “This will all be over in a couple weeks.”, “This is nothing like 2008.”, “Everything will be fine.”, “Seems like a lot of ruckus over something that does not appear to be a big deal.”  There is only one comment in there that I would agree with – “This is nothing like 2008.”  My concern is that this could be much worse than 2008 in terms of economic fallout, but my even bigger concern is the potential for societal breakdown if our healthcare system gets overwhelmed and/or our food supply chains fail. 

I have many concerns over some of these lackadaisical comments: 1) these well-meaning folks, in their true belief that “everything will be fine,” will not be taking prudent financial measures to hunker down their businesses aggressively enough, and 2) more importantly, they may not be taking the health safeguards seriously and unwittingly aid and abet the contagion.  Case in point: because younger people have read that this virus takes its biggest toll on the infirm and elderly, many are still going to parties, parades, mass gatherings with reckless abandon.  The same argument potentially goes for businesses who are anticipating a "V"-shaped recovery – especially those businesses with high, fixed obligations.  Normally, Darwinian self-selection takes care of stupid, reckless behavior; unfortunately, because of the disease dynamics here, these behaviors endanger us all, both in terms of physical and financial health.   

I believe there are two main reasons why doubters doubt: 1) recency bias, and 2) one-dimensional comparisons. 

In terms of recency bias, let’s face it: life has been good for those of us in developed nations for a long time.  It’s been a 20-year bull-market, it’s been 75 years since the last World War, it’s been 100 years since the last global pandemic.  But history can be a good teacher: the Spanish Pandemic of 1918 is the best historical parallel to the current COVID-19 pandemic, and that pandemic killed 50-100 million people between a two-year period (1918-1920) on a global population of 1.9 billion for a mortality rate of ~2.5%-5%.  For perspective, WWI claimed an estimated 30-50 million lives.  Two reasons why the experience of the Spanish Pandemic might be worse than today: 1) WWI created uniquely bad conditions that accelerated the spread of the virus, and 2) we have much better science today in 2020 than we did in 1920.  On the flipside, however, two rebuttals to those rebuttals are: 1) we also have a much larger global population of 7 billion today, and 2) we are far more globally interconnected, with an estimated “2.8 million people flying each day” (quote from Larry Summers in a recent Goldman Sachs deck).  

The other sobering lesson we can glean from 1918 is that the pandemic came in multiple waves, with the second and third waves (coming 5 and 10 months later, respectively) being far more lethal than the first wave.  Three reasons for multiple waves include: 1) seasonality pattern of influenza viruses in general, 2) mutations (there already have  been 100+ mutations of COVID-19, but they’ve generally been fairly stable -- so far), and 3) early relaxation of mitigation protocols (more on this later).  In any case, we are only in the early innings of the first wave of COVID-19.  See Exhibit 1: Spanish Pandemic Came In Multiple Waves.

1918 waves

Exhibit 1: Spanish Pandemic Came In Multiple Waves

For additional perspective on the Spanish Pandemic of 1918, I recommend the following book, Very, Very, Very Dreadful: The Influenza Pandemic of 1918, by Albert Marrin.

The second reason why doubters doubt is due to one-dimensional comparisons, which in my opinion, drastically understate the danger of COVID-19.  By one-dimensional comparisons, the main example lies in people comparing the “low mortality rate” of COVID-19 as only “slightly worse” than a bad case of influenza.  Some presentations I’ve seen (like McKinsey’s) attempt a two-dimensional comparison by plotting contagiousness as captured by the R0 (“R-naught”) reproductive factor vs. the case fatality rate (CFR), showing how COVID-19 is kinder and gentler than a myriad of other notable outbreaks like SARS, Ebola, measles, smallpox, Influenza of 1918.  I argue that this analysis also understates the danger of COVID-19.  At a minimum, I think we need 4-dimensional space to do a proper comparison: 1) R0, 2) Fatality Rate, 3) Incubation Period, and 4) Hospitalization Rate.  Piecing together various charts from various studies I’ve read, I think that COVID-19 may have one of the worst profiles of any of these outbreaks when you factor in all 4 dimensions.

Here’s a quick explanation of each of these 4 variables:

  1. R0 (pronounced “R-naught”) denotes the reproductive factor and signifies the number of people 1 person is likely to directly infect.  The “naught” designation is something used often in physics to denote the initial state of a system.  If R0<1, each inflection causes <1 new infection, and the virus starves out.  If R0=1, each infection causes 1 new infection, but an outbreak/epidemic is unlikely.  If R0>1, each infection causes >1 new infection, and the higher the number, the higher the likelihood of outbreak.  According to various sources, R0 for COVID-19 is 2-3, whereas the R0 for Seasonal Flu is 0.9 to 2.1 (with 1.3-1.5 as the most commonly quoted range), depending on the strain.  Taking the low end of these ranges and rounding R0 for Seasonal Flu to 1, we may be tempted to conclude that “COVID-19 is only twice as contagious as Seasonal Flu.”  Alas, that would be a gross misunderstanding of exponential math; whereas an R0=1 virus could still spread linearly, an R0=2 would explode exponentially as each infection would in turn infect 2 more and so on and so forth.  The Spanish Pandemic had an R0 of 1.4-2.8, which is very comparable to COVID-19 in terms of contagiousness.  Basically, anything with R0>2 is extremely contagious, and even the hypothetical virus in the movie Contagion had R0=2 (that eventually mutated to R0=4).  Like that fictitious virus in the movie, COVID-19 spreads both via airborne transmission as well as fomite transmission (via surfaces), which accounts for the extremely high R0.

Related to the R0 is the concept of attack rate which is basically the probability of infection of a given population (the infection percentage of the population at risk).  According to Professor Jeremy Farrar (see the entire transcript of his 2/25/20 Wellcome Trust COBIT Conference Call), an expert on infectious disease from Oxford, the attack rate is about 5-10% for Seasonal Influenza and only slightly higher at 16% for H1N1 Swine Flu.  Ominously, he is estimating a 25-40% attack rate for COVID-19, using 30% as a base case.  Essentially, this means that up to 30% of the global population may be infected.

2. The Fatality Rate (sometimes called Case Fatality Rate, or CFR) is the percentage of total deaths within a diagnosed population.  The problem with this number is that it’s only as good as testing data can provide, and we all know that the world is woefully under-tested.  According to the CSSE/Johns Hopkins dashboard today (3/20/20), the global Mortality Rate is 4.4% based on the latest data.  As more and more of the world gets tested, this number likely drops dramatically as the denominator swells.  Looking through the overstatement due to inadequate tests, Professor Jeremy Farrar estimates an ultimate CFR of 0.5-1%, with Seasonal Influenza at only 0.1%; takeaway – COVID-19 has a fatality rate that is 5-10x that of Seasonal Influenza.

3. Incubation Period refers to the amount of time elapsed between exposure to first symptoms.  This is where COVID-19 is extremely pernicious.  Whereas Seasonal Influenza has an Incubation Period of 1-4 days, COVID-19 could be 2-24 days (although CDC is only estimating 2-14).  In other words, by the time you become symptomatic, you may have already inadvertently been transmitting this virus for 3 weeks – this alone makes COVID-19 far more insidious than most outbreaks of the last 100 years. 

4. Finally, as if we don’t have enough to worry about, the Hospitalization Rate for COVID-19 is estimated to range from 10-20%, and the Critical Car Rate is estimated at 3%-5%; for Seasonal Influenza, the Hospitalization Rate is only about 2%.

The bottom-line here is that when people brush off COVID-19 as “just a bad flu,” they are grossly underestimating the danger of the combined quadfecta of COVID-19.  If there was a way to plot COVID-19 in this four-dimensional space against the other significant outbreaks of the last 200 years, I would guess that COVID-19 emerges as one of the most serious contenders for the crown of "most dangerous disease."

The Ugly

Now let’s apply some of these numbers to the world population of 7 billion.  If we use Professor Jeremy Farrar’s attack rate of 30% and CFR of 0.5-1%, we get 0.3 x 7 bn = 2.1 bn infected.  Of this 2.1 bn infected population, 0.5-1% equates to 10.5 million to 21 million deaths globally!  Closer to home, assuming a population of 325 million, we get 0.3 x 325 mm = 97.5 mm infected and 0.5-1% of that number resulting in 487k to 975k deaths.  In my home state of California with a population of 40 mm, we get 12 mm infected and 60k-120k deaths.

Next, we need to talk about Hospitalization Rates and how that compares with our ICU surge capacity.  For the purposes of being optimistic as well as opting for simple math, let’s assume 10% of those infected require hospitalization (the predicted range is 10-20%).  This equates to hospitalization needs of 210 mm people globally, 9.75 mm of which are in the U.S. and 1.2 mm of which are in California.

How do these needs compare with hospital capacities?  This is where things get Ugly, with a capital U.  According to various sources (this article is one of them), the U.S. is estimated to have only 1 mm hospital beds in total, of which 68% are already occupied, leaving 300k beds available nationwide against surge demand of up to 9.75 mm; put another way, surge demand outstrips capacity by 32.5x!  Quoting this article:

At a 10% hospitalization rate, all hospital beds in the U.S. will be filled by about May 10. And with many patients requiring weeks of care, turnover will slow to a crawl as beds fill with COVID-19 patients.

If I’m wrong by a factor of two regarding the fraction of severe cases, that only changes the timeline of bed saturation by six days (one doubling time) in either direction. If 20% of cases require hospitalization, we run out of beds by about May 4. If only 5% of cases require it, we can make it until about May 16, and a 2.5% rate gets us to May 22.

On March 16th, Imperial College in the UK put out a controversial yet alarming study entitled “Impact of non-pharmaceutical interventions (NPIs) to reduce COVID-19 mortality and healthcare demand."  The gist is that they modeled the effects of applying 5 different “non-pharmaceutical interventions (NPIs)” as strategies to mitigate/suppress R0; strategies include: isolation at home, voluntary home quarantine, social distancing, and closure of public schools and universities.  Their paper came to the same conclusion that I reached above -- that surge demand could outstrip capacity by over 30x if no mitigation strategies are employed; however, if these mitigation/suppression strategies are implemented, they estimate that the surge demand would “only” exceed capacity by 8x.

Since then, Nassim Taleb (of Fooled by Randomness fame) published a pedantic critique of this study but did not offer any original insights of his own.  Similarly, Bill Gates chimed in with an equally unsatisfying comment from this interview.

Q: What about this Imperial College study suggesting 1-4 million Americans will die with current approaches, but total shutdown would limit deaths to a few thousand?

Fortunately it appears the parameters used in that model were too negative. The experience in China is the most critical data we have. They did their “shut down” and were able to reduce the number of cases. They are testing widely so they see rebounds immediately and so far there have not been a lot. They avoided widespread infection. The Imperial model does not match this experience. Models are only as good as the assumptions put into them. People are working on models that match what we are seeing more closely and they will become a key tool. A group called Institute for Disease Modeling that I fund is one of the groups working with others on this.

Meanwhile in California, Governor Gavin Newsom just released statewide hospital metrics:

  • 74,000 hospital beds at 614 facilities.
  • Surge capacity of 8661 beds.
  • 11,500 ICU beds (includes pediatric and neonatal).
  • 7587 ventilators.
  • EMSA has additional 900 ventilators.
  • Procured an additional several hundred ventilators.
  • Negotiations are underway to re-open healthcare facilities to significantly increase surge capacity.
  • A minimum of 750 new beds will be added to surge capacity by end of the week.

If the above hospitalization need of 1.2 million is even half accurate, well, you get the picture.

Bottom-line: our (and the entire world’s) healthcare system was never designed to deal with a pandemic that could cause surge demand in hospitalizations to eclipse capacity by multiples.  Although we are already hearing the anecdotes of wartime triaging in Italy and China as their healthcare systems get swamped, many here still brush it off as unlikely, citing that “hospitals are currently not that busy.”  With all due respect, I think this blasé attitude will cause some rude awakenings here and around the globe in the next several weeks, as exponential growth socks reality in the face with a haymaker.  Best thing to do: stock up as best you can and assume you may be limited to self-care if/when the system is overwhelmed. 

Caught Between the Scylla and Charybdis

scylla

In Homer’s Odyssey, Odysseus at one point during his wanderings had to steer a narrow course between Scylla, a multi-headed monster, and Charybdis, a whirlpool-like creature who could devour whole ships.  All world leaders are now caught in a similar quandary between the “Scylla” of letting the virus run rampant and eventually “burn itself out” and the “Charybdis” of enacting draconian measures to drive down R0 but at great economic/societal cost.  Embracing “Scylla” will lead to overloading the healthcare system, likely lead to massive numbers of deaths and undoubtedly wreak societal havoc.  Embracing “Charybdis” on the other hand may buy time in the short-term, but how long can a government enforce strict quarantining and the massive economic hemorrhaging that will result without even a guarantee that infections won’t spike again the minute vigilance is let up?

Goldman Sachs put out a very comprehensive update today (GS_3_20_20_Coronavirus_Call_5_Materials (2) which not only gave a status report of various promising initiatives, ranging from addressing various testing bottlenecks (kit availability, lab capacity, availability of swabbing technicians) to the various pharmaceutical trials and timelines (unfortunately all fairly far off).  In addition, they showed how aggressive containment efforts can indeed “flatten the curve.”  Despite China’s initial cover-up of their COVID-19 outbreak, their full clamp-down of Hubei province seems to have achieved the desired effect of compressing R0 quickly and “flatten” their infection curve – see Exhibit 2.

flatten

Exhibit 2: China Has Quashed R0 from 3.86 to 0.32 in One Month, source: Goldman Sachs

As a result, media pundits and friends alike seem to have limitless appetite to praise the efforts of China, South Korea and Singapore as the paragons of how to navigate the “Scylla/Charybdis strait” while lambasting our own efforts in dealing with this crisis.  There are definitely best practices that we should be adopting – this blog post lists some good ones.

That all said, this story is far from over, and it is way too premature to declare that China/South Korea have found the optimal path through these dire straits.  In fact, another paper authored by University of Maryland Professor Mohammad Sajadi entitled “Temperature and latitude analysis to predict potential spread and seasonality for COVID-19” found that the hardest-hit cities were all correlated by a tight temperature range (Table 1 on page 5), makes some interesting predictions about where the next “hotspots” will be (London and New York figure prominently in this list) and noted that the “marked drop in cases in Wuhan could well be linked to corresponding recent rising temperatures there.”  That said, there seems to be conflicting evidence that warmer weather will help mitigate the spread, as there appears to be prolific transmission in currently warm places like South America and Australia.

If seasonality is an unlikely catalyst for resurgence and mutations have thus far remained stable, that leaves relaxation of lockdown protocols as the likeliest reason for an uptick.  The 3 experts in the reports I have cited (Dr. Jeremy Farrar in the Wellcome Trust call, the authors of the Imperial College report, Dr. Barry Bloom in the Goldman presentation) and the history of 1918 all seem to point to relaxation of protocols as a key determinant of resurgence.

In addition, Professor Farrar hammers home just how difficult it is to put this genie back into the bottle:

But with this infection, with the amount, the degree of how infectious this is, the measures even in Wuhan can dampen the peak of the epidemic and they can spread out and delay the time to the epidemic. But given how infectious this is, you cannot prevent an epidemic with this level of infectiousness. So, the containment strategies of the moment are absolutely right and they've essentially bought other cities in China and the rest of the world time, but they will not be able to prevent it completely.

Taking this into account and noting the recent uptick in Chinese and Korean infections lately, despite their “best-in-class” protocols, I can’t help but wonder: did they relax their protocols too soon?  See Exhibit 3.

rising again

Exhibit 3: Chinese and Korean Infections Are Ticking Up Again. Source: Goldman Sachs

Finally, I want to express my skepticism at the Chinese and Indian numbers in particular.  China and India not only boast the two highest populations in the world, each with over 1.3 billion people clustered in many dense urban centers, they also have the dubious distinctions of having the lowest critical care beds per capita in the world.  That is not a good combination.  Given this and the fact that neither country is hermetically sealing its populations, I find it difficult to believe that we’ve seen the worst of it – especially when India is only claiming 250 infections!  See Exhibit 4.

icu beds per capita

Exhibit 4: China and India have the lowest critical care beds per capita

What about a vaccine? 

So far, every mitigation/suppression technique that’s been used has been non-pharmaceutical – because we don’t have a vaccine, and the consensus seems to be that we are 12-18 months away from one.  The Goldman Sachs deck I referenced earlier has comprehensive lists of both potential therapeutics and potential vaccines.  The good news?  The lists are long, and the Who’s Who of Big Pharma around the world are on the case.  The bad news?  We are in the very early innings on almost every single one.  Professor Farrar summarizes the challenges of fast-tracking vaccine development:

The Coronaviruses are a completely different challenge. And as I said, we don't have a vaccine for SARS, for MERS or indeed for the common cold. And so, the ability to make a vaccine and a strong immune response, the response that would protect you is a much bigger challenge in Coronavirus than it is in Ebola.

We are fast tracking. I mean to go from the sequence of the virus, which is what we needed in the first few days of January to having the first person received the vaccine in the first week of March has never been done in history before. I mean that process from sequence to first person would normally take somewhere between three and five years. So, we've brought that down to about five weeks. The other of course is when you're giving a vaccine, particularly to a disease, which for the vast majority of people will be mild, then you have to be absolutely sure of the safety of that vaccine. With Ebola I was much more gung ho. If you get Ebola, you've got a 70 to 80% chance of dying. And therefore, you'd take a pretty big risk to receive a vaccine that you hope would prevent you getting it.

With this Coronavirus you've got a less, in my view, less than 1% chance of dying. And therefore, you've got to be absolutely sure that that vaccine is safe before you roll it out to 350 million Americans or seven billion people around the world. So, the safety requirements and the threshold that you need to go through to prove that what you have is safe, let alone effective is very significant.

One more from Farrar:

And it won't be at least until 2021 until we have a vaccine that we can use as a public health measure. And that will assume good luck and good fortune all along the way. Just to again, underline the fact we've been trying to make a vaccine for SARS for 15 years, for Murs for seven years, and the common cold for about 50. And we've failed in each of those so far. So, although I'm more optimistic that science can deliver a vaccine now that it's not going to impact in 2020 on the public health outcomes of this.

What about those rumors that keep surfacing about potential vaccines in 2-4 months?  I wouldn’t count on it.

Questions Abound

As I write this missive on Day 1 of California’s lockdown, I find that I have far more questions than answers about the ramifications of COVID-19 on our society, economy, and politics.  In no particular order:

Societal Concerns:

  • What happens to the fabric of society if our healthcare systems do get overwhelmed as the math suggests and/or our food supply chains fail?  How will the government keep order if people are turned away at hospitals and grocery shelves are bare?
  • What happens to our already serious homeless problem and the related health risks to themselves and to society at large?
  • What about our crowded jails?  Other countries have released criminals to stave off mass infections at jails.  There are similar calls here to do that and at the same time for law enforcement to not focus on the “little stuff.”  What constitutes “little stuff” and what happens when criminal elements are emboldened and their numbers are bolstered?
  • What happens when one country embraces the “Scylla” path of letting the virus run rampant and “burn itself out” and a neighboring country embraces the “Charybdis” path of clamping down to stave off transmission?  The two goals are mutually exclusive, so what do we do about our borders?
  • Does this make people more xenophobic and socially distant or does it have a unifying effect?

Economic Concerns:

  • If the goal is to “starve out” the virus by driving R0 down, how far are we willing to go in terms of cutting into the muscle and bone of our economic engine, realizing that if we relax too soon, infection rates may spike back up?
  • Unlike the 2008 crisis of confidence in primarily Wall Street (whose metastasis into Main Street was forestalled by massive injections of liquidity), here we have a severe supply shock and demand shock of Main Street (which will inevitably metastasize to Wall Street) which is not curable by monetary policy and maybe not even fiscal policy.  What kind of deficits are we willing to incur and for how long?  Will the markets even permit this?
  • What sectors/companies are worth saving, and how will government pick winners and losers?  What price will government exact for those bailouts?
  • The Baby Boomer generation is a high-risk demographic.  If a significant percentage of this cohort perishes, what are the ramifications of their wealth redistribution?
  • What does this crisis do to global supply chains and logistics planning?  Do we wind up seeing a wave of onshoring and redundancy in stark contrast to decades of offshoring and just-in-time?
  • Does this crisis call into question the fundamentals of the “sharing economy” and being “asset light”?  Is there a reversion to wanting to own versus rent?

Political Concerns:

  • Similarly, the Baby Boomer generation wields an inordinate amount of political power in this country.  If a significant percentage of this cohort perishes, how does that impact the power dynamics in Washington and around the world?
  • Things are further complicated by an election year.  What happens if any of the Presidential contenders gets infected?  Can an election be postponed?
  • Similarly, what happens if members of Congress get infected?  Ditto for SCOTUS?
  • Part of the secret to America’s success economically is its free-market system, which is inextricably intertwined with its federalist system of government, with each branch of government exerting checks and balances on the other two.  Unfortunately, unless we mobilize into a full wartime mode, this federalist system is far more encumbered in its ability to respond quickly to crises than authoritarian systems like China and Singapore.  So what course will we choose?
  • Right now, certain states are on lockdown, but many are not.  Meanwhile, interstate travel is still allowed, so what is the point of lockdown?  Is martial law necessary and for how long?

The Good

As I write this, my closest friends are making some of the toughest decisions of their lives in a bid to survive this crisis.  I feel privileged to witness such courage under fire and am truly inspired by these acts of leadership.  I know of nothing else to say besides the adage: it is darkest before the dawn, and the dawn will come.

We are a tough, scrappy nation.  Yes, we’ve made mistakes.  Yes, it’s easy to Monday-morning quarterback those in power.  Yes, it’s easy to say “the grass is greener elsewhere,” to say that other countries are “doing it right” and we’re “doing it all wrong.”  Unfortunately, none of that is helpful.  We are all in this together, and now is not a time to be divided.  We have a common, invisible enemy that is the Great Democratizer.  It does not care about your political affiliation, your race, or your socioeconomic background.

The US was criticized heavily in WWII, as it stood by and watched its European Allies get decimated and the Holocaust was carried out.  Yet, when it finally did act, the US mobilized with decisive action, eventually turning the tide; not only did we end the war, we helped our Allies rebuild their nations and economies.  At home, we had a multi-decade post-war boom – not just economically but in babies!  I foresee the same thing happening again when this is over.  We just need to keep our eyes on the long game while taking the steps now to make sure that we’re around to see that day.

Since the beginning of this month, I’ve started keeping a gratitude journal.  When I reflect upon the common items that I personally am grateful for, the following themes come up for me:

  • My family, and in particular, new-found time with my kids that I would not otherwise have given my recent empty-nest status
  • My friends and the incredible support network they provide; new-found excuses to reconnect with people I haven’t spoken to in a while
  • My health and a new appreciation for how precious this commodity is and how protective and vigilant we need to be to safeguard it
  • My home and how lucky we are to have a place of refuge in this time when not everyone is so lucky
  • My wonderful experiences and how they can be had even in the confines of home without the need to go anywhere or do anything

What’s notable to me is that even though I’ve spent my entire adult life in the pursuit of making money and despite the last several weeks not being fun financially (I am sure I am not alone), given the new-found time for reflection, the most important things to me are bubbling up, and – surprise, surprise – they’re not money!  With that, I think I’m going to whistle my favorite Ennio Morricone soundtrack and watch my favorite Clint Eastwood flick.

fun

Stay safe and healthy, my friends!

 

Resource Compendium

Useful Dashboards

CSSE/Johns Hopkins

Worldometers

EVNTL Virus Watch

Relevant Books

Spillover: Animal Infections And The Next Human Pandemic by David Quammen

Very, Very, Very Dreadful: The Influenza Pandemic of 1918 by Albert Marrin

For Preppers

prep

lombardy dosing

european dosing

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Down the Rabbit Hole of Climate Change / ESG Investing & Disruption of Hydrocarbons

Down the Rabbit Hole of Climate Change

I debated long and hard about whether or not to write a piece on the topic of climate change because it has become such a political hot-button, but because the topic has become front-and-center in just about every forum from Davos to ESG talk on CNBC, I feel that a dedicated Musing is in order.

I have many friends on both sides of the aisle and have had many debates on this topic, but I’ve never really understood why a topic that should be grounded in hard science repeatedly gets hijacked by politicos on both sides of the aisle with religious zealotry.  The fact that this debate has polarized around two extremist camps, “climate alarmists” and “climate deniers,” highlights the current state of affairs.  I am neither.  I have always believed that to be a successful investor, one must have an open mind, have a healthy skepticism of consensus opinions, not be wed to any particular thesis, and to continuously learn.  Thus, I decided several months ago to really get educated on the topic of climate change.  The more I delved, however, the more that I found that there was so much misinformation on this topic, much of it touted with “100% certainty” or “97% consensus” to promulgate political and/or economic motives.  Furthermore, the pragmatist in me wonders how there can be so much emphasis on the “how” (e.g. solutions to mitigate CO2 emissions) without clear-cut agreement on the “why” (e.g. is CO2 really the right variable to solve for?).  After several months of reading numerous books/ papers/articles and engaging in debates/conversations with experts on both sides, I’m going to take a shot at summarizing the state of the debate and share some of my learnings – hopefully in as apolitical of a way as I can.  My goal in writing this Musing is not to press any agenda, political or otherwise; rather, I’m hoping to cut through the political noise and to provoke thought and to stimulate intelligent dialogue.

In the name of full disclosure, if you’ve been reading Kaoboy Musings, you know that I am also currently invested in the oil & gas industry based upon a bullish cyclical thesis, so my original interest in this topic was purely pragmatic – I wanted to better understand the secular disruptive threats to my thesis.  Philosophically, I do not believe that politics should enter the investing realm and find the trend toward “ESG” or “socially responsible” investing somewhat misleading and in some cases downright disingenuous (more on this later).  I believe that an investment thesis should ultimately stand on fundamental economic precepts.  Although it is true that I have an economic interest to see the hydrocarbon industry flourish, if I find that the risk/reward calculus of renewables dominates, I will pivot accordingly.

Finally, I will caveat this discussion by saying that I am not a scientist, but rather an inquisitive investor.  Although I’ve taken a healthy share of math/physics for my undergraduate engineering degree and economics/statistics for grad school and know enough about the scientific method and statistical analysis to be dangerous, I’ve spent almost all of my professional career in the world of investing, which is a far less exact “science.”  My modus operandi from an investing perspective, however, has always mixed the “scientific method” of formulating a hypothesis based upon collecting imperfect and incomplete information, and then borrowing the methods of an investigative journalist of canvassing a myriad of diverse and often opposing viewpoints from experts to test that hypothesis before committing capital.  Keeping an open mind and questioning the underlying incentives of who says what in this debate is also important.  I’ve tried to take the same approach here and am grateful to have made the acquaintances of several prominent experts in the field of climate change.  One expert in particular who has been an invaluable and non-partisan advisor in my quest for knowledge is Professor Robert Giegengack, former chair of the Department of Earth and Environmental Science at the University of Pennsylvania and is now emeritus faculty there; I have run many articles and papers by him, and he has given me permission to quote his thoughtful responses.

What People Agree On

Let’s get the low-hanging fruit out of the way first and list out some facts that virtually everyone is in agreement on:

1. The planet is currently in a warming trend.

2. Atmospheric CO2 concentrations have been rising.

3. Human civilization does indeed have an effect on the environment, in some cases deleterious and in other cases beneficial.

4. The Earth is 4.5 billion years old and has seen varying climate epochs throughout the ages.

5. Humans have fretted about climate change for hundreds of years – the current debate is not new.

6. We all want a cleaner, healthier planet.

I am sure that there may be some extremists that even take issue with some of these statements, but for the most part, I see agreement on these statements.

What Is Controversial

What surprised me most as I descended this rabbit hole is how there is still tremendous controversy behind seemingly “obvious” questions:

1. Global Warming (GW) is real, but is Anthrogenic (man-made) Global Warming (AGW) real, and if so, to what degree?

2. Should CO2 be our primary concern?

3. Whether we as a species can really do anything to influence the climate, and if so,

4. What should we do about it, and how much would it cost?

Some Historical Context

Humans have fretted about climate change for eons and have always believed in the ability to influence climate, ranging from archaic solutions of  prayer and human sacrifice to modern solutions of climate accords and CO2 emissions quotas.  The “modern” debate over AGW originated in the early 1800’s, with Joseph Fourier’s first attempt at modeling the “greenhouse effect.”  Since then, the climate debate has morphed many times, ranging from the 70’s fears of the next Ice Age to the current “existential crisis” of AGW.

Perhaps the best-known and most controversial chart in the climate change debate is the “Hockey Stick” chart put forth in 1998 by Michael Mann of Penn State, which shows a clear spike in temperatures in the last 100 years as compared to a relatively flat period over the last 1000 years.  This chart (Figure 1) was made famous in Al Gore’s 2006 book and documentary An Inconvenient Truth.

How do scientists reconstruct temperatures from ancient times?   They identify “proxy variables” in things like ice cores and tree rings and then use these proxies to reconstruct the paleoclimate record.  The problem with statistical methods, of course, is that when there is human discretion involved in how to manipulate and interpret data, very misleading results may arise.  As economist Ron Coase is famous for saying, “If you torture the data long enough, it will confess.”

hockeystickFigure 1: The Mann “Hockey Stick”

In 2009, Mann was embroiled in what became known as “Climategate” – this article (https://wryheat.wordpress.com/2017/12/12/climategate-comes-back-to-bite-the-university-of-arizona/) by Jonathan DuHamel (another scientist with whom I’ve had much dialogue) does a good job of summarizing what happened.  Here’s the key quote:

There are problems with the Hockey Stick according to Canadian researchers Steve McIntyre and Ross McKitrick. “The first mistake made by Mann et al. and copied by the UN in 2001 lay in the choice of proxy data. The UN’s 1996 report had recommended against reliance upon bristlecone pines as proxies for reconstructing temperature because 20th-century carbon-dioxide fertilization accelerated annual growth and caused a false appearance of exceptional recent warming. Notwithstanding the warning against reliance upon bristlecones in UN 1996, Mann et al. had relied chiefly upon a series of bristlecone-pine datasets for their reconstruction of medieval temperatures. Worse, their statistical model had given the bristlecone-pine data sets 390 times more prominence than the other datasets they had used.

Furthermore, the statistical algorithms in Mann et al. where shown to be flawed. McIntyre ran the Mann’s algorithm 10,000 times, having replaced all palaeoclimatological data with randomly-generated, electronic “red noise”. They found that, even with this entirely random data, altogether unconnected with the temperature record, the model nearly always constructed a “hockey stick” curve similar to that in the UN’s 2001 report.” 

I am in the middle of a book entitled The Hockey Stick Illusion by A.W. Montford, which delves into his methodology in great detail.  In short, Mann not only used cherry-picked proxies (like tree rings from specific pines in very specific locations), he also used an algorithm that effectively over-weighted near-term trends and under-weighted history, which effectively erased the so-called Medieval Warm Period (MWP) – a 300-year period during which temperatures were significantly warmer than they are now. See Figure 2 below, also taken from Jonathan’s article:

battle-of-the-graphs

Figure 2: Mann’s “Hockey Stick” Compared With Other Temperature Reconstructions

I bounced this “Climategate” article off Professor Giegengack, and here is his response:

I saw the Mann, Bradley, Hughes curve when it was published, and I was immediately struck by the absence of the well-documented Medieval Warm Phase and the Little Ice Age.  The graph was on the cover of the 2001 IPCC summary, but absent from subsequent IPCC reports.  Mann has become embroiled in a series of lawsuits, based in part on reaction to the hockey stick, and in part on the emails hacked from the Climate Research Unit.  Mann has declined to share his raw data with several critical statisticians, and then announced that data had been lost. Bradley and Hughes have not leapt to the defense of their co-author.

To be fair, I have since seen many rebuttals to this rebuttal that have come to Mann’s defense (one of them is here: http://berkeleyearth.org/summary-of-findings/).  In my opinion, the fundamental problem with all of these analyses is that they rely upon arbitrarily incomplete data sets. The earth is 4.5 billion years old — with Coase’s “data torturing” quote in mind, I keep wondering why people continue to arbitrarily pick incomplete data sets to present their AGW conclusions.

The Big (Phanerozoic) Picture

In my many correspondences with Professor Giegengack, I learned the importance of considering the big picture -- necessary for the topic of climate change which is, at its heart, a geologic process requiring a geologic time scale.  Figure 3 is a chart of atmospheric CO2 concentration over the last 450 million years – a period referred to as “Phanerozoic time.”  Figure 4 is a regression of atmospheric CO2 concentration against temperature proxies over this period.

There are some interesting conclusions to be drawn and questions raised:

1. CO2 concentrations have been much higher than they are now (currently around 420 ppm, or 0.04% of the atmosphere).

2. CO2 concentration correlation to historical temperature proxies is zero to negative throughout the eons.  If this is the case, what else could be causing the current GW?

3. The Earth teemed with life during these periods of much higher CO2 concentration, but did these spikes in CO2 corroborate with mass extinctions?

4. To put things in perspective, homo sapiens have been around only 200,000 years.  The Agricultural Revolution began around 12,000 years ago, and the Industrial Revolution began about 170 years ago.  Most of the “Hockey Stick” analyses arbitrarily focus on a negligible period on the geologic time scale.

5. The implication here, of course, is that the current bout of GW might not be anthrogenic; if that is the case, many of the proposed solutions predicated upon curbing CO2 emissions (many of which come at great economic/human cost) as the answer to halting AGW might be based on a fundamentally flawed thesis.  If CO2 is the wrong variable to solve for, what is the “right” variable to solve for?

co2

Figure 3: Atmospheric CO2 Concentration over Phanerozoic Time

co2 regression

Figure 4: Regression of Atmospheric CO2 Against Temperature Proxy

Questions Abound

This next section attempts to answer some of these questions, and I will present it in a Q&A format.

Question 1: If anthrogenic CO2 is not the cause of GW, what else could be causing the current GW?

From my readings, there are many, many variables that affect the climate, with no one variable claiming any disproportionate effect.  Correlation does not mean causality, as much as the “Hockey Stick” analyses would like to conclude, and what makes those claims even more suspect in my opinion is the use of arbitrarily limited data sets that just happen to coincide with the beginning of the Industrial Revolution.

Professor William Happer of Princeton, in his testimony to the U.S. Senate Environmental and Public Works Committee in 2009, stated:

The existence of climate variability in the past has long been an embarrassment to those who claim that all climate change is due to man and that man can control it. When I was a schoolboy, my textbooks on earth science showed a prominent medieval warm period at the time the Vikings settled Greenland, followed by a vicious “little ice age” that drove them out. So I was very surprised when I first saw the celebrated “hockey stick curve,” in the Third Assessment Report of the IPCC. I could hardly believe my eyes. Both the little ice age and the Medieval Warm Period were gone, and the newly revised temperature of the world since the year 1000 had suddenly become absolutely flat until the last hundred years when it shot up like the blade on a hockey stick. This was far from an obscure detail, and the hockey stick was trumpeted around the world as evidence that the end was near. We now know that the hockey stick has nothing to do with reality but was the result of incorrect handling of proxy temperature records and incorrect statistical analysis. There really was a little ice age and there really was a medieval warm period that was as warm or warmer than today.

Many of us are aware that we are living in an ice age, where we have hundred-thousand-year intervals of big continental glaciers that cover much of the land area of the northern hemisphere, interspersed with relative short interglacial intervals like the one we are living in now. By looking at ice cores from the Greenland and Antarctic ice sheets, one can estimate past temperatures and atmospheric concentrations of CO2. Al Gore likes to display graphs of temperature and CO2 concentrations over the past million years or so, showing that when CO2 rises, the temperature also rises. Doesn’t this prove that the temperature is driven by CO2? Absolutely not! If you look carefully at these records, you find that first the temperature goes up, and then the CO2 concentration of the atmosphere goes up. There is a delay between a temperature increase and a CO2 increase of about 800 years. This casts serious doubt on CO2 as a climate driver because of the fundamental concept of causality. A cause must precede its effect.

The full testimony can be found here: http://carbon-sense.com/wp-content/uploads/2009/09/happer-testimony.pdf

I also came across a paper entitled “Climate Change In Perspective” by geologist Jonathan DuHamel who runs a blog called Wryheat (https://wryheat.wordpress.com/about-2/).  In it, Jonathan describes many of the same issues raised about the disappearance of the Medieval Warm Period, the lack of long-term correlation between CO2 and temperature, but he also presents other explanatory variables for the Earth’s climate change including the 3 Milankovitch cycles of the sun, which are long-lived cycles spanning 23,000 to 100,000 years.

Here is Jonathan DuHamel’s “Climate Change In Perspective” paper:

https://wryheat.files.wordpress.com/2018/01/climate-change-in-perspective-2018.pdf

I shared the paper with Professor Giegengack and got this response:

I agree with most of which DuHamel says in the article you sent me. He knows a lot more than I do about some of the atmospheric processes he describes.  I have some thoughts about his statements about sea level and the history of CO2 in the Phanerozoic atmosphere.

As I will lay out, my study of a longer time perspective has convinced me 1) that there are many good, fully defensible reasons to stop using fossil hydrocarbons as “fuel”, and 2) that our pre-occupation with AGW has kept us from addressing many environmental problems that are more immediate and more threatening to human welfare than AGW, and can be addressed with resources and technology now at our disposal.  We are barking up the wrong tree!!!

We can’t “stop climate change”, or “reverse global warming.”  Nothing we are doing, or even contemplating doing, will have a measurable effect on the atmospheric concentration of CO2 for many years, probably centuries.  Climate will continue to change.  If we run out of extractable hydrocarbons, or if we choose to stop burning hydrocarbons, we will have the opportunity to wait centuries to see if reduced CO2 emissions will have a measurable effect on global climate.  Meanwhile, we will have learned, again, to adapt to changing environmental conditions.

Finally, Freeman Dyson is a highly respected Princeton physicist who is politically a Democrat, yet he is one of the most prominent AGW skeptics.  Dyson believes that it is hubristic to think that we can predict climate change or that we can meaningfully alter it.  He also calls into question the entire presupposition that more CO2 is bad for the earth.  I perk up when retired academics with impeccable pedigrees like Dyson and Giegengack speak up, because that they have no other “dog in the hunt” other than to pursue “academic purity”  -- sadly this claim cannot be made for many of the scientists/researchers on either side of the climate change debate.

This interview with Freeman Dyson is worth a watch: https://youtu.be/BQHhDxRuTkI

Question 2: Did past spikes in CO2 cause the mass extinctions? Isn’t only recent history relevant since what’s good for “green slime” isn’t necessarily good for humans?

This is how Professor Giegengack answered this question:

A lot of things happened at and around the end-Paleozoic mass extinction event.  It has proven frustrating to separate out cause and effect. An atmospheric CO2 spike is more likely to have been an effect of a mass die-off than its cause.  The PETM (Paleocene-Eocene Thermal Event) of ~55 million years ago shows both a brief (~200,000-year) CO2 spike and an equally brief temperature excursion.  There is no agreement as to what “caused” the PETM, but lots of people are trying to use the PETM as a means to get on the AGW bandwagon. One hypothesis for the PETM is collapse of a continental shelf that would have released gaseous CH4 from the mass of methane hydrate that is accumulating within the shallow sedimentary column off many of the world’s coasts.  A sudden landslide would have lowered confining pressure, and released billions of tons of methane from the methane-hydrate molecular structure. CH4 is a “potent” greenhouse gas, but a short-lived chemical species.  That CH4 spike would have been quickly oxidized to CO2, also a greenhouse gas, and the feedback effect might have kept Earth warm for the requisite 200,000 yrs. Atmospheric levels of both CH4 and CO2 would have returned to pre-landslide values at the end of those 200,000 years.

Under much higher CO2 concentrations than 180-400 ppm, plants and animals very much like what we have now thrived.  Green slime was much earlier; we have no reliable reconstructions of atmospheric chemistry for “green-slime time.”

Again, most studies supporting AGW I have seen arbitrarily use time periods that correlate with human existence and in some cases choose to only show the last 200 years – this would equate to focusing on the just last couple seconds of a 470-day period if each day was equivalent to 1 million years!  In fact, I have yet to see one pro-AGW study that takes Phanerozoic time scales into account.

Question 3: If CO2 increases have little effect on temperatures and may even lag temperature increases, could rising CO2 concentration itself be dangerous?

Giegengack:

Analyses of stomatal density for the period during which fossils of land plants are available (the last ~470,000,000 years) show that atmospheric concentration of CO2 has been as high as 7,000 ppm (Ordovician-Silurian) and fell as low as 180-400 ppm only in the last few million years.  The error bars are large, but probably a “good” average value for atmospheric CO2 over the last 470,000,000 years would be 2500-3000 ppm.  As I (may have) pointed out in an earlier note, commercial greenhouse operators in USA and Europe routinely maintain a level of ~1500 ppm in their growing spaces to enhance photosynthetic productivity. It seems that higher levels of CO2 confer no additional benefit.

Some people have chosen to describe CO2 as a pollutant, and refer to “carbon pollution.” The implication, by some, is that levels of atmospheric CO2 higher than the pre-industrial value may be injurious to human health, because higher levels of CO2 have not prevailed through the period of rise of human civilization (the last ~10,000 years). But the atmospheric concentration of CO2 through the 8 glacial/interglacial cycles now documented from the Antarctic ice cores, 170-280 ppm, is probably the lowest that CO2 concentrations have fallen in Phanerozoic history (the last 540,000,000 years). Some students of the carbon cycle (e.g. Will Happer) have suggested that the world is on the verge of a “CO2 crisis,” as atmospheric levels of CO2 fall low enough to compromise photosynthesis.

At what concentration is CO2 an atmospheric “pollutant”?  400 ppm is only 0.04% of the atmosphere. Oxygen remains at 21%. Water vapor can rise as high as 4%.  By any measure, CO2 is in the atmosphere as a “trace” component, but nonetheless an essential component.  It is disingenuous, and deliberately misleading, to refer to CO2 as a “pollutant.”

Nobody knows more about the chemistry of breathing mixtures than the US Navy, who operate nuclear submarines that can remain submerged for months at a time.  A healthy breathing mixture is maintained in submarines by scrubbing CO2 out of the interior atmosphere, and adding O2 as needed. The US Navy Submarine Guidebook that I last saw instructs submarine commanders to surface and vent the interior atmosphere if the CO2 concentration reaches 7,000 ppm, or 17 times the current atmospheric concentration of 400 ppm. (The US Navy has measured “some cognitive impairment” at ambient levels of CO2 above 7,000 ppm)

At ~60,000 ppm, CO2 in the atmosphere becomes lethal, because metabolic CO2 cannot be transferred across lung epithelial cells to be exhaled when the concentration in the inhaled air becomes that high.  60,000 ppm is 150 times the current concentration of CO2 in the atmosphere. If words have meaning, CO is not a “pollutant.”

If the average atmospheric CO2 concentration over the last 470 mm years was 2500-3000 with a high of 7000, and the “recent lows” of 170-180 ppm were the lowest in Phanerozoic history during which life flourished, this begs the question: why is the current 420 ppm an “existential crisis”?  My market analogy would be this: imagine a stock that averaged $25-$30 (after hitting a high of $70) over 470 days crashing down to $1.70 in the last 12 hours (each “day” in my analogy is equivalent to 1 mm years, so each hour = 41,000 years), where it bounced around between $1.70 and $3 for a couple hours.  In the last 40 minutes (~25,000 years ago to now), the stock popped up to $4.20 – does this rally portend a return to anywhere close to the long-term average?  Not so sure about that.  Curiouser and curiouser.

Question 4: I’ve read about some regenerative agricultural initiatives (https://terraton.indigoag.com/about)  that claim to be “the answer” to AGW by sequestering CO2 in the soil. Thoughts?

Giegengack:

Most students of the C cycle would agree that the amount of C now resident in extractable fossil fuels that would be transferred to the atmosphere if all those hydrocarbons are combusted is more than the world’s soils can hold, regardless of whatever process might be used to sequester that C in the soils.  It’s a good idea, but if anthropogenic CO2 is the primary cause of contemporary climate change, soil sequestration of C will not “save” us.  Sure, our agricultural technology, which evolved without much concern for long-term sustainability, is inefficient and destructive.  We know how to “reform” that industry in ways that will allow photosynthesis to take excess CO2 from the atmosphere and store it in soil, standing vegetation, etc. etc. We are beginning to do that, on a modest scale.

Photosynthesis is slow and inefficient (~1-2%), but it works. It will take photosynthesis a long time to store away the “excess” CO2 that human industry has dumped into the atmosphere. One way or another, the allocation of C among Earth-surface reservoirs will probably return to what we have described as a “pre-industrial” concentration, but not in a time frame consistent with what is now almost universally described as an “existential threat.” However, the pre-industrial concentration (280 ppm) is very low compared to the history of CO2 concentration in the atmosphere, and is approaching the level at which photosynthesis  may struggle to transfer essential CO2 to plant tissues. At the very least, at concentrations below 280 ppm, increase of stomatal density in land plants will make those plants more vulnerable to drought stress. [Commercial greenhouses now routinely maintain a CO2 level of ~1500 ppm in the growing space]

There are lots of very compelling reasons to reform global agriculture. That reform will be far too slow to reverse what is now widely described as a dire emergency. I see no evidence to support the assertion that the temperature change since ~1825 AD must be attributed to anthropogenic CO2.  It would be a stunning coincidence if the myriad processes that we know have controlled Earth’s climate for a very long time suddenly all ceased to operate ~200 years ago just to accommodate our need to attribute climate change to  anthropogenic emissions.  Yes, we must reform modern industrial agriculture. To invoke climate change in that argument is a counter-productive distraction.  What happens when we do all those good things and climate does not respond as we predict it will?

To me, this last paragraph is key.  It seems premature to tackle the “how” when it is not clear that the “why” we are solving for is the right “why.”

Question 5: If CO2 is indeed the wrong variable to solve for, what is the “right” variable to solve for? What can/should be done?

Giegengack:

My “geoengineering” solution:  Plant vast areas of the Earth’s surface with eucalyptus trees, known to be the most efficient plant to fix carbon as woody tissue via photosynthesis.  Allow those trees to reach “maturity,” the size/distribution at which they lose C as fast as they fix it, or about 50 years.  Cut down those trees, float them down rivers to the ocean, tie them up in giant rafts, inoculate those rafts with oyster spawn (to allow CaCO3 shells to grow attached to the rafts), pile the rafts high with industrial organic waste, and tow those rafts (slowly, to save energy) to locations over major subduction zones (e.g. Puerto Rico, Aleutian, Mindanao, Marianas, etc. trenches), and let the rafts grow waterlogged and sink, to be recycled through the Earth’s mantle and eventually to return to the Earth’s surface as volcanic CO2 30-150 million years in the future.  To “recycle” via this mechanism the 7.5 billion tonnes of C/yr now delivered to the atmosphere as CO2 via anthropogenic processes would require that we dedicate to eucalyptus cultivation an area the size of Australia (we would cut down, and re-plant, 1/50 of that area each year).  Tall order.

Increased/decreased desertification; melting/growing ice caps have been features of Earth history as long as irregularities in orbital trajectories of planets in the Inner Solar System have driven cyclic climate change on Earth.  We might “stop” those cycles, or at most reduce their amplitude, by altering the orbit of Mars so that it would always remain at 90° to the position of Jupiter.  Or else, we might reduce the amplitude of cyclic climate variation by moving the Antarctic continent off the South Pole.  This would allow equatorial warmth to be transferred to the pole via ocean circulation, and would eliminate “permanent” snow/ice from the South Pole. Thus, the reflectivity of Earth would be reduced, and open water in the southern ocean would absorb more solar radiation. [Of course, global sea level would rise ~90 m when the Antarctic ice sheet melted.  Oh, well, we can’t have everything….]

The professor may well have been facetious in advancing these implausible solutions, but maybe that was his point – that maybe there really is nothing we can feasibly do to influence the climate (at least at reasonable cost) by manipulating just one variable that is far from being established as the clear-cut “right” variable to solve for.

Question 6: What about all the extreme weather events we’re reading about almost daily in the media? Isn’t that due to climate change?

I recently saw a fascinating presentation on climate change, entitled “Climate Change: Does The Data Support The Mania?” given by Chris Wright, a successful energy entrepreneur who is also an engineer and self-professed “climate geek.”  Although this was not the exact venue I was at, the presentation is nearly identical: https://m.youtube.com/watch?v=WY00mrMGFVE

Chris, like me, is a fan of using complete data sets and has given me permission to share this slide (Figure 5) from his deck, which shows that the data around “unprecedented” weather disasters doesn’t really support the media hype.

extreme weather

Figure 5: Extreme Weather Events Not Corroborated by Data

As a resident of California, I’m no stranger to wildfire risk.  In fact, I was evacuated for a week during the Woolsey fire of 2018, and many of my friends were evacuated during the fires of 2019.   While it’s tempting to cast blame on “climate change” as the culprit for “unprecedented” wildfires (as the media and politicians love to do), the actual fire data dating all the way back to 1926 (as collected by the National Interagency Fire Center, NIFC) points in the opposite direction: https://www.nifc.gov/fireInfo/fireInfo_stats_totalFires.html.

Somewhere along the line (specifically around the time of the Agricultural Revolution 12,000 years ago), we humans stopped adapting to climate change and running away from disasters.  Perhaps that is why it is so easy for the media to wax hyperbolic about “extreme weather” when it really hasn’t been extreme at all.  Channeling my inner Star Wars geek, imagine that we lived on a planet like Coruscant which is one gigantic planet-wide metropolis; even a once-in-a-century natural disaster would be heralded as “unprecedented” and “extreme” simply because there would be no place to hide!  Maybe we should be spending more money on adapting to climate change versus trying to change it.

Summary Points

We’ve covered a lot of ground here, so I’m going to try to summarize my learnings in the following bullets:

  • This has become a politically divisive topic.  Both sides of the debate have come out with countless rebuttals of the other side, and it is admittedly difficult to cut through the political noise.  I have learned that no matter what “proof” someone comes up with, there always seems to be someone with a rebuttal “debunking” or “discrediting” someone else.  My North Star in my quest to cut through the obfuscation rests upon 3 factors:
    • Reliance upon complete data sets whenever possible
    • Questioning studies that pick arbitrary starting points for analysis
    • Examining underlying incentives and motivations and paying particular attention to authorities with “no dog in the hunt”
  • GW is real, and the planet is currently in a warming trend — but the Earth has been in cooling and warming cycles countless times before and will continue to do so regardless of what humans do.
  • Be wary of studies that conflate correlation with causality – especially over arbitrarily short time periods.  The modern AGW movement originated with the so-called Mann “Hockey Stick” which was produced using questionable/controversial techniques.  That Mann presided over his own “peer review” for the IPCC Third Assessment severely calls into question the credibility of that body in my opinion.  I’m very wary of sources that have financial/career incentives that are direct beneficiaries of policies supported by their findings.
  • Despite all the defenses of the Mann “Hockey Stick,” I have yet to see a study that incorporates “Phanerozoic time” (the last 500 mm years) that still asserts that today’s temperatures/CO2 concentrations are “unprecedented.”
  • Based on everything I have read, I believe CO2 is one of potentially thousands of variables that play a part in determining the Earth’s temperature, but it does not appear to be a statistically significant variable in and of itself (Figure 4), so the “Anthrogenic” in “AGW” seems suspect.
  • Many people conflate CO2 with air pollution, but that is just factually incorrect.  Where I suspect people get confused is that while it is true that the particulate emissions resulting from burning hydrocarbons can be “dirty,” the CO2 emissions themselves don’t appear to be the culprit many in the media or political realms claim.  Despite the fact that hydrocarbons have become much cleaner over the last century and have at the same time brought cheap energy abundance to billions, modern politics has latched onto CO2 as the bogeyman responsible for everything from floods and fires to malaria and drought.
  • To quote Professor Giegengack: CO2 at  400 ppm is only 0.04% of the atmosphere. Oxygen remains at 21%. Water vapor can rise as high as 4%.  By any measure, CO2 is in the atmosphere as a trace component, but nonetheless an essential component.  It is disingenuous, and deliberately misleading, to refer to CO2 as a pollutant.”
  • The Earth has been much warmer and has had much higher CO2 concentrations (Figure 3) long before the Industrial Revolution – yet life flourished. As Dyson and Giegengack both point out, it’s not clear whether more CO2 is bad or good for life. There’s a lot of evidence for the latter (see next bullet).
  • To put “400 ppm” into perspective, again requoting Giegengack, “atmospheric concentration of CO2 has been as high as 7,000 ppm (Ordovician-Silurian) and fell as low as 180-400 ppm only in the last few million years…probably a “good” average value for atmospheric CO2 over the last 470,000,000 years would be 2500-3000 ppm [The] atmospheric concentration of CO2 through the 8 glacial/interglacial cycles now documented from the Antarctic ice cores, 170-280 ppm, is probably the lowest that CO2 concentrations have fallen in Phanerozoic history (the last 540,000,000 years). Some students of the carbon cycle (e.g. Professor Will Happer of Princeton) have suggested that the world is on the verge of a “CO2 crisis,” as atmospheric levels of CO2 fall low enough to compromise photosynthesis.”  You heard right – some reputable scientists think our level of CO2 might be too low.
  • Despite all of these factors, there are extremists who just choose to focus on the 50% increase from 280 ppm to 420 ppm (while ignoring the 2500-3000 ppm average and 7000 ppm high) and claim that unless we take action now to get back to 300 ppm or below, the Earth’s very existence will be threatened.  Again, putting things into perspective, this is saying that if we don’t get a trace element down by 0.01% (the difference between 400 ppm and 300 ppm) we will face extinction.  The paleontological record says otherwise.
  • Not only does the statistical correlation appear weak, the direction of causality appears backward.  CO2 concentration increases appear to follow and not precede temperature increases to the tune of an 800-1000 year lag.  Both DuHamel and Happer papers cited earlier say this, and Professor Giegengack corroborates this as well.
  • The DuHamel paper also does an excellent job of explaining the logarithmic effect (diminishing returns) of increasing CO2 concentrations on temperatures -- even if we are causing anthrogenic GW through CO2 emissions, it would have smaller and smaller effects at higher and higher concentrations.
  • Yes, there are negative externalities to hydrocarbon use, but there are also negative externalities to solar and wind, because these are intermittent sources of energy that require battery storage.  Current battery technologies require lithium and cobalt, the mining and disposal of which requires hydrocarbon energy as an input, is harmful to the environment in its own way, and is done in politically unstable countries (Bolivia and Congo) with questionable labor practices.  Furthermore, unless EV’s get their electricity from all-solar electric plants with no hydrocarbon-burning baseload, the CO2 emissions just move from the freeway to the power plants.  Think about that when you see a Tesla license plate boasting “Zero Emissions.”  There is no legitimate discussion without weighing all factors, and this article sums up some of the externalities I talked about: https://www.weforum.org/agenda/2019/03/the-dirty-secret-of-electric-vehicles/
  • Nuclear is the only energy source currently that can supplant hydrocarbons from an energy density/non-intermittency standpoint but environmentalists hate nuclear even more than coal – likely because the externalities are much more violent and obvious (e.g. a meltdown like Chernobyl or Fukushima).
  • Despite the “shale miracle” that brought cheap oil to the world, the world is still energy starved, with 2-3 billion people who still lack basic cheap electricity which can really only be delivered via hydrocarbons. There is also no legitimate discussion about “climate change solutions” unless you consider the effects of removing hydrocarbons from an energy-starved world.  The developing world would most assuredly feel a disproportionate effect from such policies. 
  • In terms of solutions, I believe that money is far better spent on how to adapt to inevitable climate change instead and making hydrocarbons cleaner instead of quixotically attempting to curb CO2 emissions, which again seems like the wrong variable to solve for.  Prior to the Agricultural Revolution of 12,000 years ago, humans adapted to inhospitable environments simply by moving. That all changed when we set down our agrarian roots and decided to populate ever-denser urban centers.  So even though the data do not support “unprecedented” storms or fires, they feel a lot worse because we no longer flee inhospitable environments like we used to, i.e. we stopped adapting to the environment and started blaming climate change for our problems.  Instead of forcing mitigation of a chimerical variable like CO2 by curbing hydrocarbon use (which would bring untold misery to billions) it may be more productive to pour funds into adaptation, e.g. how better to weather fires, droughts, floods as well as how best to harvest hydrocarbons more efficiently with less particulate pollution (again, CO2 is not a pollutant).

ESG Investing & Disruption of Hydrocarbons

  • There has been a lot of attention in the press recently regarding ESG investing.  Blackrock’s big announcement has been all over the news (https://apple.news/A51l0EY9yTq6Qf9kfGl8Ecg).  Climate change has become the centerpiece at Davos.  I think this is both a significant and potentially treacherous development.  As I alluded to at the outset, I believe politics should never drive investing, but when they do markets/sectors run the risk of getting distorted and divorced from economic reality.  That said, there may be ESG investments that prove to be very sound – I believe fundamental economics will be the primary determinants of that soundness and not politics.  Investment theses need to be viable without government subsidies, and it is not clear that we are there yet (here is one example: https://www.bloomberg.com/amp/news/articles/2020-01-13/electric-car-stocks-jump-as-china-signals-lull-in-subsidy-cuts).
  • On the investment side, I’m constantly in search of reasons to invalidate my cyclical call on the oil & gas sector.  This whole debate has gotten me thinking much more about the possibility of secular disruption, but it’s not apparent to me whether a) the advent of renewables will be evolutionary or revolutionary (disruptive), and b) how best to play those themes.  Not only are there polar opposite schools of thought regarding the level and speed of disruption, economics of certain verticals like solar are still heavily distorted by China’s willingness to lose money in order to dominate that market.  I have not yet identified an obvious part of the supply chain that to me will benefit disproportionately in terms of ability to extract economic rents consistently.  Please let me know if you do!
  • Tony Seba, an author and evangelist of “clean energy,” is a true believer of rapid disruption of the oil & gas and auto industries by renewables and EV’s: https://youtu.be/6Ud-fPKnj3QSeba is a big believer in S-curve adoptions and believes that the energy and auto industries will be rapidly disrupted by the confluence of rapidly declining costs of EVs and autonomous driving.  If he is right, the oil & gas and internal combustion engine (ICE) industries may not exist in 5-10 years.  Humorous aside: the last time I heard so much “S-curve” talk was when George Gilder pronounced, circa 1999, that fiber optics stocks like JDS Uniphase (JDSU, also known as “Just Don’t Sell Us”) would rule the world forever because of similar S-curve predictions of the Internet adoption.  While the Internet did change the world, there was also a spectacular crash of “New Economy” stocks that were the disruptors.  I am not a Luddite – just a contrarian investor that is skeptical of the risk/reward of some of the disruptor business models.
  • Mark P. Mills, a senior fellow at the Manhattan Institute and a faculty fellow at Northwestern University’s McCormick School of Engineering and Applied Science, wrote a paper entitled ‘The "New Energy Economy": An Exercise in Magical Thinking’ (https://www.manhattan-institute.org/green-energy-revolution-near-impossible) in which he argues very persuasively that “systems that produce energy and those that produce information” have profound differences based on physics that make any near or even medium-term disruption impossible, because “in the world of people, cars, planes, and factories, increases in consumption, speed, or carrying capacity cause hardware to expand, not shrink” as is the case with bits, which is why Moore’s Law works in that realm but not in the energy realm.
  • In particular, Mills makes a point about hydrocarbons which I have mentioned in past Kaoboy Musings: that nature has already invented the perfect “battery” in terms of energy density, transportability, storability and now low-cost thanks to the shale revolution.  “In practical terms, this means that spending $1 million on utility-scale wind turbines, or solar panels will each, over 30 years of operation, produce about 50 million kilowatt-hours (kWh)—while an equivalent $1 million spent on a shale rig produces enough natural gas over 30 years to generate over 300 million kWh.”
  • That said, I think renewables will benefit society, because as I stated many times, a large chunk of the world is energy starved. Any new energy sources are good energy sources.
  • Meanwhile, I believe that the world will not even come close to weaning itself from hydrocarbons any time soon, whether you believe in AGW or not. I think that it will take a lot longer to supplant hydrocarbons as the world’s primary energy source.  Solar and wind are great except for intermittency, so the gating factor comes back to utility-scale battery storage, which in turn is constrained by lithium and cobalt mining and disposition (I already mentioned the externalities).  Quoting Mark Mills: The annual output of Tesla’s Gigafactory, the world’s largest battery factory, could store three minutes’ worth of annual U.S. electricity demand. It would require 1,000 years of production to make enough batteries for two days’ worth of U.S. electricity demand. Meanwhile, 50–100 pounds of materials are mined, moved, and processed for every pound of battery produced.”
  • Bottom-line: I think we are a long way from a fully solar-powered grid that can store enough power to avoid the need for a hydrocarbon-based baseline capacity.  And if we are a long way off, forget about the developing world where 2-3 billion people lack basic electricity from any source!
  • As an aside, look no further for a poster-child riding the crest of ESG than TSLA, which trades at a stunning 128x 2020 estimated earnings.  I think part of the reason for TSLA’s bubblicious valuation is that there is no obvious pure-play winner anywhere else.  With TSLA stock hitting $580+/share and approaching $110 bn in market capitalization (vs. GM’s $50 bn) and shareholders making the case for $6000/share on CNBC (yes, that would be over $1 trillion in market cap!), the expectations built into TSLA’s valuation are downright reminiscent of the 1999 era.  Meanwhile, oil & gas stocks trade at a moribund 2-4x EBITDA, are inflecting to free cash flow, and collectively as an entire industry are still worth less than AAPL alone!  I’ve never seen a relative market distortion of this magnitude.  Maybe I’m the “Old Economy” toad that doesn’t realize the “New Economy” pot I’m sitting in is boiling until it’s too late, but a lot has to go right for TSLA and a lot has to go wrong for oil & gas over the next several years for this to persist. 

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Happy New Year! / Oil As A Safe Haven / Take Your Minerals Supplements / Going On-line!

 

Happy New Year!

What a difference a year makes.  In Q4’18, the market dropped 20% up until Christmas Eve, before recovering about 5%, bringing the Q4’18 loss to just under 15% and finishing the year with a ~6% loss and a lot of people calling for global recession.  In Q4’19, the market rip accelerated into year-end, adding 10% to an already strong year to end with a whopping 29% gain on year – one of the best performances for the decade.

A couple key takeaways here: 1) a lot can change during the course of a year, so resist the urge to straight-line current trends and, 2) don’t always believe the consensus (which was climbing a wall of worry and calling for global recession)!

One of the biggest worries I always had as a fund manager at this time of year was performance anxiety.  Not that performance anxiety, but worrying about either 1) how to make up a bad year, or 2) what to do for an encore after a good year.  One year into managing my own capital as opposed to being a fiduciary for investor capital, I have to say that even though some old habits die hard, on this front at least, I am far less obsessive over an arbitrary demarcation point on the calendar.  I don’t really care whether it’s quarter-end or year-end anymore – I just want my portfolio to grow over the long-term, and I’m much more at peace with resisting FOMO and being patient.

That all said, my goal is to constantly upgrade my portfolio and optimize for risk/reward – this is one of those old habits that die hard.  What should one do now given the headiness of the markets (now trading close to 19x forward earnings) and the fact that the once-contrarian view (that we’re not going into recession, which I’ve been saying since Kaoboy Musings 3) is now becoming consensus?

 

 

Oil As A Safe Haven

As I alluded to in Kaoboy Musings 10, 15-17, I believe a relatively low-risk way of participating in a global economy that may now be reflating after the trade headwinds of yesteryear is to bet on the worst-performing sector of the last 5 years – the down-beaten oil & gas sector.  Since 10/29/19 when I first opined about the opportunity in Kaoboy Musings 10, the sector as represented by the XOP ETF has gone up “only” 10%, although it first went down 10%.  The nadir was reached on 12/3/19, and the XOP rallied 20% since, with some of the names I track up 35-40% in the last month!

For all of the reasons I listed in Kaoboy Musings 17, I still think it’s early days for this particular thesis – especially if I’m right about the global economy reflating after a protracted period of trade-negotiation inspired headwind.

I listed two primary risks to my oil thesis: 1) the risk of global recession, and 2) a removal of Iranian sanctions. 

Risk #1 was greatly reduced with the Phase 1 deal with China – the naysayers say this deal didn’t accomplish much; my rebuttal: it didn’t have to accomplish much – it just had to stop getting in the way of an otherwise strong economy.  There are signs that this reflation is already under way: https://www.bloomberg.com/news/articles/2019-12-27/china-s-economy-picked-up-in-december-early-indicators-show.

Risk #2 was a bigger wildcard in my opinion, because if the past is any guide, Trump’s market sensitivity has proven to be a great predictor of policy.  Alas, I remember all too well how he sanctioned Iran in 2018, initially signaling “no possibility of waivers,” leveraged Saudi Arabia’s political weakness in the face of the Khashoggi murder to get them to open the spigots to make up for the inevitable loss of Iranian barrels, and then at the last minute granted waivers anyway – this is exactly what caused the oil collapse from $77 to $42 in December of 2018.

This year, with the attacks on Abqaiq in September pointing suspiciously to Iran, the U.S. chose not to escalate tensions in the Middle East by conspicuously not coming to Saudi’s aid to retaliate against Iran.  After an initial spike to the mid-60’s, oil fell right back to $50 on the lack of escalation and on Saudi’s assurances that “everything was fine” and that production would be fully back on-line in a month.  This always seemed suspicious to me, and we’ve since learned that Saudi Arabia did a masterful job of finessing the press on its reliability as a supplier due to its impending Aramco IPO but that it also decided to unilaterally “over-comply” to its already agreed-upon cuts at the OPEC meeting; as I wrote in my last musing, I think this is based on a very real need for Saudi to restock its storage that it used to shock-absorb the lost production from Abqaiq.  This has created a dynamic of supply tightness that is only going to get exacerbated with the pickup in global demand from reflation, the rolling over of Permian production, the lack of major projects for the last 5+ years, etc.

To me, the only real source of spare capacity in the world is Iran, which has effectively been shut-in on 1.8 mm bbls/day of production due to the sanctions.  With Trump knowing that Saudi is now “once bitten, twice shy” after the December 2018 head-fake and the fact that it is now on its own with respect to defending itself from attacks, I figured that the obvious lever for Trump to pull was to re-open negotiations with Iran and make a deal, hence my caveat.

The probability of lifting Iranian sanctions went to almost zero given the events of last week, culminating in today’s big headline about the surprise drone strike that took out Qassem Soleimani, Iran’s top general in the IRGC (Islamic Revolutionary Guard Corps).  The escalation actually began on 12/27 when a U.S. civilian contractor was killed in Northern Iraq by Iranian-backed militia.  On 12/29, the U.S. responded with airstrikes in Iraq and Syria against this same Kataib Hezbollah group.  On 12/31, pro-Iranian protesters broke into the U.S. embassy in Baghdad, evoking memories of Benghazi.  On the evening of 1/2, when U.S. intelligence found out that Soleimani himself was visiting Baghdad (possibly to incite further unrest), Trump gave the order to launch the drone strike that took out this target.

Although crude only closed up 3% today, note that it was already off the back of a steadily rising price due to the tightening supply/demand dynamic.  Coincidentally, today’s closing price of $63.05 WTI is almost exactly the closing price of oil on the day of the Abqaiq strike on 9/16.  See chart below:

oil spike.jpg

This time, I think the market is under-appreciating the significance of this escalation, perhaps because of the post-Abqaiq correction.  Unlike Abqaiq, where the U.S. chose a path of de-escalation, the Administration has now crossed the Rubicon with this attack by making it very clear that it would draw line at the loss of American life.  What remains to be seen is how Iran will retaliate and how this situation will escalate.  Suffice to say that the probability of Iranian barrels returning  to the market just went way down – this time likely without a Saudi shock absorber. 

Geopolitical instability has become an increasing source of concern for me, and I have been thinking about how to balance these risks against the otherwise bullish theme of global reflation.  Aside from current headline-grabbing Iranian news, the world was beset by an unusually large amount of “protest pockets” in 2019.  This article (https://www.voanews.com/americas/global-protests-2019-demonstrators-around-world-demand-reform) has an eye-opening chart:

 

Global Protests in 2019.jpg

 

Not surprisingly, many of these pockets of unrest stem from dissatisfaction with governmental corruption and crackdown on personal freedoms.  Between a fully-priced stock market and escalating geopolitical tensions around the world, we are one major terrorism act away from a severe correction in many pro-cyclical sectors – especially tourism and travel-related.  From an investment perspective, while it may be tempting to bail out of the market for these reasons, as Peter Lynch is famous for saying:  “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”  My solution?  Invest in a sector that not only is attractive in and of itself (Kaoboy Musings 17 has a good summary of all the reasons) but is also potentially a direct beneficiary of the biggest pocket of geopolitical instability (the Middle East) --  I never thought I’d say it, but the oil sector could actually be a safe haven given recent developments. 

 

Take Your Minerals Supplements

The quick, somewhat lazy, rebuttal to the bullish oil thesis is that high prices will provoke a very quick supply response from U.S. shale.  The problem is that the spike in spot prices does not do a whole lot for the majority of shale players.  Witness the chart below:

 

backwardation.jpg

The charts show the increasing degree of backwardation in the oil market – similar to the concept of an “inverted yield curve” for interest rates.  What this shows is a steady steepening of the inversion in the last several weeks.  The orange line shows that despite spot prices reaching $63, forward prices one year out are around $55 and drop to almost $51 a little further out.

As an ex-commodities trader, I will tell you that current forward prices are not a good predictor of future spot prices and that I think this supply/demand tightness will persist for longer than most people think; I believe this will eventually pull the entire price curve up and eventually provoke a price response.

But in the short-term, that isn’t going to happen, because OPEC (which doesn’t hedge and sells its product at spot prices) benefits directly from high spot prices, and U.S. shale operators mostly hedge forward production by selling swaps out to 2021-2022.  Many of the levered players beholden to covenants in reserve-based loan (RBL) facilities are required to hedge out a large chunk of their forward production even if it means selling at prices $8 below spot!  Even the few players that don’t hedge still base their forward development capex plans largely based on the forward curve.  Lastly, most equity analysts are valuing stocks in this sector based upon $55 price decks.  Where do they get the $55?  Look at the forward curve!  But wait, didn’t I just say that current forwards are terrible predictors of future spot?  Yup – despite that, basically everyone in the business – from operators to stock pickers – relies on the forward curve.  This is also why I believe it is crucial to look beyond the forward prices and actually try to predict future spot based upon fundamentals.

In the meantime, I have been racking my brain, trying to figure out how to align my own incentives with those of OPEC.  In other words, how do I pick securities that benefit most from spot prices that are high and going higher? 

That is where “minerals” companies come in, and I will try to give a simple tutorial here.

In the U.S., landowners own the rights to the minerals produced from their properties, including hydrocarbons like oil and gas, and retain the rights to the royalties generated by the production of these minerals.  Because landowners are often not in the business of exploration and production of oil and gas, they will sell off a large chunk of these mineral rights to developers who will bear the cost of exploration and production.  The retained mineral rights still carry their pro-rata ownership of any royalties received from the production of the minerals (in our case, oil and gas) – without any burden of costs.

In recent years, a number of publicly traded entities have emerged that are “pure-play” minerals companies, where the managements have cobbled together “net royalty acres” that represent the implied pro-rata ownership of the mineral rights of these acres.  Mineral rights owners may sell these rights for any number of liquidity-related reasons, and the successful minerals companies are able to amass concentrated net royalty acres in high-quality basins operated by high-quality developers.  Because minerals companies don’t bear the costs and have no control over the development of the underlying acreage, all they can do is be smart in the acquisition price and selection of operators.

The value proposition to the investors of these publicly traded minerals companies is that they represent pure, unhedged plays on the royalties produced by the underlying net royalty acres owned by these companies.  For my own purposes, this is almost a perfect fit for my desire to be “in the same boat” as OPEC and directly benefit from rising spot oil prices without having to worry about costs of production, leverage and capital structure, etc.  Because these entities are like REITs in that they pass through 90+% of their free cash flow, they also avoid one of the biggest pitfalls in this sector – that of terrible capital re-allocation skills on the parts of management teams (a theme I wrote extensively about in Kaoboy Musings 16).  In short, I believe that the current backwardated state of the oil market disproportionately benefits these minerals companies, which is why I have been buying them.

In the name of full disclosure, two publicly traded minerals companies I own currently are VNOM (Viper Energy Partners) which currently yields 7% and FLMN (Falcon Minerals Corporation) which currently yields 7.7%.  I’m not going to delve deeper on the individual companies for now except to say that I believe both companies should be growing their distributions and should benefit directly from rising oil prices.

As always, caveat emptor.  This sector has had many false starts in the past, and you have to do your own homework.  This is just where I am currently perceiving good reward-to-risk potential in an otherwise fully-valued market – now vulnerable to geopolitical tensions.

 

 

Going On-line!

I have been writing Kaoboy Musings for about 4 months now and am enjoying the conversations and devil’s advocacy that it spawns – for me, that is what makes it worthwhile.  That said, I’ve had a vision for making it a more forum-like experience where folks can comment and opine around each thread, so I’ve spent the last several months learning WordPress and designing a website to house all my content.  I have not yet fully locked down the site registration tech, so please bear with me.  While it is definitely not ready for prime-time, I’m happy to announce that Kaoboy Musings now has a dedicated website:

https://kaoboymusings.com/

Please check it out.  There you will find all the “back issues” as well as a separate section that collates all of the content reviews I have done in past musings.  At the bottom of each post, there is also a section where you can comment.  I am hoping to foster an interactive community so that everyone benefits from the interaction – please don’t be shy and comment often!  It’ll also help me test it out, as I continue to refine the site.

Thanks for reading, and best wishes for a Healthy, Happy, and Prosperous 2020!

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Being Cheap In A Rich Market / The New “Plastics” / The Force Is With This One

Being Cheap In A Rich Market

 

So here’s the conundrum as you look to decide what to put in your holiday financial shopping cart in preparation for the big ‘20: we have a rip-roaring economy with strong jobs numbers and very low unemployment, we have a Fed that’s on hold until we get sustainable inflation over 2% (so far ephemeral), we have a thawing of global trade tensions that have arguably been the main drag on global growth and certain segments of the US economy – what’s not to like?

The problem is that the stock market anticipated this well in advance (you might have too if you’ve been reading Kaoboy Musings 😉) and has already priced in “rational exuberance.”  With the market pricing in close to 20x forward earnings, stocks are not cheap, but I would argue that they’re not “irrationally exuberant” either as they were in the late 90’s.  That said, with a year-to-date performance of around ~30%, the heady market makes the contrarian in me wonder whether even the Anti-Oracle I call the Bearded Hamster would be reversing his parting  “get-out-of-the-market” call right about now (see Kaoboy Musings 16).

Again, the conundrum: if you believe, as I do, that the economy still has legs and may even be re-accelerating now with trade tensions on détente, what do you buy if you’re a cheap bastard like me and don’t want to pay market rates for forward earnings but don’t find sub-2% bank interest rates appealing?

What if I told you that there was a sub-sector of the market that has never been this historically cheap and that the “widgets” these companies make are “must-haves” for the global populace?  What if I told you that the reason why this sector has been so battered over the last few years is because of a confluence of factors that have led to a temporary oversupply of these “widgets” but that these factors are now starting to align in the opposite direction and are likely to lead to a supply crunch of these “must-have” widgets?  What if I told you that many of the companies in this space are now generating free cash flow even as they’ve significantly curtailed future “widget” production?

 

 

The New “Plastics”

 

If you haven’t figured out what this sector is yet (and haven’t read the last several Kaoboy Musings), I’m going to quote Mr. McGuire in The Graduate as he takes young Ben (Dustin Hoffman) aside and gives him career advice: “I just want to say one word to you. Just one word.”  Nope, I’m not talking about “plastics” – I’m talking about “oil & gas.”

I attended an oil & gas conference in Houston this month and met with 14 companies, mega-cap down to small-cap, up and down the oil & gas food chain as well as many investors and analysts in this space  – I was surprised that so many of us “endangered species” are still alive!  Nevertheless, I have come back with some new micro and macro insights as well as more conviction in my thesis than ever before.

Let’s start with a chart that shows you in stark relief what oversupply in oil & gas has done to this sector relative to other sectors within the US stock market:

This chart shows 11 sub-sectors of the market as well as the S&P 500 (in white), normalized to the same starting point exactly 5 years ago.  The top performing sector in green is large-cap tech.  The massive underperformer in red is – you guessed it – oil & gas.

In past missives, I’ve outlined some of my bullish arguments already, so this time I’m going to start with the opposite, devil’s advocate, opinion as outlined in this article:

https://www.bloomberg.com/news/articles/2019-12-22/oil-s-2019-milestones-tell-decade-s-story-of-energy-abundance

The article makes several key points:

  1. The US shale revolution of the last decade has given us a global surplus of oil & gas “widgets” that have not only cushioned the world against unprecedented geoplitical risks but have also led the US to become a net exporter of oil & gas and surpass Saudi Arabia in production.
  2. OPEC no longer has the market power it once did, and its cuts have only stoked shale competition.
  3. Even as shale growth is slowing, other non-OPEC sources of growth are “springing to life.”
  4. Demand for oil & gas is predicted to stall out by the end of the next decade due to EV adoption in an to forestall climate change.
  5. In an era where the words “oil & gas” have become politically incorrect, financial players are increasingly embracing ESG (Environmental/Social/Governance) investing standards and shunning this sector.

I’m going to address each of these points, one-by-one:

1. The US shale revolution has indeed decoupled oil, once a geopolitically semsitive commodity, from even extreme events like the attacks on Abqaiq in September.  In the past, a shock event that takes 5.7 mm barrels/day off-line would’ve resulted in triple-digit prices; this time, we had a muted and brief spike that faded almost immediately after the Saudis assured the world that “everything was fine” and that full production would be restored within a month.

Several oil analysts I have met have called bullshit on the Saudi “everything is fine” narrative and think that they drew down more than 30 mm barrels from internal storage and that the recent voluntary Saudi “overcompliance” over and above the increased cuts is nothing more than a “face-saving” way to rebuild their reserves.  Given the recent Aramco IPO, Saudi credibility as a reliable supplier of oil is paramount, and I buy into this thesis that the additional cuts weren’t a magnanimous “gift” to US shale (as the Saudis suggested) but a necessary action to replensih their own lost supply.

Despite what Saudi Arabia claims, many analysts believe that true spare capacity (short-cycle capacity that can readily be brought on within 3 months) in OPEC is less than 2 mm barrels/day, or roughly 2% of global daily demand.  That is a razor-thin margin for error no matter how you slice it.  The one big caveat in all of this is that Iran has about 1.8 mm barrels/day of capacity that is effectively shut-in due to the sanctions and isnot included in this estimate of spare capacity; if sanctions were lifted for whatever reason, the additional supply would negate much or all of the OPEC cuts. 

2. The bigger issue of OPEC’s loss of influence and the US resurgence as a major world oil supplier rests entirely on the US “shale miracle” of this decade, which was enabled by a unique confluence of factors including:

    • Plentiful domestic shale deposits
    • Technological advances in horizontal drilling and hydraulic fracturing
    • Abundant water supply (necessary for frac’ing)
    • Economic and political framework of mineral rights that incentivizes drilling and exploration
    • Plentiful access to cheap capital that enabled not just runaway drilling but also infrastructure buildout
    • Abolition of the export ban that allowed US producers to access global markets

Not only do I believe that this alignment of factors is unique to the US and not replicable in other parts of the world that do have shale deposits but lack many of the other ingredients, I think several of the aforementioned factors are beginning to reverse here, namely:

 

  • Most US basins outside of the Permian have already peaked, with “Tier 1” acreage already drilled out and “Tier 2” locations only half as productive according to some analysts.  As a result, annual decline rates are ticking up from mid-30%’s to low-40%’s, which means that producers need to drill more just to keep production flat.  To show how dangerously dependent the world is on the Permian Basin, this small slice of Texas accounts for 2/3 of US shale growth, and US shale represents about 2/3 of total non-OPEC growth going forward.
  • Improvements to well productivity and drilling times are starting to plateau; in other words, technological improvements are likely to be incremental going forward as opposed to be revolutionary.
  • Plentiful access to cheap capital has come to an end, given the value destruction in this sector over the last 5 years.  Exploration & production companies are battling a two-front war, with capital markets demanding free cash flow and return of capital while their service providers are barely earning their cost of capital.
  • The result is that most prognostications of US production growth are going to fall way short of expectations.  Some of the folks I’ve spoken to think that US production growth for 2020 will be closer to 400-700k barrels/day vs. “consensus” expectations of 1-1.5 mm barrels/day of growth.

3. The point about non-OPEC growth “springing to life” is backward-looking.  Outside of US shale growth and OPEC+, the last of the big projects are coming on-line now (including Brazil and Norway) from the 2010-2014 vintage of $100 oil-inspired wave of long-cycle capex (these projects have 5-7 year lead times), and this has already been priced into the market.

Looking at the chart above, you can really see why the last 5 years have been characterized by an era of oversupply.  The supply from the projects put in place during the 2010-2014 era hit the market at the same time US shale production was going bonkers.  Looking forward, no money has been spent on these long-cycle projects during this recent period of low oil prices, and that drought projected forward 5-7 years is about to hit us at the same time US shale production is rolling over – this is literally the opposite dynamic of the last 5 years.  If I were a betting man (and I sure as hell am), I’d bet that the next 5 years look more like 2010-2014 than 2015-2019.

This article spells it out: https://oilprice.com/Geopolitics/International/The-Dark-Outlook-For-Non-OPEC-Oil.html

 

4. Global oil demand has been growing 1.25 mm barrels/day on an annual basis, consistently for the last 5 decades, and only 7 of the last 49 years since 1970 have seen negative blips in demand, according to Art Berman of Labyrinth Consulting Services (see Kaoboy Musings 15 where I included Art’s full deck).  The notion that the “EV Revolution” is going to make this time different and cause forward demand growth to plateau or even decline presupposes the following:

 

    1. That EV adoption will continue based on economics alone.  Evidence suggests the contrary as sales have slumped along with an end to subsidies: https://oilprice.com/Energy/Energy-General/Chinas-Electric-Vehicle-Bubble-Has-Popped.html
    2. That EV adoption will not encounter its own issues with respect to lithium and cobalt mining/disposal externalities.  The whole focus on “ESG investing” seems disingenuous to me when it chooses to focus on one variable (carbon emissions) and disregard everything else. Witness: https://oilprice.com/Energy/Energy-General/The-Human-Cost-of-the-EV-Revolution.html
    3. On a current global base of 1.4 bn vehicles, EV sales of 2 mm in 2018 are inconsequential.  Taking this number up 10x by 2030 (as some manufacturers have forecasted) will still only result in 60-90 mm total EV’s out of an even higher base of ICE (internal combustion engine) vehicles.  If we then factor in the fact that 40% of annual car sales currently are SUVs which consume a lot more gasoline than cars, the number of EVs on the road just won’t matter at all to oil demand.
    4. The rapidly industrializing emerging economies of China and India are energy-starved and are far likelier to support urbanization initiatives that are viable with the current infrastructure as opposed to waiting for the EV revolution.  The analogy of “going straight to wireless” in the realm of telecommunications just doesn’t hold up in this case. 
    5. The whole ESG focus revolves around the debate around climate change and the focus on cutting carbon emissions.  While I’m not going to get into a whole political debate about this topic here, I have been reading extensively on this topic and engaging with several experts in the field.  In short, while there is no denying that the climate is indeed changing (and it has for the entire 4.5 bn years of Earth’s history), the science does not appear to support Anthrogenic (man-made) Global Warming (AGW).  This is one of the most comprehensive papers I’ve come across that suggests that the focus on curbing CO2 emissions is tantamount to “barking up the wrong tree,” as Professor Giengengack, Chair Emeritus of UPenn’s Earth and Environmental Sciences said to me.

Here is the link to the paper: https://wryheat.files.wordpress.com/2019/04/climate-change-in-perspective-2019.pdf

As an investor and believer in free markets, I believe the capital markets tend to ferret out the most viable and economic solutions in the long term – capitalism culls out the weak in Darwinian fashion. 

 

The following regression is from a site called https://wattsupwiththat.com and shows a very clear correlation of electricity costs with renewables adoption, i.e. the less you depend on hydrocarbons, the more expensive your electricity is.  Note that Germany and Denmark, the poster-children of renewables adoption, have electricity costs that are 3x that of the US.

Bottom-line: I have very high conviction in this oil & gas thesis over the next several years, but this sector is not for the faint of heart.  The two biggest risks are global recession and a removal of Iranian sanctions, neither of which I place high probability on. 

There are many ways to play this thesis: through the commodity itself, through oil & gas weighted ETF’s like the XOP (exploration and production companies) or OIH (oil services), or through individual equities (which I would not recommend unless you do your own homework and are comfortable with idiosyncratic company risk).  In the name of full disclosure, outside of my sizeable bets in GSE preferreds, individual oil & gas stocks comprise (by far) the biggest chunk of risk assets I have in the securities markets.  I own FANG, VNOM, NOG, FLMN, ET on the public side and Birch Resources on the private side.

 

The Force Is With This One

 

Not only are the holidays upon us, Star Wars season is once again here as well.  I officially submit my review of Star Wars, Episode IX: The Rise of Skywalker for your perusal.

As a long-time Star Wars fan, I had great hopes when Disney acquired Lucasfilm in 2012.  Seeing what they did with the Marvel franchise, I naturally extrapolated similar success to what they might do with the Star Wars franchise, supercharged with the might and muscle of Disney behind it.

When the greatly anticipated Episode VII: The Force Awakens came out in 2015, while I was disappointed by the fact that the story arc resembled the original Episode IV: A New Hope very closely, I was still entertained because the director, J.J. Abrams, introduced some intriguiing new characters and plot elements that invited speculation (something the Star Wars fan community loves to do).

Along came Rogue One in 2016, the prequel to Episode IV: A New Hope.  I loved this movie and was lucky enough to attend the red carpet premiere, replete with a full-scale X-Wing fighter on Hollywood Blvd -- the fanboy in me was in heaven!  I remember thinking to myself that George Lucas made a huge mistake selling too cheaply and that Disney would usher in a new Star Wars Golden Age. So far so good!

Then came Episode VIII: The Last Jedi in 2017 – and my Star Wars dreams imploded faster than Death Star 2 over Endor.  Inexplicably, the director Rian Johnson, systematically shut every plot door that J.J. Abrams opened in the The Force Awakens and simultaneously discarded every bit of fan-revered “canon” in one fell swoop.  It’s as if he systematically hunted down and destroyed everything fans loved about Star Wars, a la “Order 66”!  Honestly, forget about it being the worst Star Wars movie by far, it might’ve been one of the all-time worst movies I’ve ever seen in any genre, and Rian Johnson deservedly earrned his own entry in the Urban Dictionary as a result: https://www.urbandictionary.com/define.php?term=Rian%20Johnson.  I could just picture George Lucas LOL’ing, knowing that forlorn fans like me would beg him to come back at any price – even with Jar Jar Binks in tow!

 

Meanwhile, as you can see below, the “official” critics gave it a 91% rating on Rotten Tomatoes – Jedi mind trick by Disney?  Fans like me crushed it with a 43%, which I thought was generous (I would have rated it 1 out of 10).

 

 

So when a neighbor invited me to the “Friends & Family Pre-Showing” of Star Wars IX: The Rise of Skywalker at the El Capitan on December 16th, you can imagine my level of indifference.  For the first time in the history of Star Wars films, I had seriously considered waiting for this one to hit Blu-Ray before seeing it, but since it was free, I figured “why not”?

 

Imagine my surprise when halfway through the movie, I’m not only not hating the characters any more, but I’m actually enjoying the movie!  J.J. Abrams now has my undying respect as a Jedi Master for levitating this wreck out of the swamp – not only did he fix all of the issues that Rian Johnson created, he managed to do so in a way that almost allows you to think that some of the gaping plot holes in The Last Jedi were done on purpose.  Almost.  There were still a couple moments that made me cringe (watch it and you’ll know what I’m talking about), but not enough to keep me from seeing it a second time this weekend with my family.  After Round 2, I actually liked it even more and would actually assign an 8 out of 10 for this one – I even rank it slightly ahead of Rogue One, and that’s saying a lot

Note, however, how wrong again the “critic consensus” is.  If you’ve been reading my Kaoboy Musings, you know how much I value contrarian thinking.  Let this be no exception.  Don’t trust the critics – go see The Rise of Skywalker.  J.J. is a Jedi Master, and this is the finale you’ve been looking for!

May The Force Be With You, and Happy Holidays!

 

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Trump’s “Delta” / Jobs & OPEC Friday / The Oil & Gas Opportunity / The GSE “Piggy Bank” and the Government “Mob” / Hamster Tracks

Trump’s “Delta”

Here we go again.  On 12/2/19, Trump indicated that a trade deal might have to wait until “after the elections,” sending the markets swooning a ghastly 2% (gasp) from an all-time high on 11/27/19 before recovering the entire move by the end of the week after “new” signs of progress yet again.  That the market isn’t completely inured to these about-faces by now is beyond me.

In options lingo, we have a term called “delta,” which denotes an option’s sensitivity to the underlying stock price (mathematically, the delta is equivalent to the first derivative of the option price function with respect to stock price).  A call option with a delta of 1 indicates that the option will move 1-for-1 with the underlying stock and is thus very sensitive to stock prices; a call option with a low delta, say 0.3, will only move $0.30 for every $1 of stock move and is considered relatively insensitive to stocks.

If President Trump were an option, he’d have a delta of 1.  Enough said.

Jobs & OPEC Friday

Friday, 12/5/19, was quite eventful.  Despite our high-delta President’s penchant for calming the market after any kind of swoon, the U.S. economy at least appears to have real underlying strength and does not need require the jawboning.

In Friday’s unemployment report for November, the U.S. economy crushed expectations, adding 266k jobs in November versus expectations of 180k.  Although the resolution of GM’s strike accounted for 46k of these “adds,” recall the 128k surprise last month vs. 85k expectations during the strike.  Indeed, in this Friday’s report, there were also upward revisions of 41k for the previous two months.  It actually seems like the U.S. economy is reaccelerating, despite the lack of a trade deal.  I have contended for months that folks shouldn’t put too much credence in the unprecedented length of the expansion but should instead focus on the relative lack of intensity of expansion over the last decade; for this reason, I continue to believe that the U.S. economy can continue to surprise people in its virility – especially if we get a trade deal.

Next, OPEC+ concluded its 2-day summit and managed to surprise the world with an unexpected additional cut of 500k barrels/day from its 1.2 mm barrels/day cut level established back in 2018.  This is a big deal.  The oil markets have been remarkably complacent even after the attacks at Abqaiq earlier this year, mainly because of the elevated inventories in the system, much of which has been contributed by runaway U.S. shale production (more on this later).  This being Abdulaziz bin Salman’s first OPEC meeting as Saudi Oil Minister, the world did not know what to expect.  Abdulaziz has now shown his cards, in my opinion, by throwing full support to his brother Crown Price Mohammed bin Salman (MbS) in a bid to remove the oil glut and “juice” the recently IPO’d Saudi Aramco.

Although crude only rallied a little over 1% on the “surprise cut,” it had already bounced 4.5% from the 12/2 “no trade deal until after elections” global market swoon.  Nevertheless, I think oil is poised to grind higher over the next year.  The forward curve of oil (similar concept to yield curve) is now massively inverted (we call this “backwardation” in the commodity markets).  This chart shows how the level of backwardation has been steadily increasing over the last several months, showing an increasing wariness of supply tightness:

Oil Backwardation

This brings me to my growing conviction in opportunity in oil & gas that I began to write about in the last several Musings:

The Oil & Gas Opportunity

This is an amazing chart:

The white line shows a chart of WTI crude, the green shows Henry Hub Natural Gas, and the purple shows the XOP (Oil & Gas Equity ETF) over the last 5 years, normalized to the same starting point to show how each asset class has performed relative to one another.  The devastating underperformance of the oil & gas equities relative to the commodities is stark.

Here are my takeaways:

  • While the U.S. has benefited from the “energy independence” from the Middle East that the shale revolution has brought, it has largely been an era of “profitless prosperity” for the U.S. oil & gas industry.
  • Despite the industry’s promises of being able to prosper above $50/bbl (you can’t see it in this chart due to the normalization, but WTI crude has been consistently above $50 since the beginning of 2017, except for a brief stint in December of 2018), the lack of free cash flow to date has all but destroyed investors’ confidence that shale producers can ever inflect to free cash flow
  • The massive underperformance of the underlying equities (purple) to the commodities (white and green) indicate a growing disenchantment with the sector – arguably reaching crescendo extremes at this point, with the entire U.S. oil & gas space accounting for less than 4% of the S&P and worth hundreds of billions less than Saudi Aramco’s $1.7 trllion alone! 
  • Note that this massive underperformance of the XOP actually understates the underperformance of the sector since this ETF only contains the largest, best-capitalized names in the space.  I follow a basket of “post-reorganized” small-caps in this space (companies that have already been through the Chapter 11 wringer once), and of the 22 or so names that I began following a couple years ago, the median ytd performance for 2019 is -54%, excluding the 5-6 names that have been complete wipeouts a second time around, going to the “Chapter 22” (2nd consecutive bankruptcy) route. 
  • I believe that investor disenchantment is warranted from the standpoint of companies showing terrible capital re-allocation skills.  This is the crux of the problem, in my opinion, for a public E&P company – what do you do with the cash flows from producing wells that are supposedly highly profitable from a well-specific perspective?  For public companies with stories to tell and empires to build, managements have typically diverted this cash flow into new projects and new acreage in sometimes unproven regions with questionable geology and economics.  So even if individual wells show 50% IRR’s, what good is it if the company continues to burn cash in aggregate?  This is why so many public E&P companies are trading below the present value of their reserves (“PV10” in industry parlance) – public markets are ascribing continued value destruction.
  • This brings to mind an interesting “arbitrage” opportunity that ideally requires activist, private equity – buy up some of these sub-scale operators trading at significant discounts to proved/developed/producing (“PDP”) reserve value, sell off the proved/undeveloped (“PUD”) reserves, and run the companies off like liquidating trusts.  In my mind, this is the only way to ensure convergence to reserve value and eliminate poor capital re-allocation as a risk. 
  • The public market alternative is to invest in low-cost operators who have a combination of good capital discipline, strong balance sheets, good inventory depth, and shareholder-friendly initiatives.
  • What is different now than years past is that company managements are finally “finding religion” and finally listening to shareholders in terms showing capital discipline; in many cases, lack of liquidity is forcing this discipline upon producers. 
    • One aspect of capital discipline is restraining growth.  Rig counts have fallen to multi-year lows as a result (although the counter argument is that increased drilling efficiency have countered much of this effect):

  • The other aspect of capital discipline is returning excess cash flow to shareholders either through buybacks or dividends. Naturally, only larger players with scale can afford to do this, and this is where I’m investing in the public space.

To summarize, the confluence of several factors is making me very excited about this space:

  • The Darwinian culling of the U.S. shale industry has forced consolidation and capital discipline amongst smaller players.
  • Big players are beginning to inflect towards free cash flow and the return of cash flow to shareholders.
  • The supply side of the equation is getting tighter:

Non-OPEC production growth (of which the largest component is U.S. shale) is starting to roll over.

iOPEC+ (the “+” denotes Russia) has shown remarkable discipline and not only rolled over its previous 1.2 mm barrel/day cuts but surprised the market with an additional 500k barrels/day in cuts.

  • The demand side of the equation has shown remarkably steady growth (see my notes from Kaoboy Musings 15) and may even accelerate with a lessening of trade tensions.
  • From a valuation and sentiment standpoint, we are at a nadir.  That said, this sector has been a “widow-maker” for many, and I caution would-be investors to do their homework and have a longer-term horizon (3-5 years) in order to weather the inevitable bumps.  For those not looking to have idiosyncratic stock risks, ETF’s like the XOP and OIH can be good sector substitutes. 

Full disclosure: I am heavily invested in this space and currently own FANG, VNOM and ET, although I frequently do relative-value swaps with other names in the sector.  My largest position, however, is in a private equity called Birch Permian.

The GSE "Piggy Bank" and the Government “Mob”

Outside of the oil & gas opportunity, my other favorite opportunity, as many of you know, are the GSE preferreds, which I continue to believe have 150%-200% upside from current levels over the next 12-18 months.  I have written extensively on this topic and would be happy to share my past Musings with anyone interested.

In Kaoboy Musings 13.5, I gave some soundbites from Judge Sweeney’s hearing in the Court of Federal Claims, where multiple classes of plaintiffs have sued the government and FHFA for a “Constitutional takings” of private property when it put the GSE’s into conservatorship in 2008 (some are suing over this event) and then again when the Treasury/FHFA enacted the Net Worth Sweep in 2012 (some are suing over this event). 

I’ve now had time to go through almost 300 pages of transcripts from that day in court and want to include some choice words the Judge had for the government:

  • “how does the Government justify never allowing Freddie and Fannie to pay off money it received and eventually being able to stand on its own feet, which it could have done, and then let its board decide whether or not to pay a dividend to the shareholders. It seems from the beginning when you have FHFA coming -- and Treasury coming to the board of directors of the enterprises and saying you either agree to the conservatorship or you’re out, it seems as though there was a death grip placed on the enterprises by Treasury and FHFA”
  • “they were never allowed to repay -- the enterprises were never able to repay that which they borrowed. And so they were never allowed to stand on their own two feet again as much as an entity can stand on two feet.”
  • “There was this siphoning of every dollar of profit.”
  • “I’m very concerned that Treasury approaches the board of directors of the enterprises and says, you either agree to the conservatorship or you’re out. That’s -- that sounds like undue influence, if not a death grip.
  • “It’s as though it was somebody --they were used as like a piggy bank that they could – or it was this funding stream. And I’m a taxpayer so, I mean, it’s great that the Government can generate tax revenues, that’s fine. But it should be fair and equitable”
  • “a reasonable plaintiff or investor, knowing that an infusion of capital was required and the Government was going to provide that infusion of capital and that the company -- in this case the enterprises -- would have the opportunity to repay the loan and then regain its footing and then eventually to be able to pay dividend, that’s what one would expect. One would not expect in the United States of America that the Government would step in with an infusion of capital and not then not allow -- and the dividends were going to flow to the taxpayers to repay the taxpayers, one would not expect that all profits would be directly flowing into the U.S. Treasury and that the company would never be able to repay that which it borrowed, get back on its feet, and resume normal operations and pay dividends again.”

At one point the DOJ lawyer characterized preferred investors as holders of “lottery tickets” hoping for a windfall, to which Sweeney replied:

  • “I appreciate your lottery ticket analogy, but the Plaintiffs owned stock, which is far more certain than a lottery ticket. A lottery ticket, you may have one in a billion or 100 billion chance of winning. Stock is something that -- it’s a certificate of ownership, you’re invested in that company and, God willing, you get a return. For preferred stock, they certainly were enjoying a return year after year after year. I think there was always a dividend paid except for maybe one of the enterprises in 1985, something like that. So, there was a fairly consistent return which is much better than lottery ticket, at least any of the lotteries that I know of.”

And finally, perhaps with Martin Scorcese’s The Irishman fresh on her mind, Sweeney says on pages 275-277:

  • “I hate to say it, I’m not -- this is going to sound so flip, and I don’t mean for it to, but this is like the mob. And it’s not, of course, but, I mean, you have all the money is being turned over to the Treasury.”
  • “But, you know, what kind of – how are they saving -- it’s almost as though the companies or the enterprises have become shells, and they’re able -- and they’re supposed to continue on in their work, but they will never make a profit because everything’s being diverted to Treasury.”

Hamster Tracks

Lastly, I want to pay homage to a long-time market pundit whom I’ve affectionately named “The Bearded Hamster.”  The Hamster was a frequent market prognosticator on CNBC; after several decades of doing this, he finally decided to call it quits last week. 

Predicting the future is damn hard to do with any sort of consistency, but what I found remarkable about the Hamster’s calls, however, was how consistently wrong he was – there is signal value in any kind of consistency, even if points you 180 degrees in the opposite direction!  In fact, long before I started writing Kaoboy Musings, I thought I would one day create a blog with a dedicated section called “Hamster Tracks” to spot what the Hamster was doing and then make the opposite recommendation. 

Tongue-in-cheekiness aside, I suspect that his consistency in making terrible calls stemmed from two primary mistakes.  First, his worldview was largely informed by “trend-following,” which generally places you among the consensus.  Now I’m not saying the consensus is always wrong.  In the financial markets, powerful long-term trends do occur and can make patient investors a lot of money.  The problem, however, is that in the short-term, being in the consensus can often mean that you’re the “Johnny-come-lately” left holding the bag when short-term winds change direction.  This leads me to the Hamster’s second big mistake: being too short-term on his calls and getting scared out of his thesis at precisely the wrong time, exposing himself to severe whipsaws, both financial and emotional.  One of the biggest impediments to investment success is one’s own emotions, and not doing proper due diligence and/or not giving a thesis enough time to play out will make it easy for Mr. Market to shake you out at the worst imaginable time.  Alas, the Hamster allowed this to happen all too frequently.

I try very hard not to be Hamster-like by 1) trying to gauge the “consensus view” embedded in the market and then deciding whether or not to join that consensus; more often than not, I tend to take the other side, because contrarian bets usually have better reward-to-risk ratios, just like betting on the underdog usually gets better odds; 2) trying to be patient and not let the short-term schizophrenia of the markets scare me out of a solid thesis; truth be told, I’ve often been “too patient” and overstayed my welcome in certain situations, so this is always a work-in-process for me. 

So I am genuinely bummed that the Hamster has called it quits, because I am losing a valuable signal going forward.  He did, however, offer one last nugget of wisdom last week: he advocated getting out of the market and going mostly into cash ◊ I guess this bull market may yet have some legs! 😊

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Why I Continue To Invest In Oil / Recent Reads / Recent Listens / Happy Thanksgiving!

Why I Continue To Invest In Oil

I’m not actually a masochist, even though it may seem like it with respect to this investment theme.  In Kaoboy Musings 10 & 13, I talked about a deeply contrarian investment thesis I’ve had for the last several years – oil and oil equities.

This has been an extremely challenging space to be invested in during the last several years, but I want to share some thoughts about my thesis and refer to some slides from a deck put out by energy consultant Art Berman (see attached):

LSU-NOV-22-2019_REDUCED-1

This has been an extremely challenging space to be invested in during the last several years, but I want to share some thoughts about my thesis and refer to some slides from a deck put out by energy consultant Art Berman (see attached):

  • Despite the growing share of renewables, oil/gas’s share of world energy consumption will continue to dominate for decades to come (slide 1, 31).
  • The hydrocarbon is, quite literally, the most efficient “battery storage” for solar energy that nature has devised and will be difficult if not impossible to fully displace given the sheer energy density, lack of intermittency, and economic efficiency with which it can be produced, stored and transported.
  • Although the U.S. does not have a monopoly on shale deposits, the U.S. does wield a confluence of factors that have enabled a “shale miracle” in our country that is not easily replicable in other countries These factors include:
    • Plentiful shale deposits spanning contiguous acreage (required for horizontal drilling) – see slide 8.
    • A political system that allows private land ownership to retain mineral rights (provides the right economic incentives to develop this resource)
    • An advanced economy with unparalleled access to innovation and technology
    • An abundance of water (required for hydraulic fracturing)
    • Cheap cost of capital
    • An extensive transportation network that does not require international cooperation to build out/maintain
  • Yet despite these advantages, I believe U.S. shale oil alone will not be enough to cover the world’s growing appetite for oil – even without a frac ban, which would be economic catastrophe for the U.S. and the world in my opinion, given shale’s nearly 60% share of total U.S. production (see slide 4).
  • Key statement from slide 13: “U.S. and the world have been borrowing forward on their surplus energy.”  I agree with this statement and find it ironic that the debt-fueled boom that enabled rampant land-grabs and undisciplined production have led to cheap oil for the world but resulted in massive value-destruction for investors.
  • As Slide 20 shows, this is changing.  With energy now comprising an all-time low of 4% of the S&P, investors are demanding capital discipline and free cash flow.
  • As mentioned in Kaoboy Musings 13, I believe the process of consolidation is occurring in the U.S., and the day will be won by the players in the best basins, with the strongest balance sheets, who can execute the most efficiently and be the lowest-cost producers.  These will be the “last guys standing.”
  • I believe the supermajors will continue to shift their resources from higher-cost projects to lower-cost projects, and this augurs well for the “last guys standing.”  See this article: http://www.ejinsight.com/20191122-exxon-aims-to-sell-us25-billion-of-assets-report/.
  • In the U.S. I believe the “last guys standing” will be the best players in the Permian Basin in West Texas, which is blessed with geology that features multiple zones of hydrocarbon deposits “stacked” on top of one another.  This feature allows the Permian producers to have much lower well-costs as well as greater inventory depth than anywhere else; already, every other basin in the U.S. has peaked in production.
  • The Permian alone cannot carry the day, and I believe the EIA production projections (which have historically been terrible) are going to disappoint.  See Slide 17.  Art Berman has been saying this for years.  I will caveat this point by saying that U.S. technology ingenuity has surprised us in the past, but I wonder if the best days of those surprises are behind us at least with respect to U.S. shale.  For other higher-cost sources of oil like deep-water or Canadian tar sands, much higher oil prices will be required to enable economic viability.
  • So the bottom-line of all this is to say that I believe, barring global recession, oil prices will continue to grind higher and possibly spike if shale production overall disappoints, and that the best way to play this theme will be through the best-capitalized “last guys standing” in the Permian Basin.  Full disclosure: I am long both public and private equities of various Permian oil/gas producers.

Recent Reads

Andrew Carnegie by David Nasaw

I already gave a synopsis in Kaoboy Musings 12, so I will keep this short.  My biggest takeaway from this book was how “history may not always repeat itself, but it often rhymes,” to paraphrase Mark Twain.  The exorable march of technological progress has consistently exerted deflationary pressure on wages and forced labor to become more educated/skilled in order to adapt.  Another recurring theme that is topical to today’s world is how the capitalistic engine of the Industrial Era in the U.S. both laid the groundwork for tremendous economic growth as well as some of the social issues that go with that growth (wealth inequality, labor rights, etc).  Finally, germane my own investments in commodity industries, it outlined the importance of being the lowest-cost producer when one has no control over commodity prices as was the case with Carnegie and the steel industry. 

The Politically Incorrect Guide to Climate Change by Marc Morano

My intent was to get educated on this subject, because it has become such a political hot potato when it seems to me that it should be a discussion that is fact-based.  This book, although partisan at times, was very revelatory on several fronts and at least gave me an overview of the main points of controversy in this debate.  I believe it is an important topic that affects everyone on Planet Earth and that there are extremists on both sides of the argument that obfuscate the issues in the name of politics and policy objectives.  At the minimum, it has led me to purchase several more books on the topic and led me to create a chat group on WhatsApp to discuss this topic intelligently.  Please feel free to join if you are interested: https://chat.whatsapp.com/DT2bQrLyb5AJxhZuN2I8EI

The Man Who Solved The Market: How Jim Simons Launched the Quant Revolution by Greg Zuckerman

This was a quick, fun read but as an investor I was selfishly hoping for something a little more market-insightful, but I guess it’s not surprising to me given the iron-clad NDA’s required of all of Simons’ employees.  After reading this, I don’t know whether to be inspired or depressed as a fundamental investor, because it seems like the Renaissance team has truly carved out an almost unassailable edge through the successful harnessing of complex mathematical algorithms and machine learning.  I used to require my hedge fund employees to read Reminiscences of a Stock Operator by Edwin Lefèvre, which was about a legendary speculator named Jesse Livermore (1877-1940) and his incredible ups and downs in the markets during the end of the 19th century/beginning of the 20th century, because I always said that, “Markets and technologies may change, but the two market constants are investor greed and investor fear.”  While I still largely hold this thesis, this book was sobering to me in that it shows that technology can even disrupt a highly uncertain and dynamic field like investing, so as in Carnegie’s/Livermore’s era, we need to keep learning new things to adapt. 

Recent Listens

I recently discovered a great, free app called Hoopla that allows you to “borrow” audiobooks from your local library electronically for free!  Hence, I’ve supplemented my reading with a healthy dose of audiobooks as well.  Here are some:

The Power of Vulnerability by Brene Brown

This was more like a 6-7 hour podcast interview than a traditional audiobook, but it was a very effective format for the content.  I’ve always liked to read self-help books, but now that I’m discovering this medium, I find that listening to the actual author convey his/her message may even be more effective – at least for this genre.  There are a lot of great nuggets of wisdom in this book about how to be present, but I had one powerful takeaway from this book: when confronted with demands that may not work for your present circumstances, it’s more important to be authentic and uncomfortable in saying “no” than it is to say “yes” inauthentically and harbor resentment.  Lots of wisdom in that, in my opinion.

Stillness Speaks by Eckhart Tolle

I’ve read several of Tolle’s books, including The Power of Now and A New Earth.  Stillness Speaks covers roughly the same topics about how to find presence in stillness as well as learning to recognize one’s attachment to ego.  Honestly, none of this material would have resonated with me even 5 years ago, but in 2016 I attended a life-changing retreat in Napa Valley called “The Hoffman Process” which introduced to me the practice of being present as well as recognizing that we are not our patterns.  Since then, I’ve come to realize that almost all of these books and seminars basically share the same essence – just with different vocabulary and perspectives.  Eckhart Tolle to me is one of the best authors on the subject, and I highly recommend his podcast with Oprah Winfrey:

https://podcasts.google.com/?feed=aHR0cHM6Ly9yc3MuYXJ0MTkuY29tL2EtbmV3LWVhcnRo&episode=Z2lkOi8vYXJ0MTktZXBpc29kZS1sb2NhdG9yL1YwL2ZadkJOQjI3enZVRkM1aUUtUU5kVDZsc0NMblFJZHRLZFlDbDgzNjZXU3c&hl=en&ved=2ahUKEwixp4rzg__lAhUmc98KHfn3CyEQjrkEegQIChAE&ep=6&at=1574467346121

With that, I wish you all a wonderful and Happy Thanksgiving -- we can all be grateful that we are not turkeys!

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Climate Change Chat Group

Climate Change Chat Group

Hi friends,

We all know that climate change is a politically charged topic these days when really it should be about the legitimate science behind it, imho.  I have been reading a lot on this topic lately and think it is an extremely important topic for discussion, but given the strong polarization of views on this topic, I have decided to create an opt-in chat group to discuss this topic in-depth.

The goal is to have a fact-based discussion on the science and NOT to have a partisan flame war.  I am hoping to add some leading authorities on the topic as well.  If you would like to join, here is the link:

https://chat.whatsapp.com/DT2bQrLyb5AJxhZuN2I8EI

 

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

GSE Update — COFC Hearing

GSE Update -- COFC Hearing

I guess I should have waited one day before hitting “send” on yesterday’s missive, but since this is timely, I wanted to share this ASAP. 

Of the myriad lawsuits against the Treasury/FHFA by different classes of GSE investors, one very important hearing regarding the government’s motion to dismiss in the Court of Federal Claims (COFC) was held yesterday.  

While I don’t have the full transcript yet, I’ve heard several key soundbites from the presiding Judge, Margaret Sweeney, that appear quite positive for plaintiffs (shareholders):

  • She was concerned that the current terms of the Net Worth Sweep would never allow the GSEs to become solvent and exit conservatorship, and she questioned how the government could justify never allowing repayment of the liquidation preference so that the companies can get back on their feet
  • She opined that Treasury/FHFA placed the GSE’s in a “death grip” and used them as a “piggybank,” comparing government’s actions to “the mob”
  • She opined that a “reasonable investor” would not have expected all profits to be swept to Treasury forever

 While these soundbites appear way more constructive than I expected, I caution that the wheels of justice have moved very slowly in these GSE cases.  Nevertheless, if the COFC strikes down the government’s motion to dismiss, it will add to the political cover that Mnuchin/Calabria need to do the right thing for shareholders.  Stay tuned…

 

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Q3 Report Card / GSE Update

Q3 Report Card

Since Q3 earnings are now mostly out of the way, I thought it would be a good time for a recap as well as a candid self-assessment on my own prognostications.

What I Got Right So Far

Since Kaoboy Musings 3 (9/27/19), I have been sharing my then-contrarian viewpoint that the U.S. economy was not about to go into recession -- notwithstanding a spate of weak economic data, an inverted yield curve, heightened trade tensions, etc.  There is nothing magical about using 9/27/19 as a basis for comparison, but since that is the date I began pontificating about the economy, I will use that date in my forthcoming comparisons.

So far, this sanguine view of the economy has borne out.  In Kaoboy Musings 5 (10/3/19), I predicted that the Administration would use the trade tensions as a lever to induce the Fed to shift into a dovish stance and then get a trade deal done before 2020 elections.  This, too, appears to be happening.  Jerome Powell has definitively shown the markets that the Fed is more likely to let the economy run hot than allow the specter of deflation to take hold.  Jobs numbers have subsequently surprised to the upside, and whereas in the past “good” economic numbers may be negatively received by the markets in anticipation of hawkish Fed policy, Fed effectively negated this upside headwind. 

The yield curve has steepened materially (see chart below), and not surprisingly, the XLF (ETF that tracks financials) has ripped 6.2% since then (although it surprised me that this was not much better than the S&P 500’s overall 5.4% ascent over the same period).  Financial institutions, which are generally in the business of borrowing short-term and lending long-term, benefit from a steep yield curve.

On the “micro” side, the resilience of the economy is borne out by the Q3 earnings scorecard as well.  As of this writing, 93% of the S&P 500 companies have reported Q3 earnings.  The trend I outlined in my Mid-Earnings Season Gut-Check in Kaoboy Musings 10 (10/29/19) has largely continued.  Overall, the earnings beat was a whopping 4.74% with a sales beat of 0.44%.  10 out of 10 industry groups reported earnings beats, and 6 out of 10 groups reported sales beats.  The 4 groups that had negative sales surprises were: energy (-0.43%), materials (-1.48%), industrials (-1.99%), and utilities (-5.5%); it amazes me that despite these headwinds in these 4 groups, all of them still reported earnings beats, demonstrating that they’ve been able to reduce costs faster than revenue declines.

Part of my optimism about the markets and economy ironically comes from the fact that there have been almost as many “rolling recessions” within certain pockets of the economy as there have been mini-bubbles and that the overall market, while not cheap, is also not “irrationally exuberant” as it was back in 1999-2000.  The weakness in the 4 industry groups above illustrate this in real-time.  As long as this weakness does not metastacize into other industry groups, I would argue that this weakness actually provides our inflation-targeting Fed an even longer runway to be accommodative since at least 3 of the 4 industry groups that missed on revenues (energy, materials, industrials) seem to be directly exerting deflationary forces.

Although I think there is risk of a “melt-up” into year-end, it’s worth noting that the stock averages are all plumbing all-time highs already: the S&P 500 is up 24.6% ytd, the NASDAQ is up 29%, and even the Russell 2000 is up 18% ytd.  The markets are not cheap and have now discounted a lot of good news already.  I tend to get more cautious as contrarian views become more mainstream, and I believe that is happening now.  I am not chasing beta here and prefer to stick to less frothy, “value” names in this tape. 

Heady markets notwithstanding, I still do not believe we are on the precipice of recession simply because we are in the “longest expansion ever.”  As I have opined in the past, I believe the intensity of the expansion matters more than the duration; given the somewhat flaccid recovery of most of the last decade, I believe that the duration of the expansion will exceed most people’s expectations. 

What I Got Wrong So Far

In Kaoboy Musings 10 (10/29/19), I gave several reasons for why oil and oil stocks may be poised to outperform.  So far, not so good.  Oil is down 1.3% since then, and the XOP (an ETF for oil and gas exploration and production) is down ~8% since.  Believe it or not, this 8% decline belies much more severe carnage in the sector as worries over free cash flow and scale have hammered smaller-cap players – the small-cap (TEV of $4 bn and below) basket of Permian shale developers I follow is down 10% to 72% ytd!  Worse, the basket of 20 post-reorg (names that have emerged out of bankruptcy over the last several years) names that I follow in this space is down an average of 51%, with several of them down 80+% and likely to go “Chapter 22” (industry slang for Chapter 11 a second time around).  Even some names that I consider to be “best in class,” like Diamondback (“FANG”) (which I own, in the name of full disclosure), have stumbled badly in this environment – down ~16% just from 10/29/19.  This sector is not for the faint of heart!

Truth be told, this sector has been my personal albatross over the last several years, as the “shale miracle” that has enabled the U.S. to export more crude than Saudi Arabia has largely resulted in massive value destruction amidst lack of capital discipline and way too many players.  Consolidation is happening now through mergers as well as bankruptcies, but the process of rationalization has occurred far more slowly than I thought. 

In the end, the situation in U.S. shale reminds me of the cutthroat steel industry of Carnegie’s heyday, plagued by long periods of brutal commodity prices.  The winners in these industries will be those with strong balance sheets who can execute with capital discipline and be the low-cost producer. 

Although it’s always challenging to be a deep contrarian and look for “treasure” amidst what is being tossed out as “garbage,” other investors that are more well-known and well-capitalized than me appear to be doing the same thing:

https://www.bloomberg.com/amp/news/articles/2019-11-14/sam-zell-says-he-s-buying-distressed-oil-assets-amid-slowdown

 

GSE Update

Another name that I’ve been wrong on so far is the GSE preferred securities, which I recommended all the way back in my Kaoboy Musings debut on 9/18/19.  The on-the-run benchmark that I view as the proxy for all 40 flavors of these securities is FNMAS, and this name is down 28% from 9/18/19, with 10% of it coming today.  What’s even more surprising is that most of the news that has come out has been generally supportive of the thesis even if the timing is not 100% known.  Therein lies the trickiness of timing markets and the importance of being patient – in the short-term, it is often impossible to ascertain what kind of expectations might be embedded in the market.  In the longer-term, I might be 100% right on my thesis and potential upside target in this name, but in the short-term, I could be very wrong in knowing what market participants have embedded into the stock price.  In my experience, volatility and timing uncertainty almost always accompany situations with outsized return potential.  For this trade in particular, it has been an 11-year roller coaster; the difference this time, however, is not if GSE reform is happening, it’s when; given that, I’m surprised at the depth of the selloff even if timing is pushed out by a year or so (and I’m not convinced that it is).  As I have previously indicated, I have owned these securities from much lower levels for 11 years now.  The reasons why I continue to think these preferred securities are interesting (far more so now given the near 30% decline) can be summarized in Kaoboy Musings 1-4, 9, 12.  I added to my position today for the first time in several years.

The Billion Dollar Question, however, is timing – I believe recent comments from FHFA Director Calabria have introduced some uncertainties regarding timing of the outcome, and I think this is the primary catalyst for the selloff as opposed to anything material to the thesis.  On November 15th, Calabria suggested that Fannie/Freddie may not exit conservatorship until 2022-2023 but in the same breath mentioned that they would likely need to raise new capital by 2021-2022 – this suggests to me that they still have a lot of heavy lifting to do (negotiating with Treasury, settling the lawsuits, etc.) in a hurry despite Calabria’s comments about the process not being calendar dependent.  On November 19th, Calabria and the FHFA announced that it will re-propose capital requirements for the GSE’s in early 2020, and since a capital raise is unlikely to happen before such capital requirements are finalized, the bearish argument I’ve heard is that this pushes out the capital raise/conservatorship exit to a date beyond the 2020 elections, which then presents political risk in that a Warren Presidency could conceivably fire Calabria and name its new FHFA Director with a different agenda entirely. 

I have several problems with this bearish thesis: 1) it should not be a surprise to anyone that it will take time for the GSE’s to rebuild capital even under the partial uncapping of the Net Worth Sweep enacted on 9/30/19, 2) given the hostility Calabria/Mnuchin encountered at the 10/23/19 testimony in front of the House Financial Services Committee, I don’t think it’s a bad idea to avoid making GSE reform a political football until after the 2020 elections, 3) as I’ve opined many times, I don’t think even a Democratic Administration will ultimately risk destabilizing the mortgage markets by severely altering the trajectory of the GSE’s; if the end goal is to get them well-capitalized enough to stand on their own in the future and still preserve the 30-year mortgage, I don’t see many alternatives to the current plan, 4) I still believe that between now and the 2020 elections, the FHFA/Treasury are likely to take several steps (in addition to some of the ones already taken) that will make it difficult if not impossible for a new Administration to “unscramble the egg” without risking disruption to the housing market; as mentioned earlier, if they plan to raise capital in 2021-2022, this only gives them a year or two to accomplish a lot of milestones – almost all of which should be positive for the thesis, 5) finally, if the depth of the selloff can be truly attributed to a real chance that Warren may win the Presidency, one would think the overall markets would be correcting severely instead of plumbing new highs. 

There is one more credible explanation for the severity of selloff, since I don’t believe it has to do with the fundamentals of the thesis.  Two other widely-held “hedge fund” names, Pacific Gas & Electric (“PCG”) and Intelsat (“I”) have collapsed due to idiosyncratic issues (see below).  My sell-side trading contacts tell me that there is significant cross-ownership of these names along with the GSE preferred securities and that heavy losses in these unrelated securities may have led to forced selling of other holdings like the GSE’s.  Taken in isolation, I would be a bit skeptical of this as the proximate reason for the GSE selloff; however, taken with the concurrent Calabria comments that may have disappointed some weak-handed holders with perhaps unrealistic expectations on timing, I think it is very credible.

Interestingly, I came across a blog post from Todd Sullivan who is a fellow value investor that has been invested in these GSE preferreds for years.  The following are paraphrased notes he took from a talk Craig Phillips (a Treasury official who worked extensively on GSE reform with Mnuchin before he resigned on 6/17/19) gave on 11/15/19:

  • He thinks the GSE’s will be privatized Administratively with “zero chance” of Congressional involvement
  • Treasury thinks that its warrants are potentially worth $60-$80 bn and that it wants to IPO
  • He thinks that Treasury must deal with junior preferred holders in order to IPO
  • He thinks that preferreds get equitized to common (see my “home run” scenario below)
  • After this equitization, he thinks the capital raise occurs
  • The “receivership option” mentioned in the 10/23/19 hearing was just “posturing” and “not even being considered”

The most interesting thing that Todd speculated on is that Warren Buffett was being considering to write the sizeable check required for the capital raise.  I quote Todd: “Why Buffett? I’ve heard now from 3 different people that execs from Freddie were in Omaha last week. I doubt it was for steak dinner.”  Indeed, as an avid Berkshire/Buffett watcher myself, I’ll note that Berkshire now has $128 bn of cash burning a hole in its pocket. 

The bottom-line is that outside of timing uncertainty, I don’t think anything about my thesis has changed, except that the original upside / downside risk of 100% up / 50% down has now improved to  ~180% up / 30% down based upon my original price targets for FNMAS.  For certain less liquid, off-the-run issues like the ones I own, I believe the upside / downside is more like ~235% up / 15% down.  I am basically modeling slightly above par (~107%) for the upside target and around ~27% of par as the downside.  I believe there is very low likelihood of a zero outcome in the GSE’s, and I think that there are “home run” scenarios where the preferred gets equitized to new common, and the upside becomes uncapped and can ultimately be 300-500% in this case. 

Given how long this thesis has taken to play out, I think the market is perhaps exhibiting some PTSD whenever there is any uncertainty, but I think to dismiss the very real momentum behind the push to exit conservatorship when the only real issue is timing is to miss the forest from the trees – especially when the timing of events required to occur before a 2021-2022 capital raise still suggests the likelihood of many positive catalysts within the next 12-18 months, which was the original timeframe I mentioned in Kaoboy Musings 1.  

At the end of the day, anything with this kind of potential return often carries with it an enormous amount of volatility, so caveat emptor -- if it is not within your constitution to withstand this kind of volatility, I would not get involved in this name. 

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About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

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