Refinitiv Newscasts - Breakout: Riding the cycle

Big Sky Industrial

11/11/2022 09:34

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Source: Reuters

Description: As the world braces for an economic downturn, commodities have
taken a hit. But oil and mining giants have been cutting investment for almost
a decade, Edward Chancellor tells Peter Thal Larsen. The resulting shortages
could allow these companies to buck the market downturn.
Short Link: https://refini.tv/3fZMzB5

Video Transcript:

Can the energy companies and the miners actually deliver positive returns in
the face of a global recession?

Welcome back to Breakout with Breakingviews sponsored by PGIM. I’m Peter
Thal Larsen, the global editor of Breakingviews in London and joined by Edward
Chancellor, who is in the West of England. Eddie, good to see you again.

Good to see you, Peter.

So today we're talking about the capital cycle. The investment in commodities,
in mining, in extracting oil and gas and so forth. Eddie, before we get into
your argument and the broader implications for investors and for markets, just
tell us a little bit about what the capital cycle is.

Well, Peter, you're asking the right man, because I've edited two books on the
capital cycle. So, if anyone is --- (0:56), it should be me. The capital cycle
is an approach to investment. Developed, actually, by a fund management firm
in London called Marathon. And the idea is that investors shouldn't spend
their time worrying about demand in any particular industry, because demand is
inherently unknowable, but should focus on supply conditions. And because
supply we know something about in both the short and the medium term. Now, the
point is about the capital cycle is investors should buy into sectors,
industries, where the capital cycle is in a benign position. In other words,
there's been a period of capital contraction and industry consolidation and a
lack of investment and shares are cheap. And they should get out of the
capital cycle at a period of peak optimism when there's been large over,
rising investment in an industry.

Because the point of this is, by nature cyclical, I suppose, right? Because if
you think of mines, or semiconductor plants or whatever, you spend lots of
money, you invest, then you create new capacity, and then the price of
whatever it is you're selling them, drops. And then you have overcapacity and
the cycle corrects itself.

The interesting thing about it is that investors, most investors spend three
quarters of their time or if not more, looking at demand. And the problem is
that that's where they make the most common mistakes. Whereas if you restrict
your focus to supply, if that's your discipline, you tend to deliver much
better investment results.

Right. And so, your argument is that, particularly for things like oil and
mining and stuff like that, that investment is down a lot. But it's been
relatively restricted. Why is that?

Well, I have a number of reasons, but both mining, well, both energy and
miners had a great boom, if you remember, after the global financial crisis on
the back of China's rapid investment boom itself. And that blew up in 2014.
And well, the energy companies became less profitable, the miners actually
lost a lot of money. And some of them had to be recapitalized. And it takes a
while for that to sort of flow through this system. And then, but it should,
we're now in a sort of, if you will, a benign stage to the capital cycle for
both energy and mining. And you can tell that for instance, one of the key
metrics for capital cycle is to look at capital spending relative to
depreciation. And for the US, the US oil majors to the European oil majors
capex to depreciation ratio has fallen from above two times in 2014 to below
one today. And you look same true of America. I cite the capital spending by
Chevron has collapsed. I went to a presentation the other day in New York at
the Grant's conference where a person presented on US oil rigs, that's an
industry where all the major players, except one, when bust, there's been
massive consolidation. And there are no, and a lot of rigs have been scrapped.
So, and then I also cite the case of Halliburton where its property plant and
equipment is down by a massive 65% since 2015. So there's Halliburton, the
world's, I think it's the world's largest oil services company has actually
contracted its own capital base by two-thirds. And the set roughly similar
picture is true on the mining sector. I cite a former colleague of mine at
GMO, Lucas White, head of the Natural Resources Strategy. He says that the
miners have cut that capex by 65% in real time. So, this is a really severe
contraction of capital spending in both those industries.

To follow that through then so you would expect, well obviously, at the moment
people are worrying about a slowdown and possible recession in Europe and
elsewhere. For you, so your --- (5:17) will be because the investments have
been restricted, that when, if and when demand does come back for them, you
will get a big uplift of prices and these companies will all make very big
returns.

Yes, I mean, I think that the world is worried about net wealth, the energy
companies are worried about that net zero 2050 commitments by governments,
which would lead if it were achieved to a massive contraction of hydrocarbon
demand.

But as I say, the capital cycles say, you have to be cautious about predicting
demand. And I also cite my piece, the eminent Canadian scientist, --- (6:01),
who argues that any transition from hydrocarbons will be slow. So, I think one
has to sort of put aside demand concerns over the very long term. So
multi-decade. What we do know is that if shifting to alternative energy will
require actually a large upfront investment in traditional hydrocarbons, plus
a lot of other stuff, we have concrete and a huge amount of copper. So, what I
think is interesting, you just take the question of, can the energy companies
and the miners actually deliver positive returns in the face of global
recession? On the --- (6:42), you'd say no because these are inherently
cyclical businesses. But then I cite another natural resources investor, Adam
Rosenzweig of --- (6:54) and Rosenzweig. And he says, well, actually, and this
is quite interesting, I didn't know this before I did the piece. In 1929, US
energy and mining companies had been starved of capital for the best part of a
decade. Then the great cash crash game. And as you know, the US economy
contracted I think about 25%, large numbers of people unemployed, caps and
price level. If you look at the performance of the miners and energy stocks by
1937, miners and energy stocks are both up by about a third from their price,
pre the great crash. But the rest of the stock market was down 50%. The US
stock market didn't actually reach, recovered to its peak level until 1947. By
which time the energy companies were up threefold, and the miners were up to
twofold. So, you can see, so the argument there is that the capital cycle is
actually even more powerful, a more powerful force for investors in particular
industries than actually a great depression. Now, I mean, this might be over
egging you Rosenzweig is after all a natural resources investor, but if you
look at the last couple of years, the oil companies, energy companies have
outperformed very solidly. Commodities have taken a dip, but I think going
forward, purely from a capital cycle perspective, you can expect both those
sectors, well you can expect energy to continue outperforming and I think you
can expect a rebound from the commodities.

Okay, well, there's a little bit of positive prognosis in the gloom. Eddie,
fascinating as always. Thank you for your time and I'll speak to you again
very soon