This blog has often speculated about the business of forecasting and prediction; warning commodity investors in particular of the poor track record, the dangers of faux accuracy and the often misaligned incentives of the forecaster.
“The future ain’t what it used to be” – Yogi Berra
This November marks the two year anniversary of the publication of my second book, “Crude Forecasts: Predictions, Pundits & Profits In The Commodity Casino”. The book was my attempt to formalise everything I’d learnt and written on the subject into something that would hopefully change investor and industry behaviour for the better. To mark the anniversary I’m giving away 25 voucher codes to download the Audible version of my book for free (in order to claim read the rest of this article).
“It’s like déjà vu all over again.” – Yogi Berra
The crude oil price forecasting track record has improved slightly since the book was published. Over the past few years the average oil price forecast had an error of 18% over just six months (an improvement from 27% error seen over the previous decade) and away by 11% over a 12 month outlook period (much better than 30%).
“No one goes there nowadays, it’s too crowded.” – Yogi Berra
New EU rules that came into force in 2018 forced asset managers to pay directly for research. Mifid II, formally known as the second Markets in Financial Instruments Directive, was widely regarded as one of the most complex sets of financial rules to be introduced in response to the 2008 financial crisis. EU regulators became concerned that trading costs (which tend to be passed on to asset managers’ clients) were inflated to include the cost of providing “free” research reports.
Research was frequently used as marketing fodder, raising the profile of the investment bank among current and potential new clients. Once these regulations were introduced, the incentive to appear on financial TV networks peddling their research will be much lower, or at least will only be open to those that can justify the expense.
That has also meant that forecasts of commodity prices and other assets are much less visible to the public than they were just a couple years ago. I know from my own Twitter feed that forecasts just are not as prominent as they were. And that’s a good thing.
“We made too many wrong mistakes.” – Yogi Berra
Forecasters (well some) also tend to be more humble than in the past. Whereas in the past an incorrect forecast was quickly shelved away in the basement, some are digging them out in their gory detail. CRU in particular have been open and honest about what they got wrong.
In order to claim your free Audible download of Crude Forecasts: Predictions: Pundits & Profits In The Commodity Casino simply reply to this email. Only Materials Risk subscribers.
In a recent note (The precious one) I highlighted the extreme bullish sentiment in the palladium market as evidenced by the narrative from financial media headlines. The point being that when sentiment is stretched then it can often mean that a strong move in the opposite direction in imminent.
Recall that around three-quarters of palladium demand comes from the auto-catalyst sector. The high price of palladium versus platinum has meant that car companies have been eyeing the cheaper of the two metals. A signal that manufacturers are moving out of palladium into platinum could be the spark that narrows the price gap between the two precious metals.
Back in March the feedback was that it would take 18 months to two years to make a switch once that decision had been made. What has been missing is any evidence that car companies have been substituting palladium for platinum. But where to find the first sings of this happening?
According to Matthew Turner, ex-precious metals analyst at Macquarie look no further than the central European country of North Macedonia!
This country had little to do with the global PGM markets for much of its history. It is not a producer, and in 2009 reported imports of unwrought PGMs of only $1. That might sound a little implausible, but probably not far from correct – in 2008 PGM imports were less than $20,000.
And yet in 2010 it imported over $100m of PGMs. And by 2018 this was over $1bn, with more than 1 Moz of PGMs imported. This year is approaching $1.5bn.
What gives? In 2010 refiner Johnson Matthey (JM) opened a diesel autocatalyst plant, which was expanded in 2013. This is why North Macedonia’s exports of catalysts also exploded, rising from nothing in 2008/2009 to nearly $2bn in 2018 (Macedonia has not gone its own car industry).
This is great for an analyst. Other large catalyst manufacturing countries are also PGM traders, such as the UK, and/or jewellery consumers, such as the China and the USA. This means it is hard to draw firm conclusions from trade data. But in North Macedonia it is just catalysts – therefore it is safe to assume the imported PGMs are being used in that sector.
As such because we can break the trade data out by metal we can use it to estimate what proportions of platinum and palladium JM are putting in their catalysts. If we look at its imports by volume, we see that more platinum is imported than palladium – in 2018 nearly 800 koz of the former to around 350 koz of the latter – making palladium 28% of the combined volume to platinum’s 72%. This is to be expected given the plant is producing diesel catalysts. But importantly this proportion of palladium in the mix doesn’t seem to have fallen in the last few years – indeed it modestly rose from 24% in 2015*.
The latest import data (September) shows little evidence of any substitution. Palladium as a share has averaged 36% over the past 6 months, well above levels seen in 2018.
As Matthew suggests the import data cannot prove that no substitution is taking place:
There could be other effects masking it, for example if JM have been importing additional palladium than they are using in catalysts (indeed it looks likely), perhaps ahead of the rising price or Brexit. It also might be that the mix of heavy and light vehicle autocatalyst could have changed, affecting the ratio (that’s what seems to have driven palladium’s share down in 2013 after the plant’s first expansion). And if the plant had begun manufacturing gasoline catalysts all bets would be off, though then we would also see rhodium imports, and we have not.
We also can’t assume that JM’s Macedonia plant is representative of all their catalyst plants or those of other catalyst manufacturers. And it is possible substitution is happening in gasoline catalysts, not diesel ones.
Meanwhile, trade data is notoriously volatile, SIC codes are open to interpretation and publication has a lag of several weeks. It’s far from being a perfect indicator.
Although the key bullish turning points in the price of palladium (2010 and 2016) match up with palladium’s increased market share, what is also clear from the monthly price chart below is that the price of palladium is well above levels seen in 2013 – the last time palladium had a 35% share.
All of which means that despite this analysts best efforts to understand the demand drivers for palladium we come back to where I started this note. Market sentiment is the primary driver of price.
What’s the connection between tobacco and fossil fuels? Not much you might think. Both are commodities of a sort.
Both of them have been at the centre of global anger. In the late 1990’s tobacco was feared, hated, and disgraced.
A recently updated post from Capitalist Exploits compares the current headwinds facing oil companies to those facing the tobacco industry in the late 1990’s. Capitalist Exploits lists all the things going against tobacco:
“An industry in decline. Widely considered to be murderous thugs. Banned from advertising via many traditional media channels. Fined by regulators. Enjoying a blizzard of litigation. No innovation in the industry.”
Two decades on today’s equivalent is fossil fuels and the oil company specifically. Oil majors are taking heat from the courts, from the media, from the public, from banks and from investors:
Lawsuits over climate change proliferate across the United States – Reuters: “A trial in which Exxon Mobil Corp (XOM.N) stands accused of defrauding investors out of up to $1.6 billion (£1.2 billion) by hiding the true cost of climate change regulation is expected to wrap up this week.”
Do today’s global protests have anything in common? – BBC: “Of course, many of the protests that you hear about will have been linked to the environment and climate change. Activists from the Extinction Rebellion movement have been protesting in cities around the world, as they demand urgent action from governments.”
How Climate Divestment Won Converts With Deep Pockets – Washington Post: “Norway took a partial step in selling off oil and gas stocks in its massive $1 trillion wealth fund. And a growing number of investors who control trillions more are using the threat of divestment as a cudgel to force energy companies to adopt greener ways. Together these approaches are producing a notable disruption in the energy field.”
If today’s oil company was yesterdays tobacco company what does that mean for investors? Well, most people think that means don’t invest in oil companies. Putting aside any moral, ethical or environmental argument if no one else is investing then it can’t be a great investment.
The performance of the tobacco sector over the past two decades says something very different. Far from being the laggard, tobacco companies have outperformed the broader market.
Why do sin stocks outperform?
Companies selling alcohol or cigarettes among other human vices have enjoyed higher returns than the stock market indices to which they belong. Tobacco companies have even performed better than the pharma companies making cancer drugs to combat smoking-related illnesses.
Since all active fund managers seeking to make higher returns than the benchmark this in theory makes them ideal holdings. However, investors holding them can face reputational risk, particularly as lobbyists rally against industries known to harm human health, and as we will see later the environment.
A popular explanation for the observed abnormal returns of sin stocks is that they are under-priced because so many investors shun them. According to a 2017 research note by hedge fund firm AQR Capital Management (Virtue Is its Own Reward: Or, One Man’s Ceiling Is Another Man’s Floor), investors must be compensated to buy constrained stocks through higher returns:
“What happens when one group of investors, call them the virtuous, simply won’t own a segment of the market (the sin stocks)? Well, in economist terms the market still has to “clear.” In English, everything still gets owned by someone. So, clearly the group without such qualms, call them the sinners, have to own more than they otherwise would of the sin stocks. How does a market get anyone, perhaps particularly a sinner, to own more of something? Well it pays them! In this case through a higher expected return on the segment in question.”
A more recent explanation is offered by David Blitz, Head of Quantitative Research at Robeco, and Frank Fabozzi, Professor of Finance at EDHEC Business School, in their article Sin Stocks Revisited: Resolving the Sin Stock Anomaly published in the Journal of Portfolio Management. They show that the outperformance of sin stocks can be explained by ‘profitability’ and ‘investment’:
“The profitability factor means that stocks with a high operating profitability perform better, while the investment factor maintains that companies with high total asset growth perform worse. Sin stocks tend to have high exposure to both factors; cigarette makers, for example, enjoy high margins due to relative price inelasticity, and are restricted in how they can grow their assets.”
The new tobacco
In many respects the sector is facing a perfect storm with economic, political and social factors providing the foundations for similar out-performance over the next decade or two.
The switch towards electric vehicles, the recent decline in the price of oil since 2014 and the broader public revolt against climate change. Far from being a negative for the biggest U.S. and European oil companies, it could even be positive.
The most important factor is the principle of “diminishing returns”: The more crude that oil companies discover, the lower the returns their investors can hope to achieve. This is because new reserves tend to be more expensive to develop than the earlier discoveries. This flaw was disguised for the past 40 years as oil prices rose even faster than the costs of exploration and production.
In a competitive market the rational strategy for major Western oil companies would be stop all exploration, while continuing to provide technology, geology and other profitable oilfield services to the owners of readily-accessible reserves. The vast amounts of cash generated by selling oil from existing low-cost reserves already developed could then be distributed to shareholders until these low-cost oilfields ran dry. In the real world of course, geopolitical conflicts and transport and infrastructure bottlenecks mean that consumers want energy security and will pay premium prices. Hence the need to explore and develop oil resources elsewhere in the world.
There are two reasons why this ‘rational strategy’ hasn’t happened thus far. Firstly, OPEC has sheltered Western oil companies from diminishing returns and marginal-cost pricing by keeping prices high. Secondly, oil company managements have believed in rising oil demand. Finding new reserves seemed more important than maximising returns to investors.
Tobacco consumption has dwindled over the past few decades in a generational shift. The main exception being China where per capita tobacco consumption has continued to rise.
Moving to oil, there is wide disagreement on the speed to which consumption growth will slow and go into reverse. Many point to the continued growth in petrochemicals as a source of demand for oil, even as its mainstay – transport – declines. Either way the demand for oil is set to remain price inelastic across many end applications and markets for many years.
Meanwhile, Extinction Rebellion and other forces will serve to restrict the growth in the oil sectors assets. As tobacco and other sin stocks before it, restrictions on asset growth may help support the returns of their investors.
There is always a cost to everything in life, even (and perhaps especially) virtue.