Who's Gonna Take the Weight?
Zoltan Pozsar’s latest is great and mostly takes account of logistics challenges in commodities networks. To wit:
Which then leads to the very appropriate comparison to money markets - just like plumbing can jam in the money markets you can get short term jams in commodities that are hard to move. The reason metals have given up a lot of their gains and less fungible products have not has a lot to do with this.
So short term the working capital requirements of the global economy goes up: stuff costs more, because it has to spend more time in transit on boats which requires more funding at a time at which not much is available. I was at a large bank around the time that regulators decided that physical trading and ownership of transportation equipment to move commodities was - for vague reasons that seemed to be conspiracy theory driven as much as anything - a bad thing. I would argue now that was evidently not a great move. Pushing the the physical trading business and ownership of the assets to support it out of too big to fail banks solved precisely nothing: commodity networks are too big to fail regardless and regulators have no capacity to coerce or fund the entities that now do it. Oops.
So now we have less lending to commodity trading houses that are mostly unlisted and unwilling to substantially dilute and who can simply lend less since most of their book of “loans” is short dated and can be collapsed quickly. They owe nothing to regulators and cannot be compelled not least of all because they use very little repo like funding now. Can hedge funds or regulated asset managers step into physical trading and logistics like this? That is a good question - while there are parts of the industry that look like trading houses recent developments at the likes of Greensill are going to make banks fairly reluctant here. Tradeflow might be in a good position, and there are real asset funds that own a lot of infrastructure but actually pulling it all together is yet to be seen. As Kool and the Gang once asked “who’s gonna take the weight?”
Zoltan’s final points are interesting but misses what are likely to be a very robust and durable response of the users of physical products and the networks that move and use physical products.
Energy users want motive power (gas in your tank) or heat (gas heating) or light (computer screens, lighting). There are multiple paths and means by which to deliver these goods - you could get a plugin or EV, and you could get a heat pump and solar panels or the like for heating or cooling. Light demand has already been crushed by solid state lighting from LEDs and barely merits a mention these days. Fossil is not the only game in town and while demand destruction in credit leads to slowdowns for economies every time the contraction of demand for fossil imports can both reduce the price level and lead to investment led growth - albeit at the expense of exporters. For power grids the expansion of renewables, nuclear and storage have similar impacts in improving growth in the shorter run and reducing trade deficits and the price level in the longer run - especially from the kind of obscene power prices we see in Europe today. This is where coming from the monetary world and monetary heuristics can be misleading - you really can innovate your way out of physical demand, and certainly imports in a way you cannot out of the flow of funds.
For the networks that move physical products we are likely to see massive changes as well. Russia has a large customer in China for oil and gas some of which that now cannot be delivered due to all the shipping constraints. That will change: pipelines cost $2-3.5mm per km to build and Russia shares a border with China. It would be nothing short of extraordinary if Russia and China did not improve their pipeline interconnect over the next few years and not just Power of Siberia 2 which alone could reroute almost 2/3 of Russian gas exports to Europe. This would lead to a double blow to the shipping industry and by implication logistics demand and costs:
Russian demand for shipping would fall as exports move across pipeline to China.
Chinese demand for ship based imports from other locations would fall and total tonne kilometres would fall as vessels make shorter trips from the Gulf to Europe as opposed to Gulf to Shanghai.
On that basis while the short term may indeed be “our commodity, your problem” for many countries dealing with this shock, the medium term is likely to be “our substitution, your problem” as demand is permanently impaired and transport networks are reconfigured to lock in producer and consumer networks in the what might be described as an authoritarian axis. This is likely to work well for China as Monopsonist in chief but I struggle to see how suppliers do well out of this, particularly Russia. Producers in the Atlantic bloc will at least be able to put oil on a VLCC and move it anywhere they so choose which is an inherently more appealing option than having one buyer. For this reason the fixed income market is not that crazy pricing in a lot of hikes and inflation followed by moderation. We need to invest to get out of this shock which will be on the margin somewhat inflationary but a world where most of our energy costs have very little to do with input fuel and that fuel comes from places with less geopolitical friction is likely to be one of very moderate inflation and volatility. The other world network is likely to be very similar but it will tend to lock in producer and consumer relationships. The law of one price is going to break down on a regular basis: a recession in China could lead to reduced demand but Russia will have limited takeaway capacity meaning that crude grades from different locations will likely get wildly out of sync every time economic blocs do.
These kinds of changes are far from hypothetical. In coal Mongolia has been expanding rail interconnect to China and is likely to be able to export close to an additional 50 million tonnes per annum run rate of coking coal by the end of this year - in a market that China imports about the same amount and for which the total seaborne market is a touch over 300 million tonnes. Russia has also expanded its Transsiberian railway and has taken substantive share from Australia in both thermal and coking coal exports following a politically motivated ban on Australian imports. In many respects look at coal if you want to get a sense of the future here as we exit COVID interruptions and move into a new steady state of regionalized trade in energy products.
For example the spread between Zhengzhou 5500kcal coal’s third contract and the equivalent one for Newcastle 6000kcal. Historically they would be bound around a tight range that could be explained by calorific difference and transport costs. That is clearly no longer the case - coal cannot be exported from China and China has a relative surplus onshore while offshore markets are tight due to the loss of Russian supplies and need for increased European coal burn. Things are going to be strange and non-linearly so going forward in this trade blocs and transport constraints world.
From an investing point of view Victor Shvets’ recent appearance on Oddlots gets this right: invest where the solutions to this mess come from in electrification, battery materials, nuclear and the like. It is hard to call the end of a war or when Trafigura gets back to normal or call coal prices unless you are harvesting a lot of data and running a large graph model - it is much much easier to guess that policy efforts and spending to reduce use and dependency will intensify from here.