Congratulations ESG activists! Mission accomplished. Inflation series part 1

And current positions update

Inflation will be the dominant force over the next decade of global macro, and will shape geopolitics and the world’s economies in drastic ways. It’s hard for me to express my long term views without readers understanding the path I think inflation will take and what the underlying drivers are. For that reason I’m starting a series of posts about inflation. Here is part 2 and part 3.

People who know me are aware that I’ve been into nature conservation and solving the world’s climate problems for many years. What drives me to make trading and investing profits is being able to direct money towards fighting climate change and preserving nature. When I started down this path, it felt like my worries were falling on deaf ears. Corporations polluted and emitted carbon and destroyed the Earth’s natural resources in their pursuit for profits, while governments did little to stop them. It didn’t help that most Republicans were either climate deniers or did not think fighting climate change was important.

I longed for the day when the world would wake up and realize how the burning of fossil fuels was sending the world towards climate disaster, and stop pumping it out of the ground. A day when the negative externalities of hydrocarbons would be priced into the market (via carbon taxes or higher prices), causing consumers to think twice about taking that extra flight or paying for food flown from halfway across the world instead of local, and force consumers to make sacrifices in their energy consumption. A day when the world would have no choice but to invest massive amounts of capital into clean energy, electric cars, and other technology to reduce our carbon footprint.

That day is nearly upon us.

I realized this when I was preparing to catch up with one NGO that played a crucial part organizing the 2019 climate movement. They were going to talk about how their activists were organizing protests around the world against corporations and banks to stop pipelines, fossil fuel projects, and funding of fossil fuel companies. I decided not to fund that NGO this year. Not because I think we need more fossil fuels in our lives, but because protesting against them will be futile from now on.

I realized that their activism would be like pushing on a string and would no longer be effective in today’s world where countries like China and India suffer from rolling blackouts, where Europe’s energy costs have gone up 3-5x, and where the cost of fuel in the US will result in the Democrats to lose power as quickly as they gained it two years ago. Sri Lanka’s government and economy have collapsed due to energy shortages. This turmoil is just the beginning, as the price of crude oil is at $120 today, and may reach $150 by the end of this year and $200 within the next few years. The climate transition will be messy and will require deep sacrifices from the world’s population. Poor people and poor countries will suffer the most. Geopolitical and economic instability will ensue.

Right now we need additional clean energy capacity more than we need less fossil fuels. We need to fight the anti-nuclear lobby more than we need to fight energy companies. We need to invest in upgrading grid infrastructure and more efficient appliances, cars, and buildings. To accomplish this we need governments and economies to be stable, not on the brink of collapse.

How did we get here? First we had Greta Thunberg and the climate movement in 2019-2020, which triggered a huge rotation of capital into ESG assets and out of fossil fuel and carbon intensive companies. The movement increased the cost and scarcity of capital for fossil fuel projects. The ESG movement imposed large costs on emitters, who were pressured into making net-zero commitments and investing capital into measuring and reducing emissions. I was pleasantly surprised at how quickly this sea change happened and continues to this day.

Second, COVID brought the energy industry to its knees by sending WTI to negative prices and pushing a wave of excess oil supply into overflowing storage facilities. With nowhere to store newly pumped oil, shale drillers had no choice but to shut in wells. Once an oil well gets shut in, it takes time and additional capital to restore its ability to produce oil. Much of the capacity for shale to produce oil was permanently taken out during covid.

White=Baker Hughes oil rig count. Blue=WTI price

The Baker Hughes rig count is about 36% of where it historically was when oil prices were this high.

Lastly, we had Russia invade Ukraine, resulting in the West sanctioning Russian oil and effectively removing a large chunk of global supply from the market. Europe is willingly creating acute shortages and inviting economic pain upon itself by banning Russian energy. China and India have partially stepped into the demand void, but even they can’t hire enough sanction-proof VLCCs to ship Russia’s full production to their shores. For that reason, much of Russia’s oil production will be gone for the foreseeable future.

Even the US, which touts itself to be energy independent, is suffering from escalating gas prices due to insufficient refining capacity (some of it was taken out during covid). Because Russia exports diesel and refined products that refiners need to turn crude into gasoline and jet fuel, the US can’t refine crude fast enough to keep up with demand. This is evidenced by the widening crack spread, which is the difference between the price of crude oil and its refined products, such as gasoline, diesel, and jet fuel.

White=WTI oil, Blue=crack spread, Orange=gasoline prices

Energy goes into everything we consume. Semiconductors, plastics, and metals use fossil fuels as an input, and the cost of fuel required to ship raw materials from around the world goes into the price of finished products such as iPhones, cars, and houses. With the US shale boom in the rearview mirror and Russia oil capacity permanently impaired, energy shortages will persist and make inflation sticky for the next decade. Central bankers who think they can bring inflation back to their 2% targets for a sustained period of time are simply fooling themselves. In this current cycle, we have not yet even reached prices that will force a significant reduction in demand. The unfolding energy transition will be punctuated by energy crises, recessions, and rolling inflation shocks. Policy makers will flail helplessly to fight these fires, swinging back and forth from deflationary to inflationary policies within short periods of time. Wars will be fought, governments will be toppled, and fortunes will be made and lost. Buckle your seatbelts, because it will be a wild ride!

Current positions

Short SPX futures, stop at 4210 and targeting 4000. Higher oil and European yields point to further risk off next week, while Fed Treasury auctions will be the first salvo of liquidity removal in this new era of QT.

Long WTI futures

Short ETC/BTC, stop at 0.068 - BTC is trading sideways and choppy so ETH/BTC might be a better way to play the crypto bear market as QT progresses. BTC is being supported by Asian whales, while ETH is suffering from positioning and sentiment overhang from defi and crypto funds.

My eur/usd short got stopped out on last week’s rally from the lows.

I wanted to sell Euribor futures on Friday but couldn’t get a decent rally. I’ll likely put that position on this week. The Fed had a moment back in March when they realized how behind the curve they were. Everyone on the board turned hawkish and they took whatever hikes the market gave them (which was a lot - EDZ2 went from 98.00 to 96.59 over the next two months). I believe the ECB is going through that inflection point right now.

German CPI is at 7.9%, and is likely to go higher and remain higher than the US, where CPI is probably peaking. This is because their monetary policy stayed looser for longer, and their energy crisis is more acute than the US. There are also some drivers behind the underlying components of European CPI vs US CPI causing this that I won’t get into.

German CPI YoY

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