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The Energy Report

The Energy Report

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China, Japan and Chekhov's Gun—Where Does Fracking Fit In?

If there's a gun on the table in the first act, it will be fired by the end of the play. The way legendary portfolio strategist Don Coxe sees it, the potential to bring on vast U.S. energy reserves is the gun... or is it a safety valve? Don Coxe tells The Energy Report that the fracked oil and gas boom has saved the U.S. from endless recession and explains why he remains bullish on China and Japan as sources of energy demand. Coxe also shares his preferred portfolio allocation ratios between industrial and financial stocks, bonds, metals and energy, with a weight on fossil fuels.

The Energy Report: The consensus of The Street for the last 18 months has been that the slowdown of China's economic growth is not temporary. Do you agree?

Don Coxe: Since the current commodity boom started up in 2002, critics of my strong belief in the future of China's growth have said, "It's not real. The numbers are phony. China is about to collapse. There is too much corruption in Beijing." And China just kept on growing at double-digit rates! The reason China stopped growing at double-digit rates is the economic collapse in the Europe and the United States—the principal customers for Chinese exports.

But even during the rolling recessions in the U.S. and Europe, China has grown its GDP at 7%, which means that it is experiencing substantial internal growth. Admittedly, China has added dramatically to its government debt, but because the country had a 30% savings rate before the 2008 crash, its financial system has been able to draw on a huge pool of savings for sustenance, instead of borrowing money to sustain consumer growth.

China has a built-in method of achieving GDP growth: When peasants on 1½ hectare farms are barely able to feed themselves, they migrate to industrial cities. The small farms are amalgamated into larger, more efficient farms, which produce more food and increase China's GDP. When the farmers flock into the cities, housing is built for them. There are no ghost towns in China. A real ghost town is downtown Detroit, where skyscrapers reflect the demand of the past, but not the present.

This basic model of economic growth has carried China through the worst industrial recession since the Great Depression. Rising iron ore prices alongside increased consumption of oil are growth indicators. And China's 10-year plan is to move from being the world's main producer of goods to being the world's main consumer of goods. China's leaders are planning to increase imports and to provide all sorts of consumer goods for the populace.

As for energy: People who live on farms where the air is fresh are reluctant to move into cities choked with coal smoke. The Chinese are cutting back on the use of coal and using less-polluting hydrocarbons for power generation. On the other hand, people are buying more cars. And even 10-lane highways are getting congested, which means that more highways will be built to accommodate more cars. All of this growth requires oil.

TER: Where will the oil come from?

DC: Back in the sixties, oil sold for $4 per barrel ($4/bbl). Now, a new oil field cannot be opened up if oil is priced under $60/bbl. The low-hanging fruit, the oil that's really cheap to produce, is no more. But there is still plenty of oil available through fracking in California and in the Alberta oil sands and offshore drilling. That means spending a lot of money on refining, because processing heavy crude to light crude to gasoline is a very expensive process.

TER: Where's the capital going to come from for expanding the fracking and refining sectors?

DC: The oil industry can borrow capital to expand because it can easily grow its output. U.S. refiners are aggressively taking leadership from the European refiners. The Swiss did not retool for heavy oil after the collapse of Libya removed the country's light crude source. The Saudis expand refining capacity for heavy crude, not light crude. The only good supply of light oil on land is from fracking. But the oil industry can only grow fracking so fast, and each oil field has different characteristics. Big oil cannot meet total demand with fracking alone. The next 25 years of growth in the oil industry will be a combination of light oil from under the ocean floor and light oil from fracking.

TER: Will China be able to develop its internal oil fields, or will it be forced to import large amounts?

DC: Down the line, China has a lot of potential for growing a fracked oil and natural gas industry. In the meantime, we are seeing growth in exported liquid natural gas (LNG). The oil industry aims to get higher prices for its frozen natural gas by shipping it to China.

If worldwide GDP growth averages 3% for the next five years, it is hard to see how oil prices could fall. But the current situation is a really good story for oil—in many ways the best story since the seventies. Despite the fact that there is zero inflation, oil prices have gone from $70/bbl to $100/bbl. In the past, that kind of increase in oil prices would have automatically meant higher inflation, but this time around it did not.

TER: If Europe and Japan continue to grow, how will that affect energy prices?

DC: When the Japanese ambassador spoke in Chicago a few months ago, he began his speech by saying that Japan has no commodities. This is the third biggest economy in the world and it has to import virtually everything. Japan has no oil, no gas and it cannot use nuclear power because of Fukushima. It is not going to coal, because Tokyo does not want to have the kind of air pollution problems that afflict Beijing. It is going to be hydrocarbons, one way or another. The Japanese economy is strong and will continue to grow fast. It is ironic that in less than a year, Japan went from a negative growth rate to a rate 50% higher than the U.S. growth rate.

TER: What is driving Japan's growth?

DC: The fact that Japan devalued the yen is driving its growth. Japanese manufacturing and exporting companies were in a poor position with the yen stuck at 75 to the dollar. Remember that it had fallen from 250 yen to the dollar when Japan was booming in the eighties. The 75 yen to the dollar meant that Japan's manufacturing companies had to be incredibly efficient to attract exporters. Now the yen is floating, and manufacturing cash flow is available to expand outputs. Japanese manufacturing is now competitive with China and the rest of the world.

The devaluation of the yen is causing Japanese consumers to unzip their wallets for two reasons. First, they see strong economic growth. Second, Prime Minister Abe has announced that a new sales tax will debut in April. Consumers are afraid that prices are going to rise because of the increase in Japanese exports, and also because of higher sales taxes. The double whammy encourages more economic activity, and that activity feeds on itself positively for growth.

TER: You have previously mentioned the positive economic effects of public/private partnerships on economic growth. Would you call that Keynesianism?

DC: Public-private partnerships are a form of Keynesianism because they can use the state to expropriate land to build roads and bridges. Private companies cannot deal efficiently with a farmer who says, "You bought land to my south and to my north, so I am raising my price per acre from $5,000 to $25,000." Eminent domain takes care of the gouging issue. Capital needs the public sector.

Another example is that public pension funds promote increased cash flow over the decades for retirees. After the crash, the pension funds were in desperately bad financial shape with zero interest rates. Public-private partnerships in energy ventures are now providing long-term investments with a built-in inflation hedge. These types of investments create wealth in both the private and public sectors through the magic of compound interest.

TER: You talk about "Chekhov's gun" as the implied threat of the Federal Reserve to allow interest rates to rise. How is that threat affecting energy markets?

DC: The Russian playwright, Anton Chekhov, said that if there is a gun on a table in the first act of a play it will be fired later in the play. That creates a certain amount of suspense. Chekhov's gun was spotted last spring when Ben Bernanke said, in effect, that the Federal Reserve cannot continue adding $85 billion each month to the balance sheet forever. At some point, the Fed will start tapering down the stimulus project. That tapering down is Chekhov's gun. Initially, the bond market sold off. Ben must have thought, "We are only in act one of a play that is going to last for several acts." So the gun is still hanging there, unfired.


For the energy markets, however, Chekhov's gun operates in reverse: The gun is the threat of bringing on vast new energy resources. But everybody knows now that there are enough hydrocarbons in the ground to spur economic growth for a long time. In regard to energy, the gun is a safety device, as opposed to the bond market, where it functions as a threat.

TER: You are appearing at the Casey Research Summit this week. Can you give us a preview of your talk on the energy front?

DC: The U.S. would be back on the edge of recession if it were not for fracking. Fracking produces cheap natural gas and high-quality light crude oil. Thanks to fracking, we have been able to reduce the use of coal without shutting down the utilities. In the past, it was risky to rely on conventionally produced natural gas because natural gas prices could rise monumentally in times of shortage. Recall what happened after Katrina when natural gas went to $15 per thousand cubic feet!

Fracking will provide cheap natural gas for the next century without importing a cubic foot. It is a tremendous guarantee of stability to the U.S. economy. It also means that economic growth can be energized by light crude without having to rely on heavy crude. Without fracking, we would be spending trillions of dollars refining Venezuelan and oil sands heavy crude. We would still be in recession without fracking. The energy industry has done more for the U.S. economy than anybody except … Ben Bernanke.

TER: It is always informative talking to you, Don.

DC: It's been great fun.

Don Coxe has 40 years of institutional investment experience in Canada and the U.S. As a strategist and investor, he has been engaged at the senior level in global capital markets through every recession and boom since the onset of stagflation in 1972. He has worked on the buy side and the sell side in many capacities and has managed both bond and equity portfolios and served as CEO, CIO and research director. From his office in Chicago, Coxe heads up the Global Commodity Strategy investment management team, a collaboration of Coxe Advisors and BMO Global Asset Management. He is advisor to the Coxe Commodity Strategy Fund and the Coxe Global Agribusiness Income Fund in Canada, and to the Virtus Global Commodities Stock Fund in the U.S. Coxe has consistently been named as a top portfolio strategist by Brendan Wood International; in 2011, he was awarded a lifetime achievement award and was ranked number one in the 2007, 2008 and 2009 surveys.

By. Peter Byrne of the Energy Report

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