Howard Marks, Oaktree Capital — 2022-03-23
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Memos from Howard Marks 2022-03-23T07:00:00.0000000Z" pubdate title="Time posted: >3/23/2022 7:00:00 AM (UTC)">Mar 23, 2022
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As regular readers of my memos and books know, I'm strongly interested in – you might say obsessed with – the concept of the pendulum. The following is only a partial list of my writings on the subject:
My second memo, written in April 1991, was creatively titled First Quarter Performance . It talked about the oscillation in securities markets between euphoria and depression; between celebrating positive developments and obsessing over negatives; and thus between overpriced and underpriced assets.
On Regulation , written in March 2011, discussed the outlook for rulemaking stemming from the Global Financial Crisis. I said future developments were likely to be driven by the long-term pendulum-like swing in attitudes on that subject. Over time, those attitudes tend to fluctuate between "the markets best serve the country when they're unfettered by rules" to "we need the government to protect us from participants' misbehavior."
In The Role of Confidence , from August 2013, I discussed the way shifts in fundamentals are translated into market volatility by often-excessive swings in investor confidence.
And in my 2018 book, Mastering the Market Cycle , I interrupted my discussion of the various cycles – in the economy, corporate profits, credit availability, etc. – to use the metaphor of a pendulum, not a cycle, to describe the swings of investor psychology.
Because psychology swings so often toward one extreme or the other – and spends relatively little time at the "happy medium" – I believe the pendulum is the best metaphor for understanding trends in anything affected by psychology. . . not just investing.
People frequently ask what caused me to start writing memos in 1990. My very first memo, The Route to Performance , resulted from two events I witnessed in short order, the juxtaposition of which led to what I thought was an important observation. Over the years, many memos have been prompted by connections I sensed between ostensibly unconnected events.
At a recent meeting of the Brookfield Asset Management board, a discussion of Ukraine triggered an association with another aspect of international affairs – offshoring – which I first discussed in the memo Economic Reality (May 2016). Thus the inspiration for this memo.
Background
The first item on the agenda for Brookfield's board meeting was, naturally, the tragic situation in Ukraine. We talked about the many facets of the problem, ranging from human to economic to military to geopolitical. In my view, energy is one of the aspects worth pondering. The desire to punish Russia for its unconscionable behavior is complicated enormously by Europe's heavy dependence on Russia to meet its energy needs; Russia supplies roughly one-third of Europe's oil, 45% of its imported gas, and nearly half its coal.
Since it can be hard to arrange for alternative sources of energy on short notice, sanctioning Russia by prohibiting energy exports would cause a significant dislocation in Europe's energy supply. Curtailing this supply would be difficult at any time, but particularly so at this time of year, when people need to heat their homes. That means Russia's biggest export – and largest source of hard currency ($20 billion a month is the figure I see) – is the hardest one to sanction, as doing so would cause serious hardship for our allies. Thus, the sanctions on Russia include an exception for sales of energy commodities. This greatly complicates the process of bringing economic and social pressure to bear on Vladimir Putin. In effect, we're determined to influence Russia through sanctions . . . just not the potentially most effective one, because it would require substantial sacrifice in Europe. More on this later.
The other subject I focused on, offshoring, is quite different from Europe's energy dependence. One of the major trends impacting the U.S. economy over the last year or so – and a factor receiving much of the blame for today's inflation – relates to our global supply chains, the weaknesses of which have recently been on display. Thus, many companies are seeking to shorten their supply lines and make them more dependable, primarily by bringing production back on shore.
Over recent decades, as we all know, many industries moved a significant percentage of their production offshore – primarily to Asia – bringing down costs by utilizing cheaper labor. This process boosted economic growth in the emerging nations where the work was done, increased savings and competitiveness for manufacturers and importers, and provided low-priced goods to consumers. But the supply-chain disruption that resulted from the Covid-19 pandemic, combined with the shutdown of much of the world's productive capacity, has shown the downside of that trend, as supply has been unable to keep pace with elevated demand in our highly stimulated economy.
At first glance, these two items – Europe's energy dependence and supply-chain disruption – may seem to have little in common other than the fact that they both involve international considerations. But I think juxtaposing them is informative . . . and worthy of a memo.
Russian Energy
In 2019, Russia's top four exports were crude petroleum, refined petroleum, petroleum gas, and coal briquettes. These totaled $223 billion, or 55% of Russia's total exports of $407 billion, according to the Observatory of Economic Complexity.
As shown in the following table, Russia is exceptionally well positioned to wield influence over Europe through exports of energy commodities.
Europe Russia Produces Consumes Net Produces Consumes Net Oil (bbl/day) 3.6 mm 15.0 mm (11.4 mm) 11.0 mm 3.4 mm 7.6 mm Gas (cu met/year) 230 bn 560 bn (330 bn) 700 bn 400 bn 300 bn Coal (tons/year) 475 mm 950 mm (475 mm) 800 mm 300 mm 500 mm Source: "The West's Green Delusions Empowered Putin," Michael Shellenberger, Common Sense with Bari Weiss , March 1, 2022. Some data is approximate or rounded. ( Common Sense is probably as tendentious as other media outlets, but I have no reason to believe the data is inaccurate.)
The implications are clear. Europe uses far more energy than it produces and makes up the difference through imports. Russia, on the other hand, uses far less than it produces, leaving the remainder to generate economic and strategic gains.
How did things get this way? According to Shellenberger (see source above):
While Putin expanded Russia's oil production, expanded natural gas production, and then doubled nuclear energy production to allow more exports of its precious gas, Europe, led by Germany, shut down its nuclear power plants, closed gas fields, and refused to develop more through advanced methods like fracking.
The numbers tell the story best. In 2016, 30 percent of the natural gas consumed by the European Union came from Russia. In 2018, that figure jumped to 40 percent. By 2020, it was nearly 44 percent, and by early 2021, it was nearly 47 percent.
The following chart makes the situation clear. In 1980, imports from Russia represented less than one-third of Europe's oil and gas production. European production peaked about 20 years ago and has almost halved since then, ending up near where it was in 1980. In the same roughly 40-year period, imports from Russia have tripled, meaning they're now roughly equal to