The Big Picture: With the war, E, S, and G have collectively moved back to the fore

B. G., Opalesque Geneva

Patrick Welton

Dr. Patrick Welton Founder and Chief Investment Officer [email protected]

In this interview, Dr. Patrick Welton, founder and CIO of Welton Investment Partners, offers his observations on the major macro themes expected to affect the commodity markets, including crude oil, and ESG investing this year.

Welton is an alternative asset manager based in New York City and Carmel, California, founded in 1988, that invests in alternative investments, quantitative investments, managed futures, statistical arbitrage, global macro, multi-strategy, ESG, and sustainable finance.

According to him, the war in Ukraine represents a new inflection point and has resulted in E, S, and G (environmental, social, and governance) collectively moving back to the fore – whereas before, many investors would only invest in the “E” part of ESG investing. An inflection point is an event that results in a significant change in the progress of a company, industry, sector, economy, or geopolitical situation and can be considered a turning point after which a dramatic change is expected to result.

Opalesque: What is your take on the current state of the commodities market?

Dr. Patrick Welton: The war is the new inflection point. I call it an inflection point because it did not change the story. Commodities have had many issues for some time: shortages, transport, and distribution. Most of these issues have been primarily or secondarily related to Covid, either through problems in production or consumer shifts from services back to goods, especially in Western countries. The war compounds real supply issues and multiplies them with uncertainty. The current supply-chain issues were already complex. The war further impairs all the economic actors responding to pricing and working to unsnarl them.

Opalesque: How is war the new inflection point?

P. W.: The war is the new inflection. In that continuum, there are both direct and indirect effects.

The direct effects are enormous. Russia and Ukraine are involved in the production of all major sectors of the commodities: grains, energies across the board, and metals. Not only is production being impaired now, but even if the war ended tomorrow, production would still be impaired for months or longer to come. That does not include an assessment of impairments at port and transport facilities.

Another direct effect is the sanctions. They impair financially. Beyond the immediate effects, the export restrictions, for instance, to Russia will cause pervasive downstream effects on Russian production if they can no longer get replacement parts, keep factories producing, oil rigs pumping, and even tractors running.

We have already been seeing indirect effects. Consumers and businesses around the world have choices. If those choices are not existential for them, we are finding out who wishes to support what they view either as an amoral action or who feels it is a gross violation of the world order. While a notably few express indifference, most of those with economic power choose not to support Russia. So, with loss of production and downstream issues from the sanctions, even if all the indirect long-term consumer business choices were unwound tomorrow, the commodity story is for the foreseeable journalistic and macro future here to stay.

Opalesque: How do you navigate today’s commodity markets?

P. W.: We have a long legacy of trading commodities. This experience helps us do well today. We trade commodities in all sectors. For most of those, we have been strongly profitable over the past six months of this increasing inflationary period punctuated by the war. We are systematic and quantitative in our general view of market directionality, and we use financing term structure shape and other inputs that reflect the financial positioning of hedgers and producers. So, we have generally been long grains, long energies, and long metals. Interestingly, though, as some of those markets exploded in volatility or had accelerated significant price moves, we have also been sellers. This reduction of our position sizes captures a portion of those profits while holding our risk exposure more level. These are extraordinary times, and without a disciplined process of adjusting our position in the marketplace, our risk exposure to those markets would have risen proportionally to extraordinary levels.

Opalesque: What is your view on the future of the crude oil market?

P. W.: There isn’t anyone in the world that is not thinking that crude oil is overall in a raging bull market. But if you look at February, the price has not changed on net very much. The market has been more volatile than advancing. Across all our strategic approaches, we are actually closer to neutral crude oil, still slightly long but much less than we were many months ago when it was a purely fundamentally-driven bull market instead of a war-whipped, policy-inflected bull market.

For our portfolio, crude positioning is all about the probability of which direction is best and over what time horizon and the size of those positions relative to the volatility. Oil now routinely moves $5 or $6 per barrel in a day. A year or two ago, it would typically move 40 cents a day. That’s how we would size our positions. We take wide-ranging views. Some are short-term, so we reassess the crude oil prices every 5 and 15 minutes. Others are long-term with positions that might last throughout the year.

If crude oil were to resume a robust upward path for whatever reason – facilities are damaged, the war persists, reserve releases stopped, it does not matter, the actual cause is always multiple – we would generally have more long positions. If there is demand destruction because sanctions reduce trade, people switch energy sources, crude oil may oscillate at a high level, such as $120-$140 a barrel, but we may see a lot of roller-coaster effects, in which case we’ll tend to be more neutral.

Opalesque: Is it a good time to invest in alternative energies and infrastructure?

P. W.: From the perspective of pure finance, that’s a project-by-project, company-by-company decision. The theme is right. And, and though right before the war, there is a newfound conviction today. That overlaps with ESG investing.

Within ESG investing, there was an early movement among investors focusing more on the “E,” on environmental and low carbon investing, as almost a separate class. The war has changed all that. E, S, and G collectively have moved back to the fore because E, S, and G are inextricably related.

On broad platforms, you now hear open debates on the virtue of transiently increasing oil and gas production to weaken totalitarian growth. The Social and Governance positives outweigh the perception of the short-term carbon increase. But it is usually paired with rising voices for non-carbon energy sourcing, getting serious funding to achieve real scale on renewables instead of settling for 10 and 20% increases per year on a small base. More are taking a collective policy view on scale zero-carbon energy, sourcing with terawatt goals using a collection of modern generation micro and medium-sized nuclear reactors to accompany Deca-gigawatt solar plants and wind. And you need to have a mix to achieve scale zero-carbon energy generation. Battery and storage technology will not increase as fast as scale needs.

Opalesque: What about your ESG investments?

P. W.: We look at our ESG equity investments and their rankings every day. It is an active strategy influenced by ESG rankings, ESG improvements, and the market. If the entire stock market declined, we would be in cash. Thanks to our active positioning and our belief that investment risks are specific sustainability risks to ESG investing, our ESG investments have just had the largest quarter of outperformance in their history.

Opalesque: What macro scenarios are you seeing?

P. W.: In a scenario with peace beginning suddenly (our hoped-for scenario), we would see a temporary drop in some of the pressured commodities, grains, energies, etc. Those would be relatively large moves. But the marketplace is always pricing more than just today. It is pricing the collective, capital-weighted future. There is a limit to the amount of price adjustment the markets are willing to make until they see action. These scenarios always happen in stages. The information takes time to propagate and to be trusted. So, even a short-term scenario of healing is weeks to months long.

There is a more realistic scenario of re-equilibrating, like perhaps losing a significant part of wheat and grain exports this season, replanting adjustments worldwide as farmers are now adjusting to pricing and costs, like fertilizer. Different plants use different amounts of fertilizers, so the ratio of various plants will change. The balance of plants harvested for livestock feed will be different. All these downstream effects will be occurring soon in the Northern hemisphere. Most of those plants will be in the ground in a few months, and all that acreage will be subsequently reported fueling market reaction. Then the harvest conditions will matter. All this pricing and equilibration will occur in the second and third quarters and affect our views on commodity prices. The commodity story won’t be going away.

Energy, of course, has a long ramp-up period to production. It also has intermediation levers and risks. For example, if the U.S. wanted to, it could rapidly accelerate production compared with current high price signals alone. Some of the strictest gating aspects of energy production could be overcome by simply providing financial guarantees for lenders and financiers in our shale fields to ensure against their downside tail risks. If they did so, you would realistically be able to spur production up to several millions of barrels of oil and gas equivalent. And it would spin off excess gas for export. The nation could even start converting the long-haul transportation fleet to gas, as T. Boone Pickens proposed many years ago, as a bridge to an electric transport future. That would drop domestic usage by hundreds of thousands of barrels per day, releasing more for export.

(Article reprinted with permission from Opalesque).

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