In the long-duration world created by QE, where the promise of jam tomorrow seemed preferable to the certainty of jam today, our focus on companies that are returning capital – rather than for businesses burning through cash as they chased growth – looked out of step with the zeitgeist. Today, however, things are changing…
After a long period of underinvestment in the ‘physical economy’…
The flip side of the deluge of capital being offered to growth stocks was that – in relative terms – the cost of capital for established, profitable companies in old-fashioned industries increased. As a consequence, for almost a decade, we saw underinvestment in some of those companies who keep the physical economy ticking over:
- Energy companies.
- Commodity producers.
- Construction stocks.
- Transport companies.
- Producers of building materials and industrial machinery.
In the case of the energy companies, the market was, in effect, dissuading them from investing in new fields, building new refineries or committing the capital needed to maintain and replace productive assets as they matured and degraded. Instead, it was signalling a preference for providing city dwellers with cheap taxi rides and heavily subsidised food deliveries.
Refining: where fixed supply meets rising demand…
Perhaps the clearest example of this process can be seen in the refinery sector – a defiantly unglamorous, dirty, ‘old economy’ industry whose various products nonetheless remain essential to the modern economy. Designing and assembling the byzantine riddle of pipes, tanks and distillation columns that comprise a modern refinery is both costly and time-consuming. A long period of low oil prices (and the greater attention being paid to ESG scores) made capital markets reluctant to fund new refining capacity: a full-scale refinery cost as much as $10 billion to build and take as long as a decade to complete.
The result is that refiners in the US have, over the past three years, retired capacity equivalent to around two million barrels of oil a day – enough petrol to fuel an estimated 30 million cars. As demand for petrol, aviation fuel and the host of petrochemicals that refineries produce roared back after the pandemic, the capacity to meet that demand was no longer there. The increase in the ‘crack spread’ – the pricing differential between a barrel of crude oil and the petroleum products refined from it – shows what happens when price-inelastic demand encounters fixed supply.
The snap-back in demand after the pandemic and the disruption caused by the war in Ukraine were both important triggers for revealing the lack of spare capacity in some basic industries. But investors need to recognise that they are not the only underlying causes of the inflation we see around us today. That carries important implications for your investment portfolio.
