Luke Gromen (03:39):
They were in the mortgage insurance business piece of their business. And for a long, long time, it was a great business. It was proverbially picking up nickels in front of a steamroller, but for a long time, they dodged the steam roller. And then one year the impossible happened, the “Impossible,” because it did happen in the ’30s they just chose to ignore that. When the impossible happened, they were screwed and they were not setting aside capital, the requisite amount of capital to weather the losses. And so it was going to erode a significant portion or all of AIG’s capital base, which was a problem then based on who else they were doing business with around the financial system. And so to bring that back to what’s happening now in the U.S. government mortgage insurance on baby boom generation, which when it started, this process didn’t even exist. The boomers weren’t even born. They did begin being born ’til 1946.

Luke Gromen (04:29):
So social security was in place for 10, 12 years before they were even starting to be born. And so we had this 70 year period of time, 80 year period of time now, where there was no political courage to do what everybody knew was coming, any idiot with a sixth-grade calculator and a sixth-grade math education could tell you that 75 million baby boomers were born. It would stand to reason 75 million baby boomers were going to turn 65 someday and it was always put off. And so again, it was like this AIG mortgage insurance, the government was picking up nickels in front of a steamroller. They doubled down in 1968, which again, admirable in terms of its political goals in the ’60s, being old was synonymous with being poor by and large. And so again, providing healthcare for the aging and admirable political goal, but again, no political courage in the ensuing time as 75 million baby boomers back then were anywhere from four to 22 years old, they had 50 years, 50 plus years to fix this problem.

Luke Gromen (05:27):
There was no political courage. And now the big gear problem number one in the U.S. specifically, because if the reserve currency issuer, but more broadly in Western social democracies, as the bills do. And just like AIG, the U.S. government has never set aside any capital to pay for this. They’ve always taken the premiums if you will, and immediately redeploy them into other things which when they go to things like the Eisenhower Highway System, that’s a good thing, when they go to things like the internet, that’s a good thing when they go to things like the Iraq War and Afghanistan, that’s a catastrophe because it’s like pissing money away. And so the bottom line is that we’re now in this situation where we owe a bunch of debt, the bigger deal is we owe a bunch of these off-balance sheet liabilities are coming on the balance sheet because the “Impossible happened again,” which is to say 75 million baby boomers, turn 65 surprisingly.

Luke Gromen (06:21):
And so you’ve got this same type of problem as we had immediately aftermath of World War I, which is everybody knows everybody else, and nobody has the capacity to pay in anything resembling real terms. And so it comes down to default or print. And so that I think is big gear number one, and we’ve said it before, we probably said it on this show is the Fed I think, and other central bankers are trying to ride two horses with one ass, which is just to say, they’re trying to convince global bonds holders that they’re not going to print while convincing domestic voters that they are going to print. And these horses are increasingly riding in two opposite directions. They’re going to have to choose sooner or later from, call it April of last year through April of this year, they did a very good job convincing the world, central bankers paired with their partners in the fiscal agencies and the governments themselves, that they were going to print.

Luke Gromen (07:15):
And we saw it happened in April. There’s been this concern really late April early May. This concern that well, maybe they’re not going to print and they’ve been doing everything they can sort of, “Well, we’re not going to inflate it away” and try to jump from one horse to the other horse. And so we’re in this deflation scare, I don’t think it’s going to last for very long simply because it really can’t, but that’s really the one big gear, which is this global sovereign debt, global sovereign obligation bubble is bursting. And they’re just trying to figure out if they want it to burst in real terms or nominal terms. The other big gear is something that was a much bigger theme 10, 15 years ago, and is starting to come back up, which is in 2002, Matt Simmons wrote Twilight in the Desert about peak oil, Saudi Reserves, et cetera, peak oil, Peak Cheap Oil, which is a metric I prefer simply because it, I think more accurate, it describes that the cheap stuff it’s gone and it’s getting more and more expensive to replenish the reserve base.

Luke Gromen (08:11):
Peak cheap oil was a really big theme for commodities from, call it 2002, 2005 through 2011, 2012, maybe even to 2013. And one of the big, massive surprises to the positive, post-great financial crisis was the expansion of U.S. shale production. And something that has quietly been happening post-COVID has been, if you look back from ’05 to 2014, 2016, basically the only growth in global oil production, the vast majority of it has come from U.S. shale and post COVID the shale guys have high graded so much of their acreage that they’re making noises that’s going to be really, really hard to expand production at any price for the foreseeable future.

Luke Gromen (08:58):
It’s not to say they couldn’t, there are the resources available, but the punchline is that there is this resource commodity scarcity issue. You’ve heard people talking about it in copper as well, which is obviously important for the electrification of vehicles, gas, and natural gas as well. There have been some concerns in Europe. Europe’s biggest oil field was supposed to be shut down by 2030, or excuse me, Europe’s biggest gas field Groningen, was supposed to be wound down by 2030. They’re actually going to do it by 2022.

Luke Gromen (09:28):
So there’s this theme of energy commodity as a scarcity that was a big theme 15, 20 years ago, went away for a period of time during the expansion of U.S. shale. And I think that’s starting to come back in. So I think the other big gear that we’re watching governments deal with is energy policy, energy scarcity, trying to rework economic systems and address this for their populations. And you can see that in any number of ways. So I think these are these two big gears that we’re really dealing with, which the confluence of both of them I think are make for a whole lot of volatility.

Trey Lockerbie (10:05):
I’ve got to dig more into that. I think I’d like to just go back to what you were saying a bit earlier with the debt. We’re now at 28 and a half-trillion dollars of debt. And the debt to GDP is over 143% as of today. But my question, I guess, is going back to World War II, we were in a similar position. And we did inflate away the debt. But at this stage now that there’s not a gold standard like there was back in World War II, is it apples to apples? Does the debt to GDP even matter anymore?

Luke Gromen (10:36):
It only matters to the extent that resources are available or are not available, shall we say. And so if they want to inflate away the debt, that’s fine. That then leads to two problems. If you are right, the MMT crowd would say, “Well, don’t worry just inflated away.” The constraint on the system is simply resources, they’re right. And when they say resources, it’s inflation, when does inflating away the debt drive inflation so high that they can’t behest the inflation numbers and get away with it? If real inflation is four and they say it’s two, or it’s five it’s two. Okay, great. When inflation is 15. And they’re saying it’s two, that’s hard for them to maintain their credibility. That’s an issue. And that then feeds into the second point, which is when debt is this high and critically after World War II, you didn’t have free capital flows.

Luke Gromen (11:33):
You just couldn’t move capital all over the world with a couple of keystrokes like you can now. And so it was easy to trap capital in place. A debt capital in particular, while you screwed the holders of that debt capital on a real basis, it was just what they did. And they were very upfront with that in the aftermath of World War II, that “This is what we’re going to do.” Remember our first constraint is inflation. And so if inflation gets too high, that you can’t even deny any more than, “Hey, it’s actually 10, not two.” Now, at least even if that was the case. And it was the case from 1946, 1951, U.S. real rates were at their lowest negative 14%. Bondholders lost in a single year, 14% of their money relative to the cost of living, in a single year.

Luke Gromen (12:16):
And that’s how they took debt to GDP from 110 to 50%, over five years. And it just was what it was. There was the cost of the war. Thank you for your donation bondholders. However, critically those bondholders couldn’t go anywhere else. There were not free capital flows. If they tried to do that now, bondholders can move their money out of bonds anywhere in the world into something that will battle hedge their inflation. And there are other things that factor into that rule of law, et cetera. So as a practical matter, if they try to do that same thing, what’s likely very, very likely going to happen is you’re going to see bondholders saying, “Fine, you take the bonds Fed, you take the bonds ECP, you take the bonds Bank of Japan. I’ll take the equities, the ports, houses, real estate.” And so you can see this happening all over.

Luke Gromen (13:04):
When the headline comes out two weeks ago, three weeks ago that Blackstone’s buying 17,000 houses. That is, we don’t want treasuries anymore. They are going to be inflated away we’d rather own a house. And we can raise rates on that whereas the coupon and the treasury is fixed. The Chinese have been, and by the way, Blackstone doing this now is the same thing the Chinese for 10 years, which is, “You know what? We don’t want any more treasuries, we’ll take equities, we’ll take ports, we’ll take gold, we’ll take oil fields, copper, anything but fixed-rate sovereign debt.” And so there’s this very different setup this time in terms of the freedom of capital markets that really feeds back into that point before of how they’re trying to ride two horses with one ass and why they’re eventually going to have to choose, which is to say the horses are riding in different directions because they need very little high rates of inflation to get debt levels down in a relatively compressed period time again.

Luke Gromen (13:58):
Again, and you go from 110 to 50 over five years, took a negative 14% real rate at this lowest last time. Now we’re at 130, 140% to try to do it a little bit at a time. It’s going to take too long. You’re not going to be able to get out of it, given what’s going on, on the other side, in terms of the off-balance sheet liabilities coming on due to the boomers aging. And so you’ve got to do it relatively fast, but if you do it too fast, the bond market is going to be the frog in the hot boiling pot of water. They’re going to jump out. And what that looks like is the Fed’s balance sheet goes 8 trillion, 10 trillion, 20 trillion, 40 trillion, 80 trillion. That’s really my base case of some version of that. I don’t know, 80 trillion or 40 trillion, even the right number.

Luke Gromen (14:36):
But basically, they are trying to play this game back and forth, particularly post COVID of, “Hey, we’re going to inflate this thing away, its growth.” And then in April, I think they got there and they’re watching bitcoin at 60,000, they’re watching the lumber go vertical, they’re watching used cars go vertical, they’re watching houses go vertical, equities go vertical. And I think they all said “This isn’t good. Okay, guys, let’s pretend and scare them that we’re not going to inflate away the debt for, is it two months? And it’s not two months, it’s not three months.” I would’ve thought it was sooner, quicker. I would’ve thought probably a month or two, they’ve done it for, I guess we’re going on month three now. And it’s worked, lumber’s come down, used car prices are peaking. Whole house demand is slowing, we’ve had a few scares in the equity market.

Luke Gromen (15:18):
Ultimately I think it’s a very temporary thing, but they can’t have too many days in the Dow like yesterday in the markets like yesterday, before they’re going to have to go, “Hey, hey, we were just kidding. Just kidding. We’re back to inflating again.” And that’s this world we’re in right now. So it’s a tricky operating environment for them. It’s something that has been seen many times before in the last 40 years in emerging markets. It’s not been seen in developed markets since after World War I.

Trey Lockerbie (15:42):
Okay. I was recently interviewing economist Richard Duncan and asking him some similar questions. And his base case was essentially, that credit drives economic growth, in his opinion credit have peaked because we’ve pulled forward a lot of demand on the credit side because of COVID. And we don’t really see needing more stimulus of that magnitude anytime soon, now things could change. But at the moment, that’s how it’s looking. And even the infrastructure bill will be chopped up over a number of years. So in his base case credits peaked, so therefore inflation has peaked, then we’re talking to the CPI. And so, as you mentioned, there’s some manipulation potentially there, home prices used to be in the CPI in the 1980s, for example, they’re not anymore, but it begs the question. Can we even get to, like you said, 15% on something like the CPI this day and age, when we have globalization, that’s continuously deflationary on, I would say the metrics making up the CPI as well as deflationary technology?

Trey Lockerbie (16:46):
All of those forces are combating the CPI and given that, things like bonds, number of equities, even they’re priced on CPI. So I guess what I’m wondering is does the Fed? Is it that they’re just negligent or is it that they understand that deflationary forces are in play and that they’re going to have a very, it’s going to take a lot to get the CPI up to where it used to be. So they’re just taking full advantage of that?

Luke Gromen (17:12):
The short answers I think they can generate as much inflation as they want. And the reason I say that is we can make it real simple. We can just say, okay, the U.S. Treasury decides it wants to issue $1 million directly into the bank account of every American women, children, men, everybody, and the Fed’s going to buy all of it. The Fed’s going to buy every bond, yeah, they’re going to… So it’s basically just a helicopter drop of money, a million dollars per person. There’s going to be inflation. So if we say extremes informed the means, then we say, okay, they can absolutely generate inflation. Now, there’s a couple of key caveats that we can sort of derive from that, that we would need to see to get there. Number one is it has to really be a pairing between the fiscal authority, the U.S. government, and the monetary authority, the Fed.

Luke Gromen (17:55):
And we saw that marriage between those two after COVID in a way we did not see it after ’08 and lo and behold, we got some really nice inflation rates, some really nice GDP reading, from that point to be a political question, really on two fronts, number one, can Congress and the fiscal authority ever agree on anything which to the deflation’s point has been and likely remains a very big impediment until those people’s 401(k)s get threatened? So as soon as Nancy Pelosi goes from being worth 115 million bucks to threatened, to be worth 80 million bucks or vice versa on the other side of the aisle, it’s amazing how quickly they’ll get to work together to find something, to get their net worth statements back to all-time highs. And that’s fine. It is what it is. That’s the political reality. I’m not opining on whether it’s right or wrong. It’s just is what it is.

Luke Gromen (18:44):
The other question then is also political and it comes down to be blunt. It’s a question of what is more important to you politically, America or the bond market? And in particular, the 99% or the 90% of America or the bond market? And what I mean by that is that from call it 1982 until last year, I would argue last April, the U.S. policy was basically, subjugate the American middle and working class to support the bond market. The bond market always had to be taken care of. And if that meant austerity, if that meant offshoring jobs, if that meant whatever, bailing out banks, that was what was done. And there’s very much a group of policymakers, economists, politicians that support this have supported this, if you go back to 1998 or 1999, you see the Committee to Save the World on the cover of Time Magazine.

Luke Gromen (19:42):
Those are like the crown princes of the bond market over 90% of America. And it’s the Larry Summers and it’s Robert Rubin and it’s Alan Greenspan at the behest of the Clinton administration and the Bush administration, et cetera. There was a 40-year policy subjugate, 90% of America to support the bond market. And to support the dollar, the dollar system has structured post ’71. Post-COVID, what we saw for a period of 12 months from April last year up until I would say late April early May of this year, there was a coordinated effort for the first time in 40 years to subjugate the dollar, subjugate the bond market in the interest of the 90% America, the U.S. middle and working classes. They were printing up money, handing it out. Backstopping the main street, backstopping small business, the bond market be damned and inflation reading shows that. And that was a 12 month period of time that was very different than what we saw in the prior 40 years.

Luke Gromen (20:38):
And since then, since late April early May, we’ve seen a bit of a change on that front. So to me, it really comes down to when you say, can they get inflation? It’s a political question on a couple of different fronts, the first metric, and then the second metric, which is, is it in the interest of the United States to support 90% of America or the bond market? The 10%? It’s probably more like the 5% or the 1% of America. And in the last three, four months, you’ve seen, guess who’s been out writing an article a week on Bloomberg talking about inflation? Larry Summers, our friend from the late ’90s, Bill Dudley, “Oh, watch out, inflation’s picking up.”

Luke Gromen (21:13):
And again, that’s fine. The offshoot to that then ties into some of the geopolitical points we made earlier, which is if we’re going to subjugate America to the bond market, then the offshoot to that is we’re going to offshore our manufacturing, our production base, et cetera, to China, and we’ve seen how that’s gone. And so there were the early days of that process of, hey, this is great, the Chinese, they make stuff cheap and they help us contain onions and they buy our treasuries and isn’t this thing great? And in the aftermath of COVID, we’ve come full cycle to like, oh my God, we can’t make anything without the Chinese, including weapons, including pharmaceuticals, et cetera. And so there’s been a bit of a swing away from the Larry Summers and the Robert Rubin on these policymakers that are the dollar system as structured post ’71 and the bond market over everything else, simply because the national security establishment is in their ear and other policymakers here go on “Look, guys, it is not in our interest to be so beholden to China economically that we can’t make anything ourselves.”

Luke Gromen (22:15):
And so, again, that hasn’t mattered. It looked like it was starting to matter from April of ’20 to April of ’21 in the last two, three months, it looks like it’s kind of gone back to, hey, we need to take care of the bond market for a little bit. My base case is that we have made a major shift post COVID toward reassuring, taking care of the 90% to the detriment of the dollar, to the detriment of the bond market. But it’s not going to be a straight line. So I think to summarize, we can generate inflation. I think we will ultimately generate inflation. It’s a political question. The government can create the money, hand it out and either has the Fed print it up or have it change the Fed’s charter and have it handed out directly from the Fed, however you want to structure it. But it’s a political question. And right now, the politics are in favor of not doing it.

Trey Lockerbie (23:03):
So you write a fantastic newsletter. And in the most recent one, it appears that you’ve got a couple of drivers in your opinion that could be inflationary. One being the repo market activity, the other being the Peak Cheap Oil, as you mentioned, but on the flip side, some deflationary pressures might be coming from China and it’s slowed down in credit growth. So I want to dive into each of those and let’s start with the repo market. This seems like the canary in the coal mine of sorts, right before COVID hit, there was a lot of flurry there happening before the rest of the markets seem to dive. So has this become a key indicator to you? And if so, in what way? And possibly dig in a little bit on what the repo market is as far as what is how, I understand, so the plumbing, it’s the transactions between banks, but what is driving all of this mania happening there?

Luke Gromen (23:55):
There’s any number of people that are better to talk to than me on the actual mechanics of how the plumbing works. I think I have a decent feel for how the big pieces fit together with the macro and what it’s telling us from a big picture perspective. The repo market is just an overnight or very short-term lending market where basically assets of all stripes are financed across the system. I think what the trouble we’ve been seeing in repo markets have been, there’s two sorts of schools of thought. There is the, oh, it’s just regulatory. It was regulatory on September 19. When we had repo rates spiked to eight to 10%, the repo reverse repo, it’s just regulatory and different opposite regulatory problems.

Luke Gromen (24:41):
I take a bit of a different tack. I think it was regulatory, but I think those people to turn a phrase or missing the forest for the trees and have continued to miss the forest for the trees, which is that if we look at the regulatory regime which is Basel III, so in September 2019, Basel III the constraint was that the banks did not have enough reserves relative to the amount of U.S. Treasury issuance, because they didn’t want to go any higher under Basel III. And as a result that you created the supply-demand, mismatch, and rates spike. And so the Fed then stepped in with not to weed to basically buy the short end, basically, what the banks couldn’t or wouldn’t buy for regulatory reasons under Basel III, the Fed did.

Luke Gromen (25:25):
So it is nominally correct to say it was regulatory with that said the elephant in the room is the Fed or the U.S. Treasury was issuing so much at the short end, despite rates being very, very low in part because there’s no demand. There’s not nearly enough demand to issue that much paper at the long end, without sending rates to prohibitive levels or forcing the Fed into QE at longer durations, which they were at that point still taping. They were trying to do the opposite. The repo rates spike back in September 19 was really was regulatory, but it was a symptom of too much treasury issuance to the short end because there wasn’t enough demand at the long end, from the historical creditors of the U.S. that were very, very favorable central foreign, central banks, foreign pension funds buying at the long end.

Luke Gromen (26:11):
If we go forward in time to now this reverse repo spike, they have sort of the opposite problem, which is the Fed’s been buying so many treasuries. The U.S government’s been issuing so many, the Fed’s been issuing, or the Fed’s have been buying so many, the accounting key account of the Fed buying the treasury as they buy the treasury and they credit reserves the bank’s reserves. So basically the government spending the money, they issue a treasury, the bank buys the treasury, the bank then turns and sells the treasury to the Fed. When the Fed does that, they credit a reserve balance for the banks and the Fed the treasury on their balance sheet. Now, this is the opposite problem, which is under again, nominally this is regulatory, there are also rules and under Basel III, as it relates to the amount of bank reserves that begin to elicit a capital charge for banks.

Luke Gromen (26:59):
So banks don’t want to have too many treasuries, which was the problem relative to reserves on September 19. And they don’t want to have too many reserves relative to everything else, which is the problem as we moved into April of 2021. And so when you look at it this, so what’s interesting is from March 31st to 2021, there was something called this Supplementary Leverage Ratio, which is one of the regulatory constraints on bank balance sheets that was causing this and basically the Fed said y exempted treasuries from that for the bank. So basically meant the Fed. The banks could buy as many treasuries as they wanted without bumping up against these regulatory constraints. It was basically helping the Fed do QE without calling it QE.

Luke Gromen (27:42):
March 31st, those expired for domestic political reasons, including people like Elizabeth Warren, et cetera, thinking it was a handout to the banks, not really realizing it was really a handout to her own government, ironically, but basically, the Fed decided or got political pressure that it was a bad look, but it was still a handout to the bank. So they get rid of the SLR exemptions for treasuries, for banks on March 31st and on April 1st, lo and behold, the reverse repo facility for the Fed begins going up and up and up and goes from basically zero to a trillion dollars by quarter end in just three months. And so there was a lot of talk about the weather… The reverse repo facility was tightening whether it was a sign of a crisis and most of what I saw on it nominally, again, it was too many reserves that the Fed is sterilizing there were reserves.

Luke Gromen (28:27):
So basically treasury issues a bond, bank buys the bond, bank sells the bond to the Fed, Fed credits reserves, Fed then has the bond and then Fed reverse repost the bond back to the bank repeatedly to basically sterilize reserves, to keep the reserve balance below regulatory limits, an accounting creation. So there’s a lot of talk at, hey, it’s just a symptom of too many reserves that just sterilizing the reserves, which again, nominally is true. But again, I think it misses the forest for the trees, which is I have it on very good record, that they are a very good account that these RRP. The reverse repo is not on balance sheet. It’s basically an off-balance-sheet special purpose vehicle for the banks. And if we look at it that way, the reverse repo balance rising the way it didn’t, staying as high as it has effectively meant is it’s almost like an Enron like SPV to help the U.S. government finance itself.

Luke Gromen (29:23):
Where if you go back in time this is great. Enron was repoing barges at the end of every quarter to one of their broker partners to get them off-balance sheet for when they did quarter-end books. And then they bring it back on the balance sheet, whatever. It’s the same thing, which is the government issues bond, bank buys the bond, bank sells the bond to the Fed, bank credits bank reserves, and then Fed takes bond and repose it back to the bank to sterilize the reserve pile and the reverse repo balance just goes up and up and up as the pile of reserves sterilized goes up. You’re basically helping the banks, the banks are helping the Fed finance the government while the Fed at the same time are helping the banks circumvent the Basel III regulations as it relates to both the lower constraint that how many treasuries they can own and the upper constraint, how many reserves they can have.

Luke Gromen (30:15):
And so to me, what this reverse repo and when I put it together, especially with the other one, it’s a different side of the same coin. But I think again, you don’t want to miss the forest for the trees. The fundamental issue, the big gear is that the U.S. debt is high and rising, and they don’t have sufficient global private sector buyers. And so they are getting increasingly creative with finding ways to have the Fed finance it, help the banking system finance it. And then once they started bumping up against Basel III restrictions on how much the banks could help the Fed finance the government, the Fed started helping the banks circumvent the Basel III regulations.

Luke Gromen (30:51):
And so I think ultimately what we conclude is that the reverse repo balances having done what they did in the second quarter, this suggests that sort of this inflationary trade remains risk on. That it’s, nothing’s really changed. It’s just that they’re using some creative, basically an SPV to move stuff off-balance sheet to keep financing the government and keeping it nominally within the framework of the Basel III regulations, even if not sort of in the spirit of them.

Trey Lockerbie (31:21):
When you’re looking at the repo rate activity, does that mean it’s kind of benign and that way, or should we be watching it more closely?

Luke Gromen (31:29):
It’s one of those things where, to me, it depends on the other things that are moving around at the same time. If the Fed is still continuing steady as she goes with QE, both on the treasury and the mortgage backside, then I’m not sure that it matters a whole lot. If other things start moving around and it starts moving around, that might otherwise change that. So it really depends on the context, in my view.

Trey Lockerbie (31:55):
So let’s go into Peak Cheap Oil and why you think that is where it is, but also an inflationary measure.

Luke Gromen (32:04):
A couple of things happened. You can see it in the oils, in the oil numbers, and production numbers. You can see how much shale A, caught people by surprise myself included at the time I was not doing FFTT, but it was very surprising to see that in the early days of FFTT we wrote a number of reports talking about the problem with shale is the depletion rate is so high. In other words, right now, the depletion rate of the four big basins, which are Bakken, Niobrara, Permian, and Eagle Ford. The depletion rates running at about 5.4, five and a half percent per month. So in those four basins, they’ve got to grow production about 60% per year, just to stay flat. And that number changes over time, depending on how much they’ve produced are grown production by in the preceding 12, 24, 36 months. The further away they get from that, the depletion rate slows, the more they produce, the more increases in the near term and then slows.

Luke Gromen (32:56):
But the punchline is this is once the installed base of shale gets high enough, it gets harder and harder. It’s the red queen problem is such that you’ve got to run harder and harder just to stay in the same place. And so that’s always been known, what changed in the aftermath of COVID and there were a couple of different, Go Rosen did a great piece on this. And there’s a good article on Bloomberg at the end of last year as well, where it just, there’s something called high grading your reserve base and commodity production. And I’m no expert on this other than just the topical of what it means, which is when you high-grade your reserves base, when the business slows down, you back to your highest grade or basis, and you produce there because that maximizes your cash flow. And that helps you get back to the other side of the trough.

Luke Gromen (33:43):
And in 2014, when shale, when oil prices rolled over, that’s exactly what the shale producers did. They high-graded their production, they cut Rig Count normally, but the productivity of the remaining Rig Count shored as basically they pulled back to their highest production reserve base. What changed in the aftermath of COVID was once again, prices tanked, obviously, oil prices actually went negative for a brief period of time, Rig Count collapsed, just like it did in ’14, ’15, and instead, productivity fell as well. And the implication that Go Rosen pointed out and we’ve highlighted the article for our clients is that they’d already produced most of, or they produced a substantial amount out of their highest resource, most productive resources. And from there on, you are going to have these lower grade resource bases, which means that it’s going to be really, really hard at current prices anywhere near current prices or for the foreseeable future to exceed prior peaks at a time when their world global economy still growing.

Luke Gromen (34:42):
And as I noted earlier that the shale was one of the biggest sources of petroleum supply going forward or excuse me from 2005 to 2014. And so sort of with that as context, there were a couple of things in the last two months that really hit me like a bit of a gut punch. The first was Audi coming out and saying, “We’re going to get rid of all internal combustion engines by 2026.” And that to me was a real stunner because from what I’ve been told, it’s a very, very different production process to go from internal combustion engine to electric. It’s a very different supply base. It’s a very different supply chain. And for them to do it in five years is extraordinary. And obviously, the Germans have a very longstanding tradition of very good engineering almost to a fault at times, cold, calculating rationality of what needs to happen.

Luke Gromen (35:36):
And so I went back, I remembered, it was one of those splinters that stuck in my brain for a long time. If you go back to September 2010, there was a leak German military report that came out and said that the German military thought Peak Cheap Oil would hit by about 2013, excuse me, around 2010. And that the real economic impacts wouldn’t be seen for 15 to 30 years later. And so I said, all right, well, so 2010, maybe 2011, 15 years, it says 2026. And now we got Audi, who is a subsidiary of Volkswagen, which happens to be the single largest corporation in Germany and the single largest employer here in Germany. If my data’s correct, making sure what seems to be an otherwise irrational decision to completely get out of internal combustion engines in five years, which is an extraordinarily fast period of time to execute on the supply chain structuring that would imply.

Luke Gromen (36:31):
And so for me, it implies one of two things, either Audi and the Germans have lost their minds and they’re basically bedding a subsidiary of one of Germany’s biggest corporations and employers on a green energy gambit, which I suppose is possible, or Germany’s biggest corporation is very politically tied in, and they’ve been given a tap on the shoulder, say, “Listen, here’s what’s happening to the underlying resource base for the fuels for internal combustion engines. And if we are going to be in a proper place to compete, Mr. and Mrs. biggest corporation in Germany, if we’re going to be in a position to compete in 2030, in 2040, this has to happen now.” If I had to wait, which of those is more likely in some of that, given my German background of just being very pragmatic and again, as sometimes to a fault sort of coldly objective, I think it’s more likely that it’s the latter than the former, that Germans aren’t just taking a flyer on, “Hey, let’s just bet our biggest corporation employer on some green energy thing, maybe it’ll work, maybe it won’t.”

Luke Gromen (37:40):
I think what’s happening is there is underlying depletion, not just to what’s happening in shale, but if you look back and reference Matt Simmons work a staggering percentage of the world’s oil production comes from a handful of the biggest fields and the youngest of those fields are now 50, 60 years old. The oldest is nearly 100 years old. And the depletion, they all follow some belts curb of depletion rates. And so I think we have gotten away from shale sort of pushed to the back of everyone’s mind, this underlying Pareto principle that exists in global oil production. That was always there, was always going to be there. And I think when we start looking at what Audi did, when we look at what GM came out and did earlier this year, which is they ran their first national ad campaign in 10 years on the Super Bowl, bragging about how they’re going to roll out 30 new electric cars in five years, writing about their battery, getting welfare aligned to talk about it was the Sweden commercial, we hate the Swedes because they’re ahead of us in electric adaption.

Luke Gromen (38:45):
Again, GM makes all their money in huge trucks and heavy… it’s sort of the prototypical American. My wife’s got one of them that giant truck, and it’s a gas guzzler and GM makes all their money there. And so for GM to say, “We’re going to have 30 new models, and we’re gonna do this national ad campaign on the Super Bowl.” Again, are they just going, spending a bunch of money and restructuring supply chains on some virtue signaling, gambit? Or is there something else happening here that they see the need to reposition to just begin to significantly accelerate the repositioning of their supply chains towards more electric vehicles over the next five years?

Luke Gromen (39:21):
And again, I just think the latter is more likely, I don’t know if that’s a 60, 40 more likely, or 90, 10 more likely, but I think it’s more likely that what was once a big catalyst for fossil fuels prices, for commodity prices more broadly and went away from 2008 through 2014 because of U.S. shale? I think we’re going to start seeing it come back on the scene in a much bigger way in coming years, notwithstanding the current deflationary scare pullback.

Trey Lockerbie (39:50):
So what I’m taking away from that is essentially a lot of these forces are going to drive the price of shale and therefore oil, much higher to a place where it’s untenable for someone like Audi to continue to compete.

Luke Gromen (40:02):
I do think gasoline will get much more expensive, but I do think that there’s a sense of urgency where yeah, if you start to have supply issues, I mean, if you start with the fundamental, let’s assume a first principle that there’s an oil supply problem in 2030, 2035. And we want to push that time out and you just came to me and you said, “Luke, what would you do to reduce that, to push that number out further?” And I would say, “Oh, that’s easy. Number one thing is you got to get global passenger car down as big as you can, as fast as you can.” And if getting global passenger car down, there’s a couple of different ways you can do that. It’s easier in certain places that have a much more rail-centric culture. You’ve seen what the Chinese are doing in high-speed rail, obviously. In America, we’ve been stubborn and we’ve gone the other way with rail.

Luke Gromen (40:50):
And so high-speed rail, rail is still a non-starter here politically. And so the only thing we can do is okay, we’re going to go full speed electric, and then that will buy us time. So I think that’s more what we’re seeing. I don’t think it’s an issue of, hey, we’re going to have shortages of oil or oil is going to be 20 bucks a gallon in America in five years, I think oil could be four or five bucks a gallon in four or five years.

Luke Gromen (41:16):
And certainly, that’ll change behavior, but I just think the proactive nature of these major politically tied incorporations and the implied inconvenience and expense to them of restructuring massively embedded supply chains in such a compressed period of time, suggests that either they’ve been fully drinking the Kool-Aid on and basically betting their corporation on virtue-signaling dynamic, or they’ve been tapped on the shoulder and said, “Listen, here’s a series of potential paths of what the supply chains look like for oil. And you need to start thinking about restructuring your internal combustion engine supply chain sooner rather than later.” I think when we go back to the pre-shale, that to me doesn’t sound crazy at all. I think that there’s probably a lot to that.

Trey Lockerbie (42:07):
All right, shifting gears let’s talk a little bit about the gold NSFR rule changes and how that might impact gold and gold miners in the future.

Luke Gromen (42:17):
We have written a lot about this. There was a big net stable funding ratio rule change, again under Basel III banking rules. And the gist of it was historically been a huge on the allocated gold market in London. And so effectively London has set gold prices. If someone wanted to buy more gold, one of two things can happen. You can buy gold and if there’s more demand for gold, broadly speaking, one of two things can happen. You can either have the price of gold go up to address that increased demand, or you can keep the price of gold relatively constrained and allow the number of claims on that same ounce of gold to rise instead of the price of gold. And since 1980, 1985 ish, what has happened is in London in particular, the number of unallocated claims has been allowed to expand more than the price of gold.

Luke Gromen (43:07):
This NSFR rule to my reading made it seem as if Basel III was moving toward, making it much more expensive to continue floating these unallocated claims on gold. There was basically a capital charge being brought to bear in London that hadn’t existed prior. And it was going to go live in Europe, in the U.S. at the end of June this year and in the UK in January one of next year. As far as I know, it did go live in Europe, in the U.S. but ultimately the big kahuna there in terms of the gold market is London. So January 1st of 2022, so less than six months from now. Last week or a week and a half ago at the last minute, the PRA the Prudential Regulatory Authority, I think it stands for in the UK, basically gave the London Bullion Market Association. The LBMA is a last-minute reprieve where, I mean, I’m going to probably misquote this.

Luke Gromen (44:02):
It still applies for loans and leases, but not for an allocated amount, not for clearing, excuse me, the clearing side of their business. And so I’m still trying to make heads or tails of what that means. I do think a couple of different resources that I’ve read Bob Coleman, as well as Alistair McClard, have written really good pieces on it. And I agree with basically their conclusion of it, which is it probably takes away some of the urgency that existed in terms of the removal of that unallocated gold market, which would have probably put upward pressure on the gold price and make it a more physically driven market. So maybe not necessarily upward in price, but basically going forward. If people wanted gold, gold’s price would respond rather than gold leverage responding higher.

Luke Gromen (44:47):
The rules that as they exist in their view, still continue a shift toward moving it toward a more physical market, but just maybe at a slower pace. So we’ll see what that ultimately means. My bigger picture on that is I think it’s part and parcel to a bigger shift of moving gold back into the system as a neutral reserve asset, where central banks begin reserving more gold as a reserve asset at a floating price, rather than reserving treasury bonds, U.S. Treasury bonds as the reserve asset for a number of the reasons we just highlighted.

Luke Gromen (45:19):
If the U.S. ultimately has to inflate away its debt. The other side of that same coin is the U.S. ultimately has to inflate away the real value of other central banks’ treasury holdings, and they need something to offset that otherwise the wealth of their nation of operates the reserves backing their currency operates on a real basis. And that’s no good. So I think there is still this movement of the foot, but I would say it’s probably been delayed a bit or maybe slowed down a bit by this change or this loophole, this carves out that was given by the PRA for the LVMH.

Trey Lockerbie (45:53):
Now I noticed that you mentioned gold and not bitcoin, and that becoming a new neutral reserve asset. Have you seen a change in bitcoin? Are the price has been down for a number of months now for seemingly a lot of reasons, pretty much everything is down? I think a lot of that has to do with the Delta various some concerns there. I just find it curious that you’re leaning more towards gold in that fixed reserve asset. Is that something you think other countries are more prone to adopt in the near future?

Luke Gromen (46:20):
It’s a great question. As I look at what they’re doing. Yeah, it appears to me that when you look at what China’s doing, where it seems like it’s been more pro-gold, less pro bitcoin in the last two or three months certainly. Russia, I think has been more pro-gold, less pro-bitcoin. The Europeans, to me, it seems as if there is more of an establishment proclivity toward gold as a neutral settlement asset if the system’s going to move in that direction, that’s not to say bitcoin, couldn’t continue to do it. And I’m on record. I continue to think this is the case that there’s probably a lot that would recommend the U.S. choosing bitcoin over gold as a reserve asset, just given relative gold reserve basis, given the potential that others have more than we do, et cetera.

Luke Gromen (47:08):
But for the time being, ultimately, it appears that yes, there seems to be more of a movement of the foot, particularly by the creditors in the system in Eurasia, broadly speaking, they’re reserving gold, they’re buying more gold, they’re repatriating gold. They’re not doing so with bitcoin. We’ll see that could change. Ultimately, bitcoin, I think can still serve as a neutral reserve asset for the people, if you will. And I continue to use it alongside gold myself in that manner.

Trey Lockerbie (47:36):
So let’s kind of wrap up here and talk a little bit about how you’re positioning yourselves to benefit, to take advantage of some of these macro environments playing out. What’s your goal position look like versus other commodities. You mentioned the electric vehicle bullishness, so underlying metals, perhaps that tie into that, walk us through your framework about your own portfolio, kind of how you’re approaching this?

Luke Gromen (48:00):
I don’t really trade it, a whole lot, day-to-day. I’m not a trader. To me, I am positioned for really two things, which is I have pretty high conviction that ultimately we’re going to do what every other sovereign has done in this position with a fiat currency, which has inflated away. And that this sovereign debt bubble, global sovereign debt bubble will resolve itself like the last one did. And the way the last one resolved itself was that the six industrial powers of the time, the U.S., UK, Germany, France, Japan, and Russia saw the real value of their sovereign debt relative to gold fall anywhere from 75 to 100%. The Russians and the Germans saw their sovereign debt hyperinflate to zero against gold, within 10 years after World war I. Germans had only took three or four years. Everybody else massive devaluations of the currency. And so I think that is the end game this time around as well.

Luke Gromen (48:55):
And that’s how I’m ultimately positioned now with that said, historically, it would lead you to a conclusion of, okay, I want to borrow as much as I can and own these assets. And there was a chart I’ve cited numerous times, all credit for it goes to Dan Oliver at Myrmikan Capital, but it shows the month-over-month price movements in gold in German Reichsmarks, as the German Reichsmarks was hyperinflated to infinity. And what’s fascinating is if you were levered long gold, which nominally is absolutely the right trade, you would have lost all of your money four or five times in the three years that the German Mark was disappearing as you were right ultimately. And so to me, the way I’m positioning my own assets, what we’ve been advising for clients is we’re overweight gold, we’re overweight energy and metals commodities. We are overweight industrial equities and foreign equities, simply from the standpoint of, I think the dollar has to get weaker because the Fed has to do more than every other central bank by virtue of the existence of the Eurodollar system.

Luke Gromen (49:57):
Ultimately the dollar is our problem. It’s the Fed’s problem. And we also like big tech because ultimately big tech does well when real rates get very negative. And as we mentioned before in World War II, which is the last time we were in a sort of a similar position, I would argue we’re in a far worse position now. U.S. real rates went to negative 14%. And so I think it’s good for big tech, industrials, energy and metals commodities, some foreign equities, gold, bitcoin, silver. This trade has been going against us for the last two, three months. And this, I think speaks to the last point. And that point I made about the Dan Oliver chart is that we’ve been saying for the last couple, probably the last 12 to 18 months, that we’re talking about the bursting of a global sovereign debt bubble we’re talking about, and what is in my view, the first change of a global currency system in at least 50 years, I think the volatility is going to be higher and continue to be high.

Luke Gromen (50:49):
And so you need to get from point A to point B. So I think it’s important to remember pigs get fat, hogs get slaughtered. I think maybe a little leverage is okay, but I think being minimally levered is really important for exactly what we’ve just lived through for the last two, three months, which is bitcoin has gotten slaughtered from the highs, gold is down from it’s actually held in okay. From 1,900, 1,800 whatever, oils’ done okay. It’s backed off now, et cetera, so.

Trey Lockerbie (51:17):
How much of this trade going against you do you attribute to what you’re highlighting in your newsletter about China’s credit impulse declining? How much do you think that’s playing in all of this?

Luke Gromen (51:28):
I think a big part of it. I think it’s a pretty substantial part. And I think in the last week we’ve had this Delta variant fears get layered onto it, but if I was the perfect analyst you always want to look and see, what did you miss? What would have you had done differently? And that’s, I think I would have waited that much more from a trading perspective, just to say, hey, this thing’s real this China credit impulse is really rolling over, and this is going to be a headwind for the next X months for these inflationary trade. So you always want to check back and cross-reference yourself in terms of what you could have done better. And certainly, I think that’s something in my case if I could do it again and say, all right.

Luke Gromen (52:02):
This is going to be a way to… These big gears are still absolutely turning, they’re absolutely turning faster, but between the rebound in the U.S. economy, the China credit impulse rolling. I think part of it too, the U.S. economy rebounding, there’s this belief that this is just like all these other cycles. Oh, we’re going to rebound. And it could not be more different. We haven’t seen a cycle like this in 80 to 100 years. So it’s a little bit of the narrative that, oh, it’ll be just like a way, it’ll be just like a one, it’ll be just like 91. It’s not going to be in all likelihood it’s not going to be. But I think the biggest thing has been this China credit impulse.

Trey Lockerbie (52:36):
Fantastic. Well, with that said, before we let you go, Luke, this conversation didn’t disappoint just like I expected. And I’m so happy you came back on the show to share these insights. Before I let you go I just want to make sure everyone knows about your newsletter. So give them a handoff there. You also wrote some books, so inform our audience here where they can follow along and learn more about you.

Luke Gromen (52:56):
Absolutely. So the easiest place to find out what we’re doing, what we’re up to is fftt-llc.com. So Frank, Frank, Tom, Tom dash llc.com. Find a lot more about our different research product offerings there. I’ve also written a couple of books, Mr. X Interviews, Volume one and two. I’m working on volume three. It’s been a little slower than expected this summer, but those are mock interviews with a fictional sovereign creditor of the United States conducted in the Socratic method. And so it’s really gotten great feedback on it in terms of just how it talks through the thought process and gives me a lot of freedom for laying out various paths along the decision tree, which is a lot of fun for me to just explore. It helps my thought process. And I think it helps the reader as well. So you can find those both on amazon.com if you’re interested in ordering those.

Trey Lockerbie (53:43):
Fantastic, always a pleasure, can’t wait to have you on again soon.

Luke Gromen (53:46):
Absolutely. Thanks for having me on Trey, is great being here.

Trey Lockerbie (53:49):
All right, everybody, that’s all we have for you today. If you’re loving the show, go on your favorite podcast app and follow us, please, if you can leave us a review, we’d love to know what you think of the show. It really helps. And with the market being down like it has been lately. It’s the perfect time to go on our TIP Finance tool and check out the filter where we list out what we believe are the most undervalued stocks at the moment. And with that, we’ll see you again next time.

Outro (54:11):
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