Oil Prices Rising? The Answer Comes into Focus by Jim Kingsdale
June was a good
month for energy stocks and for the EIS portfolio but the broad market tanked.
The impact of high energy prices on both inflation and consumer discretionary
spending is being reflected in stock prices. Energy pressures present a special
risk to economic stability by coming on top of the twin collapses in the credit
and real estate markets.
So far Mr. Market
seems able to distinguish between the very healthy energy sector and the tenuous
economy. I fear that at some point well get a sustained - 1930s
style - bear market in all stocks which will take down the energy stocks along
with everything else. In fact weve seen a few days like that already,
generally followed by big pops in energy stocks later.
That fear is
why I have a commodity strategy included in the EIS (Energy Investment Strategies)
portfolio. It is insurance against the collapse of energy stocks as part of
a general market collapse. I implement it with options on long dated crude
and natural gas futures contracts. If you do not use a futures account and
depend only on stocks but want to be invested in physical oil or gas, you
can use an ETF like USO or OIL for oil or UNG for gas.
S&Ps 8.8% drop in June, stocks in the EIS portfolio were up 4.2%
for the month which beat the broad oil ETF, IYE, but was slightly under the
oil service sectors sterling 5% gain as represented by OIH. My shipping
stocks held the portfolio back. Apparently the stock market thinks the China
boom is peaking. I doubt that.
strategy was up only slightly in June despite large gains in the commodity
prices due to heavy-handed meddling by yours truly. Total EIS performance
including the commodity strategy was up 4.4% for the month of June and the
year-to-date gain of 32.9% has to be considered attractive given the 12.5%
S & P loss since 1/1/08. I guess outperformance by 45.4% for the first
half of the year should make my stockholders happy. Ill go ask my wife.
the Lesson Here?
lesson, I think, is the value of Tsunami
Investing so Im going to spend a little time reviewing it.
Oil and gas
are a perfect investment Tsunami. Oil scarcity is increasing and will be with
us for at least another ten years. Natural gas will also soon become scarce.
(Its price has actually risen faster than oil so far this year.) So the short
version of my advice to myself is dont try to be clever. Keep the investment
posture simple in terms of both stocks and commodities. Dont try to
trade it. Be there when oil becomes truly scarce after 2010.
of Tsunami Investing
If a major trend
- an economic Tsunami - is unfolding why not be invested in the companies
that will be lifted by it? In fact one might dare ask why be invested anywhere
else if you can stand the volatility associated with a concentrated portfolio.
Why not let the vast bulk of investors who are pushed by a trained army of
brokers, advisors, and lawyers to be diversified buy all those
stocks that together by definition yield an average return?
Investing Really That Easy?
Well, no. In
addition to buying Tsunami stocks you have to do one other thing. You must
hold on. Dont sell when you think the stocks have become temporarily
overpriced. You could be wrong about the timing. And even if you are right,
the payback in trading turns out to be small compared with a buy-and-hold
There are a
few other Tsunami rules also:
1. It must
be a real Tsunami not just a macro-trend.
2. You must
identify the Tsunami early enough in its lifecycle to benefit from it.
3. You must
pick stocks that are central to the Tsunami, not peripheral.
vs. Long Term Trends
Long term trends
are what create growth stocks and there are a lot of growth stock managers.
It is a fine strategy. You pick a trend like the aging population or the growth
of China or biotechnology or the Internet. Then choose some companies that
are benefiting from whatever trend youve identified.
That is not
Tsunami investing. The difference between a long term trend and a Tsunami
is that the Tsunami is (as the name implies) very concentrated and very powerful.
It will be over within one or, at most, two decades. It is easy to identify
exactly which companies are part of it and all of those companies will be
successful so long as the Tsunami is gaining momentum.
Long term trends,
on the other hand, are identifiable but not as strong. They contain many more
companies, most of them are only indirectly affected, and some of them will
not be winners. A successful growth stock manager must know his companies
very well to be sure that he picks a Dell and not a Gateway, for example.
You want a Genentech or Biogen, not an EntreMed.
When I was building
a cable TV business in the 70s and 80s the right answer
to any cable property acquisition opportunity was yes. It did
not pay to be clever. It did not matter which company you bought. And if you
were an equity investor in the stock market, it also did not matter which
cable companys stock you bought. The only thing you had to do was just
buy it! Oh, and hold on to it too. The same thing held true for cellular companies
in the 90s and also for real estate investment trusts in the 90s
and the first part of this decade.
The same thing
is pretty much true for todays energy Tsunami. Companies that are central
to the long term production of oil and gas will all win. It does not matter
if you choose Encana or Devon or XTO. It only matters how well whatever companies
you pick are able to secure oil and gas. Thats why my favorites are
the oil sands plays; they have enough oil to last well beyond anyones
investment horizon, so they are the most central to the energy shortage Tsunami.
Gain Speed, Then Peak, Then Lose It
Unlike a long
term trend that may extend at roughly the same rate of growth for many decades,
a Tsunami is like a bell shaped curve. So timing is important for the Tsunami
investor. If you bought into cable in the late 90s you were wrong. If
you bought any time before the mid- to late 80s you were right,
and the earlier the better.
By the same
token, you would not have gained much if you waited until the year 2000 to
figure out that cell phones were going to be the future of telephony. It was
too late. You should have seen that coming by, say, 1995, when there was still
enough time to make good money. Better would have been 1992. I began attending
investment seminars on cellular in 1988.
What about the
oil and gas Tsunami? It started in 2004. Probably it will peak some time in
the 2015 - 2025 time frame. So using the cellular time frame, now may be roughly
the equivalent of 1993 for oil. There is certainly still time for major gains
in oil and gas stocks despite the fact that a lot of the money already has
One thing about
the oil Tsunami that is different from other Tsunamis is that its power
is so enormous that it could have a destructive impact on societys financial
infrastructure similar to a real tsunamis impact on the place where
it lands. The cresting of the oil Tsunami in the 2010 - 2018 time frame could
destroy stocks, including even energy stocks. That is why a position in the
physical commodity seems like a necessary aspect to a strategy concentrating
in energy investments.
You also need
to pick stocks central to the Tsunami, not ones that are a mini-trend or a
sub-wave related to the Tsunami but not inherently part of it. For example,
in the energy world today there are a lot of companies making photo-voltaic
(PV) electricity generators. Some have been good investments, some not, depending
a lot on when you bought the stock and which company. But PV solar is only
indirectly connected to peak oil and the related demise of the age of petroleum;
not all PV companies will be successful.
tend be acquired as the industry matures. No matter how expensive
a cable stock or a cellular stock seemed to be at any given time, none of
those companies ended up selling out at any price other than near the highest
price they had ever sold for. Granted, a few of them such Comcast and Time
Warner made the mistake of buying late in the game when they should have been
selling, just as the Tsunami was peaking. But the other 98% of the cable companies
sold out at their peak price.
On the other
hand, I managed to find some ill-fated investments that were related to cable
and cellular but were not right at the center of the Tsunami. One was a Chinese
cellular company. Back in the early 90s China was a different
animal than it is today in terms of its business and financial practices.
That company went under. Why I felt it necessary to go to China to invest
in cellular when there were fine opportunities right here is not clear.
was a television distribution technology like cable in some ways called MDS.
Companies that chose to bypass cable by using MDS did not end
happily, nor did their stockholders. There were specialized cable companies
too that served sub-markets like hotels. Some of them ended badly.
are false profits in the energy space today. Most of them are
part of the alternative energy universe. Some are involved in
battery technology and other aspects of electric cars (which might become
another Tsunami at some point). Some, like ethanol have already fallen on
The heart of
the energy Tsunami is the production of oil and, secondarily, natural gas.
The companies with the largest reserves and the greatest proven ability to
increase reserves of oil and gas will grow in value the most. Close to the
heart of the Tsunami are those drilling and service companies that enable
the production of oil and natural gas.
think that the smartest thing an investor can do these days is put everything
into Canadian Oil Sands Trust. With a nearly 8% dividend and more oil reserves
than they have even bothered to prove, what could go wrong? Well, politics
for one. And the possibility that they will get bought out requiring a tax
payment and reinvestment program. Plus something will change if/when the Canadian
taxes on trusts are revised. So some diversification of corporate vehicles
is a good idea. Thats the least a Tsunami investor can do to earn his
On the other
hand ,and as a final note on investing in the energy Tsunami, the S.E.C. is
currently revising its rules for reporting by oil and gas companies. The revision
will allow them to count oil sands as reserves which could unleash a massive
oil sands acquisition program by the oil majors. Best to own these stocks
before Exxon starts writing checks.
Oh, and India
is another rumored buyer of oil sands properties, but because they need the
oil, as discussed below.
Why Are Oil
Prices Rising? The Answer Comes into Focus
and analysis has clarified the dimensions of the energy Tsunami - what is
causing the price to rise and how future prices and supplies will behave.
The distinguishing characteristic of the picture is complexity. People want
simple answers which is why so few of them understand oil. The oil world is
huge and its behavior is multifaceted. Understanding it takes more than a
simple minded idea like blame the speculators.
is that the oil market is undergoing a sort of perfect storm of
many different factors, including:
group of countries that together produce 13% of the worlds oil
are mismanaged or infested with political violence causing them to produce
far less oil than they could if they had a stable government and market economy.
The underproduction could be as much as 5 to even 10 mb/d (million barrels
oil production is declining. That fact has dire implications for the
amount of oil available to future export markets, as discussed in the link.
When you combine declines in Russia with those of Mexico
and the North Sea, the extent to which non-OPEC supply could decline in coming
periods becomes significant.
3. Within OPEC
it is uncertain as to whether Iran
will increase or decrease their oil exports in future years. Saudi Arabia,
Angola, and Libya are the only OPEC countries likely to increase oil production
near term. Iraq is a potential bright spot starting in a few years at best.
4. Old oil
fields produce less oil each year, which is called the decline rate and the
amount by which they decline must be made up by production from new fields.
Global decline is estimated to be about 3.5 - 4 mb/d per year, a much greater
number than additional oil demand that is estimated to range from 1 - 2 mb/d
for existing fields have been rising and will probably continue to rise as
more extreme methods of recovery are applied to old wells. The geological
rule is that as efforts to increase the output of a field by extraordinary
pressurization and drilling efforts becomes greater, the field will decline
much more rapidly once the decline starts. For that reason, there is a risk
that the largest Saudi fields - and others such as Russian fields - may decline
more rapidly than currently is projected and such increased declines could
start to happen fairly soon.
important fact regarding decline is that newer fields tend to be offshore
and offshore fields exhibit much higher decline rates than land based fields.
Offshore fields often decline by 8% - 15% per year compared with 5% - 8% for
analysis indicates oil supplies coming from new oil fields will substantially
drop after 2010 and will drop even more steeply after 2013. Some projects
scheduled for the next few years could face substantial delays. If so, some
of the projects now projected to start up in 2008 - 20010 will be delayed
into the 2011 - 2015 time frame. That will add to price pressures in the near
term. The megaprojects
work is the most tangible evidence of a coming oil supply crisis.
6. New oil
fields are located in increasingly difficult environments such as deep offshore
or difficult fields like Kashagan. Costs of oil recovery in these fields are
much higher. Higher costs are partly due to the fact that it takes more energy
to recover the oil from these fields, so the Energy Return on Investment is
the amount of net oil recovered after oil expended in the process of recovery
is lower in these new, more expensive fields. If you project this trend into
the future, at some point there would be no net gain at all from the process
of extracting oil from new fields. At that point, which is well out into the
future, there could be no more oil available at all.
7. In addition
to the real historical phenomena discussed above, oil prices reflect to some
degree whatever fears there may be that future political events may reduce
oil supplies. The most important risk today is clearly the possibility that
military action will be undertaken to keep Iran from having nuclear weapons.
There are clearly no good choices for the West. An Iranian bomb would be a
very clear and present danger to the security of the developed world but a
military attack would clearly bring immediate instability and the risk of
even greater future conflicts.
8. At the same
time that all the above factors are influencing oil prices, higher oil prices
are moderating demand somewhat, particularly in OECD countries. But while
demand is declining in developed countries it is continuing to increase from
developing countries, particularly in oil-exporting countries where fuel prices
are subsidized and therefore market mechanisms do not impact consumer oil
demand. The enormous - almost unimaginable - new wealth of oil exporting countries
is being used by many of them to develop new industrial bases, which growth
adds to their enhanced consumer demand to yield huge increases in their own
use of their oil and thus decreases in their ability to export it.
It is not clear
that the reduction in subsidies in developing countries that do not export
oil such as China will reduce demand. In fact it could have the
perverse impact of increasing usage in developing countries if higher
prices cause an increase in the supply of fuel available to their consumers.
9. One way
to sum up the outlook for the oil supply available to importing countries
is to look at all the countries which produce more than one million barrels
per day and which together supply 88.4% of world oil. An analysis of these
countries that accounts for the projected internal use of their own oil production
projects that their exports (which is not the same thing as production) are
likely to decline going forward from today. If true, that would account for
an increasing price of oil.
this discussion was so long. Unfortunately, there are simply a great many
influences on the price of oil. It is quite wonderful that all this complexity
gets boiled down into a single price that changes minute-to-minute. Oh well,
blame the speculator.
all this is just too much, you might enjoy a more general perspective and
one better expressed by Peter
Lynch that I recently came across. Happy Independence weekend, and
may we some day become independent from oil.