No Way Out
Comedian Rob Newman used to do a routine about the world’s dwindling supplies of oil, the essentially doomed nature of the petrochemical economy, and the increasingly desperate attempts governments and oil companies would employ to keep the lights on. But whichever way they turned, however hard they tried to escape from the inevitable, eventually they would have to face up to the fact that there was no way out – fossil fuels would run dry. In the routine, this sobering fact was epitomised by a cackling Baron Samedi figure in a gloomy stairwell.
It is still possible to find people who cite the supply argument in favour of a decline in the oil price – perhaps they’re banking on those Canadian tar sands coming up trumps. Others argue that even if a recession reduces demand in the West, any fall in price is likely to be modest and short-lived, as India and China keep industrialising.
The historical oil consumption per capita charts certainly make for grim reading. Whilst India and China are still at the usage level of the US in 1904, the experiences of Japan and South Korea are instructive. The charts show that whilst consumption is low in the early years of industrialisation, the following decades see a sudden exponential increase per capita. For Japan it happened in the 1960s, for South Korea, in the 1990s. It will be interesting to see how such a spike in usage by China and India will affect the market for oil in the next 20 years.
Energy crisis
Newton Investment Management, for one, is worried. In a recent research note it commented: “Unlike previous oil price spikes, there appear now to be few options to ‘get out of jail free’. We are witnessing not simply an ‘oil problem’, but rather the first stages of what could become a global energy crisis. The challenge now is the dearth of inexpensive, available energy sources to permit the reduction of oil demand through fuel switching.”
Ah yes, if only we had started investing in alternative energy back in the 1980s, then perhaps we wouldn’t be in this fix. Unfortunately, election cycles are too short to incentivise governments to take the tough decisions that are necessary to deal with such issues. And the longer we delay, the more expensive the bill when it finally falls due – which discourages subsequent governments from making themselves unpopular by stepping up investment.
“Failing to take tough decisions will lead to an extended period of energy inflation,” warned Newton. “This will prevent OECD economies from stimulating growth through monetary policy, while developing economies, burdened with subsidies, will be forced into trade controls and commodity hoarding.”
It suggested that governments should consider adopting mandatory investment in hydrogen networks, carbon sequestration and the development of second generation bio-fuels that do not compete with the food chain: “The real cost and impact of energy prices must be tackled, or the lights really will start to go out.”
Unfortunately, such Cassandra-like cries are rarely welcomed. Demand will fall in the West, the oil bears insist, and supply will start to come through, then the oil price will tumble. The bulls respond that once the industrialisation genie is out of the bottle, it can be hard to stuff it back in again.
Although most analysts have tended to be behind the curve in predicting the oil price, insisting that it must come down because that’s how it behaved in previous cycles – you remember, when the two most populous nations in the world weren’t industrialising – Global Insight recently revised its forecasts. It now believes that oil, food and raw materials costs will keep rising throughout the first half of 2009, and expects the price of West Texas Intermediate crude oil to peak at $160 a barrel in December 2008, up from $124 in its previous forecast.
“Growth in both real GDP and energy demand in emerging markets is likely to remain strong for some time,” said Nariman Behravesh, Global Insight’s chief economist, and Sara Johnson, economist, in a forecast alert. They pointed to a combination of stimulative monetary policies and fuel subsidies, which weaken the incentive to conserve energy.
“While some countries are beginning to tighten monetary policy and some are cutting fuel subsidies, these moves have been modest and are unlikely to have any significant impact until late 2009 or 2010,” they said. “In the meantime, strong energy demand growth in emerging markets will outstrip additions to non-OPEC supply and will offset the declines in demand that have already occurred in the US and Europe.”
Fuel subsidies
The question now is how long non-oil producing nations can afford to maintain fuel subsidies. India is already facing a ballooning fiscal deficit, but Vinay Gairola, manager of the Atlantis India Opportunities Fund, doesn’t see fuel subsidies being ditched in an election year. “There are 500 million poor voters who won’t allow this subsidy to be cut – the government doesn’t dare tinker with this,” he said. Instead, he sees the possibility of a windfall tax on Reliance Industries and Cairn Energy to help plug the gap. And Tata’s plans for an affordable runabout are likely to keep oil demand ticking along for a while yet.
Meanwhile, countries like Russia and the Middle East are simply using the receipts from their oil revenues to fund domestic fuel subsidies. Newton points out that in previous crises, natural gas has taken up the slack, but recently liquefied natural gas prices have risen faster than crude prices. “In the Middle East, a shortage of natural gas is having a direct impact on the oil supply: first because oil products are being burned instead of natural gas, and secondly, because reduced gas injection into oil reservoirs is curbing the production of crude oil.”
But isn’t it just the activities of those naughty speculators that have pushed up the price, say the oil bears. Well, Newton believes that the rise in price to $135 per barrel in May owed much to capitulation by commercial buyers, such as airlines, who had been waiting for the price to fall – as had been forecast by most commodity specialists in light of an impending slowdown in global economic activity: “Even the bullish, and widely-followed Goldman Sachs commodity team suggested a near-term correction in the oil price.”
Buying the curve
So when Goldman Sachs increased its forecast for the end of 2008 oil price from $115 to $149 a barrel, commercial buyers scrambled to ‘buy the curve’. “The rise in the oil price was exaggerated by the actions of hedge funds, which as the true speculative buyers, reversed the time spreads, which had entailed their betting on the short end of the curve, against the long end,” said Newton.
Even if the oil price does eventually roll back, it is likely to do so to a price well above previous plateaus. Global Insight is now predicting a fall in the oil price by the end of 2009, to $130, compared with $111 in its prior forecast, and to $105 by the end of 2010. But it warned that geopolitical events, such as conflict between Israel and Iran and more supply disruptions by rebels in Nigeria, could easily push prices higher.
If you want to read more about oil demand and supply dynamics and how the oil price is impacting earnings at energy companies, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=3&storycode=43565
Make Room! Make Room!
From Thomas Malthus to the Club of Rome, every hundred years or so the human race is given a dire warning as to what will happen if it continues to multiply at its existing rate. According to these doomsayers, we will become too numerous for the planet to support us, and whilst we have not quite arrived at Soylent Green extremities, agricultural commodity prices have been sprinting up over the past 12 months, triggering food riots in many parts of the developing world.
“For any government, food shortages are the bottom line,” says Henry Boucher, who manages the just-launched Sarasin AgriSar Fund. “If a population can’t feed itself, the government is unlikely to stay in power.” The problem is that the population has grown by 120% since 1961, but arable land has only increased by 13%, and in the short term, shortages are intensifying due to biofuel policies.
This has created a pinch point in some agricultural commodities, with inventories at record 30 to 60 year lows. Nicholas Brooks, head of research and investment strategies at ETF Securities, says the problem has been exacerbated by higher numbers of extreme weather events and increasing input costs. For example, fertiliser costs have doubled over the past five years whilst operating costs are up 40%.
This tightness of supply coupled with strong demand has driven up agricultural commodities prices, attracting speculative interest. This in turn has increased volatility, often leading to head-scratching amongst commodities commentators trying to account for particular market movements. Even when hard data appears and the market seems likely to move in one direction, it will often confound by moving in the other.
Gone Soft
For example, in the first week of April the US Department of Agriculture released its Prospective Planting Report, a big annual event for the agricultural markets, and an important driver of prices in the short term. In the report, the soybean planting intention was significantly higher than most market participants had been expecting, whilst corn, wheat and cotton plantings were below expectations.
However, the soybean and soybean oil price rose, as the market decided actual plantings will be lower than those reported. This is because corn is so high in price right now, farmers are expected to substitute corn instead, says Brooks. Not surprisingly, this kind of price swing is discouraging asset managers who wish to offer less volatile products.
“Foreseeing price moves in the context of rapid crop rotation, substitution and weather disruption is a mug’s game. It is better to sell a call premium on volatile commodities and occasionally take a modest directional bet,” says Christopher Lindsay, Sarasin’s head of research. Boucher adds that the sheer amount of money going into agricultural commodities at the moment raises some questions. “This is speculative. We need to look at a longer time period and understand the basic drivers before leaping in on that premise.”
And it would be a mistake to think that all agricultural commodities have performed equally well. Indeed, livestock and lean hogs, have been some of the worst performing commodities over the last 12 months. The ETFS Lean Hogs product is down 13.2% in the year to date whilst ETFS Livestock is not much better, down 12.3%. In the last 12 months they are down 34.4% and 24.9% respectively, bumping along the bottom with nickel and zinc.
Very lean hogs
Charlie Morris, manager of HSBC Investments’ Absolute Return Service, who recently sold all his remaining exposure to soft commodities, attributes the poor performance to the fact that as the price of feed goes up, farmers send their animals to market early – the hogs are even leaner than usual. This has led to an oversupply of livestock, pushing down prices, but there is likely to be an undersupply later.
The softs basket, which includes items such as sugar and coffee, has also disappointed, falling back down to near where it was a year ago, after spiking in March. The plummet in price has been attributed to market expectations of a bumper Brazilian coffee crop, way above Brazil’s official estimates.
This kind of volatility has prompted managers like Sarasin and Axa IM’s Sebastien Lagarde, who manages the Hybrid Resources fund, to look at agri-related companies as a way of playing the long-term agriculture theme. Boucher is seeking companies likely to benefit from government incentives to develop new technology that can improve productivity yields, for example.
But as Lagarde points out, finding stocks that haven’t been driven up in price substantially already, is far from easy. This is a problem that afflicts crop science companies and Potash Corp of Saskatchewan, which is up 176.3% in the last 12 months. It can mean searching for micro caps such as Asian citrus, an AIM-listed company that is China’s largest operator of orange plantations, in order to play one specific product.
Sarasin identifies a variety of themes including the monetisation of water – in Australia, water rights are already being sold – and aquaculture to offset dwindling wild fish stocks. Structural angles would extend to buying shares in the Chicago Mercantile Exchange and traders with an information advantage to capitalise on heightened commodity price volatility.
If you want to read more about the kinds of stocks asset managers believe will benefit from the tightening in agricultural commodities, please visit:
Forever Blowing Bubbles
June 11, 2008 at 3:17 pm (Asia equity markets, Commodities, Macroeconomic commentary, UK equity markets) (bubbles, buy to let, China, Commodities, contrarianism, dotcom, miners, SVG, UK, value investing)
This time it’s different – the plangent refrain of the investor suffocating in a bubble. Ah, what bliss it is to recall the golden days of the dotcom era, when we thought the mini-scooter-driven party would never end. We would all be commuting to work via the internet and downloading our memories into cyberspace in a kind of Neuromancer-meets-Facebook “mash up”.
Now we look back and scoff at the delusions of our younger selves. What on earth were we thinking? Boy, we were really stupid 10 years ago! We forgot to ask important questions like: What does this company do? And: How will it make money? Thank goodness the commodities super-cycle is nothing like that.
And just why is it so different? Because China and India are industrialising like crazy, of course! Who could pass up that opportunity? Hmm, well let’s just run a slide rule over that shall we?
Tony Dalwood, head of public equities at SVG Investment Managers, believes that mining stocks and other natural resources plays, which have run up on the back of the commodities boom, are heading for a fall. “Value investing has underperformed because commodity stocks like the miners have got ahead,” he says. “The market is focusing on cyclical peak earnings, but miners are heading for a problem when returns normalise.”
Panic and crisis
Adam Steiner, head of research, public equities, at SVG adds: “The investment time horizon of hedge funds and traders is microscopic compared to pension funds, and the markets are now very momentum driven. In moments of panic and crisis no one is using valuation to pick stocks – they just churn their portfolios to try and keep up to date. They don’t want to be underperforming the market at the end of the quarter.”
He argues that resources companies are “grotesquely overvalued” – mining is a cyclical industry and is generating the highest returns it ever has, but as costs go up and more capacity comes on stream this won’t continue. “Whenever you have a bubble there is always an argument that this time it is different,” he says. “People are pointing to the impact of China, but the increase in the oil price is not completely accounted for by that. To pretend the demand for resources is in no way influenced by the global economic cycle is crazy. If oil goes to $200 a barrel then the average US driver has to spend 10 to 20 percent of their income on petrol. So you have to ask – if everyone in China owns a car, how will they afford to drive it around? High commodity prices in themselves slow global growth.”
He adds that the population of China is only three and a half times that of the US, and the majority are peasants in the north and west. So the Chinese economy will only become two or three times bigger than that of the US and it will take a long time to get there. “You also have to keep in mind that a lot of China’s growth has been financed by US debt.” That is, consumers withdrawing equity against their homes to keep spending – something they are unlikely to be doing much of in the foreseeable future.
The commodity gurus argue that prices are supported by years of under-investment, which has created a pinch point – miners can’t get the stuff out of the ground fast enough, so prices keep increasing. But when new capacities come on stream, shouldn’t prices correct to more realistic levels, especially if the US is in the doldrums? So investors have to ask themselves: How far do we want to ride this boom? You can bet the chartists are hunkered down over their models right now trying to call the peak.
Buy-to-let blow up
Steiner is also worried about the horrors that may lie ahead for the UK, especially if the buy-to-let boom turns out to be the UK’s very own sub-prime meltdown. “The banks have only written down their lending impacted by the US so far, not their UK lending losses,” he argues. “That will come if we have a nasty house price plunge. For the last few years there has been a very strong tailwind that has helped retailers, banks and property, but that has now gone into reverse, and it is likely to be a headwind for another three to five years. The issue will become – how are banks going to make money now? The ratings will recover but the earnings won’t.”
SVG takes a contrarian approach and is focused on companies not at the peak of the cycle – particularly, telecoms, pharmaceuticals, software and media companies. Steiner says that pharma stocks are interesting as they are “off the scale cheap” – some 40 percent below their 20 year average. “All the arguments for pharma – such as the ageing demographics – remain intact, but they have been hit by the FDA tightening up its approvals process and the market is fretting over near-term fears.”
He adds that media is “mind-blowingly cheap” because of fears that if the economy does turn down, media will do badly. SVG is focusing on business-to-business companies such as DMGT and the WPP agency, which is more diversified, and therefore less cyclical than people seem to think. “This is the exact inverse of 1998 to 2001,” he argues.
It’s an interesting idea – that TMT will ride again after a speculative bubble in commodities goes pop. M&A activity in the small and mid-cap telecoms and software sectors has been brisk in the last couple of years, with strong private equity interest. “A lot of small and mid-cap deals are happening and they have raised a decent amount of money,” says Steiner. Telecoms has now re-rated a little, but SVG believes there is further to go. Perhaps it’s time to dust off that mini-scooter and drive back into the TMT market again.
If you want to read more about developments in the TMT sector, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=42257
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