October 24, 2004
Dow Jones Average: 9,758
S&P 500: 1,096
Energy Squeeze
Worldwide economic expansion has been fueled for the past century
by cheap, plentiful supplies of hydrocarbons. There is a direct, powerful
correlation between increased energy consumption and rising economic
output. At current rates of consumption the world’s population
uses about 120 million barrels per day of oil and oil equivalents
such as natural gas. On an annual basis this comes to a staggering
44 billion barrels (1.9 trillion gallons) of oil and equivalent hydrocarbons
extracted from the earth, transported, refined, and burned or turned
into the chemicals that make up plastics, clothing, carpets, and other
products. Automobiles account for most of the oil burned each year,
while power plants are major consumers of natural gas. As more nations
industrialize and experience a greater per capita level of vehicle
ownership, the demand for oil and natural gas is only going to increase.
Considering the vast amount of oil consumed each year it is surprising
that the price has remained so low. Adjusting for inflation the price
of oil is less today than it was twenty five years ago. However, a
recent doubling in the price from 27 to 54 dollars per barrel may
be one indication that the era of cheap oil is drawing to a close.
The current surge in oil prices is being driven by increasing worldwide
demand for petroleum, as opposed to the major supply disruptions that
triggered past energy crisis.
The question facing the world economy is whether supply can be increased
fast enough to maintain high consumption levels in the developed nations,
while satisfying growing demand from Asia and other developing regions.
There are two schools of thought regarding future world oil production.
One holds that production is currently peaking in non-OPEC countries,
and will be at peak levels for OPEC in about ten years. After that
it is thought that supplies will tighten relative to demand, leading
to a long, inexorable upward climb for the price of oil. The other
theory is that trillions of barrels of liquid and gaseous hydrocarbons
remain below the earth's surface ready to be discovered and tapped
economically. There are notable geologists on opposite sides of the
debate. While there are differences of opinion there are two areas
of broad agreement. Virtually all energy forecasters believe that
production from current oil fields will drop by 50 percent over the
next ten years to fifteen years, and will have to be more than offset
by new production to satisfy growing world demand. And most see a
larger share of future production coming from OPEC countries located
primarily in the Middle East. The future for world oil and gas production
over the next fifty years looks a lot more problematic than has been
the case during the past one hundred years. There are likely to be
price shocks, a battle for political control of OPEC countries, to
say nothing of the environmental issues associated with burning trillions
of barrels of hydrocarbons.
The stock market has been reacting negatively to rising energy prices
during the past six months. Investors fear that the doubling of oil
prices will lead to an economic slowdown in the U.S. and other energy
consuming nations. Higher energy bills are the equivalent of a tax
increase that has the potential to offset the stimulative impact of
the Bush administration's tax cuts. Consumers of energy have not even
felt the full shock of higher crude prices yet. If crude prices stay
at 54 dollars a barrel it would not be surprising to see heating oil
prices above $2 per gallon this winter and gasoline prices near $2.50
a gallon in the spring of 2005. There are inflationary implications
from higher energy prices as well, as companies try to pass on higher
raw material and transportation costs to consumers. The combination
of slower economic growth and higher inflation is known as stagflation,
a dreaded word in the investment lexicon.
Current Strategy
The stock market has been grinding lower throughout the year. Of
the four largest industries represented by the major market indices,
i.e., medical, financial, technology, and energy companies, only the
latter has done well. Pharmaceutical stocks have been noticeably weak
as new drug approvals have been limited, while established drugs have
lost patent protection or been withdrawn from the market for safety
reasons. Technology stocks have declined in general, because the exuberant
earnings forecasts made by investors in 2003 did not come to pass
for this group. The financial sector has been weak as investors have
worried about a listless trading environment for stocks and bonds,
longer term structural issues such as deficits, and charges of conflict
of interest and collusion brought first against the brokerage industry,
then the mutual fund companies, and most recently the insurance sector.
While there are always individual stocks that have a good year, most
diversified portfolios and mutual funds have struggled to show overall
gains in this challenging environment.
Our strategy with regard to equities has been company specific for
the past nine months. We have been buying into special situations
as prices allow in a variety of industries. We did not see any reason
to over weight a particular industry given the economic backdrop.
In retrospect we should have increased exposure to energy stocks,
but did not foresee the last part of the crude oil price increase.
It was really the breakout above 40 dollars per barrel that created
a bit of a stampede into energy stocks. The new purchases we have
made over the past year are an eclectic mix of companies that include
the dominant mobile phone company in Latin America, a major worldwide
steel producer located in South Korea, a premier technology and solar
energy producer in Japan, the largest semiconductor manufacturer in
Taiwan, and a number of software and medical companies in the U.S.
We have moved more money into foreign markets, as we were able to
buy leading companies at very attractive prices relative to higher
prices for U.S. equities. While most of our recent equity selections
have moved up in price, we are not seeing the kind of rapid, broad
gains that occurred in the bull market of the 1990’s.
The bond market has been on a roller coaster ride all year. Bonds
gain value when investors lose confidence in the economy and other
asset classes such as stocks. In the first quarter of 2004 bonds rose
in value as the economy continued to lose jobs. When the job market
improved in April and the Fed signaled a rate increase bond prices
plummeted and yields rose. Bond values reversed course once again
over the past few months as worries about the economy resurfaced in
light of higher oil prices. The net result has been little change
in bond prices over the course of the year. The return from bonds
has come from the regular interest they pay, which ranges from two
percent on short term treasury bills up to about five percent on thirty
year government bonds. The inflation protected securities which we
have favored over the past few years remain an important component
in portfolios, as they provide a modest amount of interest while automatically
gaining value in line with inflation. With shorter term interest rates
and inflation still on the rise, we are maintaining our clients’
current bond holdings in inflation protected securities and shorter
term treasuries.
