Energy Squeeze – October 2004

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.

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