The Energy Crunch – October 2000

October 8, 2000

Dow Jones Average: 10,597
S&P 500 Index: 1,409


Energy Crunch


Modern society can be defined in large measure by energy consumption. Economically developed regions such as the United States use large amounts of energy per capita, while less developed nations use far less. Fossil fuels, i.e., oil, natural gas, and coal are still the predominant sources of energy used by the world. Over the past one hundred years dramatic increases in energy consumption have been met by vigorous exploration and extraction programs.

In spite of the long term price stability of oil, many consumers believe that oil and gas prices are out of control. Recent price spikes in heating oil and gasoline have alarmed consumers throughout Europe and the United States. Protesters in England have blocked roads, paralyzing the country. In the United States energy prices have become a major issue in the presidential race. The reality is that energy prices are high only when compared to the ridiculously low prices that prevailed over the past fifteen years. At the national average of 1.54 per gallon, the price of gasoline is exactly the same as it was in the 1950’s after accounting for inflation. And as the President of OPEC pointed out, a gallon of gasoline is much cheaper than a gallon of milk or a gallon of Coca-Cola. It is shocking that a dwindling natural resource so critical to modern civilization would be priced so low. It won’t always be that way.

Even though OPEC is vilified by many westerners, the cartel strives to maintain oil price stability. Leading OPEC producers such has Saudi Arabia, Kuwait, and the United Arab Emirates have small populations and one natural resource, oil. These countries want the world to remain dependent on oil, so they try hard to meet world demand at prices that undercut competing energy sources. They do not want to encourage the development of alternative energy sources until their oil fields are nearly exhausted.

It is apparent that the world can not move to a higher level of economic growth without putting strains on the energy supply/demand balance. Energy consumption continues to rise in the United States, thanks in part to more gas guzzling cars and trucks on the road. The increase in energy usage is even more dramatic in emerging economies that are rapidly industrializing. Newly developed economies in Asia, South America, and Eastern Europe are the swing factor in worldwide energy consumption. When these economies were growing in 1997, energy consumption and prices accelerated. The international debt crisis of 1998 dampened world economic growth and oil prices fell. Now that most nations are in a growth phase again, energy prices are pressing higher. We think that the upward pressure on energy prices will continue and intensify in the years to come.Profit Squeeze

The rise in energy costs has widespread implications for corporate profitability. In announcing lower than expected earnings many companies are citing weak European currencies (notably the euro) as the primary reason. Weakness in European currencies often correlates with high oil prices. Companies that do business in Europe are seeing the revenues and profits they earn in euros translate into fewer U.S. dollars. Energy prices have a more obvious impact on transportation and raw material prices. Many companies are complaining that higher shipping costs and more expensive raw materials are hurting profitability. Consumer patterns are also affected by higher energy prices with more of a family’s budget going to gasoline and heating oil and less to clothes and computers.

Tightness in the labor market and the collapse of stocks are the other factors impacting corporate profits. For the first time in twenty years workers have companies over a barrel. Help wanted signs are everywhere as companies scramble to find staff from a labor pool that is all but dried up. Some companies are enticing workers with higher pay and flex time, while others offer generous stock options. Stock options are a hidden expense that reduce corporate results over a longer period of time. The collapse of internet related stocks is having a swift, substantial impact on advertisers, technology equipment suppliers, and e-commerce consulting firms. The companies raised billions of dollars from stock offerings last year and frenetically spent the money setting up web sites and advertising their existence. Now that the seed money is all gone, the companies are disappearing, most without a trace of recognition having been realized. It’s a tough time to be a shareholder of a company or any of the companies that benefited from their lavish spending over the past year.

Current Strategy

Investors are shell shocked trying to survive the worst stock market in eighteen years. High stock market valuations, profit pressures, interest rate hikes, and relentless selling by corporate insiders, have made the market a discouraging place for shareholders. Investors seeking shelter from the storm are attracted to companies that have little foreign (euro) exposure, limited competition from imports, are fully staffed, have modest valuations, are recession resistant, and NOT internet related. What a difference a year makes! The problem is that few such companies exist. Energy stocks are a possibility, but are rather high in price. The same can be said of the other safe havens, such as drug stocks and utilities.

We sold positions throughout 1999 and have continued to garner profits in the current year. Capital preservation has been our primary concern over the past eighteen months. Overpriced and vulnerable holdings have been weeded from our clients’ portfolios. We have kept remnant positions ( fractions of the original holding) in a few blue chip technology companies such as Cisco, IBM, Texas Instruments, and ADC Telecoms. Even these relatively small, scaled down positions are hurting results as all tech stocks tumble.

Over the past nine months we have made some new buys in the food sector, along with a few purchases of beaten down industrial and technology stocks. One recent purchase, Brio Technology, was selling for 62 per share in March before falling to 8 dollars per share where we bought it in July. We continue our disciplined approach to buying with the hope of not overpaying for any purchase.

Bonds and cash are important components of our accounts in difficult market environments. The interest income from bonds and cash produce a positive flow that can be used to buy stocks or meet the cash withdrawal needs of our clients.

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