The Globe and Mail, Report on Business
Published June 14, 2008
We can't go anywhere or do anything without feeling the impact of high oil prices. It is the topic du jour and we are at the stage where every self-respecting politician and oil executive is weighing in on the subject. In our household, my wife Lori's conspiracy theory is alive and well.
It is now a foregone conclusion that we have entered a new world. Most Canadians feel that the era of cheap oil is over and prices are only going higher. There are very few dissenters.
In a tiny subset of the population known as asset managers, however, the view is not that unequivocal. For these perverse individuals, opinions range from one extreme to the other.
Some managers are very much in the "new world" camp. Eric Sprott is the poster boy for this group. But others have the view that high prices are transitory and this is "just another cycle."
The former group is winning the game at this point. Their arguments are well known - the growth in "Chindia" will increase demand at a time when the outlook for supply is uncertain - and they are well into triple digits on the scoreboard ($134.86 U.S., up $1.88 yesterday). If this were the NBA finals, the New Worlders are up three games to zero and are leading game four with minutes to go.
The barely standing "just a cycle" team acknowledges that this cycle has been more powerful and lasted longer than expected, but they insist that it will play out like all cycles do. The magnitude and duration reflect the fact that there are no quick adjustments to be made on either side of the supply/demand equation. It is like turning around a super tanker. It takes time to build the infrastructure to pump more oil out of the ground and get pipelines and refineries up and running. While there are exciting things happening in alternative energy, any meaningful impact is years away.
Similarly, we can't just dial down demand in the short term. But there is significant change going on. Despite a strong economy, oil usage in the Organization for Economic Co-operation and Development countries has been declining for two years. The developing economies are using more, but growth has moderated there too and is likely to slow dramatically in countries where subsidies are being reduced or eliminated.
It's irrefutable that when people are spending more on energy, they have less money to spend on other stuff. That results in the makers of that other stuff cutting production and in turn using less oil.
So while the "just a cycle" team is staggering, it is ticking off the boxes on its commodity-cycle checklist. A shortage of supply leads to higher prices (tick). Demand increases as users stock up (tick). A new paradigm is declared (tick). Capital investment is ramped up to increase production and develop alternatives (tick). A strong consensus emerges and higher prices are assumed (tick). Increased supply and weakening demand lead to lower prices (TBA). Inventories grow and profits plummet, leading to restructuring of the weak, high-cost producers (TBA). A consensus builds that the world has more energy than it will ever need (box last ticked in 1999).
Interestingly, the current rise in prices makes each side dig in further. For the "new world" bulls, it confirms their thesis. For the "just a cycle" curmudgeons, it means the downturn will be more severe.
It should be obvious by now that I've given the "just a cycle" team significantly more air time. That's because their arguments have disappeared from the current discourse. The media coverage overwhelmingly reflects the "new world" view. And such a strong consensus should always be questioned.
There is nothing simple about what's going on today. We seem to be in a world where cycles are prone to going to extremes (think technology, U.S. housing and reality TV).
Underlying the energy boom are a multitude of cyclical and secular forces. A strong world economy has been partially responsible for pushing prices up, and a contraction will have the opposite effect. The supply challenges we are facing represent a secular shift on the energy landscape. But there are also profound changes happening on the other side of the equation. Sustained high prices are ensuring that the falloff in demand will also be significant and long-lasting.
No matter which side asset managers are on, the job does not stop with their call on the oil price. It isn't good enough to just have the correct industry view. Company fundamentals and stock valuations have a little to do with portfolio returns as well. The exciting outlook for the automobile in the early 1900s proved correct, but making money on the auto makers was more challenging. The promise of the Internet and digital world in the late nineties has been more than fulfilled, but many technology investors have still not recouped their losses.
When assessing any cycle - oil, mining, agriculture or autos - investors should remember two things. Don't assume a strong, broadly-held consensus is always right. As the expression goes, they are "often wrong, but never in doubt." And make sure to separate the cyclical call from the investment decision. You want to find stocks that don't already have your outlook factored into them.