The oil price hit a record level of US$92/barrel at the time of writing. The Straits Times had an article on China Government rationing the supply of diesel as the price of diesel can no longer be passed on to the consumers due to the already high inflation in the fast growing China economy.
The situation prompted me to pick up a book that talked about the highly possible oil crisis that is coming. The author, Stephen Leeb, predicts that the oil price will probably hit US$200/barrel by end of this decade. This price has actually increased 2 times from his US$100/barrel prediction in his a earlier book, “The Oil Factor”.
He had 2 purpose writing this book and it is rather interesting that they tend to contradict each other. One of his purpose is to teach investors how to benefit from this coming crisis and the second, is to warn the society about the danger, so that they take precautionary measures and prevent it from happening. I do hope the latter happens as an energy crisis would potentially disintegrate our economy and cause us to retrograde our standard of living. In the worst case scenario = end of our civilisation. Coincidently, when I relook at the front cover of the book, I noticed that it captured both his puposes. Firstly, the main title, “The Coming Economic Collapse” (black words in white background), states the impact of the coming oil crisis and serves as a warning to mankind. Secondly, the subtitle, “How you can thrive when oil cost $200 a barrel” (white words in black background), is trying to tell us his purpose of teaching us to invest in an energy crisis.
I must admit that the agenda that I bought the book was to see how I can benefit from the possible oil crisis. But I became concerned and perhaps, a little paranoid after I read the consequences and the scenario of it. I would recommend you to read what he has to say as it is a genuine concern to mankind. Save Earth if you can! Or at least prepare and protect yourself for the worst!
Chapter 1 – The Bursting of the Tech Bubble: Did Our Most Recent Brush with Disaster Teach Us Anything?
The tech craze was like any other investment mania that pushes share prices to ridiculous levels. The burst of the tech bubble was the biggest scale since the Great Depression, with NASDAQ falling from 5,000pts to just over 1,000pts. U.S. economy was in an perilous situation and the Fed had to cut interest rates to nearly zero, and the government had to reduce taxes as well to save the economy. In “Defying the the Market”, his earlier book in 1999 before the crash, he highlighted that improvements in science and technology has actually slowed since 1960s despite all the great promises. It was companies like Dell that was making money through good business management rather than technological breakthroughs. The media and Wall Street analysts were also liable for fueling the frenzy by relentlessly providing bullish reports to encourage more people to buy stocks. The oil delusion is a mirror image of the technology delusion – people believe in 1999 that tech bull run will endure is equivalent to people of today who believe the oil market bull run is temporary.
Chapter 2 – A Collision Course with Disaster
3 points the author wants to stress:
- Since 1973 and the founding of OPEC, the price of oil has been the most important leading indicator of both the U.S. economy and the stock market.
Between 1973 to 2000, he discovered that economic downturns and bear markets were preceded by rising oil prices.
- Over the past thirty years or so, the United States has been losing control of its energy supply, and as a result our economy has grown increasingly vulnerable to external political and economic factors.
Hubbert’s law states that if half of the oil from a given field is being extracted, production starts to decline. Hubbert was right that U.S.’s oil production would peak in 1970s and since then, it has been declining. United States is now importing more oil than producing it and thus, dependent to OPEC nations’ oil supply and exports. With many anti-american feelings in OPEC nations, the problem seems to complicate further.
- Most serious, the world’s demand for oil is growing faster than oil production can increase.
People who suscribed to Hubbert’s law believes that oil production is near its peak and even if it is far from it, the escalating demand from fast growing developing nations like China and India will eventually drive it to the point.
Myopia on Wall Street, in Government and the Media
Wall Street analysts decided oil to have normalized prices (no long term uptrends but fluctuates around the mid-point of long term). Department of Energy and the International Energy Agency are not giving an accurate picture of our energy supply and help ensure needs can be fulfilled over the long term. Drawing attention to an article titled “The Breaking Point” by Peter Maass from New York Times Magazine, the author cited well-known data that made a compelling case for an imminent crisis but he left it hanging by not directly point out that oil is indeed an immediate problem.
Chapter 3 – The Collapse of Civilization: Causes and Solutions
Michael Shermer concluded in his article (“Why ET hasn’t called” in Scientific American) that an average life span of civilisation is only 421 years and United States has been around for 229 years. Modern civilisation is more expensive to maintain than ancient ones as they demand more natural resources. According to Joseph Tainter, complex societies (modern civilisation) concentrate resources towards solving a problem. Easiset problems are tackled first and gradually, problem solving become increasingly difficult. It seems familiar with the present oil situation where oil is becoming increasingly expensive and harder to find. Jared Diamond in his book Collapse also think that downfall of civilisations is caused by declining resources and he further states that the decisions of leaders is the crucial factor to prevent the downfall.
There are 3 keys to survival:
- Decline in complexity of the society to reduce cost of maintenance
- Adopt strict measures to achieve a fixed sustainable level of population, production and consumption (zero growth)
- Develop new energy supplies – the best option
Chapter 4 – Our Psychological Blind Spots: Conformity, Authority, and Groupthink
Humans have a strong tendency to trust and obey authority such that they will shed all personal responsibility and morals for the sake of following orders. The conformity is further enhanced in a group and groupthink arised. Thus, a society with a bad leader will not be able to acknowledge or deal with a growing problem. The present groupthink is that energy prices are not in a long-term uptrend.
Chapter 5 – The Madness of Wall Street: How Investors Can Profit by Overcoming Groupthink
For investors to make profit from the market is to avoid following the crowd and free away from groupthink. The academics have developed the Modern Portfolio Theory (MPT) and Capital Asset Pricing Model (CAPM) which many professional fund managers practised and 75% of managers underperforms the market. Extraordinary investors like Warren Buffett, Sir John Templeton and George Soros profit greatly by deviating from groupthink. To resist groupthink is more than just having a rational thought. It takes great emotional control to go against the majority even when they are right in the short term.
Another essential investment skill is to be open minded to accept situations are always changing and the recent past is not necessary an accurate guide to the future. For e.g. one of MPT and CAPM parameter, betas, are calculated based on a stock’s recent history and such a narrow view of time and closed mind approach will ignore the warning signs of major changes. In behavorial finance, Richard Thaler has found that investors tend to weigh potential short term losses more heavily than potential gains even when they are expecting to stay invested for the long term. Other researchers also found that investors who made recent gains are more willing to buy riskier investments. Nicholas Barberis’s study showed that market tends to underreact to first to twelve months of good news from a company, and overreact to a consistent pattern of good news over a three ot five year period. It is therefore important to keep an open mind to enable you to spot the turning points.
Currently, stocks are priced and funds are allocated based on the assumption that oil prices will remain stable over the long term and there are enough evidence to prove this premise wrong. Besides helping invidividual investors to profit from this, Leeb hopes that Soro’s concept of self-defeating prophecies can come true – if everyone believes that the oil crisis is coming, society will undertake steps to prevent it from happening.
Chapter 6 – The Most Dangerous Crisis of All
The first big lesson was the government’s mishanding of the Great Depression. President Hoover balanced the government budget, hoping that it will restored business confidence. However, this policy reduced the demand for goods. Roosevelt’s New Deal though moved in the right direction of government spending, the level of spending was insufficient to pull America out of Depression. It was World War II, where large orders of armament from Europe gave jobs to Americans. When America entered the war, government spending reached the level that John Maynard Keynes had advised and the economy was rescued. Thereafter, the government had learned the lesson and during the technology crash and Sept 11, they were quick enough to provide the much needed financial liquidity that prevented the economy from slumping. However, an energy crisis cannot be solved by money alone, it required many years of development of alternatives. The energy crisis in 1970s was a political crisis, not a crisis of supply, as the world still had plenty of ability to increase oil production. United States has not seen what an eventual oil shortage would be like. Yet, little effort has been made to prevent the crisis which may be the biggest problem that our civilisation have ever faced.
Chapter 7 – Chindia and the Future of Oil
With Chindia (China and India) having 35% of world’s population, even a small per capita consumption is significant. Assuming Chindia is developing into a high income group within the next 20 years, and with no growth in energy demand from the rest of the world, energy demand would rise 5% a year (a figure greater than what we witnessed so far).
The developed nations experienced 2 recessions in 1980s as a result of energy conservation. However, the conservation was only able to decrease the consumption in mainly OECD countries. Oil consumption in Chindia still continued to grow 1% a year during that period. An article in Business Week said that Chindia would need annual growth of 8% in order to provide jobs for tens of millions joining the workforce each year. Conservation could lead to massive unemployment and political revolution which the government would not allow.
Increasing oil production is not possible too as oil exploration has declined since 1962. Saudi Arabia is the only possible source of additional oil production but their high internal consumption of oil is not helping the situation. Like Saudi Arabia, if Russia tries to produce and export more oil, its economy would grow rapidly and consume more energy at the same time. At the end of the decade, a $200-plus oil seems possible.
Chapter 8 – The Havoc That Will Result from $200 Oil
The rising cost of energy is both an inflation and a deflation at the same time. It creates inflation as energy is used to produce goods, which in turn causes the price of goods to increase as well. It also discourages business expansion as the cost of operation will be high and seems unprofitable. Hence, it will be very difficult for the government to decide whether to stop growth and risk a recession, or stimulate growth and allow inflation to run. If the leaders are to choose the lesser of the two evils, they would rather allow inflation to rise as home price increases and debt burden lowers (devalued). Americans would be able to keep the value of their homes and the world would not be affected by a contracted US economy.
Chapter 9 – What the 1970s Teach Us About Investing in the Coming Decade
1990s was a special period in that there was a large number of investors in the market due to the baby boom generation reaching thier peak savings for retirement. With more money flowing into the market, it drove stock prices up and supported the bull run. In addition, the economy was good with relatively low, stable inflation and oil prices. Even in the 1990-91 bear market, the loss was minimal compared to history. Therefore, by late 1990s, the general groupthink was that the stock market always go up.
The closest resemblance of an energy crisis and a high inflation period will be in the 1970s (2 energy crisies and double digit inflation), where many people fear the uncertainty of the future. They were worried about the rising costs of groceries and needs, while their salaries were stagnant. High inflation destroys value of all investments, making it hard to preserve capital, let alone grow wealth. The situtaion of a coming energy crisis would be worse than 1970s as the baby boom generation will be reaching their retirement age and will depend on their retirement funds. High inflation will definitely lower their spending power significantly and as a result, may not be sufficient to see them through their old age.
The market between 1966 to 1982 was very volatile, it gone through 6 bear markets and prices fell 20% or more with bull runs in between. The volatility is expected to be worse for the coming crisis but of a lesser extent in fall during bear markets. This is because the economic growth is a necessity in today’s high-debt world and hence, the government would always try to stimulate growth and in turn, prevent stock prices from falling tremendously. Even so, it isn’t good news as inflation will kill your real rate of returns. If you stayed invested between 1966 and 1981, you would have lost 14% in real terms even if S&P 500 produced an average gain of 6%.
The strongest growth during the period came from small-cap companies, oil related companies and gold. Investors who buy and hold a diversified portfolio like what they did in 1990s will not work in a high inflation period, and making money would require more effort to actively scout the best ones to invest in.
Chapter 10 – The World of Tomorrow: Decline, Stasis, or Armageddon?
No matter how advanced technology is, it would not be able to defy the law of nature. There is limited amount of oil on Earth and not technology can change the fact. James Howard Kuntsler believes that the scale of human enterprises will contract with the energy supply and envisions Americans living on farms or in small towns when society reduced in complexity.
Herman Daly believes that zero-growth society can achieve increment in wealth and quality of life through quality of products rather than higher consumption. Transition to this level of long term sustainable zero growth society is necessary given current ecological and resource constraints. The transition will require the rewriting of traditional values – seeing high consumption as immoral and measure progress more in terms of quality and efficiency. Many people will not be able to fulfill their dreams and desires, especially of a higher lifestyle supported by sufficient energy.
Peaceful relations among nations may be hard to maintain as the oil shortage grows. Desperate nations may become vicious in their competition for the remaining oil supplies. A nuclear war is the last thing that we want.
Chapter 11 – Planning for Survival: Alternatives to Oil
We should put our effort and resources to develop alternative energy before conventional sources run out. The preconception that renewable energy is not worth developing as it will never be able to compare to oil in terms of price and energy amount, is a barrier to find energy alternatives. Wind energy by far is the most promising, with the current type of windmills able to compete economically with coal. Using hydrogen fuel cells to power for automobiles is an alternative but the drawback is that hydrogen does not exist naturally, and requires electricity to break it down. Mark Jacobson said that it will be economical to use windmill to provide electricity to produce hydrogen. The crucial factor that alternative energy is going to be able to replace oil is that our government has to set clear direction and allocate enough funds and resources in developing it.
With rising price of oil, ‘clean’ coal may serve as a good alternative. But due to its notoriuos polluting nature and like oil, supply will be running out soon, we cannot expect it to replace oil as primary energy source. The third alternative is nuclear fission, but being accident prone, difficulty in disposal and potential development of nuclear weapons, have discouraged widespread usage. In addition, it is in lower supply than oil. Solar energy looks appealing due to its abundance and cleanliness. But current solar cells have efficiency of 10% only and not economical as a primary energy source.
Last option is to use ‘exotic’ fossil fuels like liquefied natural gas (LNG), tar sands and bio-fuels. LNG may offset some oil for energy production but not possibly replace the latter as production cannot rise fast enough and is a diminishing resource as well. Extracting tar sands is expensive and have environmental issues. Bio-fuel still requires more research to bring its price down.
Chapter 12 – Misplaced Priorities: Our Biggest Obstacle Today
The government has been heavily subsidizing gasoline and if free-market forces were allowed to determine the price, Americans would pay between $5.60 to $15.14 a gallon. The government should stop the subsidies and let people experience the real cost. In this way, the society would then make an effort to develop alternatives. Academics put climatic change and environment as the priority and the energy problem is not even in the consideration.
Chapter 13 – Your Personal Choice: Insane Wealth or Pitiful Poverty
Investment Pitfall #1: Cash
Effect of inflation will erode the buying power of money. Savings account, Cash Deposits, Treasury Bils and other short term deposits are not advisable to put your money in.
Performance of cash in 1970s (high inflation period):
Av. annual nominal return = 6.3%
Av. annual real return = -1.1%
Total real return = -10.5%
Investment Pitfall #2: Bonds
Bond price and its yield is inversely related (one goes up, the other goes down). With high inflation, the yield on the bond may be lower than the inflation rate, and it means that you are having lower real returns. The only worthwhile bond to buy is the Treasury Inflation-Protected Securities (TIPS), where its principal and interest payments is peg to the inflation rate.
Performance of bond in 1970s (high inflation period):
Av. annual nominal return = 5.5%
Av. annual real return = -1.9%
Total real return = -17.5%
Investment Pitfall #3: Stocks
The overall market will offer poor returns and only certain sectors will do well. Thus, avoid index investing in the near future. Sectors to avoid are so-called the defensive groups (cosmetics, food, retail stores) as their P/E ratio will fall dramatically. P/E ratio will fall because investor are wary of paying too high a price for stocks during high inflation period. Moreover, companies are not likely to grow during this period and would not be able to increase their earnings. Companies that are highly dependent on oil (airlines, autos, chemicals) are vulnerable too and should stay away from them.
Performance of S&P 500 in 1970s(high inflation period):
Av. annual nominal return = 5.9%
Av. annual real return = -1.5%
Total real return = -14%
Investment Pitfall #4: Small-Cap Stocks
Small cap companies need a fast growing consumer market to grow their earnings rapidly. In 1970s, that was in US but now, it is in Chindia. US small cap stocks do not have the access to these markets and thus, a real disadvantage.
Performance of small stocks in 1970s (high inflation period):
Av. annual nominal return = 11.6%
Av. annual real return = 4.2%
Total real return = 50.9%
Chapter 14 – Making Money in the Coming Collapse
Investment Jackpot #1: Gold and Gold Shares
Gold performs poorly in good economic times but is a good hedge against inflation. The tech boom was not even comparable to the rise of gold prices in the 1970s. From $35 an ounce in early 1970s to $850 an ounce in early 1980s, nearly 10 times in real terms. It is now convenient to own gold bullion through passively managed gold trust exchange traded funds (ETFs) which tracks the gold price closely. These ETFs are preferable than mining companies as the latter are susceptible to unanticipated opertaion problems or regulations imposed on them. If you insist on putting money in miners, big gold miners like Newmont and Barrick Gold are safer bets.
How gold stocks fared in 1970s:
Av. annual nominal return = 28%
Av. annual real return = 20.6%
Total real return = 550.8%
How gold bullion fared in 1970s:
Av. annual nominal return = 33.1%
Av. annual real return = 25.7%
Total real return = 884.8%
Investment Jackpot #2: Oil and Oil shares
Oil prices are undervalued now which are based on the assumption that it will remain at $30 a barrel. It is not easy to trade crude oil directly and the only way is to buy future contracts. However, futures trading require skill and knowledge which not many ordinary investors have. Alternatively, we can invest in big oil companies where their revenues go up with the oil prices. The list includes British Petroleum, Chevron, ExxonMobil and Royal Dutch Petroleum. Not to forget the oil service companies like Schlumberger, Noble, Nabors and Transocean, who are lagging further behind (in terms of gains) than the big oil companies.
Performance of Big Oil Companies in 1970s:
Av. annual nominal return = 14.2%
Av. annual real return = 6.8%
Total real return = 93.1%
Performance of Oil Service Companies in 1970s:
Av. annual nominal return = 31%
Av. annual real return = 23.6%
Total real return = 732.1%
Investment Jackpot #3: Real Estate
The only thing that would kill real estate is high interest rate (method used by govenment to curb inflation). As discussed before, the government would rather let inflation run instead of causing a deflation. Instead of owning pieces of property, it is now easier to invest in real estate with Real Estate Investment Trusts (REITs) where the individual investors share the cost and ownership of properties.
Performance of real estate:
Av. annual nominal return = 10.1%
Av. annual real return = 2.7%
Total real return = 30.5%
Investment Jackpot #4: Chindia
American large cap companies who can tapped into the Chindia market will be able to capitalize on their rapid growth for years to come. 5 companies are touted to do well are 3M, Coca-Cola, Intel, Proctor & Gamble and Texas Instruments.
Although all the above investment advice is based on a high inflation scenario, the government may curb inflation and result in a deflation. To protect against deflation, investors can buy zero-coupon bonds. As zero coupon bonds rise faster than most bonds (due to its yield derives from the discount), they will perform better when interest rates fall in the deflationary period.
Chapter 15 – The Next Hot Investment Sector: Alternative Energy
In the coming years where oil prices are permanently on the uptrend, alternative energy will be a huge growth industry. Use of wind energy is growing 30% a year for the past 6 years. The potential wind generation companies are FPL Group, Scottish Power and General Electric. LNG which is expected to add 5 to 6 million bpd (barrels per day) to the energy supply is another possible growth sector. Leading companies in this area will be General Electric, Chicago Bridge & Iron (CBI) and Air Products and Chemicals (APD). Although CBI and APB are not producing LNG, they support the industry. CBI construct LNG terminals and refineries while APD build heat exchangers used in conerting natural gas into liquefied forms for storage and transportation. Moreover, APD is the principal producer of hydrogen which is essential for oil refining and developing alternative energies from shale and tar sands.
As mentioned in previous chapters, tar sands and nuclear are the other alternatives. Tar sands companies include Petro-Canada, Suncor, EnCana and Canadian Oil Sands Trust, and they would probably have the capability to increase production in the long term. An established nuclear company to look at will be Exelon while Cameco is a prominent miner of Uranium. As ‘clean’ coal involves gasification of coal, Sasol who is a leader in coal to liquid and gas to liquid production looks good as an investment choice.
Given the high oil price, hybrid cars will be in demand, replacing conventional fuel inefficient cars. Leaders in hybrid cars are Toyota and Honda and supplying the NiMH batteries to these 2 companies is Panasonic EV Energy (or the parent company, Matsushita Electric Industrial).
Based on the analysis described above, you may consider the weightage in the following portfolios:
|Category||Securities||Typical weighting||Aggressive weighting|
|Inflation hedges||Precious metalsEnergy||25%25%||10%10%|
|Chindia||Large cap American companies expanding into Chindia||30%||30%|
|Deflation hedges||Zero coupon bonds||20%||50%|