Thursday, November 29, 2012

Why the Oil Boom is Over

Long term investors make long term decisions and none should have longer time frames than those in the commodity markets. In this article I want to focus on energy and look at some of the developing trends within the oil market. Essentially, if you are going to buy an oil related company, you are betting on oil prices.

Oil Demand Varies With Pricing

One of the biggest and most pervasive of myths surrounding oil demand is that somehow it is price inelastic. In other words no matter how much the price goes up the demand will remain the same. This idea is simply not true and here is the evidence to prove it.

Note that European oil demand has fallen in recent years and is currently significantly below where it was 17 years ago. The situation is not quite the same in the Americas, but if we break out North America from the number its demand is running pretty close to 2000 levels.

The bulls would have you believe that this is merely a reflection of the ongoing shift in manufacturing production to the Far East, and investors should focus on overall demand. There is some truth in this, but I don’t think it is reflective of the big picture. Nor does it explain the fact that growth has been good in the US and Europe over the last 17 years, and if you add forecast demand in the US and Europe for 2013 it is only 6% above what it was in 1996. This does not suggest that demand is inelastic.

The evidence is that China in particular has seen a rapid escalation in demand in line with its strong economic growth. This fact is even more relevant when we understand how inefficiently China has been using energy.

Here is a graph of the composition of growth in oil demand.

There are some fascinating developments here. First, note how strong Asia/Pacific has been; but as the first chart demonstrated, things are somewhat tailing off. Second, Europe has really managed to reduce oil demand in face of high prices. Third, the Middle East and former Soviet Union have started to be large contributors to demand growth in recent years.

The third point is the key to understanding the dynamics. The growth in demand has been greatest in the regions that subsidize oil prices. Asia/Pacific and the US are also contributors to this trend because, they too, subsidize oil, but few places in the world pay less for gasoline then the Middle East or the former Soviet Union.

The lesson is clear. Demand is not price inelastic, and if you subsidize it more oil will be used.

Road Hogs

There is no more emotive topic in energy usage than that of gasoline. It makes up over 25% of global oil demand and the statistics are simply amazing with regards to who uses what.

You can draw your own conclusions here, but I think the idea that the US necessarily has to use 4.2x as much gasoline as the whole of Western Europe is not a tenable one. As for blaming China gasoline demand for high oil prices, this graph says otherwise.

Where Next With Oil?

I can’t make this anything more than a cursory analysis that tries to highlight the key points.  I haven’t gotten into the supply side or the geopolitics of many of the suppliers (oil is overwhelmingly produced by the Government sector) but increasingly we are seeing developments like shale gas or LNG, which suggests that oil is not that critical an energy demand resource as many previously thought it was. Throw in productivity enhancements (fuel efficient engines, solar powered cars etc.) and demand can be reduced.

If you are going to invest long term in a Chevron (NYSE: CVX) or an Exxon Mobil (NYSE: XOM) you need to appreciate that their evaluations will be based on the long term value in their proven and probable reserves. The price of this depends on the continued willingness of governments to subsidize oil demand (particularly gasoline) and/or to allow for the growth of alternative energy sources. For example the country that is believed to have the largest shale gas reserves in Europe (France) appears to be the most reticent to allow fracking, yet the President claims to be ‘pro-growth.’ Plus ca change?

On the other hand, China is doing anything it can to maintain growth but move away from gasoline usage. This is not great news for a company like Harley Davidson (NYSE: HOG), which would dearly love to make significant inroads into China. Instead I think Harley should look at the second chart and go for growth in the Middle East (the brand is loved there) and other emerging parts of the world.

Just as oil exploration companies would suffer if there were political changes, so would oil services companies. Therefore any investment in oil services company Halliburton (NYSE: HAL) might not quite see as favorable an outcome as when Dick Cheney was in office.  If you are buying an oil services company you are usually making an investment in a company with a high correlation to spot prices.

Where Next Without Oil?

In my opinion, the next decade for oil prices will not be as favorable as the last. Shale gas has changed the way people think and it’s time for the US and others to gradually wean its populace of gasoline subsidies. Moreover, the Chinese look set to become more energy efficient in the future and may well revolutionize the way the world thinks about electric cars powered by LED based systems.

Not only are the Chinese investing in electric cars but also in high speed railways. It is not often that Warren Buffett is cited as a growth visionary but I think he was right to buy Burlington Northern. Obama has been somewhat thwarted in his pursuit of extensive high speed rail lines, but the free market has been voting for rail. For example, FedEx (NYSE: FDX) was very clear recently that its customers are prefer using slower, cheaper (non express) delivery methods at the moment. This inevitably involves using more railways and fewer airplanes. This is not a disaster for FedEx but it will have to reorganize its investment priorities.

Perhaps it’s time for the US consumer to do something similar and start traveling inter-city by train rather than by car or plane? That is one way to reduce gasoline demand.

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