This chart chronicles the carnage in the energy sector over the past year. I reviewed my holdings (many which are not recorded in the Financial Logbook) and their performance is consistent with the chart.
Does the miserable state of the market present an investment opportunity?
It all depends.
Arguments which Favour the Thesis
1. The Consistency of Increased Demand for Energy
While estimates vary according to the biases of reporting agents, the general consensus is that demand will increase substantially over time. I believe that the following estimate of demand is reasonable. Note the increased importance of fossil fuels and alternative energy sources.
Note also that demand reflects a long-term trend which obviously fluctuates in response to factors such as the state of the global economy. Sometimes, when demand abates, many "experts" opine that it represents the "end of oil" and the dawn of a new age of energy sustainability. They are deluded.
2. Slowness in Weaning Off Fossil Fuels
There will be no sudden shift off oil and gas for a variety of reasons: the lack of infrastructure to support alternative energy distribution (including social and financial institutions to support the adoption of new technologies on a wide scale); the power density of fossil fuels for uses such as transportation; the ready availability of fossil fuels and the effectiveness of distribution systems; the initial cost and risk of adopting newer technologies, etc.
3. The Fickle Nature of Investors
The current exodus of investors from the energy sector is symptomatic of the "herd mentality". In my experience, declines represent an excellent opportunity for investment. The cycle always repeats. My belief is that the age structure of western societies is such that older investors are very mindful of the risks of market declines on their quality of life. Most are fearful of losing their savings - also that they won't have the time to make up losses in the market. This mindset accentuates market gyrations.
4. Human Ingenuity
Time and time again, human innovation has surmounted seemingly unsolvable problems. For example, technical innovation in the oil and gas sector has unlocked new sources of supply and, over time, technological improvements have made previously uneconomic formations a very viable economic prospect. We are indeed fortunate in North America that barriers to applying technological innovations are fairly low in comparison with the rest of the world where over-regulation and socio/political constraints impede creative approaches to problem solving.
Arguments which Discount the Thesis
1. Slowing of the Global Economy
Economic slowdowns have the potential to reduce the pace of demand, but history has shown that the effect is temporary. However, markets these days are hypersensitive to "bad news" and respond accordingly.
2. Shift to Alternative Sources of Energy
The expression of this process will be uneven both in time and geographic area. There will be special situations where alternative sources of energy constitute a significant economic, social and ecological advantage, but for the majority of people, conventional energy will meet most of the demand for energy.
Some "environmental groups" will press the case for alternative energy strongly, but in my view, they are misguided in their efforts, some of which are strategically directed in the self-interest of supporting the growth of their organizations. In my view, some costs to implement sometimes unproven policies/technologies may frequently outweigh the benefits. In fact, I would argue that it is only the very richest of countries have the ability to implement new technologies on a widespread scale ... and the social cohesiveness and infrastructure to support innovation. I may be cynical in this view, but sadly, I believe that only the industrialized world will have a viable chance of coping with climate change and other challenges such as novel diseases.
Least I be labeled as an extreme right-wing Libertarian or one who is in the pockets of the petroleum industry, I say this from the experience of having work professionally in the field of landscape preservation and wildlife management. After many years, we realized that economic and social considerations must be incorporated in the design and management of protected spaces - otherwise they will not survive with a significant degree of ecological integrity. This may sound counterintuitive to many but we live in a very nuanced world where extremes in ideology of any bent do not do much to contribute to resolving the challenges faced by people everywhere. Investors everywhere would be wise to discount the ideological bleating of mouthpieces in any camp.
3. Trend to Greater Energy Efficiency
This trend has the potential to reduce demand. The energy intensity of manufacturing in the western world has been reduced very significantly in recent decades in the sense that manufacturers are able to produce products using less energy than before. This trend is now being realized in juggernauts such as China and India. However, this ignores the raw increase in global demand - something which "trumps" energy efficiency due to the sheer size of the demand resulting from a notably higher material quality of life throughout much of the world.
4. Competition Among Producers
An uncritical reading of some recent news reports might lead naive people to believe that the North American energy industry is dead - that it will be overtaken by more efficient producers in the Middle East, or that Russia will eventually get its act together and outcompete North American producers. I am always alert to potential advantages of energy producers and factor such considerations into my decision-making. Among these considerations are: finding/extraction/transportation costs; the social/political/economic circumstances faced by producers; etc. To my mind, some producers may have an advantage for a period of time, but gradually it may be eroded for a variety of reasons: geopolitical disruption; resource mismanagement; corruption; technological innovation by competitors, etc. The current contention that Saudi Arabia is driving prices down in an effort to control its market share may hold some water at present, but I believe that the strategy is unsustainable for a variety of reasons. I do not give it great significance in my decision making.
Criteria for Investing in Energy Enterprises
I will look for companies with the following attributes:
- seasoned, ethical management with a successful track record
- strong balance sheets
- ample reserves which can be brought on line quickly and cheaply in response to changes in demand (or on the other hand, where a company has the financial capacity to "warehouse" reserves at low cost until markets improve)
- the majority of operations in geopolitically stable countries where the rule of law prevails
It Will Pay to be Selective
Quite aside from the attributes of individual companies as discussed above, it will be prudent to consider some strategic factors:
- The historical pattern of "rebounding stocks" in the energy sector. Some sectors will rebound more quickly - ditto for some geographic areas. This is worthy of further investigation. For example, will historical patterns repeat themselves or will a few things be "different this time"? Is it possible to identify some leading sectors as harbingers of better things yet to come?
- How are global patterns changing? Are there some developments which are conferring a competitive advantage on some geographic areas for producers or other sectors of the energy industry? For example, what is the outlook for uranium? What are the prospects for more economically viable methods of energy storage which could accelerate the spread of alternatives to fossil fuel energy sources?
For example, the rise of fracking in the US has fundamentally changed the global supply situation for oil and gas.
Production has soared:
Rig efficiency has improved dramatically:
Does this present a fundamental change to the global supply of oil and gas? I think it does. Does it present opportunities for the export of LNG? The jury is out as there are many complicating factors which could frustrate efforts in the US to build LNG export facilities. Does it present opportunities to invest in the unconventional oil and gas in the US? Most assuredly, especially now that investor sentiment is sour.
Note the absence of the following considerations in my search for potential investments:
- prognostications on the global economy
- political trends
- climate change
- short-term prospects for the sector (instead, I focus on long-term trends)
These things are fodder for "talking heads" and others who have not been made rich by their investment acumen.
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