Tuesday, March 23, 2010

Avoiding Energy

Isn't it crazy to avoid investing in energy stocks? After all, don't we all know that energy prices are going up in the long term? After all, as large, developing countries continue to grow, demand for oil is sure to sky-rocket. Furthermore, as a non-renewable resource, the world's oil supplies reduce every single day. Unfortunately, these stories don't tell the whole tale, and the reasons for value investors to stay away from investing in commodities like energy have never been stronger.

Energy prices are volatile, and the direction of price changes is hard to predict. While the factors described above (emerging economies, non-renewable resource) will play an important role in the future price of energy, they are over-emphasized by the media and those who are bullish on the price of oil. Under-emphasized, however, is the market reaction to the high (even relative to recent history) prices.

First of all, high oil prices result in increased exploration and increased production. But neither of these occur overnight. Instead, they take place over a period of several years, as labour and capital is shifted to the energy sector in order to derive strong returns. We saw this effect taking place in the early 1980s, and we are seeing it again.

Second, high oil prices result in consumer and business shifts towards conservation and the development of technologies that increase energy efficiency. As an example, consider the increase in energy efficiency of new American passenger vehicles sold in the last few years:

Note that the last time efficiency was jumping by this magnitude was in the early 1980s, when oil prices last spiked significantly. When oil prices were low, there was no need to purchase fuel-efficient cars and there was no need to invest in technologies that would increase efficiencies.

But once again, changes in efficiency don't happen overnight, which is why oil demand is relatively inelastic in the short term (e.g. one still has to fill up his car to get to work, no matter what the price) but elastic in the long term (e.g. the car-owner will consider fuel efficiency the next time he buys a car). Over the next several years, as higher efficiency vehicles replace older relatively inefficient vehicles, oil demand in this country will start to decline.

Will this offset emerging market growth and supply constraints? It is difficult to tell. This will depend on how fast developing countries grow, how quickly new supplies are found and at what cost, and the rate at which technologies that improve energy efficiency are brought to market. Simultaneously sorting through these variables to come up with a forecast is a difficult exercise riddled with traps.

The safest bet for the value investor is not to make one at all, since being wrong on the future price of oil is too easy to do. With the number one priority of value investing being "Never Lose Money", value investors should stay away from making investments that are heavily reliant on the price of energy, either on the cost or the revenue side. Instead, investors should focus on companies that face stable pricing of their products and have flexible cost structures.


Anonymous said...

I know this is an unrelated topic, but have you read the Avatar Holdings 10K yet (I'm asking because I noticed you posted on this company some time back)? You often talk about hidden assets, etc on the balance sheet that diligent value investors can discover with effort. Turns out, there was a very well hidden asset on the Avatar balance sheet. They had a deferred tax asset for which they had taken a valuation reserve for the entire amount. Late last year, Congress passed legislation that extends the carryback period for NOLs. This law change creates a tax refund of $34 million for Avatar... nearly 15% of their total market cap. This was an asset that didn't exist unless you read the 10K carefully and understood their tax situation and the subsequent legislative change.

400k Investor said...

Nice to see your writings on Morningstar. Your audience must be huge by now. Congrats

If you get a chance, check out my chronicle of NCAV investments (the first one went pretty well!)

- Amit


segemran said...

Saj do you think that some particular opportunities in this field (oil & gas) may be excluded from the general principle of avoiding so unpredictable results?

maybe with a bigger than normal MOS, or some particular feature of the opportunity?

Saj Karsan said...

Hi Anon,

Interesting find!

Hi Emiliano,

Definitely, good point! Sometimes a feature can reduce downside risk or increase upside potential (including a large margin of safety, as you say) that can make a stock (in an unappealing industry) appealing!

theCase said...

I agree with this post to a certain extent (volatility in particular), but think you're "cherry-picking" your example of automobile fuel economy.

A more appropriate graph may be world energy demand. More efficient automobiles have had very little impact on overall energy consumption.

Saj Karsan said...

Hi the,

You're right; automotive fuel consumption is only a part of the US' oil consumption. But it's almost half of it, so it does have a huge effect on the overall usage. Also, don't be surprised if energy efficiency gains are taking place in the other, less significant areas of oil consumption, as when there are profits to be had (and there are, with such high oil prices), there will be investments made to chase those returns.