Isn't it crazy to avoid investing in oil stocks? After all, don't we all know that energy prices are going up in the long term? As large, developing countries continue to grow, demand for oil is sure to sky-rocket, right? 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:
Bureau of Transportation Statistics
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.