A World of Scarcity: Investing in long-run trends
By Tony Allison, June 4, 2008
The world of investing is increasingly a world of frantic action, of high leverage and short attention spans, of a desperate search for the “next big thing.” There is a great fuss made in the financial media over quarterly results, and mass exaltation if results beat expectations by a penny. There is constant chatter regarding “sector rotation” and “market timing.” I believe the average investor would be better off ignoring these short-term, caffeine-enhanced machinations and occasionally climb above the forest for a clearer view.
Since the turn of the 21st century, the world has changed in many ways. Although their historic expansions began in the 1990’s, the economic explosions this decade in China, India, Brazil, Russia, Vietnam, Dubai, etc. have been without precedent. This great industrial leap includes countries that make up over half the people on earth. This expansion will not be without obstacles and set-backs, but it is far from over.
One of the hurdles to continued rapid growth will be the limitations provided by Mother Earth, which can only provide so many resources, so fast. We are likely to be living in a century of scarcity, and most of the world is not yet aware of this, or its consequences.
The pundits in the financial press confidently speak of “the commodity bubble” and expect it to deflate in the same manner as tech stocks and housing. This is typical of the short-term thinking that pervades the industry. While every market can become dramatically overextended, and correct back to trend, it doesn’t mean that the trend has ended in a burst of hot air. Commodity bull markets typically last 15 years or longer, and we’ve never experienced one during a global industrial revolution.
Bubbles are normally accompanied by massive oversupply, such as the millions of routers and other communications gear dumped on a saturated market in the late 1990’s, or the frenzied overbuilding by the real estate industry in 2003-2006. In 2008, the only item in massive oversupply is currency, and perhaps hubris as well.
Even some in the mainstream media are starting to notice the scarcity problem in this “commodity bubble.” The Wall Street Journal last week published a startling article entitled “Oil exporters are unable to keep up with demand.” The following excerpt illustrates the growing trend.
"The world's top oil producers are proving unable to put more barrels on thirsty world markets despite sky-high prices, a shift that defies traditional market logic and looks set to continue.
Fresh data from the U.S. Department of Energy show the amount of petroleum products shipped by the world's top oil exporters fell 2.5% last year, despite a 57% increase in prices, a trend that appears to be holding true this year as well.
There are several reasons behind the net-export decline. Soaring profits from high-price crude have fueled a boom in oil demand in Saudi Arabia and across the Middle East, leaving less oil for export. At the same time, aging fields and sluggish investments have caused exports to drop significantly in Mexico, Norway and, most recently, Russia. The Organization of Petroleum Exporting Countries also cut production early last year and didn't move to boost supplies again until last fall.
In all, according to the Energy Department figures, net exports by the world's top 15 suppliers, which account for 45% of all production, fell by nearly a million barrels to 38.7 million barrels a day last year. The drop would have been steeper if not for heightened output in less-developed countries such as Angola and Libya, whose economies have yet to become big energy consumers.
For all the attention paid to China's increasing energy thirst, rising energy demand in the Middle East may pose the greater challenge. Last year, the region's six largest petroleum exporters -- Saudi Arabia, United Arab Emirates, Iran, Kuwait, Iraq and Qatar -- curbed their output by 544,000 barrels a day. At the same time, their domestic demand increased by 318,000 barrels a day, leading to a loss in net exports of 862,000 barrels a day, according to the U.S. Energy Information Administration.”
Exporters become Importers
The UK and Indonesia not long ago exported over one million barrels per day of oil each into the world market. As of 2007, they are now both net importers of oil and Indonesia is withdrawing from OPEC at the end of the year. This is very likely not a temporary situation.
In Mexico, net exports dropped 15% in 2007. Mexican officials recently announced that output at Cantarell, their flagship offshore oil field, had plunged by one third in less than a year. Mexico’s oil exports to the US, roughly 1.4 million barrels per day (over 11% of our imported oil) look increasingly at risk, as Mexico heads toward net-importer status. Which country will make up those 1.4 million bpd, and at what price? And what will happen to Mexico’s economy, which is heavily subsidized by Pemex revenues from oil exports?
As depletion continues in the giant oil fields discovered 40-60 years ago in the Middle East, new discoveries must be enormous as well to offset the losses. Thus far the recent discoveries have not been enormous, and their development is slow and very expensive. These are not the classic ingredients of a bubble.
Inflation shell game
In his monthly Investment Outlook, Pimco’s Bill Gross unleashed another sharp attack on how the government has continually fooled us on the real inflation rate. Using humor as his sword, he also indicted Americans for caring more about Britney Spears than why gasoline costs $4.00 per gallon. The following excerpt summarizes his investment implications.
“A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate re-pricing or the BLS was ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of the world during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to be “entertained” with the notion of artificially low inflation than to be seriously “informed.” But just as many in the global economy are refusing to mimic the American-style fixation with superficialities in favor of hard work and legitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact is closer to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets are increasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?
What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.”
Commodity-based assets should be excellent investment candidates. Hmmmm. And this is coming from the world’s largest bond manager.
Gross was once again trying to issue a wake-up call to an un-attentive financial media. The following line applies to everyone however, especially the younger generation. His historic analogy, though humorous, should not be taken lightly.
“It’s Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headed for modern day Rome — better educated, harder working, and willing to sacrifice today for a better tomorrow.”
A fine line between abundance and scarcity
We have seen the results of supply and demand imbalances in food commodities; much higher prices, scarcity and food riots in some countries. It only illustrates the precarious balance between abundance and scarcity. Perhaps the US government would like to re-think its decision to subsidize corn ethanol production. Food may be a renewable resource, but its production relies heavily on fossil fuels, which look to be ever scarcer in the years ahead.
Food production also relies heavily on water, which is a growing concern as world population demand grows. Declining soil moisture levels are leading to a depletion of fresh water tables in many countries around the world. There is a growing need for the rebuilding of water infrastructure in the US and globally. There would appear to be great investment opportunities for well-run companies with expertise in water treatment, purification and infrastructure, as well as desalination technology. Dealing with a general scarcity of water may be one of the major global challenges this century.
Raw materials- low hanging fruit is gone
Raw materials and energy are the building blocks of growth around the world. Copper, iron ore, lead and other raw materials are still in great demand. Inventories are not overflowing, despite record high prices. As the world continues to industrialize, the demand for raw materials will grow. The mining giants such as BHP, Rio Tinto, and Freeport McMoRan are running flat out to increase supply. They are often forced to look in areas of geopolitical turmoil and harsh climates. It isn’t easy, quick or cheap. It is nothing like mass-producing routers. The low-hanging raw material fruit has already been picked.
Copper Inventory (metric tons)
Source: Bloomberg — London Metals Exchange
Nickel Inventory (metric tons)
Source: Bloomberg- LME
Zinc Inventory (metric tons)
Source: Bloomberg - LME
Lead Inventory (metric tons)
Source: Bloomberg LME
Precious Metals — strong fundamentals - limited supply
Despite billions in exploration over the last seven years, mining companies are not replacing depleting levels of gold and silver production. Peak gold may have already arrived.
Newmont’s general manager for Australia, Adriaan van Kersen recently told a gold mining conference in Perth, Australia that Newmont is having trouble finding gold, even as it spends $225 million this year on exploration.
“Exploration is not only becoming tougher and riskier, it is becoming more and more difficult to find gold in any surface quantity. As an industry, we are spending more and more on exploration, but even in a high demand and high price environment, and more drilling happening, the gold sector is not discovering the same ounces it used to.”
Central banks are still printing currency far in excess of GDP growth rates. Inflation remains a major threat, not just in the US, but across the globe. The dollar is under attack from all sides, and the Fed is in no position to defend it as it struggles to save the housing market.
The mainstream mutual fund investor in the US has yet to even discover precious metals as an investment sector, or as a store of value against rising inflation and a falling dollar. China and India both have centuries-old traditions of owning gold and silver. As the level of affluence rises throughout Asia, so will the demand for precious metals.
The relative scarcity of both gold and silver will of course help when the public discovers it needs an anchor in a financial storm. When supply is limited, and demand increases dramatically, a significant re-pricing occurs. That is what happens in a world of scarcity.
Invest in long-run trends
Invest in trends that have legs. While markets move up and down, quality companies that discover, develop and deliver tangible assets will likely do exceptionally well in future years. We are not going back to an age of abundant resources. Hopefully we will eventually develop mass-market alternatives to fossil fuel and raw materials, but it won’t happen anytime soon.
In addition, those leading firms that are involved in building infrastructure (roads, bridges, factories, dams, pipelines, sewer lines, rail lines, electric grids, power plants etc.) should prosper mightily as America’s overdue “rebuilding” gets underway, along with the ongoing infrastructure build-out in the developing world.
As far as a store of value and protector of wealth, gold and silver are simply irreplaceable.
U.S. stocks on Wednesday ended nearly flat and largely failed to retain gains after Moody's threatened downgrades of two large bond insurers, MBIA and Ambac.
The Dow Jones Industrial Average was down 12.37 to close at 12,390.48. The S&P 500 Index was flat, losing .45 to close at 1,377.20. The Nasdaq however was higher, ending at 2,503.14, up 22.66.
Crude-oil futures closed at their lowest level in a month Wednesday after U.S. government data showed that a jump in refinery activity helped boost supplies of petroleum products though demand for gasoline is on the decline. Crude for July delivery fell by $2.01, or 1.6%, to close at $122.30 a barrel on the New York Mercantile Exchange after trading as low as $122. The contract closed at its weakest level since May 6th.
Gold for August delivery closed down $1.70 at $883.80 an ounce on the New York Mercantile Exchange. Nymex prices lost $11.50 on Tuesday.
Personal Anecdote: My wife and I were walking along the coast last Sunday afternoon and noticed people gathering by the train tracks, many with cameras and tripods. We learned a vintage 1927 steam engine would be passing by soon, taking passengers from San Diego to Los Angeles, the first such trip by steam engine since the early 1950’s. Sure enough, it was soon seen chugging toward us, a large plume of steam announcing the arrival of the handsome black locomotive, decked with flags. People waved and shot photos. A man beside me mentioned that all trains will have to be steam engines again one day. Perhaps he might be right, either steam or electric engines, powered by “clean coal.” Back to the future meets 21st century reality.
Wishing you a good evening,
© 2008 Tony Allsion