Oil as a Deflationary Investment 19 comments
Bruce Vanderveen
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We all know that in an inflationary environment oil and other real assets are good places to invest. It is easy to find asset classes which keep pace with inflation. Gold, oil, real estate, stocks, collectibles, maybe even your car and your boat. Your choices seem endless.
But what about in today's deflationary environment? Investments that do well in a deflationary environment are much more difficult to find. Here are some possible candidates with my comments in italics.
- Cash - No upside, but safe, liquid and purchasing power increases with time. Example: If you had sold a Florida house 3 years ago for cash, put the cash in a savings account you can now buy two houses with the money.
- Quality long term government and corporate bonds - This was a great place to be the last 1/2 of 2008, but the trend runs its course as interest rates approach zero. Even worse, with trillion dollar deficits and quantitative easing you know this game will end someday.
- Currency plays such as the US Dollar (UUP) or Japanese Yen (FXY) - These currencies do well when the fear factor is strong and markets tank.
- Inverse ETFs such as SDS, SH, DOG, and DXD - Great for short term trading, but if you are not a day trader stay away, especially the double inverses. SA has numerous articles on why.
I propose a 5th item: Investments in companies rich in oil and other natural resources. Consider oil rich stocks such as OXY, PBR, and EOG. For diversification, but with a higher natural gas component, consider XLE.
Remember "inflation is always and everywhere a monetary phenomenon". Prices are determined by supply/demand, not just inflation/deflation. Worldwide, the supply of "easy" oil is falling quickly, even as demand stagnates. The large middle eastern fields are in decline. It is telling that when oil was over $100/barrel Saudi Arabia and the rest of the middle east was unable to up production much. Therefore, oil prices could continue to rise, even in recession.
Economies such as China, India and Indonesia are again strengthening, if not booming. Tens of millions of first time customers are looking to buy autos, this has to be bullish for oil.
I would stay away, for now, from the natural gas ETF UNG. There is an oversupply of this relatively inelastic commodity thanks to technological advances in production. Eventually, natural gas will start replacing oil as it becomes relatively cheaper, but the process will take time. How many natural gas powered vehicles have you seen on the road lately?
Of course the current rally is not only in natural resources, it is also in world markets. It is best not to buck a trend. However, nothing goes up forever. The test will come when market indices decline, then we will see to what extent oil follows. For this reason, I would stay at least 50% in cash. You may find better entry points later.
With dark under-currents of impending doom and crash rumors swirling just below the surface, I would keep a close eye on the rear view mirror. At least with natural resource positions you have something which, short of Armageddon (and we will all be dead then anyway), will always be in demand for the foreseeable future.
Disclosures: Long SH, OXY and FXY
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This article has 19 comments:
Bruce,
This article seems to be about peak oil.
I didn't see how your thesis for oil is related to deflation. You mentioned other assets that are clearly defensive: cash, bonds, and inverse ETFs. Your thesis for oil, however, seems to rely solely on diminishing supply/peak oil.
Thanks,
Rob
Yes, I should have mentioned that peak oil thinking is behind some of the logic Oil is not intrinsically a good deflationary investment (rather the opposite). However, the point is a depleting resource is a good investment no matter what inflation/deflation is.
"Demand Destruction" in US and Europe is being offset by "Demand Explosion" in large Asian countries such as China, India and Indonesia. One must take a world view.
True, some of the same arguments for oil can be made for gold. However, oil is a working asset while gold is purely defensive. (If you like to handle assets, gold beats oil).
On Aug 13 10:07 AM Robert Martorana wrote:
>
>
> Bruce,
> This article seems to be about peak oil.
>
> I didn't see how your thesis for oil is related to deflation. You
> mentioned other assets that are clearly defensive: cash, bonds, and
> inverse ETFs. Your thesis for oil, however, seems to rely solely
> on diminishing supply/peak oil.
>
> Thanks,
> Rob
The replacement cost of the commodity to bring online new supplies matters.
The cost to bring on new supplies of oil is $80/barrel or so for many places around the world. When oil stays below the cost for an extended period of time, the depletion rate of oil will sink in of the lower cost fields....and your supplies drop.
The more experienced oil watchers know that what matters in the oil market is exportable oil.
More and more countries are importing oil because of declining supply. A major exporter to the USA (Mexico) is about to become an importer. They used to export 2-3 million barrles....now they will be importing oil in a couple of years. in 10 yrs time....just one country could change the export game from +3MBPD to -2 to 3MBPD. a swing of 6 MBPD.
Throw this in for a lot of countries...increased demand from other countries and no new supplies coming online....the numbers don't add up quick.
Oil and other commodities that the world needs are the safest investments IMO....as they are limited to in a price range between supply replacement cost and demand.
If the price is below the replacement cost....BUY it up. High dividend paying companies with large reserves are even better.
Paul
I am providing it for two main reasons -
1) It provides some valuable insights into events.
2) I agree with the basic trust of the article & believe that the information & ramifications are likely to be proven correct, as history unfolds.
That said, my apology to those readers who prefer short posts, as this is not short.
=========================
Temporary Recession or the End of Growth?
Energy is the ultimate enabler of growth (again, this is axiomatic: physics and biology both tell us that without energy nothing happens). Industrial expansion throughout the past two centuries has in every instance been based on increased energy consumption. More specifically, industrialism has been inextricably tied to the availability and consumption of cheap energy from coal and oil (and more recently, natural gas). However, fossil fuels are by their very nature depleting, non-renewable resources. Therefore (according to the Peak Oil thesis), the eventual inability to continue increasing supplies of cheap fossil energy will likely lead to a cessation of economic growth in general, unless alternative energy sources and efficiency of energy use can be deployed rapidly and to a sufficient degree.
Of the three conventional fossil fuels, oil is arguably the most economically vital, since it supplies 95 percent of all transport energy. Further, petroleum is the fuel with which we are likely to encounter supply problems soonest, because global petroleum discoveries have been declining for decades, and most oil producing countries are already seeing production declines.
So, by this logic, the end of economic growth (as conventionally defined) is inevitable, and Peak Oil is the likely trigger.
In effect we have borrowed from future generations so that we could gamble away their capital today.
Why Did Oil Prices Fall? And Why Didn't Lower Oil Prices Lead to a Quick Recovery?
The Peak Oil thesis predicts that, as world oil production reaches its maximum level and begins to decline, the price of oil will rise dramatically. But it also forecasts a dramatic increase in the volatility of prices.
The argument goes as follows. As oil becomes scarce, its price will rise until it begins to undermine economic activity in general. Economic contraction will then result in substantially reduced demand for oil, which will in turn cause its price to fall temporarily. Then one of two things will happen: either (a) the economy will begin to recover, stoking renewed oil demand, leading again to high prices which will again undermine economic activity; or (b), if the economy does not quickly recover, petroleum production will gradually fall due to depletion until spare production capacity (created by lower demand) is wiped out, leading again to higher prices and even more economic contraction. In both cases, oil prices remain volatile and the economy contracts.
One way or another, growth will be highly problematic if not unachievable.
Big Picture Diagnosis: Continuing the Trail of Logic
Thus the Peak Oil crisis is really just the leading edge of a broader Peak Everything dilemma.
In essence, humanity faces an entirely predictable peril: our population has been growing dramatically for the past 200 years (expanding from under one billion to nearly seven billion), while our per-capita consumption of resources has also grown.
If we step back and look at the industrial period from a broad historical perspective that is informed by an appreciation of ecological limits, it is hard to avoid the conclusion that we are today living at the end of a relatively brief pulse-a 200-year rapid expansionary phase enabled by a temporary energy subsidy (in the form of cheap fossil fuels) that will inevitably be followed by an even more rapid and dramatic contraction as those fuels deplete.
The winding down of this historic growth-contraction pulse doesn't necessarily mean the end of the world, but it does mean the end of a certain kind of economy. One way or another, humanity must return to a more normal pattern of existence characterized by reliance on immediate solar income (via crops, wind, or the direct conversion of sunlight to electricity) rather than stored ancient sunlight.
This is not to say that the remainder of the 21st century must consist of a collapse of industrialism, a die-off of most of the human population, and a return by the survivors to a way of life essentially identical to that of 16th century peasants or indigenous hunter-gatherers. It is possible instead to imagine acceptable and even inviting ways in which humanity could adapt to ecological limits while further developing cultural richness, scientific understanding, and quality of life (more of this below).
But however it is negotiated, the transition will spell an end to economic growth in the conventional sense. And that transition appears to have begun.
Whom should we believe?
Could the Alternative Diagnosis be altogether wrong? That is, might conventional economists be right in thinking that growth can continue forever? It is often said that anything is possible, but some things are clearly much more possible than others. The perpetual growth of human population and consumption within the confines of a finite planet seems like a very long shot indeed, especially since warning signs are everywhere apparent that ecological limits are already being reached and surpassed.
What Not to Do: Prescribe Punishingly Expensive Placebos
If the physical scientists who warn about limits to growth are right, confronting the global economic meltdown implies far more than merely getting the banks and mortgage lenders back on their feet. Indeed, in that case we face a fundamental change in our economy as significant as the advent of the industrial revolution. We are at a historic inflection point-the ending of decades of expansion and the beginning of an inevitable period of contraction that will continue until humanity is once again living within the limits of Earth's regenerative systems.
Other nations, including Britain, China, and Germany have committed to paying for stimulus packages and bailouts that, while much smaller in absolute terms, represent an impressive (or should we say frightful?) share of national GDP.
If the Alternative Diagnosis is valid, none of this will work in the end, because existing financial institutions-with their basis in debt and interest and their requirements for constant expansion-cannot be made to function in a context where energy and resource constraints impose effective caps on manufacturing and transport.
What is required but is still utterly lacking is a fundamental recognition that circumstances have changed: what worked decades ago will not work now.
What To Do: Adapt to the New Reality
If the Alternative Diagnosis is correct, there will be no easy fix for the current economic breakdown. Some illnesses are not curable; they require that we simply adapt and make the best of our new situation.
If humanity has indeed embarked upon the contraction phase of the industrial pulse, we should assume that ahead of us lie much lower average income levels (for nearly everyone in the wealthy nations, and for high wage earners in poorer nations); different employment opportunities (fewer jobs in sales, marketing, and finance; more in basic production); and more costly energy, transport, and food. Further, we should assume that key aspects of our economic system that are inextricably tied to the need for future growth will cease to work in this new context.
What can we do to adapt most rapidly and successfully?
Rather than attempting to prop up banks and insurance companies with trillions in bailouts, it would probably be better simply to let them fail, however nasty the short-term consequences, since they will fail anyway sooner or later. The sooner they are replaced with institutions that serve essential functions within a contracting economy, the better off we will all be.
Without cheap energy, global trade cannot increase. This doesn't mean that trade will disappear, only that economic incentives will inexorably shift as transport costs rise, favoring local production for local consumption.
Without cheap fuel for agriculture, farm production will plummet and farmers will go bankrupt-unless proactive efforts are undertaken to reform agriculture to reduce its reliance on fossil fuels.
With oil becoming increasingly expensive in real terms, we will need more efficient ways of getting people and goods around.
However contentious, the population question must be addressed. All problems that have to do with resources are harder to solve when there are more people needing those resources.
But those in charge need to understand that looking on the bright side doesn't mean promising what can't be delivered-such as a return to the days of growth and thoughtless consumption.
Can We? Will We?
It is important to state the implications of all this as plainly as possible. If the Alternative Diagnosis is correct, there will be no full economic "recovery"-not this year, or the next, or five or ten years from now. There may be temporary rebounds that take us back to some fraction of peak economic activity, but these will be only brief respites.
We have entered a new economic era in which the former rules no longer apply. Low interest rates and government spending no longer translate to incentives for borrowing and job production. Cheap energy won't appear just because there is demand for it. Substitutes for essential resources will in most cases not be found. Over all, the economy will continue to shrink in fits and starts until it can be maintained by the energy and material resources that Earth can supply on ongoing basis.
Some readers may note that climate change has not figured prominently in this discussion. It is clearly, after all, the worst environmental catastrophe in human history. Indeed, its consequences could be far worse than the mere destruction of national economies: hundreds of millions of people and millions of other species could be imperiled. The reason for the relatively limited discussion of climate here is that (assuming the Alternative Diagnosis is correct) it is not climate change that has proven to be the most immediate limit to economic growth, but resource depletion. However, while there is not as yet general agreement on the point, climate change itself and the needed steps to minimize it both constitute limits to growth, just as resource depletion does. Moreover, if we fail to successfully manage the inevitable process of economic contraction that will characterize the coming decades, there will be no hope of mounting an organized and coherent response to climate change-a response consisting of efforts both to reduce climate impacts and to adapt to them. It is important to note, though, that the measures advocated here (including the development of renewable energy sources and energy efficiency, a rapid reduction of reliance on fossil fuels in transport and agriculture, and the stabilization of population levels) are among the steps that will help most to reduce carbon emissions.
Is this essay likely to change the thinking and actions of policy makers? Unfortunately, that is unlikely. Their belief in the possibility and necessity of continued growth is pervasive, and the notion that growth may no longer be possible is unthinkable. But the Alternative Diagnosis must be a matter of record.
But even if policy makers continue to ignore warnings such as this, individuals and communities can take heed and begin the process of building resilience, and of detaching themselves from reliance on fossil fuels and institutions that are inextricably tied to the perpetual growth machine. We cannot sit passively by as world leaders squander opportunites to awaken and adapt to growth limits. We can make changes in our own lives, and we can join with our neighbors. And we can let policy makers know we disapprove of their allegiance to the status quo, but that there are other options.
Is it too late to begin a managed transition to a post-fossil fuel society? Perhaps. But we will not know unless we try. And if we are to make that effort, we must begin by acknowledging one simple, stark reality: growth as we have known it can no longer be our goal.
Link -
www.theoildrum.com/nod...
There are so many things that could be done differently by wealthy nations that could alter oil consumption/production (efficiency enhancements, alternative fuels/energy, technological advancements in extraction/refining). Yes oil has been a cheap source of energy for a long time; that's why it has been used so inefficiently. As long as profits are good and consumers get what they want why would you make a change to the way you do things? Now that there are new variables to consider affecting both corporate profits and consumers buying oil products changes will be made in the marketplace that allow mankind to continue to advance.
OIl will continue to be a good investment. Its going to be the primary fuel used for transportation for a long time to come.
In the face of no significant INNOVATIONS, I am calling it now, that the "exponential Econonmic Growth Fairy" is no more, it died of "shortages of natural commodities (oil), in 2005.
The world is heading for a catastrophic energy crunch that could cripple a global economic recovery because most of the major oil fields in the world have passed their peak production, a leading energy economist has warned.
Higher oil prices brought on by a rapid increase in demand and a stagnation, or even decline, in supply could blow any recovery off course, said Dr Fatih Birol, the chief economist at the respected International Energy Agency (IEA) in Paris, which is charged with the task of assessing future energy supplies by OECD countries.
In an interview with The Independent, Dr Birol said that the public and many governments appeared to be oblivious to the fact that the oil on which modern civilisation depends is running out far faster than previously predicted and that global production is likely to peak in about 10 years - at least a decade earlier than most governments had estimated.
But the first detailed assessment of more than 800 oil fields in the world, covering three quarters of global reserves, has found that most of the biggest fields have already peaked and that the rate of decline in oil production is now running at nearly twice the pace as calculated just two years ago. On top of this, there is a problem of chronic under-investment by oil-producing countries, a feature that is set to result in an "oil crunch" within the next five years which will jeopardise any hope of a recovery from the present global economic recession, he said.
In a stark warning to Britain and the other Western powers, Dr Birol said that the market power of the very few oil-producing countries that hold substantial reserves of oil - mostly in the Middle East - would increase rapidly as the oil crisis begins to grip after 2010.
"If we see a tightness of the markets, people in the street will see it in terms of higher prices, much higher than we see now. It will have an impact on the economy, definitely, especially if we see this tightness in the markets in the next few years," Dr Birol said.
"It will be especially important because the global economy will still be very fragile, very vulnerable. Many people think there will be a recovery in a few years' time but it will be a slow recovery and a fragile recovery and we will have the risk that the recovery will be strangled with higher oil prices," he told The Independent.
In its first-ever assessment of the world's major oil fields, the IEA concluded that the global energy system was at a crossroads and that consumption of oil was "patently unsustainable", with expected demand far outstripping supply.
Oil production has already peaked in non-Opec countries and the era of cheap oil has come to an end, it warned.
Even if demand remained steady, the world would have to find the equivalent of four Saudi Arabias to maintain production, and six Saudi Arabias if it is to keep up with the expected increase in demand between now and 2030, Dr Birol said.
"Many governments now are more and more aware that at least the day of cheap and easy oil is over... [however] I'm not very optimistic about governments being aware of the difficulties we may face in the oil supply," he said.
*What is "peak oil" and when will it be reached?
This is the point when the maximum rate at which oil is extracted reaches a peak because of technical and geological constraints, with global production going into decline from then on. The UK Government, along with many other governments, has believed that peak oil will not occur until well into the 21st Century, at least not until after 2030. The International Energy Agency believes peak oil will come perhaps by 2020. But it also believes that we are heading for an even earlier "oil crunch" because demand after 2010 is likely to exceed dwindling supplies.
Link -
www.independent.co.uk/...
======================...
So, notwithstanding their propensity to lean away from risks, they (the IEA) have mentioned the governmental Peak date of 2030, then the revised the IEA Peak date of 2020, before finally admitting it also believes that we are heading for an even earlier "oil crunch" because demand after 2010 is likely to exceed dwindling supplies.
However, I still use and refer to 2005 as an EFFECTIVE Peak, because the very small difference in Production, between 2005 & the absolute top in 2008, didn't cover inflation &/or demand.
In the face of no significant INNOVATIONS, I am calling it now, that the "exponential Econonmic Growth Fairy" is no more, it died of "shortages of natural commodities (oil), in 2005.