Oil at New Highs: Heading to the Exit Lane

Vruz sent me a copy of this CIBC research report called "Heading For The Exit Lane." I read it yesterday morning and couldn't stop thinking about it for most of the day. So I uploaded it to Scribd and reblogged my favorite line in the report on my tumblog. But that didn't get the report out of my head.

This oil thing sure has legs. Even if we aren't in a "peak oil" situation (and even the Saudis can't agree about that), we've gotten to a price point where consumer behavior is going to change significantly over the next few years. Over the long term, that's a good thing. The world economy is addicted to oil, largely because it's been so cheap for so long. But it's not cheap anymore and given the pace at which the rest of the world is developing these days, it's not going to be cheap ever again. Unless we find another source of energy that is a lot cheaper than oil and I am not aware of any developments that will get us there soon.

This has big-time ramifications for slowing growth and rising prices (inflation). And these impacts will not be limited to the US economy. They will be felt worldwide. The hypergrowth economies of China, India, Brazil, Russia, and other developing economies may not be impacted as much as the more mature economies like Japan, Europe, and most of all the US. Russia, in particular, stands to benefit greatly from the spike in oil prices.

Slower growth and rising prices (inflation) cannot be good for equities. Rising rates, which is what will have to come, will not be good for any kind of financial assets.

Which, of course, leads me to venture capital. The value of your equity in a startup company is a financial asset. It may not be publicly traded but like all other financial assets, it is ultimately worth the present value of future cash flows discounted at an interest rate that takes into account market rates of interest plus a risk premium.

We've been operating in a world where real interest rates have been hovering around zero (at least in the US). That has propped up the value of equities and venture capital assets have been part of that prop-up.

All we have to do is look at the 70s to see the effect of low growth and high inflation (stagflation). Here is a chart of the Dow Jones Industrial Average during the 1970s.

Click to enlarge

Yes, that's right, the Dow Jones Industrial Average ended the 1970s right about where it started.

I wasn't in the venture capital business in the 1970s. I was a teenager that decade. I remember Vietnam, Watergate, the oil shocks, the gas lines, Gerald Ford, whip inflation now, Jimmy Carter, the Iran hostage crisis, and Paul Volcker and Ronald Reagan.

The first venture capital firm I worked for, Euclid Partners, was formed in 1971. The two founding partners, Milton and Bliss, raised about $4.5mm in 1971. They didn't raise another fund until 1983. They struggled mightily during the 1970s with their portfolio and ultimately made it work when the technology market took off in the early 80s. I heard a bunch of stories from them about that time and it was not an easy time to be an entrepreneur or a VC.

Surely the next 10 years won't be identical to the 1970s. A lot has changed, particularly the global economic environment. But it's also clear that the economy we are in (and maybe have been in for the past 18 months) is going to be tougher for owners of financial assets than the past 20 years have been. And I don't think the startup economy and venture capital is immune to this new reality.

So what should we do about it? Well first, we need to be careful with valuations. If financial assets are going to be subject to downward pressure then inflated valuations will not be sustainable. We need to be careful with the amount of money we invest and burn. Companies that are capital efficient and cash flow positive will fare better in this environment. And we need to be prepared to wait a long time for liquidity.

It's ironic that the title of the CIBC report is "Heading For The Exit Lane", because I think the exit lane will take longer to find and possibly be less rewarding in the coming years.

A Final Thought: This may mostly be good news for cleantech investors. As oil gets more expensive, cleantech and alt energy technologies can become commercially viable more quickly. But it takes a lot of money, biotech-like capital investments, to get most cleantech investments to profitability. So if the capital markets are going to be more difficult, it's not all good news for cleantech. And the web clearly has a role to play in all of this too. More on that later.

Comments

[Zeb:]

Hey Fred,
Best regards and interesting article! Indeed the exit lane concept weighs heavily on me as well. For now, I am hanging on to my USO and also physical gold. I know, one of "those" people. Nothing in the linked article about commercial air disruptions, but there will be a blood bath there too...

2008 Jun 30 01:49 AM

[pockyclips ...:]

I disagree. I believe that this downturn is very similar to the 1970s
malaise. We will be in a decade long slump due to:
1) Mortgage scandal.
2) Runaway energy costs.
3) Deferred War on Terrorism costs.
4) Uncle Sam not able to "borrow" from Social Security after 2010.
5) Deferred Reaganomics debt of $3 trillion due next decade.
Time to pay the piper.

2008 Jun 30 08:52 AM

[john s. gordon:]

which is worse - reaganomics or bushanomics? my grandchildren will not be happy to learn that they have to pay for both,
> jack

2008 Jun 30 09:14 AM

[richjoy:]

I get confused when authors say it is not like...(the 70s in this case), and than proceed to make a gloom/doom case that it is.

Frankly, I share the fears of most investors who are moving a major share of their investment assets to the (cash) exits.

However, the problem with moving on fear is that it is a weak conviction. We are quite likely to start buying again at the first sign of 'maybe it ain't so bad/there are bargains out there/you can't time the market, so buy & hold is best'.

2008 Jun 30 09:21 AM

[Loup-Garou:]

There are multiple exit lanes. Each has its own peculiar political no-go signs. Nobody writes much about petrochemicals--just about fuel. For America, fuel is only about half our 22 million bpd consumption.

Maybe "You just can't get to the post office from here." Or more likely, a lack of political leadership to lay out the alternatives to the public, develop a national dialogue, and make decisions.

2008 Jun 30 02:26 PM

[longoil:]

"Heading for the Exit Lane" is another fine CIBC report.

I always liked all CIBC economic & strategy reports authored or co-authored by Jeff Rubin. His stuff is always clearly written, plenty of good figures and well referenced

Remember they were laughing at him in July 2007 when he predicted $100 oil before 2010. No one is laughing now with his updated predictions of $200 oil and $7 gasoline for 2010.

2008 Jun 30 03:10 PM

[King of Sanity:]

The end is near. Soon it will not matter if oil is $10.00 or $1.00 per gallon. We are heading for an economic collapse that will dwarf what went down in 1929. I hope that I am 100% wrong, but all of the signs are pointing more and more with each passing day to a very bleak, long term outlook that is going to turn our world upside down. All I can say is enjoy these last few days of the good life and prepare yourself for the economic horrors that are just around the corner.

2008 Jun 30 10:28 PM