Why Investors Should be Looking at the Lucrative Energy Sector

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In yesterday’s Daily Reckoning we showed you that food and beer are cheap in America and that sweet potato fries are worth a go. Today, we’ll investigate more urgent matters. Falling US bond prices are the prime mover in markets right now. As bond prices fall, yields rise. The investment implications multiply.

There’s one simple way to view rising US rates: it signals the official end of the global credit expansion underway since the early 1970s. That may not sound simple. But it is when you break it down. So let’s break it down.

Credit is a form of energy. When credit is sourced from available savings — the real profit households and businesses put in the banking system after doing productive work — the amount of fuel for economic growth is constrained by savings. The engine can only be revved so fast when the fuel is real savings.

The chart below shows that the central bankers found a way to rev the engine without real savings starting in the early 1970s. By ditching the dollar standard, the Federal Reserve created a world of unlimited fiat money growth. In energy terms, there was now limitless fuel for the apparently limitless expansion of growth. It’s no accident China began to liberalise its economy in the late 1970s. This further accelerated the credit-induced expansion of the economy which we now know as globalisation.

Here we are then, at what looks like the end of the credit expansion cycle. If you measure that cycle in long-term US interest rates, it’s hard to argue that you’ll get more growth by keeping interest rates lower for longer. Long-term US rates are back where they were in the post-war era. If they do stay lower for longer, it will be a sign of Fed failure.

The Federal Reserve will probably fail either way. Credit financed economic expansions can’t afford higher interest rates. Booms financed by borrowed money become busts when rates move higher. A rise in real interest rates will be a mortal blow to borrowers, which includes governments, businesses, and households.

But interest rates ARE rising. Exactly why they’re rising makes for an interesting debate. Are they rising because the Federal Reserve has succeeded in reducing the US unemployment rate? Or are they rising because the bull market in bonds is over? It’s no small question.

Our answer to this question — from last year — is that you can view these asset allocation decisions in terms of John Exter’s liquidity/risk pyramid. In an extended financial crisis, money moves away from theoretical value toward real assets. In the current context, that means away from fixed income and towards stocks.

Mind you, that’s not an endorsement of stocks based on valuations or growth prospects. It’s just an observation that in a world of rising interest rates, you’re likely to see a lot of money move out of ‘safe’ fixed income investments into something that’s going to beat the real rate of inflation. You still have a tug of war between the forces of debt deflation and inflation. But within asset markets, it gets easier to make the argument for stocks on a relative basis.

But let’s get back to energy. Credit is a form of energy, setting in motion the extraction of real resources and labour. But it’s not actual energy in the same way oil and gas are. That’s why we remain interested in oil and gas as investment opportunities. They are real energy, for which there is no substitute.

In that vein, we read with interest an article in yesterday’s Financial Times about a ramp up in Saudi Arabian gas drilling. The Saudi gas rig count is set to hit 200 by the end of this year, up from 150 at the start. The Saudis currently burn oil to generate domestic electricity for industrial and household use. They have realised this is a prodigious waste of a valuable export commodity.

The Saudis realised this years ago, in fact. We remember hearing a speech by a Saudi oil minister at the Offshore Technology Conference in Houston in 2011. He said the Saudis would drill for more gas (including shale gas) in order to run their power industry and petrochemical industry. Gas is cheaper. More importantly, you export the oil for cash rather than burning it to free electrons.

But the Saudis are also reacting to the tectonic shifts in global energy markets unleashed by technology. Horizontal drilling and hydraulic fracturing have given us a US gas boom and a model to replicate in other shale-rich countries (Australia, Argentina, China). The shale gas boom has also unleashed political shockwaves in the Middle East, as the US withdraws from the region militarily because it no longer needs boots on the ground for energy. Egypt’s chaos, for example, is a perfect example of the US no longer backing autocratic regimes (or any regime) for the sake of energy.

Events could be getting even more interesting and possibly more lucrative for investors. There could be 50 billion barrels of recoverable oil in Texas’ Permian Basin, according to a new report published by Leonardo Maugeri of Harvard’s Kennedy School. How this oil got missed in the original Texas oil boom is an intriguing question. Whether there’s that much oil there and whether it can really be extracted profitably is yet another question.

But a big quantity of new energy has an economic quality all its own. What higher interest rates take away from the consumer, cheap energy could give back. This is why so many investors have a better feel about America right now. Real, cheap energy is a much sounder reason to have a punt on US stocks than Federal Reserve policy.

Of course it could all be a giant con by the oil and gas industry. The decline rates on unconventional oil and gas wells are higher than on conventional wells. You get a lot of energy in the short term. And then production falls of a cliff instead of gently declining. In a way, the boost to growth from unconventional energy is comparable to the boost to growth from artificial credit: short, powerful, and fading.

There are also real capital costs associated with energy production. As we’re finding out in the gold sector, you don’t last long in business if the underlying commodity goes below the cost of production. Companies will go out of business. Supply will drop. The cyclical adjustment will continue.

But for Aussie investors, and for energy consumers, the energy sector is easily the most exciting for the rest of 2013. Australia faces much higher energy costs if it fails to unlock its own oil and gas reserves. It’s already baked in the cake. Tomorrow, we’ll tell you what that cake looks like.

Regards,

Dan Denning+
for The Daily Reckoning Australia

From the Archives…

Central Bankers in Driving Seat
5-07-13 – Greg Canavan

China’s Economic Rebalancing and the Impact on the Australian Economy
4-07-13 – Greg Canavan

Gold Market Rhyming
3-07-13 ­– Greg Canavan

How Low Can the Gold Price Go?
2-07-13 – Bill Bonner

No Real Economic Recovery Without “Hitting Bottom” First…
1-07-13 – Bill Bonner

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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9 Comments on "Why Investors Should be Looking at the Lucrative Energy Sector"

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JS
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Huge risk! The energy markets and the shale bubble are a huge risk. Shale production runs on a classic ‘Red Queen Syndrome’ where you need increasing amounts of money, naptha, water and steel to expand production. Simply it is sucking as fast and as hard as you can on a straw to guzzle the Coca Cola out of the bottle as fast as possible.
naturally the press, politicians and growth lobbiests assume that shale production is the saviour of our decadent, aging, politically-correct black-haired, brown-eyed world from peak oil.

It won’t

BP
Guest

It isn’t quite that easy to frack our communities, Dan…

Lachlan
Guest
US not doing much in the ME anymore? What about all the people, other nations and interest groups that they aid and or work with in the region? Still looks like a giant mess to me. Gold prices too low for producers? Maybe for a few at the upper end of cost basis. Generally however I have to doubt the assertion… which is all over the internet. Yes gold shares have gone back to where five years ago, or even a tad lower. But the gold price is generally $400 higher than it was then. Lets say 40% higher. Are… Read more »
watcher7
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* James Stack, Avoiding the Lure of the Lemmings, investech.com, Investech Research, [subscription], June 28, 2013, p.1: … what history teaches us about Fed tightening cycles is very different from most of the advice in such articles – particularly those that are saying to batten down the hatches and run for cover. The bottoming of interest rates in an economic cycle and/or reversal in Fed policy seldom sounds the “death knell” for a bull market… Today’s investors would also likely be surprised to learn that since 1960… During the past 11 tightening cycles when the Federal Reserve made its first… Read more »
BP
Guest

Some of these ‘poet laureature’ attempts to predict any financial future have taken decades to rhyme, W7.

This kind of crystal-ball-gazing has recently been invoked to tell us we have a decade-plus boom in property on the near horizon. If that’s true, it certainly pushes back predictions of 60% falls in Australian property values, wouldn’t you say?

BP
Guest

Thought at first you were referring to that other Paulsen, Watcher.

The Paulsens certainly are able to predict what will rhyme… and what won’t… and act before the last stanza:

http://www.cnbc.com/id/100871383#_gus

Robt
Guest

The economy hasn’t recovered in real sense and now that the recent Fed meeting prompts no windup of its easy money measures in the near-term, it concretes that the economy hasn’t improved miraculously. Gold, the safe-haven asset, is still trading low. The clock is ticking, so buy as much as you can, while you can.

BP
Guest

Yep, concrete’s safe, Bob. Bricks ‘n’ mortar, too. Beats stucco-on-chicken wire every time!~

BP
Guest

Hey, c’mon back W7. We need visionaries!

(What we really DON’T need is folk who track the prophecies… and call the prophets on their punts… . ;) )

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