Sunday, October 24, 2010

The End Of The Golden Age

King Oil

One can argue that the world would be very different from what it is today if we hadn’t found crude oil and invented how to leverage this very convenient and relatively cheap energy source. The energy density of oil derivatives such as gasoline is superior to any other substance in liquid or gas form. That’s why majority of cars are propelled either by gasoline or diesel and airplanes use kerosene. Also, approximately 15% of oil is used to make asphalt, plastics and wide variety of critical chemical products. Therefore, crude oil plays a key role in the modern globalized world economy. It has truly enabled a golden age for those that can afford to leverage it.

Oil derrick in Okemah, Oklahoma, 1922 (Source: Wikipedia)

Peak Oil

Unfortunately, oil is a finite resource and some day we will run out of it if we continue consuming it like we do. Long before this happens we will have serious problems - as soon as demand exceeds the supply. This is the essence of “peak oil” concept. International Energy Agency (IEA) estimated in their 2008 World Energy Outlook that oil production should not peak before 2030 if 64 million barrels per day (mb/d) of additional capacity is taken into use between 2007 and 2030. In theory, this is possible, but in practise there is a very real risk of under-investment since the required new capacity is equivalent to six times the current production of Saudi Arabia. Therefore, the report concludes that an oil-supply crunch can happen as early as 2015.

It is immensely hard to estimate the maximum rate at which the oil can be extracted from all different sources, both conventional and unconventional. Therefore, it is also hard to estimate when oil production will peak. What seems fairly certain is that it will do so within the next 30 years and I am personally tilted towards it happening within the next 10 years. US production has already peaked long time ago (early 1970s) as predicted by Hubbert back in 1956 using knowledge of past oil discoveries to predict the future production. Hubbert’s ideas are taken increasingly seriously by main stream analysts. Guardian published a very interesting article back in 2005 in which Chris Skrebowski, editor of Petroleum Review, predicted that the peak would be 2008. Remember those oil prices back in 2007? The financial crisis might have actually masked the problem – for now.

The Ever Increasing Demand For Black Gold

China, India and other fast growing economies are currently far behind in per capita consumption of oil compared to EU or U.S. Consider this: If you sort all of the countries by per capita daily oil consumption and start from the lowest consuming countries, you need to sum up the consumption of nearly 100 counties to match the daily oil consumption in US. Among these countries are China and India. Altogether the citizens of U.S. consume the same amount of oil than 4,8 billion people elsewhere.

Crude Oil Consumption Profile Of The World [Data Source: CIA World Factbook].

In the above graph, the country with the highest per capita oil consumption (Virgin Islands) is the leftmost dot while the country with the lowest consumption (Chad) is the rightmost dot. Between those two are plotted all the countries for which I found statistics for both population and oil consumption. The two parameters are summed cumulatively for each country starting from the country with highest per capita oil consumption.

As you can see, the most oil consuming 1 billion people spend more oil than all the rest 5,7 billion or so. Most of the so called developing nations with huge GDP growth rates happen to be in the group “rest”. I think it’s fairly safe to assume that they will increase the per capita oil spending from the current level in the future.

The Ever Tightening Supply

According to the CIA World Factbook there is about 1382 billion barrels of oil in the proven reserves. In addition, there are unconventional resources such as Athabasca oil sands region in Canada and heavy oil in Venezuela. The problem with unconventional resources seem to be that only a fraction of them is determined to be recoverable:

Source of estimates: Oxford Energy, CIA World Factbook and the Government of Alberta

Even though unconventional resources seem to be vast, they are estimated to add only approximately 10 million barrels per day to the supply side in the best case when taking into account all unconventional sources such as biofuels and oil from coal. For example, The National Energy Board of Canada estimated back in 2006 that the best case for oil sands production in 2015 would be 4.4 million barrels a day while the base case was 3.2 mb/d and the low case only 1.9 mb/d.

The current production rate of oil is about 84 million barrels a day so the unconventional resources will not have major effect in the long run given depleting conventional sources. Also, a major problem with all sources is decreasing EROEI ratio (energy return on energy invested). For oil it used to be 100 a long time ago and now it is somewhere below 20. EROEI for biodiesel is roughly 3 and for ethanol it is not much more than 1. Depending who to believe, EROEI for oil sands is between 2 and 4. Basically anything above 1 makes sense, but because we are used to high ratio (= cheap energy) we may have serious problem when the average EROEI of all supplies of oil goes below 5.

World oil reserves (source: Wikipedia)

The Last Hurrah Of Offshore Oil Production

After pumping oil from land deposits, the industry went offshore. First submerged oil wells were drilled already in late 1890s. Oil & gas production in Gulf of Mexico in 1990 was almost exclusively done in shallow waters (less than 1000 feet). By 2005, majority of production was in deep water (1000-5000 feet) and ultra deep (more than 5000 feet). Before the accident in Gulf of Mexico, it was estimated that by 2020 majority of production would have come from ultra deep water wells. However, there is one problem with all this in addition to the work being increasingly costly, energy consuming, difficult and dangerous: Yearly production decline in deep water wells is reported to be much higher than in shallow water wells. This makes it increasingly hard to sustain the already achieved production rate in offshore wells as production declines in older wells.

Platform P-51 off the Brazilian coast (Wikipedia/Agência Brasil)

Who Will Profit From The Raising Demand For Petroleum
The entities owning the oil and gas reserves are certainly going to profit from the peak oil as it will drive the value of their reserves and yearly production up while their costs are not likely to increase at the same rate. The big problem with the reserves is that the entity owning them right now, might not be the one owning them in the long run. If oil, gas and other critical finite natural resources are not at the heart of national interests yet in some countries, they will certainly be so in the long run. High oil prices are likely to cause unrest and discontent among citizens and politicians will respond with the usual remedies: socializing either the profits via higher taxation or taking ownership of the resources. While many of the oil majors and super majors seem to be reasonably valued and well positioned right now, one has to consider the possible outcomes of the next energy crisis. Government ownership might be actually a plus.

The companies to consider include Exxon Mobile (XOM), Chevron (CVX), ConocoPhillips (COP), BP (BP), Shell (RDS.A) and Total (TOT) all of which were featured in an excellent SA article. In addition, companies such as CNOOC (CEO), Statoil (STO), PetroChina (PTR) and Petroleo Brasileiro (PBR) are worth considering. Many of these are heavily involving also into natural gas, which is becoming increasingly important source of energy and is likely to last much longer than oil. The companies having significant investments on the unconventional side include Suncor (SU), Canadian Natural Resources (CNQ), Imperial Oil (IMO) and Nexen Inc. (NXY).

The Case For Offshore Oil & Gas Drillers

The offshore drillers pop up in my stock screens often since they got the right stuff: growing revenues, relatively low debt burden, excellent margins, low valuations in terms of P/E, P/B and price per cash flow. In exchange of all this, you have the risks which are all too familiar to everybody by now. However, these companies are less likely to experience socializing as they do not own the reserves, but only the rigs used in drilling the offshore wells. So far, it has seemed to be excellent business and I am betting my money that it will continue to be excellent business in the long run (5-20 years) as long as there is something worth drilling on the bottom of the ocean.

Different types of production platforms (Wikipedia, NOAA)

Drillers that have equipment used in deep and ultra deep production are the most appealing as that is the segment which is growing. This means that they have floating rigs, drill ships and such equipment either in use or under construction. The more they have these as percentage of their entire fleet the better. Also, I prefer ones with geologically diversified portfolio and big oil companies as customers (lower counterparty risk). The companies worth studying for these traits include (in the order of market cap): Transocean (RIG), Diamond Offshore Drilling (DO), Noble Corporation (NE) and Atwood Oceanics (ATW). Brief financial and valuation summary of these corporations:

Data source:

Related long positions: Chevron and Noble Corporation.
Full disclosure of positions:

Monday, October 18, 2010

New position: Intel

Today I opened two new long positions: Intel and Noble Corporation which I will discuss later.

Intel is probably the next best thing besides owning a monopoly. However, the chip-making giant is now so big that it's hard to grow much bigger. Therefore, in no way it can be thought as a growth play. To me it's both a defensive value play as well as a dividend play.
Picture: Intel i5 processor (source Wikipedia / Qurren).

It has some 20.3 billion in cash and cash equivalents ($3.65 a share) and operational cash flow in range of 11 billion a year. Management is authorized to spend 5.7 billion on buying back own shares. Currently Intel pays out quarterly dividend of 15.75c which is roughly 3.3% yield at $19.2 a share. Intel has very low debt to equity ratio so it is really a cash cow. In addition, it has amazing pricing power and huge technological edge to all competitors.

There are not many companies left that can build manufacturing lines by themselves for the nanometer scale structures needed in the state of the art processors. These factories require huge amounts of knowhow, skill and money to build and operate successfully. Simply put: Intel has moat (competitive advantage) like no other technology company in my opinion.

At P/E 10.3 and P/CF 7.75* I think Intel is a pretty good catch. If it still grows, it will be only a bonus.

*) P = quote minus cash & equiv. per share

Saturday, October 9, 2010

The Myth Of Moore's Law

One very good example of a reverse-engineered law (i.e. no law at all, but a presentation of what has happened) is the one called Moore's Law. From the evolution of this law, one can see how this type of laws are created: they are basically continuously modified to fit what has happened in the past. So they have actually very little predictive power in the long run. I believe many laws in economics are just like this one, but let me concentrate on this, because this is way closer to my circle of competence and work.

I absolutely admire what Gordon Moore and Intel has done so this article is in no way meant as attack against them. I don't know who have modified the law and when, but that does not matter in the end because the "law" now in circulation has very little to do with the original one.

The original prediction (later titled Moore's law) was presented by Gordon E. Moore in "Electronics" Volume 38, Number 8, April 19, 1965 and this is the direct quote from that paper:

"The complexity for minimum component costs has increased at a rate of roughly a factor of two per year (see graph on next page). Certainly over the short term this rate can be expected to continue, if not to increase. Over the longer term, the rate of increase is a bit more uncertain, although there is no reason to believe it will not remain nearly constant for at least 10 years. That means by 1975, the number of components per integrated circuit for minimum cost will be 65,000."

So the original law calls for doubling every year counting from 1959 (1 transistor). As a reference, the Intel 8080 introduced in 1974 had only 4500 transistors and not 32768 as had been predicted by Moore. Intel managed to surpass 65000 transistors only in 1982 with Intel 286 that had 134000 transistors. Moore's law predicted 8,4 million so by now it was very clear that the original prediction was way off.

In fact, the law was fairly accurate only between 1959 and 1965. I.e. up to the point when the article was written. So it did not actually manage to predict anything right. Sure, the increase of transistor count has been incredible, but not as incredible as predicted by Mr. Moore back in 1965.

Because the original law predicted way too high growth rate, the "law" has been adjusted as follows:

"The number of transistors that can be placed inexpensively on an integrated circuit has doubled approximately every two years." [source: Wikipedia]

You can see for yourself how accurate that law is. It basically grossly understates the development. According to this Law #2 there should have been only 32768 transistors back in 1989, but Intel managed to put 1,2 million transistors into Intel 486. So c'mon this law does not work either if it starts in 1959.
Because even this adjusted law (#2) is not accurate, a third modification has been made to reset the law basically early 1970 to first Intel chip (Intel 4004 introduced 1971). Now this law #3, is somewhat accurate description of what has happened, but it has absolutely nothing to do with the original prediction.

And like law #2 it too falls short. It predicts 1,7 billion transistors whereas Intel 8-core Xeon Nehalem EX has 2,3 billion and NVIDIA GF100 has 3 billion transistors. But hey, let's call that a rounding error in the law. It's really amazingly accurate if you use logarithmic scale that hide the "small" differences of, say, 1,3 billion transistors that is roughly the same as the high end chips had in total ín 2008 (NVIDIA GT200).

Note: logarithmic scale!

The increases in clock speeds and transistor counts have been truly amazing. My first computer was Commodore 64 back in 1984 and in my wildest dreams I could not have imagined the awsome power that I can harness today from my PC and the amount of data I can store. However, there have not been nor will be any hard laws of progress behind this and nor there will be. I laugh every time I see Moore's Law and it's awsome predictive powers referenced. At that is often.

Note: logarithmic scale!

Friday, October 8, 2010

Investment checkerboard

I sorted my investments by using a 6 by 6 checkerboard where the vertical axis is used to measure growth and horizontal axis has six categories to place a particular company into. The checkerboard was inspired by Peter Lynch's book "One up on Wall Street" where he introduces his method of mapping a company into one of six categories. Three of the categories are essentially growth categories and three others are: cyclicals, asset plays and turnarounds.

I wanted to give each company two dimensions: growth category and then a second property which essentially gives away the primary reason why I invested into the company.

Here we go:
The growth is measured as yearly average growth from last 3-5 years (depending on what was easily available). Dividend rate is either from Google Finance or then from a local Arvopaperi stock magazine.

At any rate, I don't have cyclicals or turnarounds as I have constructed my portfolio as defensive one. All commodity plays (oil, gold etc.) are asset plays in my opinion. I believe both oil and gold to rally long term and that will unlock the hidden value in the companies (basically the huge leverage they have on these commodities). Then rest of my stocks are pretty straightforward dividend plays. Note that some of the dividend plays also buy back shares and that is not taken into account in the grouping.

This was quite a useful excercise as I now recognise that I should look for some growth plays also. And it would not hurt to find companies that give decent dividend AND grow minimum of 10% p.a.

Saturday, October 2, 2010

On economics and physics

What's next: Deflation, double dip, inflation...?

Quite frankly, I do not think even the best economists know the answer for sure. I am no economist and after reading Economics book about half way through I don't know what to think about the dismal science. Mathematically, micro/macro economics 101 is easy to follow. The only question is: does it really work that way? Is there laws?

Atleast to the latter I can say that there seem to be very few hard laws in economics. And I am talking about the kind of laws which you can use to predict what will happen given a set of starting parameters. In physics you can make accurate predictions based on work released in 1687 (Newton: Philosophiæ Naturalis Principia Mathematica). Still works today like clockwork if given certain limitations (that were pointed out later by Einstein in theory of relativity), no need to discuss about it.

Take economics: There seems to disagreements over the very key concepts.
  • What causes inflation? Some say money printing and some say something else.
  • How about what to do if an entity (like city or country) is loaded on debt and near bankrupt due to rising cost of funding their debt load and especially due to deficit spending. How about a little bit more debt? Or should they just admit that maybe you have overextended themselves and need to cut back?
Would it be a good idea to cure hangover with some more alcohol? Maybe once, but not every day.. 

What is clear to me is that many western economies are now in the corner. Anything bad happens and shit will hit the fan. The only way out seems to be ... yes! ...more money out of thin aír!