Rise early, work hard, strike oil

Transcription

1 VIEWS FROM THE DESK (VFTD) November 2013 Rise early, work hard, strike oil These are the 6 words uttered by J. Paul Getty in reply to a question about his formula for success. Getty, who made his huge fortune from the oil industry, was a complex character. One of his most endearing traits was his commitment to advancing the understanding and preservation of the visual arts around the world, through the legacy of his Getty Foundation. Somewhat less endearing was his reputation as a miser. He famously had a payphone installed in his Surrey mansion insisting it be used by all visitors, should they wish to make a call. Perhaps more notorious was the approach he used to settle a ransom demand following the kidnap of his grandson by an Italian gang in After a period of negotiation, he finally agreed to pay the US$3m on the basis the first US$2.2m was tax deductible and the remaining US$800,000 was paid via a loan to his son at 4% interest! Like him or loathe him, there is unanimous consensus around his skill as an oil man. Getty s most successful transaction took place in 1949, when he paid Ibn Saud the first monarch of Saudi Arabia - US$9.5m in cash and US$1m a year for a 60-year concession to a tract of barren land near the border of Saudi Arabia and Kuwait. No oil had ever been discovered there, and none appeared until 4 years (and US$30m) later. From 1953 onwards, Getty s gamble produced 16,000,000 barrels a year, resulting in him becoming one of the richest people in the world. The price of oil is a crucial line in the global economy s annual P&L account and the supply that continues to flow from Saudi Arabia is a key determinant of this price. According to the International Energy Agency (IEA) Oil Market Report (August 2013), global oil demand in 2013 will be 90.8m b/day (barrels per day), rising to 92m b/day in Saudi Arabia and its closets OPEC allies (Kuwait and UAE) are currently producing 15m b/day as they try to steady the price of Brent oil at c.us$100 a barrel. This production is running at 2m b/day higher than the long term average in order to offset the disruption of supplies by Middle East unrest and the specific, well documented problems involving Libya and Iran. OPEC spare capacity is believed to be c.5m b/day (6% of world production), however, given the above average production from Saudi Arabia and the ineffective supply highlighted in the chart below supply is more constrained than it first appears. Source; Bloomberg, Guinness Funds

2 So why is this relevant for our client s portfolios? To be clear, we are not making a call on the oil price rising significantly from here. However, we are excited about the investment opportunities the energy sector currently offers. Our rationale is founded on the following three drivers; technical (supply and demand), fundamentals (valuations) and the nature of the assets themselves (inflation protection). Technicals: supply and demand Following on from our earlier comments about supply, OECD oil inventories evidently have been tightening through 2013 as global growth has strengthened and demand has increased is set to become a historic year for oil markets as non-oecd demand is forecast to overtake OECD demand for the very first time. This growing demand is driven by the adoption of mass transportation and is a subject we highlighted in our November 2012 VFTD From The World is Not Enough to Does The World Have Enough? (see here). Last year we used rising car ownership in China to demonstrate energy demand growth the chart below updates this story with the forecast growth in global vehicle population. Source; US DoE and Guinness Funds As we know, global energy demands are not met exclusively by oil. Natural Gas is an increasingly important agent in the energy mix and the US shale gas revolution has had a profound impact on the price paid by domestic industrial users. Using our earlier analogy of a hypothetical global P&L account US industries are enjoying a windfall of cheap energy, which is boosting margins and improving productivity. The competitive advantage being generated is powerfully illustrated by the next chart which details the US natural gas price versus the rest of the world. It goes a long way to explaining why Japan will become the biggest global market for solar energy in 2014.

3 Source; Published with kind permission of Gavekal In summary, whilst demand is growing, the risk that global energy supplies fall short of what is required over the next few years is intensifying as the era of low cost, easily extractable oil comes to an end. Thus, we expect the oil price to be supported at current levels and rise over the longer term. Fundamentals: valuations The oil and US gas price implicit in equity valuations is currently estimated to be $80 and $4, respectively. A simple re-rating, to reflect reality, rather than a further rise in the oil price, should deliver positive investment returns from the sector. Stocks look cheap and earnings momentum is rising. Source; Bernstein; Guinness Funds

4 Nature of the assets: inflation protection We continue to believe inflation expectations are set to rise whether this will be next year or 5 years hence, it is very difficult to predict. With most discretionary mandates benchmarked to CPI plus targets, energy equities have good inflation hedge characteristics. Source; Bloomberg (oil & gold price); Halifax (house prices); Guinness Funds (June 2013) Conclusions and asset allocation implications Investing in commodities is not without risk, as the last couple of years have shown. The volatile nature of this sector makes an allocation to energy more appropriate for long term mandates and those able to tolerate drawdowns. For this reason, although the investment case is compelling, the fund we are using will be held in our Growth and Equity Growth strategies. Performance of discretionary strategies Income Strategy ( ) Model Composite Real Return Strategy ( ) Model Composite

5 Growth Strategy ( ) Model Composite Last month s composite performance numbers are currently being calculated and will be provided on request. The performance detailed above is for illustrative purposes only and reflects the returns across Affinity Private Wealth s Income, Real Return and Growth model strategies, net of 0.95% management fees. This does not constitute investment advice and past performance should not be viewed as an indicator of future performance. Affinity Private Wealth is a trading name for APW Investors Limited, which is regulated by the Jersey Financial Services Commission. Registered office 24 Seale Street, St Helier, Jersey JE2 3QG.