Pembridgecap

A Wealth Creation Journal

Category: Macro

Book Summary: The Energy World is Flat by Parilla

I read this book because its author proved to be correct on oil.  This is a non-exhaustive book summary I made last year. In the meantime, other events prove another call in the book: the book predicts convergence of global energy prices: oil has come down and the cheapest natural gas in the world (American) is rising.

The Energy World is Flat offers a refreshing view on the oil market. I found it through one of the better Real Vision interviews with Diego Parilla two years ago. The title is a variation to Tom Friedman’s best-selling book on globalization The World is Flat. Lastly, Diego Parilla and I are alumni from the same oil & gas business school.

I only read the book now as I realized that the author’s first call on the flattening of oil call has already proven profitable. These are the main calls the book makes:

  1. the term curve of oil will flatten
  2. geographic spreads will flatten
  3. spreads between energy equivalent prices of fossil fuels will flatten
  4. oil price volatility will lessen

If we compare the oil term curve between the publishing date (1/1/15) and now, we find that it has flattened considerably.

Chapter 1: the Flattening and Globalization of the Energy World

In the oil shock of the ’70s, oil was displaced for power generation and industrial uses in favour of coal, natural gas, nuclear and others because the primary consideration is price in these industries.

Today, oil still reigns over other fossil fuels for transport purposes despite its higher price (e.g. oil was 10X more expensive per energy equivalent than natural gas in the US in 2012). The main is reason is that oil is exceptionally compact both in terms of volume and weight per energy equivalent. Over the short-term, transport is very price inelastic.

Geopolitical events that created volatility sowed the seeds for more buffers ‘flatteners’: storage, demand destruction, new technologies and discoveries. A result can be found in 2014 when the exceptional combination of the below supply disruptions failed to make the oil price spike (the move was limited to 10$/barrel from bottom to peak).

  1. the arab spring (e.g. disruptions in Libya)
  2. oil sanctions in Iran,
  3. conflicts and disruptions in Sudan, Syria and Iraq

Chapter 2: Lessons from the Dotcom bubble

The tech revolution (and bust) created huge capital inflows that led to miserable investor returns over the cycle. The big winners were consumers that benefited from stranded assets such as fiber-optic broadband.

The revolution of fracking and horizontal drilling is similar. Although there is still a lot of skepticism towards shale for environmental reasons, Parilla draws a parallel with ultra-deep-water drilling that faced critics in the early ’90s but developed into a very safe technology. Peak oil sentiment similarities to the tech revolution includes huge capital investment into:

  1. LNG terminals (requires huge upfront capex)
  2. pipelines (see European and Asian projects)
  3. E&P
  4. demand efficiency

One trap for energy investors is to follow consensus according to Parilla. The sector is driven by extremely optimistic assumptions of demand growth. Every year, demand growth estimates are revised down an average of 15-20% from the January estimates (IEA, OPEC). Since 1998, only one year, 2012, has seen meaningful upward revisions. Main reasons are

  1. optimistic GDP growth estimates
  2. using the rear-view mirror correlation between GDP and energy demand that has been breaking down since 1998

Another parallel with the dotcom boom is the diversified ‘venture capital’ approach. In the energy world a lot of capex is being made in new technologies, with a lot of losers. The mentality for

  • big integrated O&G company boards is to ‘be’ invested in new areas as it looks better on paper
  • investors to be invested in all new areas as “you only need one winner”

Examples in the transportation world are:

  1. compressed natural gas (CNG)
  2. LNG for trucks, trains and ships
  3. electric and hybrid vehicles (EV’s and HV’s)

Note: according to Parilla, governments have delayed EV’s by subsidizing combustion-engine car sales (and bailing out the companies) post-recession by a 6-to-1 investment factor to EV subsidies.

Last parallel: the bubble accelerates the impact of the revolution. The runaway oil price in 2007 set in motion a huge supply response by oil producing and oil consuming countries alike.

Diego warns that a sum-of-the-parts valuation for companies that invest in many fashionable new technologies can be very dangerous with bad capital allocators, as the good parts might subsidize loss-making ones, and that focused companies should be welcomed.

Chapter 3: The 10 Flatteners of the Energy World

Interesting excerpt:

During the super-cyclical run up in corn prices in the 2000s, most commodities were making historical highs, from crude oil, to coal and natural gas, to copper and corn. Correlations had notably increased, which was often used as an argument to justify that speculators were driving prices. And of course, high fuel and food prices were generating inflation and increasing the risk of financial stability. One again, politicians and regulators were quick to blame the speculators. “Food inflation, how dare they?” Corn was considered too expensive and would impact the poor the most and increase inequality. How cynical.

The main reason why corn prices were going up was the surge in demand for corn-based ethanol in response to both high energy prices and the regulated mandates. Corn, which had traditionally been “food and feed”, had become “food,feed, and fuel”. [..] In 2012, following an acute drought in North America, the prices of corn reached historical highs, 400% of 2005 prices. “The speculators are taking advantage of the situation.” Yet, that year over 40% of the physical harvest went to ethanol to “feed” the car. The quantities were mandated by the government as “fuel” forced the demand destruction of “food and feed” via high prices. It was the cattle and hogs who had to change their diet, not the car. By mandate.

Do spot prices converge to futures prices, or is it the other way around? A causality study by Merill Lynch, and Parilla, say futures converge toward the physical fundamentals of the spot market. Speculators will discount future fundamentals in the price. If they improperly discount future risk factors into prices, they will lose money as the future prices converge toward the in-the-future-prevailing spot fundamentals.

TC

Book Review: Our Brave New World – Louis-Vincent Gave

This book was written in 2005 (!) and predicts/explains the rise of the platform company, why the US trade deficit is sustainable, why prime real estate in Western nations is poised for long term growth, and . This book is freely available online on the website of the author.

Generally I try to shun macro investing (although I do enjoy reading about it). Nevertheless, I have followed Louis-Vincent Gave for the last years as I think he and Charles Gave are very original thinkers. The Gave’s are of the Austrian school of economics.

I previously read Too Different for Comfort, which I rate even higher than this book. A follow-up with a summary of that book will perhaps follow.

OurBraveNewWorld_small

See below for some very interesting snippets and my commentary.

The rise of the platform company & its implications

Vertical design/produce/sell company has been the usual model for the last 50 years. The future’s business model is to produce nowhere but to sell everywhere, Gave calls this “the platform company” (in 2005!). Platform companies simply organize the ordering by the clients and keep the high added-value parts of R&D, marketing in-house. They outsource production to competing producers. Examples are Dell, IKEA, Walmart, H&M.

Production is more cyclical and ties up large amounts of capital. Companies in the West are trying to shed capital-heavy parts, even in the hotel business, e.g. Mariott real-estate spinoff.

“Being capital light is like travelling with a light backpack instead of a suite of trunks: one is able to change course rapidly and avoid losses. When executed properly, the platform company makes for very high and stable ROI’s.”

If after an asset bubble, productive assets are not allowed (because the following conditions are not (all) met: governments resisting fears of unemployment, bankruptcy law that permits creditors to take over assets, efficient markets that permit) to flow from weak hands into strong hands, deflationary forces take over: zombie companies waste capital (human and/or financial), drag down returns for competitors, maintain excess capacity and keep prices low for everyone.

Commentary: this is exactly what happened in 2009, a bail-out boom created a long deflationary wave of overcapacity.

Fortunately for platform companies, it seems that most countries continue to be happy financing low return capital spending. Like parasites, platform companies thrive on other people’s excess capacity.

The Western economy is becoming less industrialized. This is great news as the economy becomes less cyclical (production is by far the most cyclical element). Overcapacity is now the emerging market countries’ problem. Positive feedback from industrial worker layoffs is primarily a problem in those countries. Less economic cyclicality is good news of course. But this has a second order effect of Western society leveraging up.

Commentary: the book does not highlight bad effects of over-outsourcing (true for e.g. Dell). Christensen discusses this in his books: companies will sometimes lose critical product know-how when they over-outsource, an example is the launch of Asus laptops as a competitor to Dell after the latter over-outsourced to them (How will you measure your life?). The Innovator’s Dillemma discusses the upward pressure for companies in the value chain on the other hand. This is all to say that emerging markets might not stay mere workshops of the world.

The world leverages up
It is perfectly reasonable then, for the consumer to leverage up if the economic cycle is less volatile (in countries like the US, UK, Sweden). For example, one generation ago 25-year-olds did not buy apartments. Today they can as they have an increased visibility over their future earnings power, and there are increasingly many parents-per-kid with seed capital to help them buy a house.

Commentary: Gave justifies the new normal of consumer debt booming in the US back in 2005.

The irresistable rise of real estate
This is where reasoning went wrong. Gave argues that real estate prices in 2005 are sustainable because

  • of mass produced goods’ price deflation (discussed in previous chapters): purchasing power for other things rises: local services and scarce goods like real estate can become much more expensive
  • furthermore, less economic cyclicality, man and woman working instead of just one person makes debt coverage visibility much better. This should support permanently higher real estate prices in the US
  • the structural collapse in inflation (thanks to better use of resources because of globalization/platform companies, and demography on the other hand) leads to sustained lower interest rates
  • houses being a very long lived asset like thirty year government bonds. As bond alternatives, houses moved up remarkably in lockstep with 30 year govt. bonds.

Commentary: the mentioned factors seem to have played out. Gave argues against the real estate bubble talk in 2005. To be fair, Gave wrote that for a true real estate collapse a lot of foreclosures are needed (with the banks being motivated sellers of houses). Indeed, the subprime borrowers turned out to be the catalyst for the price collapse (subprime are not discussed in the book!). 

Consumption & US deficits – Accounting versus economics
Gave has a great example to illustrate that just looking at trade flows is insufficient to see which continent is doing best.

Accounting 101
The flat screen, built in Taiwan, costs US$300. The margin of the Taiwanese manufacturer is US$30. The mechanical part and the box, built in China, cost US$100, with a margin of US$5. The Intel chip (designed in the US but made by TSMC in Taiwan) cost US$70 with a margin of US$35 going back to Intel and US$5 going to TSMC. The Microsoft software cost US$200, with a margin of 90%, or US$180. Dell tacks on a US$30 profit for selling the PC.

Profits for the US economy: US$35 (Intel) + US$180 (MSFT) + US$30 (Dell) = US$245

Profits for foreign economies: US$30 (Taiwanese flat screen maker) + US$5 (TSMC) + US$5 (Chinese assembly line) = US$40.

Difference: + US$205 on behalf of US companies

Conclusion: this looks like a good deal all around for the US: the US consumer gets a cheap PC and US companies capture most of the profits in the process. On an accounting basis, everything looks rosy… Now let’s see how an economist views the above transactions.

Economics 101
Imports: US$470 (price of the PC minus the Dell mark-up and Microsoft
software)

Exports: US$0 Trade Defi cit= US$470

Increase in GDP, due to Microsoft, Dell and Intel profits = US$245

Net loss for the US economy, US$ 470-US$245 = -US$225

Conclusion drawn by the economists: this is a really unsustainable situation. The US economy is moving more and more in debt to foreigners who one day could decide not to sell in the US anymore, leading to a collapse in the US$, a rise in US interest rates, etc. But in the real world, is this situation really unsustainable? Absolutely not! What is unsustainable is measuring global trade flows in terms of sales, without looking at profits – which is what trade numbers do – and deriving investment implications from these measures. If the fellows exporting to the US make on average a margin of 1%, while US exporters churn out margins of 20%, then which economy would you rather own?

In the past five years, US profits (cash-flows) have increased by US$500 billion and the US trade deficit has increased by US$250 billion. Assuming that the assets generating the profits are selling at 20x earnings, this leads to an increase in US assets of US$ 10,000 billion, to be compared with a deterioration in the external debt situation of less than US$1,200 billion. Where is the lack of sustainability?

The conclusion is clear: if America’s wealth keeps growing about as fast as it has in the past decade (and we have no reason to believe that it will not), the current account will remain sustainable, whether it stays at $700 billion, falls to $500 billion or soars to $1 trillion a year.

Commentary: In a nutshell, because ROICs in the US are increasingly better than those in China, trade deficits (measured on net sales, not net profits) can easily be financed by selling small pieces of the valuable assets that produce high ROICs (e.g. equity in Dell). And this does not necessarily mean Americans become poorer over time, as the assets they own become more valuable over time by virtue of their rising ROIC.

Takeaways from the book

  • I loved the Economics vs Accounting example on the US trade deficit, and the case for higher profit margins
    • Gave was spot on that higher US profit margins were here to stay in 2005. This brought enormous incremental US wealth. Only selling a fraction of that incremental wealth balances out the trade deficit. 12 years later many investors (e.g. Jeremy Grantham, Hussman) are still trying to time the mean reversion of “inflated” US corporate profit margins
  • meta-takeaway for a value investor: some predictions did not come true: US housing did crash. If even the smartest macro managers are often wrong, is macro solely meant as a leisure activity for me?

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