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Editor's Note:
Some of the most frequently asked questions I get from people concerned about Peak Oil are about financial preparation and asset protection.. This has especially been the case since December 2005 when I was featured favorably in a Fortune Magazine article entitled "The Rainwater Prophecy."
Unfortunately, I'm nowhere near qualified or informed enough to discuss financial preparation in anything more than a very general fashion. Luckily, in November 2005, I was contacted by Adam Cohen, Esq., a former investment banker with Lehman Brothers and current corporate finance attorney. With his professional background dam is eminently more qualified than I to discuss the investment implications of Peak Oil. (You can check out Adam's website and bio here.) He offered to write an in-depth report on these issues and I gladly accepted.
Best,
Matt Savinar
Attorney and founder, LifeAfterTheOilCrash.net
Topics Covered in this Report:
Caveats and LimitationsFuture Earnings, Price-to-Earnings Ratios, and the Efficient Market Hypothesis Timing of Peak Oil and Impact on InvestmentVolatilityOil and Gas Income TrustsOil MajorsIndependent Oil / Exploration and Development CompaniesOil & Gas Equipment and ServicesNatural GasCoalAlternative Energy and Energy EfficiencyNuclear Power ProvidersNuclear Supply and Service CompaniesEnergy and Natural Resource FundsGoldSilverPrecious Metals FundsBear FundsPuts and ShortingCashTake Your ProfitsThe Guaranteed Investment OpportunityWhile specific companies, securities, and financial instruments are sometimes mentioned as examples or to illustrate general points, this article does not make any specific recommendations as to which companies, securities, or financial instruments you should or should not invest in.
About the Author:
Adam B. Cohen is a corporate finance attorney and the managing member of The Law Offices of Adam B. Cohen, LLC. Previously, Mr. Cohen was an investment banker with Lehman Brothers and an attorney with Latham & Watkins LLP. He can be contacted at: acohen@covenantlaw.com.
Special Thanks:
Andrew Gillick, Wharton MBA Class of 2007, assisted in the research and preparation of this article.
Important Disclosures
All content is Copyright © 2006, 2007 by Adam B. Cohen. This discussion contained herein is not legal or investment advice. You should conduct your own investigation and seek the services of a competent investment professional before making any investment decision. The ideas expressed herein are solely those of the author, and not of Matt Savinar or www.lifeaftertheoilcrash.net. The author does not make any express or implied representation as to the suitability or results of any particular investment. The author may presently or in the future maintain positions in certain of the securities or other investments mentioned herein.
A. Introduction
The question of whether the "Peak Oil" phenomenon is real, and the timing of its occurrence, has been well debated in many articles, magazines, and Internet sites. But there is surprisingly little extended discussion on the investment implications of Peak Oil. Thus far, those who have addressed the issue have tended to latch on to a single investment or narrow range of investments – be it major oil company stocks, gold, land, or Euros – without an even-handed presentation of a wide range of investment possibilities. Also to date, most significant publications on the subject have been written by persons with further investments or advice to sell. This article is intended to provide a broad and basic overview of some of the investment implications for Peak Oil and offer a starting point for further investigation and selection of investments.
This article makes seven assumptions about the reader and how the reader believes that future events are likely to unfold:
Assumption 1: Peak Oil is real and imminent; worldwide oil production is unlikely to ever exceed 85 million barrels per day by a significant amount.
Assumption 2: Once at Peak, oil production will be at a plateau for some period, during which the possibility for further production increases will be in dispute and may be obfuscated by temporary recession-led declines in demand.
Assumption 3: No angels or prophets will herald Peak Oil in any way that will generate an immediate global response, and the public perception and reaction to Peak Oil will occur in fits and starts and be very uneven among countries (with the U.S. lagging).
Assumption 4: In accordance with most Peak Oil theories, there is no viable alternative to oil, at least in the short term, and none that will meaningfully ameliorate the disjunctive pre-and post- Peak economic landscape.
Assumption 5: here is some time window ahead of us before a broad recognition of Peak Oil and its implications. Otherwise, if the reader believes there is going to be a swift and imminent cascade of Peak Oil impacts, one might rapidly be paying down debts, buying up farmland, quitting "normal" employment, and retooling one’s assets and skills for a new paradigm. This fifth assumption is closely related to the sixth assumption.
Assumption 6: Most readers are still "living in two worlds". On the one hand, the reader is steadfastly tracking the breadth of Peak Oil developments and unevenly planning for the worst case. Yet at the same time, the reader is still working at a "normal" job which may have no future in a post-Peak scenario, living in an urban or suburban environment, sending children to public school, and contributing to the company 401(k).
Assumption 7: Volatility is opportunity for the Peak Oil investor, and there is as much or more money to be made in what is going to lose value as in what is going to gain value.
B. Caveats and Limitations:
A few important caveats and limitations go along with this article. First, I try to focus on the most immediate and tangible investments implications of Peak Oil (such as how the stock prices of major oil companies may be affected) and not the many possible secondary implications that would unmanageably expand the scope and complexity of this article and are quite difficult to handicap in any case. (For example, most Peak Oil theorists see U.S. military expansion as part of the overall story, which can lead to difficult speculation on which countries – and their stock markets – may be susceptible to rapid change.)
Second, I have tried to limit the discussion of investment opportunities to actionable items that are not complex or costly to execute for a person of modest means. Therefore some interesting possibilities in futures and fixed income, for example, are not discussed.
Third, while I may point out specific stocks or other investments as a means to illustrate a point, I am pointedly not recommending any particular security or other investment. Before making any investment you need to do your own investigation on matters of real importance that are outside the scope of this article. I have made no attempt to point out whether company "X" is losing market share, whether mutual fund "Y" recently replaced its investment manager, or whether industry "Z" recently missed Wall Street earnings expectations. Similarly, the tables of selected investments are extensive but by no means complete and the inclusion or exclusion of a particular investment is not meaningful.
Fourth, no matter how compelling any one investment idea may seem to you, diversification remains critical. This is especially true because your diversification may already be somewhat limited by being clustered around the central theme of Peak Oil. For almost any investment, a substantial loss of principle is possible – e.g., gold could be confiscated as happened in the U.S. in 1933, or a terrorist act in Europe could drive the dollar’s value dramatically higher, or "demand destruction" Wall Street speak for a recession or depression) could reduce oil demand and prices for a prolonged period that would crush the value of oil futures and shrink most other energy investments. Keep diversified.
C. Future Earnings, Price-to-Earnings Ratios, and the Efficient Market Hypothesis
If the world is on the cusp of fundamental change, what does that mean for the stock markets? Perhaps the best way to explore this question is with an example.
Suppose you had the opportunity to buy an ice cream store in a great location at a busy suburban traffic intersection, with no competition for miles around and no debt. The store had been growing its profits by about 3% every year for the past decade. In 2005 it churned out a cash flow of $100,000 even after paying for a full-time manager. Thus, the profits from the store were a passive investment for the owner.
Let’s say the owner comes along and offers to sell you the store for $300,000, or three times the earnings of the business. With an initial return of about 33% per year ($100,000 / 300,000 = 33%) plus future growth, it looks like the owner just made you a fantastic offer. You would be very tempted to take him up on it.
Now, let’s mix things up a bit. Suppose the owner offers to sell you the store for $1.5 million, or 15 times the earnings of the business. With an initial return of about 6.7% per year ($100,000 / $1,500,000 = 6.7%) the offer doesn’t look so great. The initial return doesn’t even beat a bank CD rate by enough of a margin to justify the ordinary risks of owning a business. At this point, you would probably lose all interest in buying the store.
If you hadn't yet lost interest in buying the store, you almost certainly would if you knew all of the following was likely to occur around 2009:
Peak Oil is not broadly considered by Wall Street and is not incorporated into the economic projections that in turn are used to build financial models for particular companies. As a result, Peak Oil is textually and numerically invisible in the financial community.
Perhaps we can reconcile the tension with Efficient Market Hypothesis this way: while there is an active market, there are very few well-informed and intelligent investors who are incorporating the Peak Oil challenge into their analysis, and the numbers of these people and the amount of assets under their control is too small to have any discernible impact on stock prices.
The rest of this report is available as part of the third issue of the Post-Oil Bulletin:
There would be a big fall-off in vehicular traffic by the store.
A new disease would begin shrinking the American dairy cow herds. This would cause your ice cream prices to increase.
An accounting scandal would hit the accounting firm the store owner had been using. It turns out the store’s "earnings" are subject to a number of accounting adjustments that the auditors had overlooked. The actual cash flow is less than $100,000 a year, while the store also has $200,000 of debt that has to be eventually repaid or refinanced.
At this point there is no possibility you would pay $1.5 million for the business. If the store owner lowers the price back down to $300,000 (3 times earnings) you might consider buying it but only with a plan to sell it before 2009. Priced at 3 times its earnings, the store offers some degree of value over the next three years. Beyond 2009, however, the value of the store is likely to be greatly diminished due to the factors listed above.
The ice cream store is a simplified analogy for the Dow Jones Industrial Average in the face of Peak Oil. The Dow was at 10,827 points on January 31, 2006, trading at approximately 15 times forward earnings (on a composite basis) with a dividend yield of approximately 2.4%. If you believe the serious effects and/or widespread realization of Peak Oil is going to occur within the next few years, then paying 15 times earnings for that basket of stocks is about as appealing as buying the ice cream store at 15 times earnings. Like owning the hypothetical ice cream store, owning the Dow may offer very meager profits after 2009.
In the case of the ice cream store, you might (cautiously) consider purchasing the store if the price was lowered from 15 times earnings down to 3 times earnings. In the case of the Dow, it would have to fall below 3,000 for the price to be lowered from 15 times earnings to 3 times earnings.
Such a dramatic fall in the Dow might seem implausible if not impossible unless it is seen through the prism of Peak Oil. To illustrate: author James Howard Kunstler is one of the most widely quoted and sought after commentators on Peak Oil matters. While not a financial expert per se, his writings do demonstrate an uncanny ability for information synthesis and analysis. Considered a Peak Oil "moderate", Kunstler has stated that he feels the Dow will drop to below 4,000. If a respected and moderate commentator on these matters such as Kunstler foresees a drop in the Dow to below 4,000, then a drop down to 3,000 and beyond should not be considered out of the question should we encounter a few unanticipated events (extreme weather, war, terrorism) in the next few years. Although time comparisons of the Dow are imperfect, note that the Dow did not even cross 3,000 until 1991 and Dow 6,000 was not even 10 years ago.
The overall picture gets worse when you consider that many of the companies in the Dow have a good chance of bankruptcy or greatly reduced earnings as energy prices climb sharply. This is particularly true for stocks that are heavily predicated on cheap transportation and suburban expansion, such as General Motors, Home Depot and Wal-Mart.
This possible outlook for the Dow is also true, albeit to varying degrees, for the other broad market indices. Certain sectors might be especially hard hit – what happens to technology stocks, which are often valued at the “PEG” ratio (price/earnings to growth), when the hopes for growth are dashed?
If Peak Oil theory is correct, how can the Dow or S&P 500 be valued so highly? If you are reading this article and the www.lifeatheoilcrash.net web site, then you likely have many possible answers to that question, from the mundane (such as broad inertia in investment choices and mass ignorance of the issue) to the conspiratorial (the government is propping up the market). Whichever theory you subscribe to, your bottom line opinion remains essentially the same: you see the market as being "wrong".
This opinion puts you in the near-heretical camp of not believing in the Efficient Market Hypothesis (EMH). EMH posits that in an active market that includes many well-informed and intelligent investors, securities will be appropriately priced and reflect all available information. With the market being significantly impacted by savvy hedge fund managers, experienced mutual fund managers, and other highly sophisticated investors, how can their collective impact on the market diverge so greatly from a stock market value that would accord with Peak Oil?
Put another way, how can so many smart people in suits be so wrong?
The simple explanation is that the Peak Oil issue is about as invisible on Wall Street as it is in the rest of the country. This may come as a surprise to those of you who do not work in or around the Street. After all, you might look at the attention Peak Oil has received from the following publications and/or individuals and assume everybody on the Street is talking about it:
Goldman Sachs and the Guinness Atkinson Global Energy Fund have both issued "Peak-aware" reports
Fortune, Forbes, and the Wall Street Journal have all published lengthy pieces on the issue
Matt Simmons and T. Boone Pickens have spoken frequently on the issue while billionaire investor Richard Rainwater has even said he reads http://www.lifeaftertheoilcrash.net & http://www.dieoff.com (the two ultimate Peak Oil doom sites) on a regular basis. Source
How can awareness of this issue not have trickled down from people like Richard Rainwater, Matt Simmons, and T. Boone Pickens to the legions of Wall Street research analysts, investment advisors and portfolio managers? I suspect the answer to this question is fivefold:
#1. Every analyst has his area of expertise, and there is little incentive for an energy analyst to stray from his core expertise and make wide-ranging economic predictions. Similarly, an energy fund has a mandate to make investments in energy-related companies; it is not supposed to short companies that will be harmed by rising oil prices (a quick perusal of any energy mutual fund’s holdings will show this is the case).
#2. The energy markets fluctuate wildly in response to news events, weather, statistical releases, and whatever else may be the story of the day. Headlines about unrest in Nigeria, the impact of the Iranian nuclear issue on oil supplies, a milder winter depressing natural gas prices, etc. are so distracting and also so important to daily commodity and equity pricing that the larger narrative of Peak Oil winds up being just another “story of the day” rather than the story of the year.
#3. Almost any investment analyst or investment vehicle is part of a larger investment bank, mutual fund company, or other financial services provider that has a variety of investment choices under its umbrella. No major financial services company would long tolerate any voice loudly proclaiming "Peak Oil! The economy is doomed!" because it would be pretty tough to market other investments alongside that shrill voice.
#4. Peak Oil might not represent a big near-term (this year) opportunity, so for fund managers who are evaluated on a quarterly basis and compensated on an annual basis, it is not an investment-worthy thesis.
#5. Wall Street is made up of human beings that are just no more interested in the Peak Oil issue than most people that you know. In my personal experience working with energy companies on stock and bond offerings during the last 3 years, I never heard any energy company employee or energy investment banker use the phrase "Peak Oil." The few times I mentioned the phrase privately to bankers, the response was "What’s that?"
The Post-Oil Bulletin, Issue #3: Investing in Peak Oil: Strategic Considerations
Title Information:
Price: $7.50Size: 8.5 x 11, 103 pagesStatus: E-Book in PDF formatavailable for immediate download.
Top-quality investing books:
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Investing in Peak Peak: Strategic Considerations
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Books and documentaries on Peak Oil:
