Counterpoint

I’m firing off this response to my friend and colleague
Chris Mayer’s recent Rude Awakening essay, "The Other Oil
Crisis."

Let me start by noting that Chris and I agree far more
often than we disagree. This applies to a wide range of
topics, discussed over many drinks and more than a few
poker hands. (We even share a taste for the same spirit,
bourbon on the rocks). On the matter of oil and energy
stocks, however, we part ways a bit.

First, Chris pointed out that everyone knows we are in an
energy bull market. On this point I am happy to agree.
Outstanding Investments readers have the stunning profits
to prove it. For example one of our flagship holdings,
Valero (VLO:NYSE) has outperformed new economy darling
Google (GOOG:NASD) in percentage terms. It is indeed true
that ‘everyone’ knows about developing world demand,
hurricanes, bottlenecks, and so forth.

But the fact that everyone knows about these issues doesn’t
answer the fundamental question: what are we doing in
response, and how fast can the problems we are facing be
solved? Consider the dire situation we face with natural
gas. There is simply not enough natural gas on the North
American continent to meet the growing scope and scale of
demand. There is plenty of natural gas in other parts of
the world – huge fields in Iran and Qatar and elsewhere –
but logistically we do not have the means of getting it
from there to here. There are not nearly enough Liquid
Natural Gas (LNG) Ports on American coasts, there is huge
environmental and political opposition to building them,
and even if we went on a full-scale building spree,
starting yesterday, it would take years to get the
necessary infrastructure in place. We do not have years, or
even months. We are reaping the fruits of our lack of
planning right here, right now. It’s the same story with
gasoline refineries. Everyone now recognizes the refinery
bottleneck problem. A new refinery has not been built in
the United States since 1975 or so. But how fast can we fix
the problem? China has the same time constraints. They may
be building nuclear reactors as fast as they can, but will
those reactors make a dent in the short term? No.
Awareness today is too late; we needed it five years ago.

So the fact that everyone knows the scope of the dilemma
doesn’t mean much, because the underlying foundations of
these problems have been built over a very long period of
time. Like America’s twin deficits, problems of this
magnitude are not solved overnight… and even the best of
solutions take years to deliver. The energy bull market is
not a fad or a flavor of the month. It is a structural
phenomenon.

Chris also argues that energy bulls are foolish in saying
"this time it’s different." He points out that "this time
it’s different" is arguably the most dangerous phrase in
investing. As a general matter of principle, I agree with
that sentiment. It is best to have extremely good
reasoning, as rock solid a case as possible, before
invoking the dreaded "this time it’s different" in defense
of one’s point of view.

So are the long-term energy bulls remiss in saying it now?
Do they have a counter-phrase of their own, powerful enough
to challenge the dreaded "this time it’s different" curse?
I would argue that they do. Try this four word phrase on
for size: "Three Billion New Capitalists." Roll it around
your tongue a bit. "Three Billion New Capitalists." As in
the combined populations of China, India, Eastern Europe,
and other various developing world countries, all piling up
export dollars, all seeking to ramp up domestic demand, all
growing by leaps and bounds, all at once. And if you think
the developing world is sucking up energy now, just wait
until the consumer culture kicks in (the seeds of which are
only now being sown).

Sure, we’ve seen all this coming for a while. But the full
effects simply haven’t hit yet, they are only beginning to
hit now, and we are woefully underprepared for the ultimate
adjustment. I agree with Chris that all kinds of
fascinating technological innovations are being rapidly
implemented in the energy space. There is huge interest in
nuclear power, and biomass, and biodiesel, and solar power,
and hybrid cars, and HCCI diesel engines, and many other
wonderful things. It is a relief that we are starting to
wake up to this need. But truly cheap energy is still a
distant dream, and will continue to be so for many years.

Here is why. If we implement all the technological
innovations we can dream up, and insist on all the
conservation measures we can think of, this will simply
reduce the price of energy from "ridiculously expensive" to
"tolerably expensive" over the next decade or so. We will
not get back to "cheap" for quite a long time. The demand
curve is set to leave the supply curve in the dust. The
only way we see cheap fossil fuel for any real length of
time is in conjunction with a global recession or
depression. And when global growth picks back up, so does
the energy bill. Don’t hope for cheap oil any time soon. We
might need a repeat of the 1930s to get it.

When pondering the value of technological advances,
consider this: It would be physically impossible for the
developing world to consume energy with the same gusto that
a few hundred million Americans do. Such a pace of energy
consumption, on a global scale, would not be sustainable
for a month, let alone any significant length of time.  And
yet some version of the western lifestyle is what these
billions of new capitalists are shooting for. That is why
we absolutely require dramatic improvements in energy
efficiency, and fossil fuel substitutions on a scale never
before seen, just for these new participants to see a
meaningful raise in their average standard of living.
We’ll need all the innovation we can get just to run in
place.

I am an optimist. The world’s energy problems will
eventually be sorted out. We will wean ourselves off the
prodigious and wasteful use of fossil fuels so prevalent
today, and much of the world will run on alternative
sources a few decades hence. But we will not get there
overnight. Infrastructure projects begun today will take
years to go online. The exponential rise in demand of the
coming years will swamp the more slowly accrued benefits of
energy substitution and conservation. Truly radical
alternative technologies will take many years to implement
on a small scale, and years more to make a true dent in
fossil fuel consumption. There will be more than one energy
crisis in our future, perhaps many more between here and
there. Shock and upheaval are historical change agents.

Last but not least, consider this point in favor of energy
stocks at current levels. Despite the breathless commentary
of late, Wall Street has long been expecting a substantial
decline in the price of crude oil. High flyer Valero
(VLO:NYSE) has a price to earnings ratio of roughly eleven
as of this writing. Compare this to Google’s PE ratio of
eighty, or Baidu.com’s PE ratio of six-hundred and seventy-
two. Why are many of the big energy names such as Valero
saddled with such low PEs? Because much of the Street has
already priced in the potential for a sharp decline in
earnings, tied to their predictions for a return to cheap
crude. There are multiple reasons why this prediction may
not come about, even if the US consumer falls all the way
out of bed. A perceived long-term stabilization of crude
above the $50 level might give compressed energy stocks
another rousing round of multiple expansions.

And the Markets…