This article was written by Paul Larson, an equities strategist at Morningstar.
Last month, I explained in an article how and why the world is approaching a worldwide peak in oil production sometime in the next decade. Although there are large implications throughout the economy, I want to say upfront that I do not think this will bring on Armageddon. Oil prices that are significantly higher than earlier in our lifetimes will bring about great change, yet I firmly believe that our economy has the ability to successfully adapt. Despite the strong headwind oil scarcity will create, I am still an optimist.
I have structured this article by segmenting the “winners” and the “losers.” These monikers may be a bit strong, and it is worth noting that even a company that might have a slower growth rate than before because of peak oil can still be a good investment. In other words, I’m not running out to buy the peak-oil benefactors, nor am I dumping the peak-oil losers. Rather, increased oil scarcity is but one of many factors Morningstar’s analysts and I consider when projecting future cash flows and business positions. With that, let’s jump right to it.
Loser: Existing Petro Infrastructure
With lower production of oil, there will be less of a need for the energy infrastructure needed to support the processing and transportation of liquid petroleum. All else equal, this will mean low-to-negative growth, slack capacity utilization, and lower profitability for refineries as well as certain pipelines and energy storage assets. In terms of companies held in StockInvestor’s model portfolios, ExxonMobil (XOM), Kinder Morgan (KMR), and Magellan Midstream (MMP) have a significant portion of their assets that are in the bull’s-eye here.
The good news is that all these companies are hedged to this trend. Concerning the refined products pipelines that are at the core at Kinder and Magellan, these operations have a hedge built into their regulatory structure; these companies have been given by Federal regulators the ability to raise their tariffs at the producer price index plus 1.5%. It’s this extra 1.5 percentage points in pricing power that should offset any volume declines created by peak oil.
Winner: E&P Companies
If oil is becoming more scarce, it makes sense that those who own rights to the resource will benefit. This is Exxon’s hedge, though it is worth noting that Exxon is much more heavily weighted toward refining (where it has 6.2 million barrels per day in distillation capacity) than it is toward oil production, where it currently produces about 2.4 million barrels per day.
It’s also worth noting that Kinder Morgan also receives roughly one-fourth of its operating profits from its carbon dioxide business unit. This unit is involved in advanced oil production and would benefit from higher oil prices.
Losers: Coca-Cola and Pepsi
The recent recession has significantly dented the popularity of bottled water, while there has been a corresponding increase in the use of tap water for drinking. Bottled water was once a major source of growth for both Coke (KO) and Pepsi (PEP), but this is a product line that is relatively costly and energy-intense. The attractiveness of a free and “green” alternative is only going to get stronger. Thankfully, Coke and Pepsi still have exceptionally attractive businesses, even without any contribution from water products.
Loser: Inefficient Transportation
Unfortunately, our entire economy is currently based upon relatively inexpensive point-to-point transportation of people and goods. Consider that little more than half of any given barrel will find its end-use in transportation (with the rest being used for everything from heating to plastics to detergents), and the United States consumes roughly 23% of the world’s petroleum. With our primary transportation fuel becoming more dear, relatively inefficient forms of transportation will find themselves no longer economical. Trucking companies and airlines are likely to continue suffering. Even traditional newspapers and the postal service–which at the end of the day revolve around moving information via dead trees–should continue their downward spirals.
Though rising transportation costs will have the largest effect on the entire economy, I struggle to find any direct connection to the portfolio companies. Perhaps Expedia (EXPE) and International Speedway (ISCA) get hurt greater than average from the higher cost of travel, though again, few companies will be totally immune to higher transportation costs.
Winner: Efficient Transportation
The corollary to above is that companies that enable the efficient transportation of people, goods, and information are likely to see higher growth and/or wider moats because of peak oil. Heavy SUVs are likely to never regain their former popularity, while we will continue to see more and more hybrid and electric cars on the road. (This is probably a wash for CarMax (KMX).) Railroads already have a major cost advantage over trucks in terms of fuel efficiency, and this advantage will only get stronger as fuel prices rise. I have no doubt this is one of the primary reasons Berkshire Hathaway (BRK.B) and Warren Buffett was attracted to Burlington Northern Santa Fe.
Telecommunications firms also stand to benefit. For one, we will continue to get more and more of our information electronically instead of corporeally. Also, telecommuting will continue to gain in popularity as the cost of getting to and from work rises. I do not have any telecommunications firms in the portfolios, as I have a difficult time seeing the technological path several years out. Will we be primarily using wireless devices? Or will it be fibre-optic systems from resurgent telecom firms? Perhaps cable will still have the fattest pipes for information? It’s not a question I have an answer for at this point.
Winner: Electric Utilities
The primary alternative to oil as a transport fuel is electricity. In a world with declining oil production, electric cars and plug-in hybrids are only going to continue to replace gasoline-fired vehicles. This will require major investments in our electricity infrastructure to be able to handle the extra load. The networking company Cisco (CSCO) recently said as much as $100 billion will need to be invested in the coming few years to upgrade the transmission and distribution systems just to be able to handle higher loads of currently planned projects and enable the “smart” grid. Other estimates vary widely, but whatever the precise number is, it will be big. Suffice it to say that there will be no shortage of investment opportunities for the regulated utilities to increase their rate bases (the assets on which they are allowed by regulators to earn a return). This includes the utilities owned by Tortoise holdings Berkshire and Exelon (EXC).
Winner: Natural Gas
While oil production is in the process of peaking, numerous new sources of natural gas are popping up all over the country. Due to new technology and discoveries, shale is now a major source of natural gas, including significant new production areas in the northern Appalachians. In 2008, natural gas production in the U.S. was up an astonishing 7.5%, which is in stark contrast to oil, which continued its slow and steady decline in 2008 by falling 1.8% in the U.S., according to BP (BP).
Combine the abundance of new supply, a weak economy, and an unusually cool summer, and natural gas prices tanked to near $4.50 per thousand cubic feet (mcf) last fall. A cold winter has brought the price close to $5.50, but on an energy-equivalent basis, this is quite cheap. One barrel of oil has about the same amount of energy as six mcf. Meaning, at a recent $75-per-barrel price, gas should be trading near $12.50 per mcf at energy equivalence, or more than double the current price. Although there are reasons that liquid hydrocarbons should trade at a premium to natural gas–namely the portability of the liquid–the premium currently in the market seems a bit extreme. If prices between oil and gas stay at such disparities, it starts to make economic sense to use compressed natural gas as a transportation fuel. This is already quite common in Argentina and Brazil.
Winner: Electricity Generators
Not only will the regulated utilities need to be beefed up to handle a shift from oil to electricity in terms of transportation, but a scarcity of oil will cause a rise in electricity prices. This will happen directly, as electric vehicles are substituted for gasoline vehicles, increasing overall electricity consumption. It will also happen indirectly, as natural gas is diverted for use in transportation, and natural gas is the marginal fuel for power generation at the moment. Exelon, with its large fleet of low-cost nuclear plants, is sitting in an exceptionally good position to benefit from higher electricity volumes and prices.
Winner: Alternative Energy
There will be no shortage of alternative energy technologies and companies vying for a piece of the energy market pie that is being vacated by liquid petroleum. Wind, solar, biofuels, geothermal, tide capturing, and so on, these are all areas that will become increasingly economical, and especially so if governments around the world continue or increase existing subsidies.
Unfortunately for us as investors, companies that make products for alternative energy are primarily small parts of large conglomerates, like General Electric (GE) and Siemens (SI). Moreover, the vast majority of firms in the alternative energy industry do not have any sort of economic moat, much less a wide one. For instance, there are several large solar panel companies at the moment– First Solar (FSLR), Suntech (STP), and SunPower (SPWRA), just to name a few. Yet solar panels are a commodity product where these and other companies are fighting tooth and nail for a finite market. Although there will undoubtedly be a high amount of growth in this area, the investment attractiveness is poor at the moment. Rest assured, if a company in this area is successful in digging an economic moat for itself, we will let you know.
Although higher oil scarcity will act as a drag on the entire economy through raising shipping costs, there is one silver lining. During the past few decades, relatively low energy prices and shipping costs, combined with the Internet, helped to “flatten” the world. Companies were no longer constrained by geographical limitations; they could source and produce their products from the areas with the lowest costs, no matter where in the world that might be. This has been a boon to areas with a surplus of low-cost laborers, such as China, but murder for workers in high-wage areas, such as the U.S. This labour arbitrage is, from my view, the primary reason why inflation-adjusted wages have been flat in this country for a decade.
But if transport costs rise as a result of higher energy prices, this frictional cost will reduce the opportunities for companies to take advantage of this labour arbitrage. As I mentioned in my previous article, it all boils down to high oil prices taxing transport and causing us to act more locally. This means goods being produced much closer to where they are actually consumed, which would benefit local laborers. Perhaps this would be a mild–very mild–tailwind for Cintas (CTAS), ADP (ADP), and Paychex (PAYX) here.
As you can see, there are actually quite a few companies that will benefit as oil production peaks and our economy moves from a heavy dependence on liquid petroleum to the alternatives. Overall economic growth will be constrained, and it will not be an easy transition. Yet peak oil will certainly not destroy the investment landscape.