On the Importance of Oil; Global Equity Markets in 2014; A Health Tip!

From: aditya rana
Date: Sat, Jan 10, 2015 at 2:38 PM
Subject: On the Importance of Oil; Global Equity Markets in 2014; A Health Tip!

Hi!,

The start of the new year has been turbulent for most stock markets around the globe (with the exception primarily of China and Turkey!). Rather than focussing on markets, I would like to devote the first two letters of the year to arguably the most important factor underpinning the growth of the global economy over the last two hundred years – oil. Jeremy Grantham, founder of the famed value investment firm GMO, wrote a fascinating quarterly recently with some deep insights into the critical role that oil has played in human growth and development since about 1800. To summarise:

Key points:

-Human development over the last two hundred years has primarily been dependent on fossil fuels, which have progressively become cheaper as a fraction of income, making the global economy larger, evermore complex, more inter-related and fragile.

-However, since about 2000, the cost of finding oil has compounded by 10% a year, while the economy has grown by only 4% a year – making oil increasingly less affordable. Since oil plays a leading role in the cost structure of agriculture, other extractive industries like coal, and in transportation, as its cost rises other parts of the economic system have to be sacrificed to acquire sufficient oil. This implies that economic growth slows down.

-It is therefore critical that we focus on fuel efficiency, reduce wastage and invest in the rapid development of alternative energy, which though currently competitive against only very high-cost oil, has the potential in 20 to 30 years to eventually replace oil at $40 to $50 per barrel.

-To highlight the seriousness of the problem – we have never before spent more money on finding new oil supplies ($700BN in 2014), but (despite U.S. fracking) have never found less – replacing only 4 ½ months worth of current production.

Details:

-The epic jump in growth that began in Europe and the U.S. around 1800 was driven first by coal and then oil. The driver of this growth was the large gap (“the fossil fuel surplus”) between what this energy was worth in terms of horsepower and human power, versus the much lower cost of extracting the fuels.

-An example to think about this – cutting wood using labour at $15 per hour, versus using a chainsaw fuelled by a gallon of oil which could keep going for 8 to 12 hours, which would be about 20 times faster than man labour. This would equate to a value of $2,400 to $3,600 per gallon of oil.

-But with gasoline priced at $3 per gallon, we are able to use the oil for trivial tasks which have little labour equivalent value. Prior to 2000, this gap based on the average cost of oil at about $10 per barrel (in 1998 the marginal price of oil reached a 20 year low of $14) was perhaps about $240 or 24 times the cost of extraction.

-Part of the benefits of this massive surplus goes to the government as taxes, to oil companies as profits and to oil workers, but the greatest benefit accrued to uses which have a far higher value than the cost of extraction. This great surplus is what drove the industrial revolution, with the resulting increase in wealth funding the growth in sciences , engineering and human development.

-The Industrial Revolution was based on coal as a source of cheap energy, and the steam engine allowed for efficient use of this energy by increasing the fuel efficiency rate from 1% to 35% over the first 100 years of its existence.

-From 1870 until 1970, technological improvements in finding oil offset the naturally rising cost of extracting oil (as you drill the best and cheapest wells first), resulting in an average price of about $16 (with considerable volatility around that). In addition, rapidly rising incomes drove up the affordability of oil, further increasing the size and complexity of the economic system.

-However, from about 2000 this relationship between oil and the economy began to change as the growing demand for oil (from a growing world population and more importantly due to rapid China growth) began to outgrow the supplies of cheap energy resulting in the marginal cost of extracting oil compounding at 10% per year.

-The marginal cost of oil (which usually determines price) rose from about $15 in 1998 to around $70 to $90 per barrel today (and average cost from $10 to about $60), deducting about $50 from the “surplus”, dropping it from around $240 to $190 per barrel. This 21% drop in the value of the surplus, while not affecting the high value uses of oil, drives out a section of the less valuable uses of oil and acts as a drag on economic growth.

-The cost of oil has a tremendous impact on all other resources, and as the price of oil quintupled from 1999 until today, the price of almost all other resources doubled (and until 2011 actually tripled).

-With the economic surplus accruing from oil accounting for much of historical economic growth, and with oil breaking out significantly over its long-term trend growth in 2004, it is a likely explanation of the increasing tendency for all countries to disappoint compared to earlier growth rates.

-The slowdown in global growth has perhaps been misattributed to the financial crisis of 2008 – financial paper losses are much less consequential than real things like people, education, training, motivation, machines, buildings and energy – and the resource squeeze has had a much more important negative impact on global growth than is currently believed.

-With the efficiency of energy usage increasing by about 1.5% a year, as long as the cost of extracting oil rises faster than that, the negative impact on growth rates will continue.

-Productivity rates are only likely to go back to historical levels if the world is able to successfully transition away from fossil fuels to alternative energy sources like solar and wind. However, this assumes that solar and wind replace oil at $15 per barrel rather than the current levels to maintain the 1950-200 fossil fuel surplus. This could take another 20 years or more, with the cost of wind power declining gradually, and the cost of solar power and energy storage declining more rapidly.

To be continued to include U.S. fracking – the largest red herring in the history of oil, productivity growth and oil prices, and the long-term outlook for oil prices.

-Will provide my thoughts on this fascinating note next week, but the key point here is that oil really matters, more so than we think, and while the recent sharp drop in oil prices will have a positive impact on some areas of the global economy, the impact of U.S. fracking is likely to be only temporary and future spikes in oil prices are likely.

-Have provided a chart below which depicts the 2014 performance for global equity markets – quite a reversal from previous years with China (up 52.9%) and India (up 29.9%) being the best performers. Note the poor performance of the Russian stock market (down 45% in roubles which equates to about down 75% in dollar terms). Applying the golden “reversion to mean” principle Russian stocks are likely to provide significant upside over the medium-term (provided you have the stomach to handle the volatility and the potential for further downside!).

The next big event in financial calendar is the ECB meeting on January 22 where they are expected to announce a Euro 500 billion QE programme to be implemented over a one year period. As per Goldman, this programme will compare in size to the average monthly purchases by the FED during QE3, but much larger than the average purchases since the onset of the financial crisis. In addition, due to the much smaller size of net and gross issuance of European government bonds, it will imply a more significant absorption of government bonds (about 62% of gross issuance versus about 20% in the U.S.). A programme of this size and impact is likely to have a significantly positive impact on European and global stocks so stay long (in a diversified manner) and use the current weakness in markets to add gradually to the portfolio.

A Health-tip:

With winter comes the usual bout of respiratory illnesses in the form of colds, coughs and the flu (as the “khapa” or water element accumulates in winter in the form of mucous in the body). A simple Ayurvedic remedy (which has been a perennial home remedy in many Indian homes!) can prove to be quite effective it controlling such illnesses (from my own experience and the experience of friends and family!):

-Take a tsp of turmeric, 1/8 tsp of black pepper and 1 tsp of honey (raw if possible) and make it into a paste. Keep in a container and have ½ tsp every 2 hours or so and take a few sips of warm water afterwards. After a day or two (when you start feeling better) , it can be reduced to 3 times a day and then once a day. Have it right after the onset of symptoms and it should prevent the onset of the cold/cough in a day or so. As always, avoid cold drinks and food, dairy, stay warm and take adequate rest. Also, take a tsp of turmeric (add Amla powder as well if available) with a pinch of black pepper with some hot water daily after breakfast as maintenance during the winter months.

-In addition, gargling with warm salt water every night and morning is very helpful. Make sure you gargle for a long enough period to cover holding your breath while gargling (about 10 seconds). You can add ½ tsp of turmeric to the salt for extra impact.

-Steaming for 5 to 10 minutes with a bowl of boiling water with 3-5 drops of eucalyptus oil is also very effective. Make sure you stay for a few minutes after steaming with your head covered to cool down.

Wishing my readers a very Happy, Prosperous and Healthy New Year!

Regards,

Aditya

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