out there. We do not have the benefit of 20/20 hindsight, but we do have the tools to analyse and understand the forces and dynamics at play.
As a senior member from the Central Bank of Spain once told me, “Trading is not a science. It is an art. But it helps to know a lot of science!” Very true.
During the dotcom revolution, expected returns were largely driven by assumptions of exponential demand growth. From telephone landlines to mobile phones. From shops to e-commerce. From regional to global. The potential for growth seemed unlimited. Invariably, many sectors built significant overcapacity. Among them, fibre-optic broadband infrastructure was one of the most critical.
Similarly, in the energy world, investment decisions are predicated on a view of “world energy demand growth”. Demand forecasts are based on “diplomatic” assumptions about global growth (which tend to be revised down more often than not) and where important forces such as efficiency or substitution are often underestimated or ignored. We know from the past that overcapacity is often the result of overly optimistic assumptions about the future. As Jim Steinman wrote, “the future ain't what it used to be”. Well, today's demand expectations seem to imply that “Asia will buy unlimited amounts of gas at an unlimited price”. Is the writing on the wall?
Furthermore, think about the impact of shortages in energy and infrastructure: “black-outs”, “brown-outs”, or simply long queues at the petrol station. Not good news for the economy. Worse news for politicians. The overcapacity of energy supply is therefore a desired state for consumers, which explains why, in addition to “private” investors, there is a strong centralized, planned, and strategic process driven by governments and state-owned enterprises. Look at China …
Efficiency is also proving to be a game changer, acting as a source of “demand destruction”, and often ignored in demand growth estimates. Think of global industrial output for example, which has increased by 2 % per annum with flat energy consumption growth since 2005.9 The world is producing more with less energy. In the US gasoline demand has fallen every year since 2007 thanks to efficiency, as the light duty vehicles went from 20 miles per gallon to 24. The IEA estimates that improving efficiency to 34 miles per gallon could reduce global oil demand by 4 %.
According to the International Energy Agency (IEA), greater energy efficiency could cut the growth in global energy demand by half. The accrued resources or “savings” from efficiency gains could facilitate a gradual reorientation of the global economy to higher added value investments and a gross domestic product (GDP) that is led more by the consumer than industry.10
We will continue to hear and read optimistic assumptions about energy demand growth. It hasn't happened since 2005, yet many anticipate that the “big demand growth” will come. These expectations are missing a key point: the change we are seeing is not cyclical, it's structural. The new economy, even in China, is less about large industries and massive construction.
Think “against the box”
One of the main traps for investors in the energy markets is to follow consensus.
The energy world is driven by extremely optimistic assumptions of demand growth, and downward revisions of estimates tend to be shrugged off as “noise” always looking at the elusive long-term perspective. This “growth mirage” that we will discuss later is best exemplified by the average adjustment in demand growth from the IEA and OPEC.
According to my analysis, every year demand growth estimates are revised down an average of 15–20 % from the January estimates. Since 1998, only one year, 2012, has seen meaningful upward revisions from initial estimates.
My experience in the past years as an analyst and a portfolio manager has taught me to use forward guidance from companies and agencies with extreme caution. This has helped me to avoid the constant stream of profit warnings and to keep a moderated view about the supply–demand picture, which has proven to be right. We have not seen a supply shock or a demand boost. This philosophy of not just thinking “outside the box” but also understanding that the compilation of data made to support forward guidance is tainted by diplomacy.
Governments are always optimistic about GDP, and always overestimate the correlation between GDP and energy demand. A correlation that has been broken since 1998, where strong economic growth does not necessarily imply industrial and energy demand rising. The best way to add value and make money is precisely to question and understand the intricacies of forward-looking guidance, put under scrutiny the details, and always know that it will be better to err on the side of caution, rather than let ourselves be guided by consensus. As an investor one must know that none of the companies' executives, analysts at agencies or brokers will suffer professionally from providing optimistic guidance. It will always be justifiable with “unexpected one-off” events. The same happens with doomsday predictions, as we have already seen with peak oil.
The assumption of ever-rising prices due to supposed depletion and alleged energy shocks has been what we call in the financial world “a widow maker” as an investment strategy.
During the early 2000s, the telecom industry continued to push the boundaries with the new 3G technology. But governments controlled the licenses, and were determined to maximize the amount of money they could raise from them. To keep the competitive pressure, they offered fewer licenses than the number of operators likely to bid. A similar auction had been applied in the United States and had to be re-run when the winners defaulted on their bids. Yet, and despite the potential harm to the telecoms future competitiveness, the European governments proceeded with the blind auction and sealed bids.
Telecoms were in a difficult position. If they lost the auction, they felt they would miss out on the next technological phase of the business. Many assigned a strategic premium and made high bids, often financed via debt. The result was staggering. The UK auctions raised £22.5 billion. The German auctions raised around £30 billion. To put this in perspective, this was 10 times more per megahertz than the television companies were charging at the time for national broadcasting.11
A similar dynamic where majors are investing “not to miss out” is also taking place across the energy markets.
Investments “to be there” throughout a possible game-changing environment are typical of the energy industry. It's called “position rent”. The economic decision to devote large amounts of money in energy investments comes not only from the possibility of generating solid returns on an equity investment, but also from the opportunity that technology gives to higher asset value and strategic position of the company in a country. Out of the hundreds of billions of capital investments made every year in energy around 5 % to 10 %, looking at the plans of the large integrated companies, will likely be in “strategic opportunities” or “security of supply” where returns are unclear, but companies feel the need to be involved. These figures are higher when we look at national companies of the calibre of Gazprom or PetroChina. A very significant amount that unwillingly helps the flattening process.
Certainly, these strategic decisions can play an important role in the future competitiveness and solvency of these companies. Whether in a real estate boom, or internet boom, or energy boom, paying too much to stay ahead may well be the kiss of death. The corporate graveyard is full of companies that paid too much at the top.
The “strategic premium” and “geopolitical risk positioning” are eroding peak demand pricing with incremental supply, both from new capacity and new technologies. The erosion of peak pricing has been instrumental in improving the economic outlook of countries, because it reduces
Enerdata (2013).
Paul Klemperer (2002). How (not) to run auctions: the European 3G telecom auctions.
