Macro Tsimmis

intelligently hedged investment

BUY iShares S&P Global Energy Sector Index Fund (IXC)

Posted by intelledgement on Tue, 02 Jan 07

OK, time to review those Econ 101 notes from freshman year. What happens when increasing demand occurs for a product with inelastic supply? If you said “the price rises” then go to the head of the class.

In 1965, the USA used 36.9% of all the oil consumed on the planet, and China used 0.7% of it. Forty-one years later, in 2006, the USA’s share had dropped to 24.6% of all oil consumed while China’s had risen to 8.9%. Note that this is not because our consumption has declined. No, indeedy, we were quaffing 79% more barrels of oil in 2006 than we did in 1965…it’s just that humans overall consumed 168% more oil in 2006 than 41 years prior…and the Chinese consumption over that time frame was up 3,328%.

The point is that the massive modernization buildout currently underway in Asia—the largest construction project undertaken in human history—is fueled by energy and other materials. It takes electricity to run factories and computers and trains and keep the lights on in the cities and the countryside. It takes petroleum to fuel the cars and trucks and planes and ships that transport people and goods.

OK, so it is an exaggeration to call the supply of energy “inelastic”. As demand outstrips supply, the consequent rise in price affords increased efforts to obtain energy assets from sources previously uneconomic. But the supply is relatively inelastic, both for technical reasons relating to the difficulty of obtaining harder-to-get oil, coal, and natural gas and because of political considerations that tend to limit supply for reasons not related to technical problems (e.g., strikes in Nigeria, the mess in Iraq that prevents most of their potential production from reaching the market, the government in Venezuela deciding not to sell oil to the USA). Bottom line: demand growth is outstripping supply growth. In this environment, suppliers—and the industries that service the suppliers—profit handsomely.

And profit they have. It took 34 of the 41 years between 1965 and 2006 for the Chinese to achieve two-thirds of their oil consumption growth; the last third of growth happened in merely seven years. And as the growth in consumption has accelerated, so have the profits of energy companies. Since the end of 2002, the S&P 500 is up about 35%…and the Global Energy fund is up 180%.

This iShares fund invests 90+% of assets in an aggregate sample of securities that reflect the predominant characteristics of the S&P Global Energy Sector index. Its component companies include oil equipment and services, oil exploration and production, and oil refineries. Among the IXC’s top holdings number companies based in the USA (Exxon Mobil, Chevron, ConocoPhillips, Schlumberger), the UK (BG Group, BP), Holland (Royal Dutch Shell), Italy (Eni), France (Total).

OK so what could change this dynamic? Obviously either a significant increase in supply or decrease in demand. It would be great for everyone if we perfected cheap, unlimited fusion power…for everyone, possibly excepting Exxon Mobil et al. Scenarios where demand decreases tend to be more problematic—bird flu wipes out 20% of the human population, global warming sinks all coastal cities and crashes our economy, a devastating terror campaign crashes the economy, the US dollar collapses along with US consumption in the next few years (that is, before Chinese consumption is big enough to take up the slack). None of these eventualities are impossible but until something like any one of them transpires, the IXC remains a compelling investment.

In the long run, energy assets also constitute a good hedge against the all-but-inevitable demise of the dollar…although in the short run, precious metals are better because a sudden dollar collapse could engender a temporary decline in energy demand but would most probably increase demand for precious metals.

Note: some data cited herein are drawn from a most useful spreadsheet prepared by BP listing oil consumption in MMBBLS for each of the planet’s major countries for each year from 1965 to 2006 inclusively.


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