Saturday, September 8, 2012

Become a farmer in the U.S. Mid-West


On the road to your life goals it is important to know the landscape around you.  How can you reach that goal if you don’t recognize the wall you’re walking into?
It may seem like eternity but it was only four years ago that we entered the financial crisis as signalled by the collapse of Lehman. In fact, the problems became increasingly clear a year earlier in August 2007 when the words ‘subprime-mortgage’ and ‘credit default swap’ became household words.  It was also the time that oil prices peaked around $147 per barrel.
In his latest book: “The End of Growth”, Jeff Rubin still attributes the real cause of the economic collapse to those high oil prices. In fact he bases a lot of the book's premise on an old economist formula states that potential GDP growth of an economy is the sum of productivity growth and labour force growth. If the labour force increases by 1% and the productivity increases by 2% then the country’s GDP should grow 3%. 

The Bank of Canada feels that based on this formula, we have the potential to grow GDP at 3% per year without running into problems such as inflation and employment shortages. In the final quarter of 2011, Alberta’s economy grew at close to 5% and in 2006 it grew nearly 6% per year. That is on the low end China’s growth numbers!  No wonder Alberta is continuously crying ‘labour shortage’ – although many Albertans, especially young university graduates, know from hard experience that the shortage is in very specific crafts and professions and that many others are standing along the sidelines.
Still, Alberta and Canada are islands of quiet prosperity in an ocean of economic turmoil. It definitely illustrates the importance of diversifying one's portfolio into both real estate and stocks & bonds. The first, as pointed out in earlier posts, is ruled by local, or even neighborhood economics; the latter is ruled by the nation’s if not the world’s economic conditions.

But before digressing farther let’s return to Jeff Rubin’s assertion that oil prices or better the price of energy should be more explicitly embedded in this GDP formula. Although a master in explaining economics in terms of words rather than formulas, I feel Jeff could have gone a step further and explicitly define the role of energy in this GDP formula.
So, I in all my economic imperfection will try to do it. Because a simple equation may explain a picture, an economic situation at a specific point in time, sometimes easier than a whole book in words. The growth of the labour force increases our capacity to produce more thus its place in the GDP formula is pretty obvious. It is that confounding word productivity, where I think the problem lies.  For years economists including Mark Carney have stated that Canada's lacks in productivity growth will prevent us to keep up with the GDP growth of other countries and yet... we have currently one of the most envied economies in the world!
Using the world’s foremost authority on any science J - Wikipedia: Productivity is a measure of the efficiency of production. Productivity is a ratio of production output to what is required to produce it (inputs). The measure of productivity is defined as a total output per one unit of a total input.

Further: The benefits of high productivity are manifold. At the national level, productivity growth raises living standards because more real income improves people's ability to purchase goods and services, enjoy leisure, improve housing and education and contribute to social and environmental programs. Productivity growth is important to the firm because more real income means that the firm can meet its (perhaps growing) obligations to customers, suppliers, workers, shareholders, and governments (taxes and regulation), and still remain competitive or even improve its competitiveness in the market place.[
An obvious source of productivity is technology and technological innovation. If you want prove look at China. It has executed a dramatic program of population control: its ‘one child per family’ policy. So its labor force counting in the billions is stable. Yet its GDP growth is in the 7 to 10% range. The answer to this ‘conundrum’ is that over the last 2 or 3 decades China’s labor force has been converted from medieval agricultural to modern day industrial and thus the productivity per worker has increased tremendously. The process is still ongoing and that is why China’s GDP is forecast to grow at high rates for many decades to come. To top this all off, the world’s technology is becoming more advanced by leaps and bounds as a result of a computer and a communication revolution.

The U.S. did so well in the 1990’s because its labor force did grow significantly, ironically mostly due to illegal immigration, but also due to the world famous U.S drive for technological innovation. This  resulted in incredible productivity growth. Both Europe (often egocentrically looked down upon from this side of the ocean) and the U.S. are virtual endless springs of innovation. But in the 1980s we were not so good at execution and thus we lost a lot of ground to the Japanese juggernaut. Still…
What we are forgetting, and this is the core of Jeff Rubin’s thesis, is the impact of energy on productivity. Hydrocarbon energy has allowed the world, in particular the West a level of life style that would have dropped the jaws of the most-powerful that lived just a century ago.

The role of affordable energy is seriously underestimated in our economic deliberations.  We know that military victories such as that of the first and second world wars can be directly attributed to access to affordable fuel sources by the war machines of the various countries involved. Without oil even today tanks and jets cannot move!  But now we’re learning that without access to affordable energy our GDP doesn’t grow very well either. Cheap energy increases a worker’s productivity many times over.

Productivity is about all our inputs other than our labor to make products. But really isn’t energy the leverage that magnifies the fruits of our labor many times? In fact, one could claim that energy is so important that it should be mentioned by itself. So GDP growth is a function of labor + technological growth (productivity minus energy) + growth in the affordable energy supply.
In Canada’s economy, the effect of technological growth in manufacturing is probably not significant enough compared to our ability to produce affordable resources, in particular oil and gas. Thus our economy is doing quite fine without the tremendous growth in productivity that was achieved by our friends to the south. Not that the resources and energy industry did not also make enormous progress in its productivity but that seems to be an implicit part of the affordable energy supply and apparently does not show up in the traditional measurement of productivity.  It is a bit like the inverse of CO2 emissions. Canada’s emissions are so high because of the oil, especially synthetic oil, that we’re producing. But that oil is for a very large part exported to other nations that do not include the emissions to produce that oil in their CO2 accounting.  But, as usual, I digress.
As discussed in earlier posts, the term ‘affordable’ is a moving target and it is the reason that the ‘peak oil’ curve is thankfully so distorted. Affordable energy will also be affected by innovations that lower energy demand. If we are conserving energy and if we make our machinery and our transportation more energy efficient then we can afford to do more with less oil and thus we will continue to grow.

Currently there are two apparently contradictory views in the world plus possibly a third ‘pie in the sky’ view. The pie in the sky view is the delusion that by combining energy conservation and renewable energy we can tame and possibly get rid of the hydrocarbon based economy. This is a pipe-dream because at this point in time we have no chance to create sufficient energy to fuel the ever increasing world demand for energy without hydrocarbons. With India, Brazil and China converting to modern economies chances are that 100 million or even 120 million barrels per day will not be enough.  When we talk about Canada’s oil sands, we’re talking about doubling production from 3 to 6 million barrels per day – that wouldn’t even fill in the added total world demand let alone production declines e.g. in the North Sea.
Yes, lets talk about multi-stage frac’ing in tight oil and gas plays.  Let’s take a relative a large tight oil play in Alberta that produced nearly 30 million barrels over the last 50 years. If the new production techniques could increase the recovery from 15 to 25% of the original oil reserves in place then we should be able to produce another 25 million barrels over the next 30 or 40 years or 500,000 barrels per year.  If there were 20 other Canadian companies that could do the same then we would add 10 million barrels per year or 27,000 barrels per day . So what is the impact of that in the world? Oh, and, by the way, if the oil price falls below $90 per barrel there won’t be many oil companies drilling for this stuff.

If you have not followed the news lately, you might have missed that a number of oil producers have already cut back in capital spending because it is too expensive to produce this unconventional oil at today’s prices. Who would have dreamed that 5 years ago? Oh… and in terms of inflation – during the seventies, oil prices climbed to around $26 per barrel if you add 4% inflation over 32 years until today the price of oil should be $91 per barrel. Hmmm… parallels?
The earlier hinted-at-contradiction of us living in an oil glut because of the new tight gas and oil paradigm and the lack of finding additional large oil reserves may not be as stark as  assumed by many. Jeff Rubin wipes the effects of additional oil and gas production of the face of oil world demand as trifling. He still holds on to his thesis. So does investor legend Jim Rogers who announces the rebirth of agriculture, oil, gas, real estate – anything that is a 'real asset' and proclaims that the financial industry including the stock market will be relegated to the backwaters where it came from in the 1960s.
So when we look around us on the way to our life goals, we see a landscape of weakening governments that just don’t have the financial means to help its citizen. They will try but only create inflation. That is why we must invest in real assets or in stock of companies that own real assets such as commodities and real estate. The world economy will stay weak because it cannot grow in the face of rising energy and commodity prices.
The people on this planet will have to learn to share their resources and control population growth. It is easy to blame the ‘Satan in the West’, but when you keep on increasing your population as is happening in many poor countries then you will have to do with ever less resources per person. Education about woman’s rights, contraception and about the real and emotional price of bringing up children in a country with insufficient resources will hopefully put a stop to world population growth.

As Jim Roger’s says (paraphrased) it is not about people in debt who demand that someone else pays it off; it is about having the wherewithal to chase the jobs and careers that will help you through these bleak times. Go where the money is and work for it. Adjust to the new reality that there may not be a social safety net to take care of you.  To again paraphrase Jim Rogers: [with a future of limited energy and food supplies ] “become a farmer in the Mid-West.”

Monday, September 3, 2012

Blueprint for getting rich – Part V


This is one of the last posts in our Blueprint series. We’re revisiting the windfall of employee savings plans in Part III. The implied assumption of the employee savings plan post was that a person would stick around at the same place of employment for 20 years or longer. That is in today’s world not a realistic expectation. Also the assumption that the employer’s share price would increase year in and year out an average rate of 10% is not realistic. Many companies don’t last more than 5 to 10 years before they are merged, are taken over, or are biting the dust.
Thus, we should see the employee savings plan as part of our overall portfolio and rebalance it from time to time. Most mutual funds and sophisticated investors do not have much more than 5% of their total portfolio invested in a single asset. That is a good rule of thumb for a passively managed investment but when you are closely involved with the investment such as being in control of your own company this rule is not very practical. Just ask Bill Gates. In fact most big fortunes are made by actually focusing your portfolio on one or a few investments where the investor has a lot of control. That is why there are so many real estate millionaires because they can invest a larger portion than 5% in a single investment asset.
When you are employed at your investment but are not in management or better senior management you may know a fair bit more about your work place than the typical passive investor but you have a lot less control or no control about how your place of employment is being run. Thus your portfolio can have more than 5% of its assets invested in your place of employment but at 30% or higher I would get worried. Sometimes it cannot be helped and your savings plan may exceed the 30% limit anyway. If that happes you should be on top of your holdings - ready to pull the sell trigger. This is especially ture when dealing with stock options, which we have not discussed in this series.
If you happen to work at a company that is booming in the stock market take from time to time some of the money off the table. Set a target price say 10% above today’s price. When your holdings increase beyond a 30% of net worth and trade above the target price cash some in and invest it in something else like an ETF or real estate (it all depends on the market). Then increase your target price by another 10% and repeat the process.
But all good things come to an end and thus make sure you’re not too greedy and end up left holding an empty bag. If you end your employment then be ready to reduce your holdings to the level of a normal passive investment, i.e. to a maximum of 5% of your total net worth. You don’t have to do this all at once and you can take advantage of price rallies to determine selling off more of your holdings.
Most employee savings plans have rules as to vesting. An employer’s contribution to your savings plan may not be yours right away, you are likely required to keep it in the savings plan for a specific period of time before you can take it out. It depends on the plan but typically you have to hold on for a year. This encourages you to stay with your current employer just a bit longer. Normally waiting for your employer’s contribution to vest is no problem because you made on your contribution basically a 100 to 150% return by holding on for the duration of the vested period plus any dividends and appreciation you earned on your and your employer’s contribution.
But after that first year, you can do with the proceeds what you want. So if your employee savings plan value exceeds your maximum portfolio weighting, take it out and put it in another investment account(s) – a TSFA or a RRSP or a non-tax sheltered account or in real estate. Your place of employment is not the only place where you can make 10% ROI per year so there is nothing to stop you from diversifying your holdings.
If you follow this strategy during your entire career then the total return will likely resemble that as outlined in part III of this series.

Sunday, September 2, 2012

Well that was quick and oil will probably go higher! Let’s thank Obama and the environmentalists


Remember the new world oil glut last July? Then, as a reminder of the nasty European crisis the oil price fell to around $80.00 per barrel similar to Oct 2011. Well oil today is quickly closing in on $100 per barrel.  I am talking WTI (Cushing prices). I wouldn’t be surprised if WTI is over $100 by Christmas.
 
Oops in Europe the oil the story is the same - only at world oil prices:



If you wondered about the economics of new pipelines and its importance to Canada let’s consider that Alberta’s export to the U.S. counts around 2 million barrels per day that are sold at a discount to world oil prices of $115 – 96 or at $24 per barrel. In the 1990’s most companies would have sold you an entire barrel for that $24!  At 2 million barrels a day that means $48 million PER DAY less in export revenue or 1.5 billion per month or $17.3 billion per year!! Now translate that into land sale revenues, royalties and corporate income taxes (not to mention into stock market gains) for Canada, Albertans and Canadians in general. Is anybody angry about the import tariffs imposed on our lumber exports?
No wonder Canada is trying to open new markets to capture these astonishing amounts of lost revenue!  No wonder we need an alternative to being held hostage to the U.S. refineries that put the discounts in their own pockets rather than into lower U.S. gasoline prices. And the environmentalists that were so eager to stop the Keystone pipeline now are confronted with the consequences of their actions.

The world needs oil and if it doesn’t go to the U.S. it will go somewhere else. It will go to refineries in eastern Canada via pipeline reversals and to Asia, in particular to the Chinese but also to countries such as Japan and Malaysia. How does it get there?  It will go through even more pristine environmental areas than some aquifer in the Mid-West. It will have to go through the mountainous areas of B.C. and it will be transported by train (much riskier than any pipeline) to refineries all over the U.S. To top it off, the U.S. will have to compete with numerous others that will clamour for Canadian oil. So long term the U.S. will have to pay higher prices and that translates into lower economic growth less jobs and less donations for said environmental groups.
Short term environmental thinking has done more harm than good. Just opposing a development at all costs does not throw off good long term results. Those same groups may get now even angrier at the establishment but in the end their impact will only be felt as a negative. Obama will look good in tomorrow’s election but in the long term he forced Canada to look to Asia and to implementing more hazardous environmental solutions to transport oil. He will have to keep importing oil from 'allies' such as Saudi Arabia and Venezuela. With friends like that who needs an enemy? What political leaders don’t do for a few votes!
In the meantime, we will be clambering for more oil to keep our lifestyle up and the oil industry will deliver oil from evermore difficult ‘reservoirs’ at ever higher prices. That is what the charts above tell us. In spite of low economic growth we will need energy; there is simply not enough secure supply. With the Middle East in shambles and Venezuela under-producing to satisfy the power hunger of its dictatorial leader the secure supply of oil is today even more precious than ever before.

Just imagine what our oil demand would be in a booming economy?  Well as pointed out before, oil prices and economic growth go hand in hand. Oil prices today are a stronger economic stimulant than interest rates which have been kept low artificially over the last 5 years by the U.S. Fed and other central banks with little effect.  You wonder about the quality of political leaders that have mismanaged such an important issue for a few more votes.