The Business Times, Wednesday 29 September, 2004

Black Gold

As investors tire of technology and the global economy slows, the energy sector may be worth a look, says JOSEPH CHONG

AT a recent roundtable discussion of fixed-income securities organised by The Business Times, I expressed the contrarian view that the underlying trends were still disinflationary and not inflationary as was the consensus. Our mea culpa has been that we were not aggressive enough in lengthening the fixed-income duration in our model portfolios. Since then bond prices have risen and yields fallen.

Indeed, the accompanying table which compares US government bonds and the inflation-protected equivalent (TIPS) shows that both long-term inflation expectations and real yields (demand for capital) have fallen, notwithstanding the Fed's bullish forecast of an economic re-acceleration.

The bond market has signalled a slower global economy. Generally for most companies, revenue growth around the world would become scarcer. Capital spending growth has been below expectations whilst domestic consumption outside the US is recovering far too slowly.

This is especially so in Asia where there is a protectionist obsession with accumulating trade surpluses on the back of undervalued currencies. In the long run this is shooting your own foot. Indeed, the current overheating problems in China are a consequence of a currency held artificially weak for too long.

Free cash flow preferred

In an environment where growth is scarce, we believe that equity investors will eschew companies which promise high growth. The preference will be for companies that generate free cash flow and return these to shareholders via dividends or buy-backs. We believe this is why the Singapore and Australian equity markets have significantly outperformed the rest of Asia Pacific ex-Japan over the past six months.

One sector which is built on the mantra of high growth is information technology. Websites and the popular media are still flogging the IT sector as a good 'long-term' investment. From the money still invested in tech funds, it would appear that investors continue to be enamoured of the idea.

Not counting insurance-linked products, I counted more than S$400 million invested in global technology unit trusts. But has tech performed? (see table) Dazzling high beta tech has not delivered.

A reality check on the long-term prospects of IT shows that the nature of the sector has changed. From an insignificant number 40 years ago, IT spending is now already comprises 65 per cent of overall capital spending. How much more can it be?

The sector has grown because it had taken 'market share' from other forms of capital spending. This appears to have run its course. Because in the long run, nominal capex growth cannot exceed nominal GDP growth of 5 to 6 per cent, the IT sector's average growth rate will trend downwards with the accompanying cyclicality.

Although there would be pockets of spectacular growth in technology, the sector is generally becoming a highly cyclical business characterised by incessant pricing pressure.

To aggravate matters, the sector is prone to state subsidies and even co-investments as it is seen as the 'right' way to create 'high-tech' jobs. It reminds one of the ship-building industry in the '70s and '80s!

One sector which appears to generate free cash flow and return it to shareholders is energy - the investment dog of the late '90s when oversupply and collapsed demand from the Asian financial crisis drove oil down to $10 per barrel in 1998. Would we see that again soon?

Politically, few would be interested in an oil price crash. It would make the volatile Middle East even more unstable. Opec, on the other hand, genuinely does not want prices to skyrocket as this would incite conservation and alternative energies and thus damage demand for oil permanently - like in the '70s.

Market Structures

However, is it easy to moderate the price of oil in the near term? Firstly, extraction and refining capacity is short. It takes time (2 to 7 years) to find and exploit new fields (not many easy ones are left) and build new refineries, although with such high prices it is profitable to do so. Also, Mother Earth is near her halfway point in crude oil reserves. Mathematically, that's where the problem begins.

Secondly, new marginal demand from China and other emerging markets has soaked up supply to the point where it is estimated that the cushion is only one per cent globally - less than the estimated 2 per cent during the 1979 oil shock.

Moreover, because of politics governments have been sheltering consumers from the effects of higher crude prices through one form of subsidy or another, for example, in India and Indonesia. This is irrational as the logical market response should be conservation

Thirdly, the global oil sector has been permitted to consolidate to about 6 large players. Less competition means more control over pricing, costs and discipline in capital expenditure by the industry players. Recent calls by governments and the International Energy Agency for the oil majors to increase capital expenditure in exploration did not get an enthusiastic response.

The accompanying table shows that the global energy sector has done well - outperforming the broader market significantly. Will the next nine months be an encore? I wish I knew for sure.

The technical analyst would probably say that the sector is overbought in the near term but fundamentals may not be so stretched.

For example, Exxon Mobil, which trades at about 14 times earnings, has a market capitalisation of around US$310 billion. According to a report in the Asian Wall Street Journal, it has oil reserves of about 12 billion barrels. Assuming a cost of extraction of US$20 per barrel and an oil price of, say, US$40, Exxon Mobil is trading at about 1.3 times its oil reserves.

Including other energy reserves and tangible assets, the company is probably still being valued by the stock market below its revised net assets. However, one area where the energy sector is clearly not stretched is among retail investors. Currently, there is only one Singapore-registered energy and resource fund available with less than S$1 million in assets.