Energy Prices, Investors and the Economy and Markets

This has been a rather peculiar year for equity investing. Last week's Wall Street Journal, on Wednesday, featured two articles on disappointing investment performance at two very well-regarded firms- Goldman Sachs and Convexity Capital.

Our own equity strategy is doing poorly at the moment, as a result of energy prices, and investors' near term reactions to those prices.

My partner emailed me a recent NY Times piece which repeated many of the comments I've made regarding this situation. It is, to me, perplexing.

First, it's notable that so many hedge funds and veteran managers are doing poorly as well this year. It's not really a "growth" economy, so far as investors perceive it. The S&P500 Index has not had a monthly closing annual return above 6% yet this year. Many have been below 4%. Hardly a year of confident investing in a growing economy.

Which brings us to energy. The track record of energy firms which have entered our portfolio is one of consistently superior revenue growth and total returns for quite a few years. They are not simply timing bets on oil and gas prices. However, this year, more than even last year, has really caused confusion in the energy markets.

If economies are growing, then investors fear the Fed raising rates to check inflationary pressures. Pressures brought on by......energy prices! Rising rates will slow the economy. And lead to less energy usage.

If economies are slowing, investors feel energy will be in less demand, and, thus, have less value. As will, they feel, the companies producing and distributing the necessary fuels and their precursors.

It would seem that, for now, and for much of the past few months, the broad middle swathe of "average" investors, and I use the term pejoratively, feel that it is an inescapable conclusion that any probably economic outcome must lead to lower growth and lower energy prices, and, thus, lower prices for energy company equities.

To be sure, the way the S&P has bumped along near zero returns for so much of this year, and in the low single-digits the rest of the time, doesn't help. Nevermind that real economic growth has been pretty good for more than two years now. And that, per Arthur Laffer's comments recently, related in this post, we aren't seeing inflationary pressures, so much as the effects of commodity prices filtered through exchange rates.

I just don't see an economic recession among the various better pundits who forecast such things. ChIndia still seems to be growing and planning to consume copious amounts of energy. No imminent additions to supply are in sight, and demand doesn't seem to have materially slowed. True, current inventories are high for oil, gasoline and natural gas. Is this a long-term effect, or simply a snapshot in the early fall? Is it truly the basis for long-term declines in energy prices?

Granted, Chevron and Devon have announced a large new find in the deep waters of the Gulf of Mexico. As the NYTimes article my partner sent me, written by Daniel Akst reminds us,

"WhatÂ’s that you say? You think this sounds like good news rather than bad? You figure cheaper oil would boost economic growth while slashing the income of such lovable oil exporters as Iran?
Don’t kid yourself. Anything that reinforces the role of fossil fuels — particularly oil — as the industrial world’s primary energy source is bad, not good. Anything that prolongs the life of the internal combustion engine is a negative, not a positive. Anything that makes it cheaper to pump greenhouse gases into the atmosphere is cause for mourning rather than celebration.What we need is not lower oil prices but higher ones — significantly higher, enough to deter consumption and make us look seriously at alternatives........HIGHER prices have worked wonders before. Today, Americans can generate a dollar of gross domestic product using just half the energy required in 1973, that watershed year of the oil embargo and lines at gas stations. In countries where energy is more expensive, a dollar of G.D.P. requires considerably less energy still. Unlike a tax, moreover, higher prices have the advantage of applying all over the world, to everyone."

The point about the growth in US productivity with respect to oil is a fact I like to quote. However, the correspoinformationmation about countries where energy is even more expensive was welcome news to me.

It's a tumultuous time in the equity markets, and the energy markets, to be sure. Occurring at such relatively modest market returns, with questions about inflation, growth and recession in the air, all of this has a depressing effect on growth equity strategies.

I'm not completely sold on the idea that energy prices are down for the count, and their equity prices, with them. For a while, I do believe the weight of average market participants will continue to keep prices low. But it won't take much to send both commodity prices, and those of their producers, rocketing upwards again, once the broad, "average" investors, meinstitutionaltional managers, realize that supply and demand fundamentals of energy have not changed materially in the last twelve months.