Saudi Arabia claimed last weekend that the global crude oil markets were oversupplied even with Libyan production essentially shut down – an incredible claim. The Saudi’s said they were cutting back on production – even in the face of high and sharply rising oil prices! Estimates by both OPEC and the IEA are for crude oil demand to increase by 1.4 million barrels per day in 2011.
And last week China announced oil consumption hit a monthly record in March with demand increasing 11 percent from year earlier levels to 9.16 million barrels per day. Inventory levels were essentially flat from year earlier levels. In the first quarter of this year oil consumption in China rose 10.2 percent with gasoline consumption increasing 5.6 percent and diesel ring 10.6 percent. More oil was used for industrial production, infrastructure construction, and in the agriculture sector. This was the sixth consecutive month oil demand in China grew by double digits.
Growth in global oil demand in 2011 will be above average according to IEA estimates and follows one of the highest rates of demand growth in decades in 2010. With the natural depletion of major existing fields, the slowdown of capital expenditures in the sector due to the financial crisis, the temporary drilling ban in the Gulf of Mexico after the BP disaster, and continuing unrest in a number of Middle East and African oil producing countries it is highly unlikely that productive capacity will rise as much as demand any time soon. Violence was reported in the press last weekend in Libya with continued fighting, with violent protests in Syria, Yemen, and Bahrain – and ongoing governance issues reported in Iraq with recent bombings. And Nigeria, another exporter of ‘light sweet’ crude is experiencing violent protests after this weekend’s elections.
The global excess productive capacity available to increase oil production (and exports) in our opinion will fall in 2011. While exact capacity data is unknown in many areas due to confidentiality laws, we think excess capacity will soon fall to levels that have precipitated price spikes in the past, provided demand is not restrained by a global economic recession.
We think, based on current trends, we are entering an era we have never seen in the 150 year history of the oil industry – one in which supply and supply growth will not be able to meet the growth in global demand. Based on historical market behavior, the elements we are likely to see when excess capacity falls to extremely low levels are as follows:
- wildly volatile crude oil prices - mostly to the upside,
- resource nationalization – domestic energy resources are too valuable to export,
- irrational hoarding behavior by consumers,
- a spillover of price volatility into the markets for other energy sources (coal especially),
- a wild frenzy to acquire domestic oil and gas resources,
- a ‘melt-up’ of the shares of energy and energy services companies,
- a focus on energy conservation,
- new opportunities in the solar and wind energy sectors,
- more focus on biofuels (emphasized by the 2007 Energy Act) - which will drive grain prices to record levels, and
- as a result of the extreme increases in food and fuel prices we expect to see food shortages, instability, riots, and the like in less developed and less stable countries.
Global oil demand and forecasts –Saudi Arabia announces it will cut oil output
The Energy Bulletin published a chart of Libyan oil production in an article last week, not much has changed from data released several weeks ago. As we have noted production activity has pretty much come to a standstill in light of the ongoing civil war – and Libyan crude oil is the ‘light sweet’ variety that is easy to refine and market:
Crude oil prices meanwhile continue to move upward on demand and supply trends, here Brent crude courtesy the Financial Times:
Which brings us to the astonishing revelation that Sunday Saudi Arabia’s Oil Minister Ali al-Naimi said ‘the world oil market was oversupplied’ and that the kingdom ‘had reduced production in March due to weak crude demand’.
The Saudi minister noted that their production in February was 9.125 million barrels per day (bpd) but was cut back in March to 8.292 million bpd. He noted that in April they might increase supplies to a level slightly higher than March’s production. Part of the problem might be that the excess capacity available for sale in Saudi Arabia is ‘heavy sour’ versus ‘light sweet’ crude – and refineries are not able to process the crude into a marketable product without extensive refinery renovations. While Saudi’s may be concerned about oil oversupply, crude oil futures indicate that global oil demand remains robust and prices are well above year earlier levels. ‘Weak crude demand’ does not appear to be an issue.
Kelly Formula & Investing
Several decades ago an engineer at Bell Labs developed a formula that dealt with digital compression and bandwidth allocation problems associated with data transmission. Named the “Kelly Formula” after the scientist who developed it, the formula determined the most efficient means to compress data in phone lines.
This basic formula was later adopted by Professor Edward Thorpe who used the mathematical relationship to address the question as to how much to wager to maximize gambling returns while minimizing the risk of going bankrupt. Thorpe used the formula to develop a system to ‘bet’ in blackjack games – with the goal of maximizing returns while keeping the risk of insolvency minimal. Using the probability theory and formula he proceeded to ‘beat the house’ at blackjack – was banned from several casinos. Thorpe later wrote a best-selling book on how to win at blackjack using his system.
Thorpe found the key to using the Kelly formula is to only place bets when an investor or gambler had an ‘edge’. When the investor had no edge, the formula says not to bet or put money at risk. The number of times a bettor has an edge at a casino is very low – and the key to using the system is to find an area where an investor or gambler can find an edge. In gambling Thorpe found that he could develop an edge in blackjack. Other games of chance provided no edge, so he focused his efforts toward that specific game. The biggest issue in using the Kelly formula was finding an area where an investor or gambler had an edge. He found that inefficiencies of the stock markets are such that it is much easier to develop an edge in the equity markets than in the gambling arena.
Appling the formula to the stock market Thorpe summarized the rule as follows: When you have a substantial informational edge and know the risk/reward relationship is tilted heavily in your favor you invest heavily. When you have a slight informational advantage the size of the investment should be much smaller. Investments are made ‘proportionally’ to the risk/reward ratio, and the edge an investor may have. If a party has no informational advantage (a common occurrence) the party does not invest or bet at all. Over a 19 year period Thorpe used the formula to manage a portfolio and outperformed the major market indexes by 6.2% a year.
The downside of using the Kelly formula is that returns can be very volatile. But the volatility can be reduced using several management techniques without giving up too much from a return standpoint. To maximize returns the formula assumes the markets are relatively stable—something not entirely true lately with the 2008 global financial meltdown—but the equity markets have recovered for the most part. Over time the formula maximizes investor returns – and the formula is subject to the ‘power law”, that is returns will be exponential over time. Warren Buffett’s partner and Berkshire Hathaway Co-Chair Charles Munger has noted that the Kelly formula is one reason he and Warren Buffett have been so successful – when they had an informational edge they invested heavily. And when they did not they did not invest.
A chart of the stock price of Berkshire Hathaway (BRKA) over time illustrates the ‘power law’ nature of the Kelly formula:
The Kelly formula led them both Munger and Buffett to managing concentrated portfolios of firms they knew well in sectors they thought they understood. It also led them to invest in very small companies – Nebraska Furniture Mart, Borsheimes Jewelry, See’s Candies, HH Brown Shoe, Geico Insurance, and the like – firms that generally have done very well over time and are now much larger and part of Berkshire Hathaway.
Professor and textbook author Paul Samuelson noted that “in my experience the very few that somehow develop a knack for risk corrected excess total returns do become rich very quickly.” Samuelson tried to use the inefficient warrant market (a warrant is similar to a call option) to develop an edge, and used Kelly formula concepts, apparently with some success but never managed money for a living.
In our opinion, in today’s market many analysts and investors have not focused on the longer term trends in the energy sector other than to note higher gasoline prices in local markets. Most analysts and investors are of the opinion that the recent run-up in commodity and energy prices will be a short term issue, or one that will be easily addressed. We think otherwise, provided China and India’s economies continue to grow (see charts of China auto production in the blog below).
We think small and mid-sized energy producers that are overlooked by analysts and the market – both crude oil and coal producers – should be prime beneficiaries of global trends. The merger and acquisition frenzy in the resource sector should continue – and should put a floor under asset prices. We think we have an informational advantage in this sector, an ‘edge’. When this situation occurs the Kelly formula is telling us to invest proportionally to maximize portfolio returns.
Investment Implications
If we analyze long term global developments in the coal and crude oil sectors and think we have an informational advantage, an ‘edge’, the Kelly formula says to allocate our investments accordingly. We find the crude oil and coal markets are such that higher demand and prices and constrained supply growth should generate substantial opportunities—and excess returns for investors. Smaller coal and oil companies, in the most inefficient part of the market, appear most attractive.
