Time to rebalance energy asset allocations

Energy experts are painting a grim picture about the state of oil reserves in the world and the implications go well beyond how much your clients are paying at the pumps. Unless portfolio holdings don’t need to last more than another seven or eight years, institutional money managers are starting to sound the alarm, saying the time has come to take a good hard look at energy holdings.

Don Coxe, BMO Financial Group, global portfolio strategist and chairman of Harris Investment Management told a small group gathered at an Economic Club of Toronto meeting on Tuesday that clients who have energy portfolios that focus on long term reserves are going to be better off than those positioned for short term income.

He says the most important speech made this year regarding energy prices came from Lee Raymond of Exxon Mobil. Four years ago, the oil giant CEO said the price of oil would not go above $50 a barrel because big oil companies would bring on new production in countries like Russia and Venezuela in order to maintain prices below $25 a barrel. Four months ago, Raymond delivered a second speech saying Exxon Mobil would not commit any new capital to Russia or Venezuela. “Those are the book ends to our current energy situation,” says Coxe.

“That speech defines the fact that big oil, which made over $100 billion last year and has over $110 billion sitting in cash on its balance sheets now, is all dressed up with no place to go, except the oil sands.”

He says the story that investors aren’t quite savvy to yet is the fact that the world’s 12 largest oil companies have a reserve life index — calculated by dividing total reserves by production volumes — of less than 16 years. On top of that, companies can’t get their price earnings ratios up because investors around the world are demanding a return on capital rather than a return of capital.

Further exacerbating the situation, China and India growth rates are adding demand in the form of more than 25 million new consumers every year.

In the future, Coxe says, historians will write about this as a time of personal economic efflorescence or developing and unfolding, measured by luxuries like indoor plumbing, electricity, basic appliances and car ownership. “If you have those things you have more personal comforts and more functions than 95% of people who’ve ever lived.” In China and India, he says “what we’re seeing is the transformation of 2.3 billion people moving up to where we are today.” Even if they all drive Smart Cars, “there is absolutely no way that conventionally produced oil is going to be able to meet the needs of these people.”

Similar warnings were echoed by Larry Jeddeloh, principal and founder of the Institutional Strategist Group, speaking at the GGOF Investment Summit earlier this week. He says world oil production is falling 8% each year and still every economy is demanding more.

Although the U.S. has admitted that production is falling, current energy policies focus on production rather than conservation. This, he says, is a “huge gamble” especially considering the fact that current Middle Eastern infrastructure is not secure. As well, both point out that consumers and the current system requires light sweet crude oil, not the barrels of heavy crude currently being brought to market by Saudi Arabia. In addition, production in the U.S., United Kingdom, Norway, China and Mexico are all declining.

Jeddeloh predicts that global production in fact peaked in 2005 and the price of oil will stop climbing and start to spike within a year. In the future, he says energy supplies will become more locally sourced, and the U.S. will become increasingly concerned about the safety of their energy supplies.

Against this backdrop he says Canada is the only non-OPEC country that is actually increasing production. Coxe says the Alberta oil sands will likely be the focal point of the largest scale of competition for resources ever seen.

“In other words, if you could own only one kind of oil stock, it shouldn’t be a royalty trust which has a reserve life index of seven or eight years, it should be one that owns 60 to 90 years of reserves of oil. You should have more barrels of oil in your portfolio than your neighbour next door because those barrels are going to be worth a lot more in the long run.”

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com

(12/01/05)