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February 27, 2006

Wild on Energy
by Chuck DiFalco

Energy is the lifeblood of any country's economy. With the recent surges in oil, natural gas (methane), and gasoline prices, US consumers have seen their first energy shock in 25 years. Are you experienced? Most likely not, since you're either too young to know about the gas lines, or too anxious to forget those ugly times. How will this time around play out? I conjecture that both the macro and microeconomic energy outlook will cycle with increasing volatility as the time horizon expands, until decades from now when the global economy is not hydrocarbon based. That means we're in for a roller coaster ride on prices, folks. Hubbert's Peak of global oil production will have greater (mostly adverse) impact over the medium and long terms. The good news is that the short term, namely 2006-07, could likely hold good news for consumers, the economy, and investors. The bad news is that not everyone will be invited to the party, and the "Wild Man" could even crash it.

Hubbert's Peak is real. Conventional oil fields are finite. Production is already declining geometrically in many parts of the world. Whether or not global conventional oil production peaks in 2006 or 2026, and regardless of how much non-conventional oil in tar sands/oil shale/extremely deep oceans delays the total oil production peak, the cheap oil has already been found and drilled. Our gas tanks aren't going to run dry; we're just going to pay more and more to do it. These truths are driving the secular (10-25 year) bull market in energy stocks that began in 1999. However, this article's two year time horizon is too short for Hubbert's peak to be the dominant factor, especially if my cyclical bear market theme plays out.

The biggest short term impact to the energy outlook, other than the geopolitical wild card I address below, is the health of the US economy. Yes, peak oil is establishing a long term up trend in energy prices. The short term oil price, however, is more highly driven by cyclical ups and downs. I don't see how over-indebted US consumers won't drag in 2006. Climbing interest rates and energy prices, combined with stagnant or declining home prices, could be the formula that creates a recession. Also, a new US personal bankruptcy law will make it harder for the over-indulgent to revive their spendthrift ways. An economic downturn translates to lower energy consumption at the margin -- i.e. curtailed vacations, reduced driving, dimmed lights, and monitored thermostats. A slowing US economy means less factory production overseas. As goes the US economy, so goes the world economy. For now, at least. Finally, countries that enjoy $60 per barrel exported oil won't easily reduce production, even if the price dips significantly. In summary, I'm predicting a drop in oil/gas commodity, as well as equity, prices later this year or next, coincident with a US recession.

Those US energy consumers not sitting on any bubbles would enjoy the decline in petroleum prices that a mild economic downturn would bring. A measurable decline in US macroeconomic health should bring down energy equity prices along with commodity and broad stock market prices, as all are now more strongly correlated. The price-fixing and excess capacity days of OPEC are over. Energy investors should also relish a decline in energy stocks over the same period. Why? To buy, of course! Stock prices don't go straight up, even though the secular trend is up. Pullbacks are a time to add to positions. Even if an investor misses the exact cyclical low with his/her new money, or money raised from selling something else, the secular bull will soon make the purchase profitable.

The preceding is not investment advice. I'm not a registered investment advisor. These are ideas for MY portfolio. I plan to buy energy stocks on the dips, especially if Mr. Market gives me a cyclical bear market in the short term. Although I'm now less than 10% allocated to energy (gold investment distractions are another article), I'm willing to hold anywhere from 10% to 40% in that one sector. Why not higher? Those who put 100% of their money in anything, let alone energy, are gambling, not investing. Now I just do mutual funds, not individual stocks, since I understand themes better than stories. As a side note, while intriguing alternative energy funds exist, I'm only willing to put a minority of my energy allocation in funds with many small and unproven companies. An interested reader can use an internet search to find the selection of open end and closed end "exchange traded" energy funds. As well, you can listen to the 10% max-per-sector rule of all those generic (and now miffed if they're reading this far) financial planners out there. Folks, the major stock averages are in a secular bear market! That means the global economic engine will sputter for years to come! That means dead money in index funds until 2010, 2015, or even 2020! The 2000-2002 cyclical bear market did not cure the hangover from the 1990's party. Energy, however, is in a secular bull market. Either get a clue about sector investing, or accept near zero inflation-adjusted returns. You can ignore my ideas at your own risk.

When I was a youth, my friends and I often played basketball. One day, we encountered a problem at the court in the local public park. All the rims were either down or missing. The horror! It was evening, and the baseball fields had no lights. The tennis courts had lights, but it's hard to play the game with five guys and no equipment. So we improvised. Two players teamed on each side of the net. We used tennis rules for scoring, even though we had a basketball and no rackets. The odd man out was the "Wild Man." He was free to roam the entire court and hop the net to disrupt the flow of play as much as he desired. Tremendous fun.

A potential leak exists in my otherwise tidy short term energy outlook. Iran is the geopolitical flashpoint that could make oil prices explode. The country does not currently dominate the mainstream news, but it could easily do so as soon as March 2006, when it plans to open an oil market denominated in euros. This new bourse threatens to upset the dollar-denominated global status quo. Meanwhile, Iran's leading politician gushes inflammatory rhetoric about Israel and nuclear programs. Iran seems anxious to become a military target. Whatever happened to the idea of keeping a low profile while trying to stir up some economic angst among powerful interest groups? Let us not forget DiFalco rule #1: "Never underestimate the power of incompetence." But my rule is probably getting lost in translation to Farsi. Iran's "Wild Man" could hasten a spike in oil prices at any time, US recession or not.

The March 20 initiation approaches quickly. The question arises, should I put some money to work an energy fund on any semblance of a dip over the upcoming weeks? Should I buy some insurance in case geopolitics in the Persian Gulf explodes sooner rather than later? The secular energy bull will eventually bail me out even if bombs don't fly this spring. If there is a bigger decline into the autumn of 2006, I can add more because of a "buy in chunks" strategy. So, for example, I could target a 25% additional allocation to energy by the end of next year. Then I could pick a spot over the next few weeks to increase my total portfolio allocation to energy by 5%. Payroll deductions into an energy fund in a 401k/403b plan are often too slow for my liking. It's time to look for an entry point.

If conflict with Iran is avoided over the next two years, both US energy consumers and investors can benefit handsomely. That is, if they properly prepare for the possibility of a recession. Lower oil, gasoline, prices will put money in many consumers' wallets and business' accounts. Lower energy equity prices will enable thankful contrarian investors to add to positions relatively cheaply. Fellow investors can ignore me, politicians do ignore me, but perhaps I can listen to my own suggestions.

Chuck DiFalco

Living in League City, Texas, Chuck DiFalco is a software engineer by day, and an unconventional thinker and writer by night. He can be reached at cdifalco@houston.rr.com.

Copyright © 2004-2007 by Charles Joseph DiFalco. All rights reserved.

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