In 1978, seeing that a career as a university professor was not going to pan out for me (in hindsight, what a stroke of luck!!), my job search landed me as a trainee at Value Line. That was the best of times for the publication, which had become a safe harbor for seasoned securities during the severe 1973-74 recession and the simultaneous end to the fixed commission regime the traditional brokerage industry relied on for its profits. As the recession waned, however, and as brokerage firms adjusted, the immense amount of intellectual property the firm had collected began to set sail for more lucrative shores.

I got a job as a trainee analyst on the strength of my ability to write a coherent English sentence and to add and subtract. Six months later, the brain drain had become so severe that I was suddenly the head oil analyst–a sector that was on fire, and that then comprised about 20% of the capitalization of the S&P 500. The friend who was mentoring me said that this meant I’d have a job forever.

Today that number is under 3%. Oil has joined gold, coal, base metals and utilities on the stock market scrap heap.

how I approach Energy

Over the past three years, the S&P 500 has made an average annual gain of +20%

Over the same period, the Energy sector as made an average annual loss of -3.8%.

What this says to me is that Energy is not a buy-and-hold sector. Add to that the facts that the sector is tiny, that natural resources accounting is unusual and that off-balance sheet data are crucial to understanding the companies, one could argue that our time would be better off spent on, say, technology or consumer discretionary stocks, where there may be greater bang for our research efforts. This has been my general approach.

An alternative strategy, probably taken more by working professionals than now-part-timers like me, is to neutralize the sector by holding a market weighting–and possibly also replicating, stock by stock, the S&P index weightings. Yes, you tie up 3% of your portfolio, but the sector won’t hurt you and you don’t have to acquire and maintain the specialized knowledge needed to be successful here. So you probably have 10% more time to work on outperformance elsewhere.

…however…

Year-to-date through yesterday, the S&P is up by +22.4%. Energy is up by +53.5%. That’s after having been down by -37.3% in 2020, a year in which the S&P gained 16.3%.

In other words, Energy has recently been a boom or bust affair. To me, this reinforces value of the ignore/neutralize strategy. On the other hand, the sector’s rollercoaster character does give it some speculative appeal.

Three things to note:

–around 1900 coal began to replace firewood; around 1950 oil began to replace coal; and 2000-ish renewables began to replace oil. In other words, oil and gas are no longer an expanding industry.

–the oil price is determined to a great degree by OPEC, a group whose members are often at loggerheads with one another–and which doesn’t include major producers like Russia and the US. So the politics of oil need to be monitored.

–medium-sized “wildcatter” exploration companies are often very highly financially leveraged. Security for these borrowings is most often the present value of economically recoverable but yet to be pumped out of the ground oil/gas the company owns. This PV is not a static number. It can fluctuate considerably as hydrocarbon prices rise and fall. Bank loans may have covenants that require accelerated repayment if the PV falls below, say, 3x the outstanding borrowings. You may have to dig through the financial footnotes, bond indentures and/or the 10-K to find this out.

Personally, I don’t think inflation is an important stock market issue, other than that it may become a textbook case of the madness of crowds.

For one thing, even if current supply chain disruptions lead to a one-time increase in the price level (I think this may well happen. That’s a story for another day, though), that isn’t inflation. Inflation is a sustained (years-long) upward movement in the price level. Often it’s engineered by a heavily-indebted government to diminish the real value of its obligations to creditors. I can’t see any reason to believe the US is in that situation now.

“Stagflation,” the tale of the US in the 1970s, is a combination of economic stagnation and rampant inflation. My unscientific view of the “stag” part is that it resulted from Europe and Japan returning to world commerce in the 1960s after rebuilding industrial capabilities that were obliterated by bombing during WWII (plenty of help from the US in both destroying and rebuilding). When I entered the stock market in the late 1970s, the US was slipping from being the only industrial game in town to being the guy with outmoded plant and equipment. Japan and Europe had brand new steelmaking plants, for example, while US Steel was still operating blast furnaces built in the 19th century.

the 1970s inflation

On the inflation front, which is what I really want to write about today, there were two key factors in the 1970s that are hard to appreciate for anyone who didn’t live through that time.

oil

The first is the price of oil, which was a much more important economic issue in the 1970s than it is today. The average oil price in the US in 1970 was about $3.50 a barrel. By 1980, that had risen to $37.50, a 10.7x increase.

Two reasons:

–the rise of OPEC, a cartel of oil-producing countries in the developing world formed in 1960. The 1970s saw two major oil price “shocks,” when OPEC demanded–and got–big price increases for its crude.

The US was unique in its bungled response to this development. Congress enacted a bizarrely complex system of price controls and output allocation aimed at keeping domestic consumers from feeling the full effect of the higher OPEC price. As these things typically go, the new rules had the opposite effect. Domestic oil producers shut down older wells, rather than sell at a steep discount to world prices. Detroit kept on cranking out gas-guzzlers, not helping conservation efforts at all–and ultimately leaving it vulnerable to more fuel-efficient imports.

Anyway, the equivalent move in today’s world would be crude at $500 a barrel. I’m guessing that won’t happen.

employment contracts tied to the CPI

–Large portions of the domestic workforce of the 1970s had employment contracts. In today’s world, that’s strange enough. But these contracts called for yearly cost of living increases. Most often these raises were tied to the CPI. Sometimes, raises were CPI plus some amount, say, 1%. Never a minus, however. More important, though, is that the CPI tended to overstate inflation in a way not clearly understood at that time (it used a fixed basket of goods in its calculation and didn’t account for substitution–the possibility that people would buy a Toyota rather than a more expensive Chrysler and be just as well off). So even if there were no explicit real wage increases specified in these contracts, they all ended up raising wages in real terms.

Economists know better now–and I think the CPI is less inflation-inducing than way back then. The demise of unions has meant fewer worker contracts.

–A third key aspect of 1970s inflation was, of course, many years of unnecessarily loose monetary policy, to the point that Washington was forced to issue Treasury bonds denominated in D-Marks and Swiss francs rather than dollars during the Carter administration. We’re nowhere near that point today.

Last week I wrote about Diversified Energy, a US-based, UK-listed natural gas company. What caught my eye was that the company’s stock plummeted on a Bloomberg article that explained what the company does for a living–and even though my reading of its financials is that it has had no problem getting external financing to support it for years. My (then) question: how could anyone not have known?

Last night INTC and SNAP reported. INTC said that it’s latest attempt to shore up its sagging fortunes would take some time and cost a lot. SNAP said that Apple’s decision to allow iPhone users to block online tracking–Verizon announced in May that 96% of its US iPhone customers are using this feature–has hurt its business.

Both stocks were down sharply in aftermarket trading after these announcements. Again, the question–what holder could possibly not have known beforehand?

I still don’t know …and I may never know. But I’ve realized that’s the wrong thing to be noticing. What’s more important, I think, and a signal of a sea change in stock market behavior, is that investors are starting to have sharp negative reactions to bad company news. Yes, the moves are reactive and not the anticipatory moves common in past market behavior. To my mind, though, the key factor is that for the first time in 18 months, individual company results are carrying more weight than general concepts.

The past two years or so have been a time of hyper-activity in the stock market. This situation is highly unusual, in my experience, but it’s something we’ve gradually become accustomed to. So the current market lull, a time when all the economic variables that will affect prices in the near future are already in plain sight, but are slow-moving enough that there’s no real consensus about how events will play out, strikes us as odd–maybe even eerie. Despite this feeling, having stocks “taking a rest,” as several of my long-ago Asian brokers used to say, is very normal.

The huge benefit of a time like this is that we have ample room to imagine how the future will play out (including what we’ll look for to test the correctness of our conclusions, and the strategy we’ll derive from them) and arrange our portfolios accordingly. This kind of “dreaming” is the best use of our financial time right now, I think.

At the most basic level, I think the dominant business cycle issue is the interplay between the desire to reduce, as fast as possible, the extraordinary government monetary and fiscal stimulus being used to counter covid vs. the desire to maintain enough stimulus to support a real rate of economic growth in the 2% – 3% annual range.

Put another way, this is the tension between wanting to raise interest rates to choke off possible inflation vs. wanting to keep them low to foster growth.

It’s already clear that the first step toward stimulus shrinkage will be taken within a few weeks. The real question is how fast/the effect on economic activity.

Taking a longer-term view, a recent academic paper points to another “cosmic” issue.

My interpretation of it: as people get older and wealthier, they become more risk-averse. They spend less; they save more; they take fewer risks. Younger people and the less affluent, in contrast, spend a larger proportion of their income and are less risk-averse. Therefore, if a country wants to maximize GDP growth, its best strategy is to raise taxes on the wealthy and lower them for the less affluent. The US strategy of the past 40 years, epitomized by the “trickle down” theory, has been to do the opposite, which is the worst thing for everyone. What I find interesting is that the analysis takes an economic commonplace and turns it into a critique of Republican tax policy.

Ever the masochist, I was listening to Bloomberg radio while driving yesterday. Nevertheless, I heard a very interesting account by two reporters of their investigation of methane emissions from older gas wells in the US.

As far as I can tell, neither knew much about the oil and gas business. But that didn’t matter much for their story. They found the owner of the largest number of mature wells in the country, Diversified, and went around with a $100,000 infrared camera and other equipment to measure and record emissions from some of them. Perhaps unsurprisingly, they found a lot of methane leakage.

They also pointed out that when wells like this finally give up the ghost, the owner is legally obliged to “cap,” i.e., plug up and seal, them …and went on to question whether Diversified, which has financial statements that I find entertainingly complex, will have the wherewithal to do so when the time comes.

The stock fell by 20% on the publication of their article.

My first thought was “So much for efficient markets,” since shareholders appear not to have had the faintest idea what Diversified does for a living.

The article also points out that the kind of wells Diversified operates might have been originally drilled by one of the oil majors, but they’ve likely changed hands a bunch of times since before ending up in the Diversified portfolio. That doesn’t sound particularly good–and may not actually be. I’m not sure the authors appreciate, though, either that special US tax breaks for oil and gas incentivize this activity or that big company wildcatters have tended to look down on on the humdrum engineering work that shepherding to mature wells requires. So for an optimist Diversified might be seen as, say, a TJX of the oil patch.

When I got home, I looked the company up on Yahoo Finance. Turns out that despite being run by Americans and operating solely in the US, Diversified is a UK-listed company. It came public in 2017 on the AIM board in London (the US equivalent would be somewhere between an OTC and a JOBS Act listing–meaning less financial disclosure) but has since made it into the FTSE 250 index.

It seems to me that Diversified’s decision not to list in its home market is the question potential investors in the US have to have a good answer for before considering the stock, given London’s “regulation lite” history that helped create the US financial crisis of a decade and a half ago. This decision may also bear on the issue of emissions that the Bloomberg reporters are interested in.