Oil flows are drying up and resources becoming scarce. But don’t dust off your copy of Malthus – invest in human ingenuity, says James McKeigue.
Thomas Malthus is back in fashion. More than 200 years ago the English philosopher, political economist and clergyman predicted that exponential population growth would result in the world being unable to feed itself.
In the two centuries after he published his pessimistic Essay on the Principle of Population, the discovery of oil as an energy source and huge productivity gains in agriculture saw living standards rise even as the population rocketed. Malthus was ridiculed and dismissed for underestimating human ingenuity.
But now, with food and energy prices squeezing living standards in developed countries, and China’s rapid development uppermost in everyone’s minds, his predictions have found credibility with a new audience. The biggest challenge we face is peak oil (the argument that we’re nearing, or past, the point where we’re extracting as much oil as will ever be possible). One expert to develop this theory was Shell geologist M King Hubbert, who in the 1950s correctly forecast that US oil production would peak by 1970. He also said that global production would peak by 2016.
However, it’s not only peak oil we need to worry about, says Jeremy Grantham of US fund group GMO, “but peak everything”. Increasing population, rising wealth and “explosive growth in developing countries have eaten rapidly into our finite resources of hydrocarbons and metals, fertiliser, available land, and water”. Take copper. Compared to 1994, miners now need to dig up an extra 50% of ore to get the same ton of copper. This is being “repeated across most important metals”, warns Grantham. Investors need to realise that “the world is using up its natural resources at an alarming rate and this has caused a permanent shift in their value”.
It’s a compelling argument. Indeed, over the past decade here at MoneyWeek, we’ve warned of the threat of resource scarcity and shown investors how to profit from the commodities supercycle. However, while it is true that we face some serious challenges, we wonder if the increasingly Malthusian tone of these arguments indicates that human ingenuity is being underestimated all over again.
Commodities are cyclical
For one thing, this isn’t the first long commodities bull market to come along. Commodities are traditionally cyclical. Rising prices cause miners to invest in more production. There is normally a lag as these new mines take time to come to fruition. Then a glut of new production hits the market and prices drop.
Bulls argue that demand from emerging markets means that ‘this time it’s different’. But while it’s true that the rapid growth of China and India will cause unprecedented commodity demand, much of that may already be in the price. For example, the copper price is up 450% in the last ten years. While the influence of speculation remains hard to gauge, independent copper analyst Simon Hunt claims that 10% of total 2010 copper consumption was bought and stored in warehouses for purely financial reasons. If sentiment changed and the market reverted to supply and demand fundamentals, copper could fall hard.
Commodities are also driven by economic policies in America and China. Barry Bannister, from US brokerage Stifel Nicolaus, points out that the decade-long bull market in commodities coincided with a huge increase in both US money supply and Chinese construction activity. If either of those takes a hit, and there are signs that both could, commodities would be due a big correction.
The hunt for alternatives
Even if we don’t get any relief from high prices in the near future, the longer prices stay at these levels, the more likely we are to find alternatives to traditional commodities. Take energy. Humans have a history of switching to alternative forms of energy when needs dictate. As financial writer Edward Chancellor has pointed out, we’ve been here before. In the years leading up to 1851, whale oil was used for lighting around the world. As demand outstripped supply, and hunters had to go ever further out to sea to snare their quarry, whale-oil prices rose to the equivalent of more than $1,200 per barrel in today’s money.
Yet as Chancellor puts it, high prices fuel the “search for substitutes. It’s hardly a coincidence that the US crude oil industry got going within a decade of the whale oil production peak.”
The transition wasn’t painless. But today’s high oil prices are again encouraging us to seek alternatives. While energy blogger Gregor Macdonald is right to say that no one substance can replace oil completely, there are a number of options that can start to take the strain of oil demand as it gets more expensive. Technological advances in the field of solar power are particularly exciting. These still need to be treated with a healthy dose of realism, but innovation in panel manufacturing means that in parts of Turkey, Italy and California, solar energy is now competing on cost with fossil fuels, while American industrial giant General Electric reckons that, within five years, solar will be cheaper in some areas than fossil fuels.
Renewable energy sources are still growing from a very low base, of course. A far more significant alternative to oil, in the short to medium term at least, is natural gas. In the past 20 years, discoveries of unconventional gas and improved extraction methods have doubled the world’s total supply of natural gas. While lacking the explosive punch of oil, gas is versatile and can supply power stations, heat homes and fuel vehicles. Indeed, a report from the International Energy Agency (IEA) this week, entitled ‘Are we entering a golden age for gas?’, concluded that demand for gas will outstrip coal by 2030 and get close to oil by 2035.
Better still, even when you factor in the lower energy density of gas, it remains a lot cheaper than oil. This discount is encouraging carmakers to develop natural-gas vehicles. Their number has risen ten-fold in the last decade, while liquid petroleum cars – another gas-based technology – are also on the increase.
Efficiency gains could be huge
High energy prices also encourage increased efficiency. In the US, fuel-efficient cars have shot up in popularity as drivers struggle to cope with $4 a gallon petrol prices. Indeed, on a macro level there is “huge scope for [energy] commodities to be used more efficiently”, says Capital Economics’ Julian Jessop. “For example, China’s economy could increase in size by another 150% in the next 15 years, but its energy demand would remain the same as it is now if it used energy as efficiently as [South] Korea does today.” This fact hasn’t escaped the Chinese. Energy inefficiency is on the government’s hit-list. Between 2005 and 2010, energy consumption per unit of GDP was cut by 20% from 2005 levels. The recent five-year plan has targeted a further 16% cut from current levels.
One area for improvement is our building methods. Much of our infrastructure was built when energy was cheap, and so is hugely wasteful. Altogether, commercial, residential and industrial buildings account for 40% of the world’s greenhouse gas emissions. Cutting back wouldn’t require any fancy technology. For example, British Gas found that fitting new boilers and insulation to the average house cut gas usage by 44%. Slightly more high-tech is the notion of a smart grid, which communicates with meters in customers’ homes to help cut down waste. The technology necessary to do this already exists. British Gas is already rolling out smart meters. It just takes rises in the price of traditional commodities and time to find solutions for changes to be implemented. Transforming agriculture
Farming is also grossly inefficient. According to the UN Food and Agriculture Organisation, around 50% of the food produced globally is wasted. In developing countries this is often because of poor storage and transport infrastructure, whereas in the West lots of produce is rejected by supermarkets for not being the ‘right’ size or shape. Increased prices for food and soft commodities will force us to deal with such inefficiencies.
On an international level, policies, regulations and tariffs also distort international food trade and damage our ability to feed ourselves. Some countries produce different types of food more efficiently than others and increasing trade could boost international food production. A potential disaster on a Malthusian scale would surely encourage policymakers to act.
Farming productivity could also be improved. The post-World War II ‘green revolution’ used machinery and fertiliser to treble crop yields. Crop yield growth has slowed sharply in recent years. But much of the developing world’s farmland is still held in the form of smallholdings. Modernising and consolidating these farms could improve yields greatly. Meanwhile, modern farms can benefit from the next wave of agriculturaltechnology. For example, precision farming uses high-tech guidance and planning systems to increase yields and efficiency. More accurate than traditional equipment, precision farming improves yields by using more detailed pesticide, fertilisation and planting schedules.
Another example of human ingenuity is genetically modified (GM) seeds. It may be controversial, but some variations have been proven to boost yields and protect crops against drought and disease. Europe has so far largely resisted GM, but China, whose government realises that high food prices lead to civil unrest, has adopted it enthusiastically, approving insect-resistant rice and modified corn. The most recent project was a herd of GM cows that produced human breast milk. That might sound strange, but as project director Professor Li Ning said: “There are 1.5 billion people in the world who don’t get enough to eat. It’s our duty to develop science and technology, not to hold it back. We need to feed people first, before we consider ideals and convictions.”
For industrial metals the situation varies depending on the metal. The urbanisation of hundreds of millions of people across Asia has spurred huge demand for metals, but there are signs that high prices are encouraging improved efficiency and substitution. Builders are switching from copper to plastic pipes, says Jessop, while fibre optics provide competition for communication. New high temperature superconducters may even replace the red metal in electricity lines.
High prices also tend to promote thrift, such as improved recycling systems that can salvage metals from industrial waste, and innovative new forms of production: several miners are starting offshore operations. Aim-listed Nautilus is planning the world’s first open-cast offshore mine off the coast of Papua New Guinea. CEO Stephen Rogers says the quantities of gold and copper at the site mean the $400m project will have better margins than a traditional onshore mine.
In short, coping with resource scarcity won’t be easy, but we are already adapting in response to high prices. That’s why we prefer to bet on companies offering solutions to resource shortages rather than the commodities themselves. Below, we look as some of the best plays on human ingenuity.
The best alternative-power plays
We’ve been talking about the ‘natural gas revolution’ for a while. In November last year, my colleague David Stevenson tipped liquid natural gas (LNG) shipping play Golar LNG (Nasdaq: GLNG). The stock has benefited from increased shipments to Japan after the tsunami and is now up 120%. Golar is now on a p/e of 27.5, so a better option for new investors would be unconventional gas producer Chesapeake Energy (NYSE: CHK). It is up 31% since we tipped it, but still looks good value on a p/e of 10.1. The US currently has a glut of natural gas, but that will change when LNG export facilities come online in 2013. The firm is also building a strong position in shale oil and has a specialist oil services unit that should benefit as more firms try to gain exposure to unconventional resources. JP Morgan analyst Joseph Allman calculates a net asset value of $36.29 per share, which leaves plenty of upside from its current price of $28.81.
Our favourite way to play solar energy is US tech firm Satcon (Nasdaq: SATC). It makes the components that help connect solar power to the grid. Its inverters convert the variable output of a solar plant into stable electricity for a utility. Since we tipped it in March, the share has fallen 24% as investors reacted to rumours of further cuts to European solar feed-in-tariffs and a lower-than-expected sales forecast. Yet it has continued to gain market share in America and Asia and is now the market leader in the North American inverter market. The price may be buffetted by news flow, but its long-term prospects are good. With a forward p/e of 9.7, it’s a cheap way to play alternative energy.
Several quality firms are developing high-tech ways to boost agricultural productivity, but they’re pricey. Syngenta (Zurich: SYNN) makes crop protection products and breeds seeds. Over the last ten years its market cap has increased five-fold. On a forward p/e of 15 it’s not cheap, but is well placed to benefit from the global drive to boost agricultural production. As for efficiency, engineer Siemens (Xetra: SIE) is king. A global leader in automation and communication systems for industrial and energy businesses, it helps clients use fewer commodities. It has a strong position in the smart-grid technology that utilities are using to cut waste. It also helps connect renewable projects to the grid. The stock is good value on a forward p/e of 11.
If you want to avoid the risk of buying individual stocks, the BlackRock New Energy investment trust (LSE: BRNE) is worth a look. It focuses on alternative energy, efficiency and clean technology. It currently trades on a 14.5% discount to net asset value, compared to a historic discount of 6%. More than 75% of the fund is exposed to energy efficiency and renewables. Manager Robin Batchelor believes the fund is “poised to benefit” from the post-Fukushima nuclear backlash.
Another trust worth a look is Impax Asset Management’s Environmental Markets (LSE: IEM). Many of the companies offering really exciting new technology to beat commodity shortages are start-up firms that have yet to prove themselves. Most of these smaller firms are not listed, or if they are, they’re very risky. The Impax trust invests in listed and private firms that provide energy, water or waste management technologies. It’s down 3% since we tipped it in January, but we still think it’s a good way to play these markets. It currently trades at a discount to net asset value of 11.3%, compared to an historical average of 5.4%.
• This article was originally published in MoneyWeek magazine issue number 541 on 10 June 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.