The Looming Oil Shocks

Back to Contents of Issue: October 2004

JAPAN remains the favored stock market among foreign investors. Foreign bulls point to a restructured corporate sector in a deflationary environment that is now producing record levels of free cash flow. If deflation ends and top line growth resumes, the operating leverage for earnings will be dramatic.
by Darrel Whitten
THEY HAVE NEVER SEEN such a broad-based earnings recovery across the breadth of the whole market. Japanese corporate profits are now at record levels in nominal terms, even as the Topix remains 61 percent below its peak reached in December 1989. Because of spectacular derating during the Heisei Malaise, the Japanese stock market is now trading at a multiple of some 17x, which is the lowest since 1975, and lower than the US market, a factoid that would be unthinkable in the mid-80s. Yet despite all this apparently good news, the Japanese market appears to be at a crossroads. The US markets are looking at a heavy correction, now that chairman Alan Greenspan and the US Federal Reserve are moving to tighten monetary policy. A slowing US economy presents risks for the Japanese economy, which is still largely dependent on external demand for growth. The OECD leading economic indicators, the Tankan diffusion index of large manufacturers and the Cabinet Office's coincidental indicator of business conditions, as well as 10-year JGBs, are giving strong hints that the Japanese economy may be heading for a cyclical peak. The recent weakness in the Topix and Nikkei 225 is a reflection of this concern, as positive quarterly earnings results have gone largely unnoticed and unremarked upon. If this is indeed a cyclical peak in the economy, the Nikkei 225 could slip below the 10,000 level again. But Japan does not look as risky on the downside as the US, precisely because it has already suffered such a prolonged deflationary cycle. What investors seem to be underestimating, however, are the implications of the recent surge in oil prices, despite waning prices of other commodities. Brent crude oil prices have spiked to over $41/barrel, from $24/barrel in the second quarter of 2003. Actually, oil prices have surged three-fold since 1998. The ostensible reasons are many, including geopolitical concerns, a government crack-down on Russian oil companies and other short-term supply interruptions. Future shock?............................................................................. However, those who closely follow the global supply-demand balance for oil prices have been warning of the possibility of another oil "shock" for some time. Some suggest this may be as little as five years away. Oil discovery in the US peaked in the 30s. Peak production came 40 years later. Globally, the peak in oil discovery was in 1964, so it should be no surprise that the corresponding peak in global production is getting close. Doctor Colin Campbell of the London-based Oil Depletion Analysis Center says the global peak could be in 2010. The steady increase in world demand naturally influences the rate of depletion. In fact, oil prices would have moved higher and faster were it not for the global recession after the bursting of the IT bubble. As the global economies continue to recover, oil demand will rise in parallel until it again hits the falling ceiling of capacity -- causing prices to soar. The major turning point comes from the "swing production" countries (Abu Dhubai, Iran, Iraq, Kuwait and Saudi Arabia). The Middle East's share of world oil supply was 38 percent in 1973, when the first oil shock hit, fell to 18 percent by 1985, and is now again on the rise, surpassing 30 percent. The Middle East's share could reach 50 percent by 2009. By then, the Middle East will also be close to its depletion midpoint, and will be unable to sustain production much longer -- regardless of political will or the availability of investment funds. According to Campbell's base case scenario, a near absence of spare capacity in late 2000 was forcing up the price of oil. Oil prices would have moved higher and faster then were it not for the global economy falling into recession. The oil shocks of the 70s were traumatic. The nearly 10-fold surge in oil prices between 1970 and 1980 was the root cause of global inflation -- and the cause of a global recession, with waning demand and output. With regard to the conventional economic theory, this was an anomaly, a curious combination of inflation and weak economies called "stagflation." The immediate effect on stock prices was also deleterious. The US market fell 48 percent in 1973, the year of the first oil shock. Japan's Topix took a little longer to adjust, falling some 36 percent from January 1973 to October 1974. In 1973 and 1974, Japanese wholesale prices surged 15.8 percent and 31.4 percent respectively. Overnight call rates fluctuated wildly from 8.25 percent in 1974, but JGB yields trended fairly steady, between 7.2 percent and 9.1 percent, largely because the JGB market was not liberalized to trading yet. Conversely, Japan's economy stagnated, decelerating from 9.1 percent real GDP growth in 1972 to -0.5 percent in 1974. Resistance.................................................................................. With the onset of the oil shocks, foreign investors believed that Japan would not be able to recover from the shock of substantially higher oil prices because of its high dependency on imported oil. Consequently, foreign investors turned net sellers each year from 1974 to 1977. Yet despite the trauma, Japan ended the 70s on a strong note. Between 1974 and 1980, the Topix appreciated 54 percent. Sectors in the Topix were not only able to provide positive returns, but these returns were in excess of inflation (consumer prices had soared 77 percent during the period). Moreover, the yen was 50 percent higher against the US dollar at the end of the 70s. We believe there is more than an even risk of another, more permanent oil shock on the foreseeable horizon, while few financial market participants are seriously considering the implications of such a possibility. Consequently, now would seem to be a good time to make one's investments oil-shock resistant. This would include the following strategies: a) Reduce exposure to bonds, particularly longer-term bonds (excluding inflation-protected securities such as treasury inflation-protected securities, or TIPS). b) Reduce exposure to companies negatively affected by sharply higher oil prices, examples being electric power, airlines, transportation companies, et cetera. c) Increase exposure to energy stocks and inflation beneficiaries. d) Increase exposure to gold and precious metals. e) Increasing exposure to alternative energy stocks, such as solar panel producers, hybrid car and component producers, fuel cell producers and wind power producers. Going green................................................................................ As for alternative energy companies, the related markets for these products are still small and their cost is noticeably higher than fossil fuel alternatives. However, demand for environmentally friendly products such as hybrid cars, solar batteries and wind power is expanding steadily with the "green" movement and technological progress. In an increasing number of cases, these green products are subject to government grants, tax breaks or other incentives. But consider the scenario where oil goes to $80/barrel and stays there indefinitely. The cost-return dynamics of these products changes dramatically. It is estimated that the US could actually wean itself from imported oil (which now accounts for over 50 percent of US consumption) completely by raising the gas mileage of every car and truck on the road by 2.7 miles per gallon. Oil at $80/barrel would provide a big incentive to the US to actually achieve this efficiency target. Japan is at the leading edge of alternative energy products. In Aichi prefecture, auto parts maker Aisin Seiki operates a next-generation solar battery called a dye sensitizing battery, whose solar cells can produce power even with low-angle morning and evening sunshine. It generates 10 percent more power on sunny days and 20 percent more power on cloudy days. The market for conventional solar batteries has grown to some JPY120 billion, with Sanyo Electric and Sharp being the major players. Lightweight, thin and economical solar panels for household heating will likely reach the market as early as 2005 under current market dynamics. Deliveries of wind power generators to domestic wind power firms totaled 2.73 billion kW worth of power in 2003, up 96 percent from 2002. The Renewable Portfolio Standard law that came into force in April 2003 requires electric power companies to use new energy sources, including wind power and solar. Japan Wind Development imports and sells wind turbines made by General Electric of the US and also installs them at its own plants. Japan aims to produce 1.35 percent of aggregate power generation through eco-friendly energy sources by 2010. Japanese hybrid cars (running off both batteries and a conventional engine) dominated the top five spots in the 2003-model fuel-efficiency rankings released by the US Environmental Protection agency, with the Insight coupe made by Honda maintaining the number one position. In terms of sales volumes and cumulative technological know-how, however, Toyota is leading the pack -- battery pack, that is. Sales growth in the US is expected to be particularly high, aided by more attractive new models and government subsidies. The major component of hybrid cars are secondary batteries and electric motors. These two components account for over half the additional cost of a hybrid car. Companies that are involved in producing key hybrid components are: Denso, Toyota Industries, Tayca Corp. and Japan Vilene. Developing fuel cells that can be used for powering next-generation automobiles and homes is one area where Japan is competing fiercely with Europe and the US. Foreseeing market potential in hydrogen cells, steel makers, city-gas utilities and petroleum companies are all eager to get into the field. Iwatani International, specializing in gases for industrial and home use, already operates a hydrogen station in the metropolitan Tokyo area. It plans to construct Japan's largest liquefied hydrogen plant in Osaka in 2006. Honda claims they are close to being able to produce a fuel cell-powered car at only 10 percent the current cost. @ Darrel Whitten is owner of Whit Consulting, LLC, and is editor and publisher of JapanInvestor.com. A veteran investment analyst, he has been following Japan's financial markets for over 20 years. Please mail comments to: dwhit@whitconsulting.com.

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