William Smead
Chief Executive Officer
Chief Investment Officer
Dear Fellow Investors:
If you are a long-time follower of our writing at Smead Capital Management (SCM), you are aware of our belief that a titanic shift is in process in the world economy. The fastest growing economy of the last ten years, China, is slowing down very quickly and the US is grudgingly growing during its deleveraging process. Since the US is four years ahead of most of the rest of the world in the cleansing/deleveraging process, we believe the US will ultimately lead the world out of the current growth funk.
We believe the long-term demand for oil will be greatly influenced by where the world gets its best future growth. As the chart below shows, the US has cut by 50% the amount of energy which is required to generate each dollar of Real Gross Domestic Product (GDP):
Source: Carpe Diem: 2011: Most Energy-Efficient Economy in History, April 2, 2012
From a personal standpoint, it is easy to see how dramatically US drivers are adapting to the $90 dollar price per barrel of oil and gas prices hovering in the $3.25-4.00 per gallon area. My wife and I bought a mid-sized sedan recently which advertised 23 mpg city and 33 mpg highway. After two months and 4000 miles of driving, I’ve confirmed that the highway mpg is consistently running around 35 mpg. A comfortable, mid-sized car which seats four full-sized adults and blends at 28 mpg means that we are going to use much less gas than we used to.
China, on the other hand, has been using a disproportionate part of the world’s commodities to produce about 10% of the world’s GDP. Professor Michael Pettis, from Peking University, computed that China used 40% of many of the world’s main commodity inputs in the year 2010. China’s use of oil rose 92% from 2000 to 2010 and coincided with a price increase of 242%. These facts are very typical of an emerging market nation whose economy becomes dependent on fixed asset investments for continued growth. If we are right and growth slows more than expected, China will demand significantly less oil than they have in the past five years and certainly their reduced demand is a huge factor at the margin.
If Europe was humming along in a favorable way, Japan was bristling with growth and Latin America didn’t have any problems, you might be able to make up lost US and China oil demand elsewhere. We haven’t even mentioned the damaging effect China’s slowdown will have on oil demand in the countries which have “suckled on China’s bounteous teat” like Australia, Singapore, Canada and Indonesia. Lastly, Brazil and Russia are hugely at the mercy of the price of oil for their prosperity. All in all, demand for oil sits in a very precarious position at best.
On the supply side of the equation, we have rarely seen so many holes poked in the ground and in the ocean looking for oil. From shale in North America to offshore drilling near Brazil, new supplies of oil are coming out of the woodwork. Iran, Syria and Egypt have done their best to keep a supply-fear premium in oil, but so much oil is being produced elsewhere in the world that it is diffusing the supply disruption threat.
Lately, Oil prices seem to trade in high correlation with the US stock market. When US stocks (as represented by the S&P 500 Index) bottomed in late May and early June of this year, oil hit the $77 per barrel mark. Those stock market worries seemed to have been about the possibility of a recession coming soon. To us at SCM, this infers that market participants believe that US economic growth, if it happens, will cause heavy additional use of oil and gasoline. Or it could mean that asset allocators and hedge fund managers are using oil as a trading vehicle to participate in market upswings. These thoughts raise some important questions.
First, where is the economic growth likely to come from in the US? Second, in what industries does the US have big competitive advantages over the rest of the world? At SCM, we believe that the backbone of US economic growth over the next ten years will come from our largest population group, the children of the baby boomers. There are 85 million boomer kids, slightly more than the 83 million baby boomers. They have been a little slower to get married, a little slower to have children and little slower to buy a house than previous generations. They are tech savvy and their attitudes associated with commodity usage have been formed in the last ten years. They are more likely to spend time online, shop online and socialize online. They are less likely to own two cars and less likely to have a landline phone when they do buy a house.
However, with hormones working like they always have and housing affordability the highest in my lifetime, we could see an explosion of household formation in the US over the next five years. Maybe, even “Jeff who lives at home” (recent popular movie) will buy a house. The boomer kids won’t have actors like Seth Rogen and Zach Galifinakis (playing unmarried slobs) as their favorite actors forever. Housing is starting to percolate in the US and you can almost feel the animal spirits start to build. We don’t believe there is any correlation between marriage, babies and buying a home with gasoline usage. Gasoline usage goes up when the kids get their own social life and that is a problem for ten years from now.
The other source of growth in the US is its dominant position in the connection between the virtual/technology world and the real economy. US Companies like Apple (AAPL), eBay (EBAY), Amazon (AMZN), Facebook (FB) and others are dominating the way technology is shaping how we live and spend money. These are US companies leading this phenomena and it is the fastest growing part of the world economy. It is not a sector of the economy which uses much oil and probably causes less oil usage per dollar of GDP produced.
We at SCM believe that supply and demand do matter when it comes to oil prices. We envision reduced demand from China and permanently lower demand in the US. Lower demand combined with spiking supply levels from all the new sources of oil spell lower prices to us. Historically, the US economy and US stock market are inversely correlated with oil prices. We’d like to think that is what comes about over the next three years. It could be the economic stimulus package we’ve been waiting for.
Best Wishes,
William Smead
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities we recommend will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
