Issue #17

Energy is too cheap. I don’t mean that $70 for a tank of gas is inexpensive, unless I compare it to my mortgage, which is two orders of magnitude larger. Energy is too cheap, because it is not yet affecting consumer behavior patterns in any meaningful way in this country.

Developing Countries are ravenous consumers of energy. Energy demand is increasing at double digit rates in China, India, Brazil, and many developing countries. Oil consumption is among the fastest growing part of increased energy demand, because only oil can currently fulfill the transportation needs of an emerging economy.

Currently we have robust global growth, even greater demand growth in energy, yet at best, 1-2% supply growth in refined Oil. The result is that oil prices in particular, and energy prices in general are going to go higher, because the supply of energy can not keep up with the demand for energy.

You’re not convinced? Then look at what the market is saying, look at the stock price of Exxon Mobile, the largest oil company in the world:

2003	$34
2004	$40
2005	$51
2006	$56
2007	$76
Presently	$85

To quote one of my favorite academic economists, long-time Fed Watcher Paul McCulley of PIMCO in his recent column:
“In the long run, the world needs the real price of energy to go up enough to encourage conservation efforts and the development of alternative forms of energy. That way, everything works out—eventually.”

It’s the eventually part, that is going to be painful. Eventually every new home in California will come with water osmosis filters and solar panels. Eventually the soccer mom’s will stop buying SUV’s and drive mini-vans and station wagons again. Eventually nuclear power will be a major source of electrical power in North America. Eventually fewer people will commute 50 miles a day or more. But what is it going to take to get there? That I think I know, it’s going to take $10/gallon gas.

Energy prices must climb to a point where consumer behavior is modified. Energy prices must climb to a point at which alternative energy sources are economically superior. It’s the bottom line that will effect change, not the tellers of fortune or the prognostications of economists and tree huggers.

So I am rooting for higher energy prices. This most likely scenario means that energy companies are going to do well, and that portfolio managers need to allocate portfolios to take advantage of inevitable rising energy prices. It’s that simple.

First Half 2007 Review
The second quarter finished with mild hysteria over housing, rising interest rates, defaulting mortgages and a few busted hedge funds run by Bear Stearns. Bond Guru Bill Gross went nuts over the eventual fall-out in the housing markets in his June column while the average American yawned, and just let their employers send in the 401k contributions on time.

Wall Street yawned too, and global growth hit front page status, so much in fact, that the $14 Trillion U.S. supertanker economy has been unseated by robust growth of the global economy. In Asia, South America, and even Europe growth rates have risen. The developing world is growing at something like 7% or more. Meanwhile the developed world is growing at 2-3%. Overall world economic growth is a very healthy 5%.

For the first six months of 2007 the S&P 500 had a total return of 6.6%. The Lehman Aggregate bond index returned 0.8%. The average account at Barnes Capital returned 7.2% over this period. Precious metals and precious metal equities were flat, while major oil stocks rose 20% and oil services equities gained 28%.

Our View
Looking forward we expect equities to continue to do well. We are focused on good dividend payers and we continue to believe that diversified portfolios should include commodity and precious metals exposure. We continue to believe that fixed income securities are priced for very modest returns. We do however like the medium maturity municipal bonds for high net worth client portfolios due to their relatively high after tax returns.

Have a nice holiday with you and yours.

Blessings,
Daniel A. Barnes, CFA

Barnes Capital is a Registered Investment Advisor located at in downtown Lafayette. With RB Capital Management, Barnes Capital develops custom tailored portfolios for its clients. Specialized in retirement income portfolios, financial planning in an integral part of our process. Call 925-284-3503.

This entry was posted on Wednesday, July 4th, 2007 at 3:12 am and is filed under Insight Newsletter. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.