By Mathew Kaleel.

Last month, I discussed three themes that we believe will be critical in the determination of investment returns going forward. Over the last couple of months, another issue has started to re-emerge that will have a significant bearing on the world in the area of (geo)politics, war, wealth and  the environment. I am of course talking about energy, and more specifically, oil. I will touch upon some aspects of the oil picture which illustrate how quickly the world is changing.

Deepwater oil

On April 20th, 2010, the Deepwater Horizon oil rig exploded in the Gulf of Mexico, killing 11 people and causing untold levels of environmental damage in the Gulf of Mexico. The subsequent efforts by BP to stop this oil leaking into the Gulf have garnered significant media attention as they have struggled to come up with a tangible solution. It seems that this leak is now capped, and hopefully this will be a permanent stoppage.

There are aspects of this which are relevant for the financial world, are as follows:

    * The fact that companies are now going into such deep water to extract oil indicates that the easy, low cost oil of decades past is literally behind us.
    * The costs of extraction from difficult environments will surely increase as insurance and enhanced technology will be required to operate. Only large companies will be able to fund this type of development.
    * The drop in production in the Gulf of Mexico will have an impact on future supplies of oil.

Ramifications: There will be winners and losers out of this. BP is the frontline loser as are all of the businesses that rely on the Gulf (fishing tourism). There will however be companies that will prosper over the long run due to this unfortunate incident. Large, well capitalised oil producers which have reserves onshore or not in deepwater will do very well going forward.  Other alternatives such as natural gas will also benefit, and the different types of gas – LNG, coal seam coal bed methane etc – will over time cumulatively reduce the reliance on oil as a primary energy source.  Gas is also a cleaner technology, emitting much less carbon than oil or coal.

Look east, not west

This week, the International Energy Agency (IEA) confirmed something we’ve know was coming for some time, but probably not so soon – China has overtaken the United States to become the world’s largest energy consumer. The following graph illustrates the immense change that has taken place since 1990. Also of interest is the energy consumption per capita. Whilst the US has become more efficient since 1990, using less oil per capita, China has become less efficient over this same period, something which will have to change as the financial and environmental costs of inefficient production and consumption become prohibitive.

China is not alone in this increased consumption of energy. A host of mid-sized countries are also dramatically increasing energy consumption, including countries in the Middle East.  Petroleum demand for use internally in the Middle East has increased by approximately 47.7 per cent since 2000, versus total global growth of 10 per cent (Source: Credit Suisse Fixed Income Research: Cooling the Desert, 19 July 2010).

The chart below highlights one country, Saudi Arabia, and the fascinating aspect of this is that the Saudi nation is consuming more and more of the oil that it produces, rising from approximately 12 per cent of production in 2004 to around 25 per cent in January 2010. This is highly significant, in that many oil producers will become greater consumers of their own product, providing less oil to the international oil markets and reducing available supplies over time.

Ramifications: In line with the first point about deepwater drilling, the simple fact is that whilst the developed world is not growing dramatically (and may not grow that much in the next decade), emerging economies (if we can call them that) such as China, Turkey, Saudi Arabia, India and Brazil will be larger consumers of all things, including energy products. Increased demand and reduced supplies would indicate higher prices for energy in the next decade.

Alternatives

The third and final point is quite positive. We will probably see significantly higher energy prices in the next 10-20 years, including electricity (as coal/gas prices increase) and food as energy is a very big input into the price of many goods. The higher that energy prices go, the greater the incentive to utilise cleaner, cheaper alternatives. The fact is that the incentive to use alternatives increases as the price of traditional energy sources rises.

As such, whilst wind, hydro, solar and other alternatives can only contribute marginally to the total global energy mix today, the issues highlighted above indicate that lower supplies going forward, and increased demand, will see significantly greater development and adoption of alternatives as traditional energy sources become much more expensive. Apart from the discussions that will take place as to the use or otherwise of uranium and coal, these energy sources plus natural gas will probably become a much more important part of the energy mix going forward.

The world is changing. We all need to start looking at where demand is going to come from, and increasingly this will be the emerging markets of today. These will become the developed markets of tomorrow that use similar levels of energy per capita and when we start looking at what is required to feed, clothe and provide energy to all of these new consumers, the investment ramifications start to play out.

Investments in areas such as land, food, energy, and inflation hedges will potentially enhance investment returns and also provide an effective hedge against unexpected future price rises in basic commodities.

Mathew Kaleel is a founding principal and chief investment officer of H3 Global Advisors