Drilling Into Fuel Prices
April 4, 2012
Gasoline, deodorant, dishwashing, liquid, eye glasses, crayons….What does this list of seemingly random items have in common? They are all made from refined crude oil.1 So even if you don’t feel pain at the gas pump, you probably rely on more products made with or from crude oil than you’d think. And of course even non-oil based products are generally shipped via fuel-consuming transport vehicles, so you’re bound to feel the pinch in the form of fuel surcharges or price hikes sooner or later.
But Beyond Bulls & Bears has never taken a fatalistic view. If volatility can present buying opportunities, surely there’s a possible silver lining to headline-making oil price heights. And so we turn to Fred Fromm, portfolio manager for Franklin Natural Resources Fund and part of the team that manages Franklin Gold and Precious Metals Fund, aka the guy with the inside scoop on all things oil, gold, and even those other less-talked-about commodities.
Fromm in brief:
- U.S. demand for gasoline is actually down, but demand outside the U.S. is strong.
- Geopolitical issues, namely in Iran and Syria, are being factored into oil pricing, but major disruptions may not occur.
- If China’s growth rate could continue indefinitely, its too-strong growth would likely strain commodity supply.
- Supply-demand balance looks tight enough to support gold, but demand can fall quickly and should be closely watched.
- Fromm opts for geographic diversification to avoid the risk of having too many investments in a country with a high degree of political risk.
Oil prices tend to follow a seasonal rise in the summer, but the recent run-up, much like the recent odd weather, has been outside the expected norm. The price of a barrel of crude oil has risen above $100 this year, and the U.S. national average for a gallon of gas rose to $3.867 in mid-March, up more than 30% over last year.1 All this, and the traditional North American summer driving season hasn’t even started yet. Fromm explains the dance of supply and demand, as he sees it.
“We’re actually seeing U.S. demand down year-over-year for gasoline, but demand outside the U.S. has remained strong. Exports out of the United States have now reached a level we haven’t seen for several decades; we’ve actually become a net exporter of fuel.1 Of course, we still import quite a bit of crude oil, but demand in Latin America, for instance, is quite robust and they don’t have a lot of refining capacity coming on line there. China’s demand has also remained quite strong, even though there’s a lot of concern about slowing economic growth. In February, China set a monthly record for oil imports.2 One of the other factors is supply. Non-OPEC supply continues to disappoint, meaning it’s coming in lower than most people had expected it. And, as a result, that helps keep the supply side fairly tight as well.
And then, of course, there are geopolitical tensions: what’s going on with Iran and the potential for a significant disruption to fuel supply, and also the issues in Syria, which are ongoing. I don’t think we’re going to have a significant disruption, but there is some probability that a disruption could occur. I think that’s being factored into crude oil prices.”
Impact of Chinese Demand
As Fromm mentioned, the impact of Chinese demand is important for the oil market. China is the world’s second-largest consumer of oil, behind the United States,3 and is also a large consumer of other natural resources. That consumption has been an economic driver for suppliers, but it’s also been a source of concern for those who fear China’s consumption will drive up prices and leave the rest of the world with expensive table scraps. Regardless, China’s GDP is anticipated to slow a bit this year from last year’s pace of 9.2%. In Fromm’s view, that’s not necessarily a bad thing, because he does believe commodity supplies would be strained if China sustained its recent high level of demand.
“I think one of the most important things to think about is that China had to slow: as I see it, there’s no way it could continue at the pace that it was growing, indefinitely. The world just does not have enough commodities to supply that level of growth. We do see some risk areas that have been growing quite rapidly, like steel production, which is a factor in iron ore consumption and where China represents a large part of world demand. That is an area, where, even if you see a little bit of slowing, it could have a bigger impact. And it’s one of the reasons why in the fund we tend to focus more on energy, because we believe it’s a more durable commodity in terms of global demand, longer term.
Our main job, as we see it, is to identify the areas that we think are going to be the strongest in terms of the supply-demand balance and then identify the companies that we think are positioned to benefit from that environment. So what we’re trying to do is figure out which commodities we think will be best supported by the environment that we see, and then stay away from those that might suffer from a slower environment.”
A Look at Gold
Gold is another commodity that’s been capturing headlines, perceived as a “safe-haven” asset class by many investors. Gold made a record run in the wake of the 2008-2009 financial crisis. What does Fromm, think of gold? And what is his strategy?
“Gold is probably the most difficult to predict among all of the commodities for various reasons, so we don’t try to come up with a specific commodity price for gold. We use ranges and try to establish a level where we feel its price is well supported. And then we look to see what the gold-based- equities are reflecting, because that’s where we invest. We do not invest in gold bullion itself. The demand side still looks fairly robust around the world, even though we do have to watch that closely because investment demand has become a much bigger portion and that’s something that, as we know, can go away pretty quickly.
But I think the supply side and what’s going on there is more important. It continues to struggle to grow, and what we are seeing right now is that costs are rising significantly, especially for new projects. And what that could mean in the future is that there could be less investment. We’re also seeing a lack of exploration from some of the major mining companies, which could impact supply longer term. So as long as demand stays fairly healthy, and the supply side continues to struggle, we think the supply-demand balance should remain tight enough to support the commodity.
I also think that, as important as how the commodity itself is priced, is what the commodity-based stocks are reflecting, and the equities have significantly underperformed the metal itself over the past year or year and a half. And because of that, in our view, the equities are looking more attractive now. So what we are trying to do is to determine if the metal will be supported at a level that will still make the equities attractive, and we do believe at this time that looks to be the case.”
Both oil and gold are markets that can be subject to geopolitical risk, which in turn can create price volatility. Vetting each individual company is always a very important part of the investment process, but political unpredictability can add a layer of additional challenges. For Fromm, it boils down to thorough fundamental research and due diligence, which often includes management meetings and site visits in far-flung locales.
“We have analysts going to small countries in Africa. I’ve been to the interior in China visiting single gold mines. And this is a very important part of the research process. But I think what’s very critical is a company’s management and their ability to find their way through the political landscape in the various countries. And so, therefore, we put a high degree of importance on management’s ability, their experience and track record to not only explore new areas but also deliver on projects. One of the areas where we are seeing costs really go up is the process of actually bringing production on line at these various mines.
The other factor is diversifying. You obviously don’t want to put all your eggs in one basket and be in too many investments in one country that has a high degree of political risk. You are always going to have some political risk; we even have it here in the United States. But in certain countries it is elevated, and we will attempt to manage that risk through diversification and also through position size. So we will strive to have smaller positions in names that we believe have a higher degree of geopolitical risk.”
Fromm’s philosophy fits with Sir John Templeton’s thoughts on the subject. “No matter how careful you are, you can neither predict nor control the future…so you diversify—by industry, by risk, and by country.”
What are the Risks?
All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.
Franklin Natural Resources Fund: Investing in a fund concentrating in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. The fund may also invest in foreign stocks, which involve exposure to currency volatility and political and economic uncertainty. The fund’s holdings in smaller companies involve special risks associated with smaller revenues and market share, and more limited product lines. The prices of such securities can be volatile, particularly over the short term. These and other risks are described more fully in Franklin Natural Resources Fund’s prospectus.
Franklin Gold and Precious Metals Fund: Investing in a non-diversified fund involves the risk of greater price fluctuation than a more diversified portfolio. Also, the fund concentrates in the precious metals sector which involves fluctuations in the price of gold and other precious metals and increased susceptibility to adverse economic and regulatory developments affecting the sector. In addition, the fund is subject to the risks of currency fluctuation and political uncertainty associated with foreign investing. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. The fund may also invest in smaller companies, which can be particularly sensitive to changing economic conditions, and their prospects for growth are less certain than those of larger, more established companies. These and other risks are described more fully in Franklin Gold and Precious Metals Fund’s prospectus.
1 Source: Energy Information Administration, U.S. Department of Energy, March, 2012.
2 Source: People’s Republic of China, General Administration of Customs.
3 Source: CIA World Fact Book 2010 – 2011.
(C) Franklin Templeton