Allocation and Energy Update

As the case strengthens for a continuing long-run trend in higher energy prices -- even though the global economy will continue its cyclical slowdown -- many individual investors may be surprised at how lightly their diversified equity portfolios are weighted in the energy sector.

We reviewed this data again this week, and it was one of the reasons why we're rebalancing our overweight energy position in accordance with our strategic allocation, rather than cut too far.

• The U.S. Energy sector comprises only 12.7% of the Vanguard Total Market Index Fund, which tracks the Wilshire 5000. Although this is up from 9.1% a year ago, it is still roughly on part with Health Care and Industrials, and well below Technology (15.7%) and Financials (17.4%).
• The rest-of-world Energy sector comprises only 10.4% of the Vanguard FTSE All-World-ex-US fund. This is on a par with Industrials and Materials, and far below Financials (28.7%).

Another reason to adhere to one's strategic energy allocation, rather than market-time a cut in weighting, was yet another in a litany of "economic nationalism" updates: China's roughly $60bn deal to secure LNG from Qatar over 25 years. For perspective (from the FT article):

• “Three to four years ago, the Qatari projects were going to send this gas to the Atlantic Basin, particularly the US,” said Frank Harris, of Wood Mackenzie, the Edinburgh-based consulting firm. “What it means is that we are going to see a lot less LNG go to the US than we thought.”

The SPDRS Oil & Gas Exploration & Production ETF (XOP) is an equity investment that has typically provided the most leverage to changes in long-run oil and gas price forecasts. The companies are engaged in upstream activities to locate and produce, which is where the global bottleneck in the energy chain is. The tremendous intellectual property required of these companies -- particularly in the increasingly difficult-to-access geologies -- gives these companies more protection from price-based competition.

We are also weighing environmental issues. On one hand, profits generated from traditional energy are being invested increasingly in "alternative" energy projects, as the economics of alternative energy comes closer to parity with traditional energy. Some traditional energy companies are therefore becoming better positioned to benefit from the diversification of energy sources that the world is beginning to undergo. However, until world governments more effectively price the externalities of the energy business (such as C02 emissions, contaminant emissions, and water -- all of which energy companies use intensively), the energy companies will continue to benefit disproportionately at the expense of sustainable life on earth.