Another Stake In the Heart of "Peak Oil" Deniers

If last week's confession by a Lukoil official that Russian oil production has peaked weren't enough to convert "peak oil" deniers, today's comments by Saudia Arabia ought to do the trick. (See the WSJ article here.) As a result, energy prices should continue their steady march upward at a much faster clip than other asset classes (at least until the oil "supply shock" hurts demand enough, which we think will happen later in '08).

So, strictly speaking, our market-weight energy position since starting this blog will remain a drag on relative performance, unless it becomes clear that oil demand is slowing down much more sharply than oil supply. That probably won't happen in the next couple of months, at the rate nations are pursuing inflationary and energy-inefficient policies around the world, and given the rising cost of extracting an incremental barrel of oil.

That said, we haven't raised our energy weighting. We're seeking to "mimic" the performance of rising energy assets with assets that instead improve resource efficiency, reduce industry's carbon & pollution footprints, and create a more sustainable world. To that end, we've written about investments along several major themes, such as agri-biotech, solar power & some other alternative energy platforms, water infrastructure & irrigation technology, green electronics, and others (scroll through our Environment subject for detail).

In addition to "mimic-ing" the performance of rising energy assets, we think these investments could decline less than the energy sector if the global economy slows down enough to drag the energy sector down, because the major environmental investment theme should remain intact.

But we have a lot more work to do before making up for being market-weight energy, rather than overweight, because traditional energy can get more expensive, and still be cheaper than alternative energies. So we're extending our environmental investment themes to include another industrial efficiency play (FLIR Systems - FLIR), and several high barrier-to-entry environmental collection and processing networks (including Clean Harbors - CLHB, and Darling International - DAR). Note that Darling, which collects and processes animal bi-products from thousands of sources, sells into many product categories as a replacement of fossil fuels, and enjoys rising average prices as a result.

Adding Equity Exposure While "Muddling Through" Crisis

Each day that brings a bit more reassurance that the financial crisis won't turn into a catastrophic melt-down represents a good day for markets, after investors fear the worst for much of 2008.

So, even though we're arguing for being underweight equities until one's semi-annual asset allocation rebalance, we've posted about adding equity exposure gradually, and to gain exposure to major investment themes that should combat the economic cycle and provide high beta if markets turn bullish.

During the week of March 31-April 4, we highlighted the Agriculture theme [specifically agri-biotech Monsanto (MON) and Syngenta (SYT)], the length of the Africa & Middle East theme (TRAMX), and the value of adding some U.S. index exposure (VTI). We also were tracking Water, Solar, Genomics, China, Brazil, Canada and other areas.

This week we extended many of those themes, and are also highlighting Suez (SZEZY - a global utility and water infrastructure company), Lindsay (LNN - a high-tech irrigation equipment company), Itron (ITRI - a global utility metering equipment company), and Origin AgriTech (SEED - a Chinese seed company with substantial "option value"). This week we also saw decreased risk in adding exposure to European (VGK), Emerging Markets (VWO), and Brazil specifically (EWZ).

Environmental Boom Ignites Stocks

Earlier today (4/16/08) stocks of companies that address the world's biggest environmental challenges soared more than the market averages. It's as if thousands of investors suddenly read Jared Diamond's Collapse (focusing on agricultural productivity) and the Socolow and Pacala paper (on ways to save the earth seven billion tons of carbon emissions), then invested accordingly today...

...Stocks like Monsanto (+7%) and the agri-biotech sector (+3-4%), First Solar (+4%) and the solar sector (+3-7%), the broader alternative energy sector (+3-15%), Badger Meter (+20%) and the metering sector (+3-7%), Lindsay (+6%) and the water sector (+3-4%), the engine and air filtration industry sector (+3-5%), the green electronics sector (+3-15%), and so on.

We'd still be adding to equity weightings selectively in key industries backed by major secular trends, as suggested by several of our latest posts (including here). See also our post titled "Climate Change -- Investment Waves Will Keep Coming" and our April 4th post after an earlier increase in environment-related equity allocation.

Today it's as if investors were struck harder than ever by the imminent major implications of skyrocketing energy prices and global warming. It makes perfect sense. Crude oil punched to $115/barrel on supply projects. Yesterday, a paper presented at the European Geosciences Union conference predicted a rise in sea levels three times higher than predicted by the U.N.'s Intergovernmental Panel that won the '07 Nobel Prize -- a full 0.8-1.5 meters that would have massive consequences for hundreds of millions of people and economies. Today, Bush, seemingly the last and most important global-warming-denier, finally highlighted the need to constrain greenhouse-gas emissions, in a speech that emphasized the need to invest in technologies (such as carbon capture and sequestration -- see some of the market's inferences, above) and his seemingly increased willingness to sign binding international agreements.

Slight Increases in Equity Allocation This Week, But Still Underweight

As the "muddle through the credit crisis" hypothesis gained a bit more credibility this week, it made sense to boost equity allocations somewhat, though we remain partial to the underweight argument.

We've tried to raise equity allocations via gaining exposure to diverse major investment trends, including:

• Agriculture - Monsanto (MON) and Syngenta (SYT), two of the leaders in agri-biotech. We summarize the major trends here ("Allocation and Agriculture"). We're also watching two agriculture ETNs: iPath Dow Jones AIG-Agriculture ETN (JJA) and ELEMENTS Linked to the Rogers International Commodity Index - Agriculture ETN (RJA).
  
• Africa & Middle East (a broad fund with some "frontier" market exposure.) See our previous post titled Allocation and Africa.
  
• U.S. - Vanguard Total Stock Market ETF (VTI), a Wilshire 5000 Index tracker - Selloff provided a better probability of a long-term entry point.

We're looking for further opportunities in these areas, as well as some additional ones, such as:

• Water and Industrial Processes - Flowserve (FLS), a leader in pumps, flow control and other flow solutions; sells into a diverse industrial end-market. Suez SA (SZE) a France-based utility planning to separate its diversified global water business.
  
• Solar - FirstSolar (FSLR) may pull back after recent flare-up after CEO's comments that he is in project talks with several large utilities. We certainly believe him -- coal-fired power projects are coming off the drawing boards as expected carbon costs rise, nuclear projects aren't being added quickly owing to NIMBY, and oil/gas/hydro prices continue their uptrends -- but collaborations with utilities may take a while to develop.
• Genomics - Illumina (ILMN), a leader in genetic analysis. Find a brief description of this super-trend here: "New Technologies Spur the Race to Affordable Genome Sequencing," as well as the backdrop for a very long-term view here on combating the increasing risk of plagues using new antibiotics, genetic testing, and anti viral drugs.
• China (PGJ, consisting of 25 ADRs) - 40% selloff from peak provided a more fair discounting of the risks, which we've discussed in several previous posts.
• Energy - SPDR S&P Oil & Gas Exploration & Production ETF (XOP), Vanguard Energy ETF (VDE), or iShares S&P Global Energy Sector (IXC)
  
• Canada - iShares MSCI Canada Index (EWC)
• Brazil - iShares MSCI Brazil Index (EWZ)
• Education - ITT Industries (ESI), a well-managed company at a 40% discount to its peak, and up sharply today after Congress introduced a new student loan aid bill. Good summary of Education credit issue here.

Allocation and Agriculture

Our goal is to (1) asset-allocate optimally and (2) give the portfolio an extra push by focusing on major investment trends, particularly the "super-trends" aided by the world's recognition that the "externalities" are no longer external (see previous post, below).

One way to help accomplish both might be to invest further in the agriculture trend, via equities if investors are underweight equities generally, and via commodities (the foodstuffs themselves) if investors are underweight inflation-beneficiaries.

We're attracted to agriculture as a way to help accomplish one's asset-allocation goals because we believe agriculture is one of the "super-trends" for the 21st century: ag gives investors exposure to scarce resources that were until recently considered external, or near-costless -- arable land, fresh water, and a clean/disease-free environment. These scarce resources are becoming expensive and thus raising the cost of producing food, and ultimately food prices.

(We acknowledge risks of incorporating a major trend -- even one as broad as agriculture -- into one's asset allocation. (1) A single class of commodities will be more volatile and have more ultimate downside risk than the broadest inflation hedge -- TIPS -- and also will not directly protect an investor's purchasing power beyond potentially his purchasing power of food. Any historical returns and correlation work I have seen regarding commodities refers to the broadest commodity indices, not a single commodity group. (2) A single sub-industry within equities can face high correlation with the overall equity market and more volatility. Therefore, we'd typically invest in major trends as relatively small supplement to an investor's core asset allocation.)

We like to think of investing in a super-trend in two ways:
(1) invest in the scarce goods themselves; in this case, the agricultural commodities, and
(2) invest in the companies benefiting most from the world's need for more of those scarce goods; in this case, we'd highlight the crop yield-enhancing biotech companies.
The dual investment approach makes sense to us. An investment in only #1, commodities, is a bet that human ingenuity won't solve the nature's scarcity and thus won't cause prices of commodities to fall. We hate to bet against billions of dollars of research and many thousands of the world's top scientists. At the same time, an investment in only #2, crop yield-enhancing companies, is a bet that competition among companies will remain subdued enough to permit continuing high profitability for the companies. We want overall exposure to the super-trend, rather than a bet on nature versus technology. Also, an investment in both lets us keep score between nature's constraints on crop supply and technology's efforts to increase crop supply, a rivalry that will determine the performance of the overall investment trend.

Why invest long-term in agriculture commodities and equities in the first place? Some of the arguments are becoming well-known, and some may not be fully appreciated yet by investors: (1) Developing market demographic shifts and wealth accumulation that are causing more consumption of meat, which is up to ten times more land-intensive than consuming grain, (2) The global shift to Biofuels, (3) Global warming and weather volatility trends that are making production of food less dependable, (4) Less available fresh water in the form of predictable snowpack/rainfalls, and falling water tables, (5) Land degradation due to soil erosion connected to over-use, salination, deforestation and other factors, (6) Pollution, invasive species, new crop disease vectors and other factors, (7) Higher production and transportation costs owing to fuel costs, and (8) The lack of recognition of agriculture as an asset class until, in a very limited sense, the last year or so. We see this as potentially similar to how the institutional investment community viewed oil in 2003.

What are the long-term risks of investing in agriculture commodities and equities, generally? (1) Rapid mitigation of trends sited above, such as global warming, soil degradation, water scarcity, the biofuels trend, etc (which we view as unlikely), (2) A rapid conquest of technology over natural constraints in high-production areas that results in declining ag commodity prices, or at least higher penetration rates of ag biotech that effectively slows the growth rate for these companies and increases price competition among them. (We think this would take years to occur, and faces a moving target of changing conditions), (3) A rapid application of new production techniques in current low-production areas. (We think most of that production would feed rising local populations rather than supply the world market.) (4) Rapid increases of new acreage (which is difficult and expensive owing to required infrastructure developments), (5) A rapid movement to free trade (but there is a countervailing trend to increase trade barriers instead to shield domestic farmers), (6) A global recession and high demand elasticity (which could be a shorter-term issue rather than a long-term mitigation). Also recall that many of the risks are mitigated by owning not only the commodities but also the companies that would be responsible for raising output.

Securities - A VERY Brief Look

In commodities, numerous ETFs and ETNs (strongly prefer ETNs in taxable accounts) track futures values for a wide variety of contracts. A commonly-cited ETF is Powershares DB Agriculture ETF (ticker: DBA), which tracks the corn, soybean, wheat and sugar futures. A popularly-cited ETN is the iPath Dow Jones AIG-Agriculture ETN (JJA).

In equities, there are many ways to invest in agriculture, ranging from fertilizer companies to ag equipment makers. We're most interested in ag-biotech companies because of their ability to raise the barriers-to-entry by adding more and more biotech traits within seeds.

Among the ag-biotech companies, Monsanto (MON) and Syngenta (SYT) are two of the leaders with high exposure. Their largest U.S. and European competitors include Dow (DOW) AgroSciences, BASF (BASFY) Crop Protection, Bayer (BAYRY) CropScience, and DuPont (DD) Agriculture.

Monsanto filings acknowledge the likely long-term competition from Chinese and Indian ag-biotech efforts in particular. For example, a quick review of China's efforts in the area reveals billions of dollars of research efforts to build an industry in the past decade, nearly all government funded, with some movement toward private companies in the past few years. Origin Agritech Limited (SEED) is a NASDAQ-listed Chinese company, and YaSheng Group trades in pink sheets as YHGG. Agria (GRO), based in China, is partly an ag-biotech company. Taiwan is also becoming a large player biotech generally, with an ag-biotech subindustry.

No Firewall in Developing Markets

As the financial crises intensifies, many investors hope that Developing Markets will be a final firewall against contagion. They hope that somehow, 30% of the world's GDP won't be affected much by the other 70% that is mainly the U.S. and Europe. Part of the hope results from Developing Markets' long-term infrastructure projects that are underway -- projects that won't stop at the first sign of global financial pressure, but are certainly vulnerable as credit becomes less available for longer periods of time.

Siemens' profit warning this morning should elevate investors' fear that there's no firewall within the financial crisis. Even though Siemens' warning seemed to have little to do with projects in the Developing Markets, they had everything to do with the pace of infrastructure development. The company presented three issues: (1) the building of power stations is being more significantly impacted by the shortage of trained engineers and blockages at suppliers, (2) delays in awarding big projects such as the Transrapid train (in Germany), (3) cancellation of a large UK government IT project. Analysts are blaming mis-management by Siemens specifically, but this should not alleviate the macro fears. The weakly managed companies are the first to falter when macro-crises roll along.

Implications for Asset Allocation

Consistent with all our posts to date, we think the crisis is far from over. We may just have entered the middle stages. This is no time to rebalance equity holdings, least of all in Developing Markets, which are even further than U.S. markets from discounting the pending economic shortfalls.