Saturday, August 28, 2004

A Contrarian View on Oil Prices

August 28, 2004 - Street Insight Consensus oil price forecasts are too aggressive, and are not sustainable in the long run. The usual bullish argument sounds among the lines: Production capacity is maxed out (Saudis are pumping all the oil they can, Russia is a mess), demand in China, India, and South Korea is growing very fast -- far outpacing the supply available.
As compelling as the argument for higher oil prices is, it suffers from a major problem: the fallacy of composition. Fallacy of composition is an economic concept referring to the mistaken assumption that what applies to the part applies to the whole. The fallacy of composition ignores the interaction between multitudes of factors that are built into the assumptions. Most analysis that predicts sustainable high oil prices assume caeteris paribus -- a Latin term for "other things being equal;" in real life all things are not equal.
Demand side: At high oil prices, consumption of gasoline should decline as consumers drive less and drive less gas consuming hybrid vehicles.
It is assumed that demand will be either rising or staying the same. The erroneous belief here is that it ignores the impact that the rising oil prices have on demand. High oil prices have not yet translated into a proportional increase of gas prices at the pump (though oil price correlation with oil prices is not perfect since oil is about 43-45% of the total gasoline cost, the rest are taxes, marketing and distribution, and refining costs). Thus consumer demand has yet to readjust to higher oil prices. For example, in Europe gas prices are several times higher than in United States (mostly due to high government taxation). European consumers have adjusted their driving habits and the type of vehicles they drive accordingly. They drive smaller vehicles and drive less.
CNBC recently reported that a small hybrid car, Toyota Prius, is one of the fast-selling vehicles in the U.S. Major car manufactures have announced that they will be coming out with more hybrid vehicles in the next couple of years. U.S. car manufactures are very sensitive to losing the lead to Toyota (or other Japanese manufactures for that matter). In addition, they don't want to make the mistake that they made in 80s, when high oil prices gave an open invitation to Japanese manufactures, who produced less gas-hungry cars to win the hearts of the U.S. consumers.
As slow as U.S. auto manufacturers are, hybrids are likely to become a very important part of their business, since their cash cow SUVs will not be flying off the lots when gas prices are high. Ford's (F:NYSE) introduction of a light, hybrid SUV Ford Escape is the first indication of that. Though hybrids cost more money than traditional cars, U.S. consumers are already used to paying up for SUVs, therefore they are likely to be willing to pay higher prices for hybrids. Also, increased scale in production and improvement in technology is likely to narrow the price gap between the traditional and hybrid vehicles in the future. As I was writing this article, FedEx (FDX:NYSE) announced that they will begin beta testing hybrid trucks.
High oil prices make a very good political campaign issue as well, because of the simplicity of the argument. The argument is us -- honest, hardworking Americans against them -- large oil companies or unfriendly, self-serving cartels. Politicians will try to jump out of their skin to create incentives for automakers to produce more fuel-efficient cars and if needed to subsidize an alternative fuel infrastructure (i.e. hydrogen gas stations).
Another factor that may decrease future demand for gasoline is China. The growth of demand that will come from China may not materialize. China is living through a tremendous economic bubble which is about to burst, thus demand may actually decline, not increase.
Supply Side: High oil prices will have wide range ramifications on oil producers causing a significant increase in supply.
High oil prices make many uneconomical (high cost) oil wells economical again, thus spurring oil exploration in harder to reach places. However, high oil prices by themselves don't cause an increase of oil production, since an increase requires a large commitment of capital. An expectation of high oil prices staying high is a must for exploration efforts to intensify. Fortunately, that expectation is forming fairly rapidly, which provides another reason to believe that though it is unexpected, oil supply will likely increase from the unexpected places.
Contrary to common wisdom, OPEC doesn't want high oil prices. OPEC understands that high oil prices will lead to the above mentioned structural changes in demand and supply. That is why the recent announcement by Saudis of an increase in oil production is not surprising. As much as it is tempting to enjoy high oil prices, OPEC's objective is to maximize present value of their oil reserves and ironically high oil prices don't do that.
I believe that it is crucial to be able to read obvious but often ignored signs, since they are a good barometer of investors'emotions. For example, when a top business magazine features a company on a front page with a title "How (fill in the blank) transformed the industry." Usually that is a good sign that the emotions are at their peak, and so is the stock.
Washington Mutual (WM:NYSE) was a great example of that, a front page article in a top business magazine marked a top for the stock. The same is true for oil. A couple of days ago, CNBC started to show oil price in the low right hand corner bar on top of the Nasdaq index. Oil is appearing in the headlines more and more everyday (even I wrote three articles about it and I don't even own an oil stock!). Those are good indicators that emotions are heading towards their peak, though I don't think they have peaked yet -- since oil has to start appearing on the covers on the non-business magazines or become a subject on a sitcom.
It takes time for the structural changes to take place, thus it is impossible to predict how high oil will rise before it declines to its historical averages or even below them. However, the market has a good track record serving as a discounting mechanism, factoring events that are yet to occur. Thus oil prices are likely to head lower sooner than the structural changes take place. As always, the obvious answer to why the oil prices have returned to their historical average will stare at us in the face, though unfortunately after the fact.
This bearish case may or may not have all the answers to where the oil prices will go in the short run, and it is possible that the truth lies somewhere in the middle between the bull and the bear. However, the hidden risk that oil companies' revenues may fall of the cliff when oil prices decline is so great that we believe risk/reward of most oil stocks is unfavorable. As a result, we are keeping them out of our portfolios. Though a more short-term oriented investor may find them to be a good trade, that is not what we do. Vitaliy Katsenelson, CFA Copyright 2004

Shedding Some Light on Investing in Russia

August 28, 2004 - Street Insight
Since I am the only contributor on the Street Insight that was born in Russia. I feel that I need to explain the Russian psyche that will shed some light on investing in Russia. Russian people like the idea of democracy, they love the idea of being able to complain about their difficult life in public, but that is as far as it goes. Without realizing it, they want a totalitarian leader who will be their moral standard, a person who will protect them from "greedy, blood sucking" oligarchs, a "true leader" who will put 'bread and butter on their table," and in return they will worship that person as if he was God. The reason religion was prohibited in Russia during communist dictatorship is because it was in direct competition with a totalitarian regime. They wanted the exclusive right to that piece of real estate in people's brain that worships God. Aspiration to be the light of communism and spread the communism around the world may be over, however, Russia has been ruled by totalitarian regime for too long to let the need for a totalitarian regime go. It is very hard to say what kind of person Putin really is. He may truly be trying to be a democratic president. However, absolute power corrupts absolutely. The absence of true opposition, the constant reminder by Russian people that he is their god, will make a person act and think like a dictator without second guessing the rightness or the morality of decisions made. The reason the American president will never act or think as a dictator (at least not for long) is because a strong opposing party will remind him that he is mortal. That is not the case in Russia. It is very likely the Kudorkovsky walked a very gray legal line in creation of his fortune. However, his biggest mistake was that he openly financed Putin's opposition. Other oligarchs still have their fortunes though they have created and ran it in a similar manner. Yukos' tax bill with huge penalties is not much different (at least in my mind) from the revolution of 1917; though it is done without the bloodshed, it is still a reverse distribution of wealth of one to many. Russian people look at the Yukos scandal with much satisfaction, because they feel the harm is done to one obscenely rich person with a benefit to many. My big concern is that the apparent success of Yukos' repatriation by the state will create an environment where it will be an everyday thing. Maybe the skepticism that comes with my Russian heritage got the better of me and Yukos received what it deserves, but I doubt it. There are plenty of fish in the sea (countries to invest in) and after the Yukos incident, I tend to think they don't have to speak Russian. Copyright 2004

Friday, August 27, 2004

Why Motorola Is Not a Good Play on the Wireless Sector

August 25, 2004 - Street Insight The real problem for Motorola will come when the growth rate of the cell phone industry slows down or stalls. Over the weekend, I was analyzing Nokia (NOK:NYSE) and while I have not reached a conclusion on the stock, one issue was evident to me: management has done a terrific job positioning Nokia to compete against Motorola (MOT:NYSE). Nokia has several strong, sustainable competitive advantages that will allow it to maintain and take market share from Motorola in the future. The wireless handset market is divided into two, almost equal-size segments: commodity-type handsets and more feature driven "fad" handsets. Nokia's management has made a conscious effort to position the company to have a strong competitive advantage in each segment. In the commodity segment, customers' main focus is price. Cell phones are considered a utility (not unlike a home phone) by consumers and as long as cell phones are perceived to be of good quality, price is the decisive factor in purchasing decision. On the contrary, in the "fad" segment, features, feel, look, shape and coolness (especially for teenagers) are the crucial factors in the consumer purchasing decision. Commodity Segment: Nokia Is the Dell of Cell Phones To be an effective competitor in the commodity segment, lower cost structure is a must. Nokia is extremely efficient in manufacturing phones and has a much lower cost structure than Motorola. On average, Nokia sells phones 27% cheaper than Motorola but makes 39% per phone more than Motorola. Larger volume definitely helps in lowering the handset average cost. But I think the real key is in the laser focus of Nokia's management on operating efficiency. While Motorola and other competitors choose to outsource a lot of manufacturing, the bulk of Nokia's manufacturing is done in house. Most factories are located in Asia (China and South Korea), putting Nokia on the same footing with Asian counterparts. Nokia Has a Definite Cost Advantage (please email to get the table that goes here) Fad Segment: R&D Is the King In the fad segment product, differentiation is the key driver. R&D is crucial for maintaining a competitive edge since products are bought for their features and look/feel-like qualities. Almost by definition, changes are quick and often unpredictable in the fad business. In the past, Nokia was in the forefront of the fad -- in fact, it created most of the fads. However, last year Nokia missed one: clamshell phones. Motorola's late success was partially at Nokia's expense. Nokia did not have a clamshell phone, and that's what consumers craved. Motorola had a good product, resulting in 52% growth in volume in the second quarter. Nokia's reaction to its misstep was two-fold: it has lowered average handset price by 22% vs. second quarter last year in an effort to maintain market share and it went to work on clamshell phone -- announcing that will be bringing five clamshell phones to the market this year. I realize that just because Nokia spends twice the amount of money on R&D than Motorola does doesn't necessarily mean that Nokia will have twice as many high-quality innovative products. I don't know if Nokia's R&D productivity per dollar spent is equal to Motorola's; that may or may not be the case. Judging R&D productivity is very difficult especially after hearing that Motorola came up with 17 new cell phones in the last quarter. However, not unlike evaluation of pharmaceutical companies' R&D productivity, I have found a company's past track record of product innovation to be one of the few good indicators of R&D effectiveness. In Nokia's defense, with the exception of the last year's snafu with clamshell phones, the company has a spotless record in product innovation, although I believe it will likely take another two quarters for Nokia to fully recover and introduce phones that are as good or better than Motorola's. Today's Feature-Rich Phone Is Tomorrow's Commodity It takes very little time for today's feature-rich phone to become tomorrow's commodity. Features for which a premium was charged in a "fad" stage of the product very quickly become ubiquitous in a commodity stage. For example, color displays were a new fad last year. Cell phone manufacturers were able to charge a significant premium for the phones with color display over the black and white ones. But color display remained a differentiation factor for a very short time since all the phones that are sold today have them. Therefore a low-cost structure leadership and constant ahead-of-the-curve product innovation are extremely important for the leadership to be sustained. The Cell Phone Space Is Motorola's Game To Lose It appears to me that Motorola's recent success is a temporary phenomenon. It is poorly positioned to stay competitive in this constantly changing industry. Nokia, on the other hand, is a low-cost producer and spends significantly more on R&D than Motorola. Current expectations for cell phone industry unit growth are fairly good; the industry expects to sell 600 million units next year. At the present time, 1.5 billion people (24% of world population) have a cell phone, 60% of the U.S. population has one, and cell phone penetration is extremely high in Europe. I have yet to research potential market size, though I have a feeling that we are lot closer to the mature stage than to the growth stage of the cell phone industry. The real problem for Motorola will come when the growth rate of the cell phone industry slows down or stalls; at that point, the real war will begin. Nokia will be fighting fiercely for market share since it will represent a significant (one of the few) source of growth (the recent price competition will pale in comparison). That is exactly what Dell (DELL:Nasdaq) did when PC sales slowed down a couple of years ago. Dell dropped prices on PCs and took market share from poorly positioned Hewlett-Packard (HPQ:NYSE)/Compaq and Gateway (GTW:NYSE). As I mentioned above, I have not made up my mind on Nokia, but one thing is apparent to me: Motorola is not a good play on the wireless sector.

Copyright 2004

Monday, August 09, 2004

TiVo: Being Acquired Might Be the Right Channel

September 9th, 2004 - Street Insight
I canceled my TiVo (TIVO:Nasdaq) subscription last week; the unit went back to Costco (COST:Nasdaq). Costco has a generous return policy. If you are dissatisfied with a product (unless it is a computer), you can return it to any Costco store at any time after the purchase.
I purchased the TiVo unit about five months ago. It worked fine with my cable box (though I had to glue my RF cable from the TiVo box to the cable box which did not simplify my already-complicated home entertainment system) and the Tivo software worked extremely well. It has a very smart and easy-to-use interface; once it's set up, it works flawlessly.
What changed? I moved. I dropped my Comcast (CMCSA:Nasdaq) in favor of Echostar Communications' (DISH:Nasdaq) Dish Network. From the very beginning, I started having problems making TiVo work with my Dish. After several frustrating hours of yelling at the unit and memorizing the user manual, I gave up and called TiVo customer service. I found that the automated voice-activated system that TiVo uses to direct calls did not understand my "slight" Russian accent or my wife's Colorado English dialect. After 20 minutes, the voice system recognized my wife's cries for help and transferred us to the operator.
It took me an additional 40 minutes on hold to get to talk to the right person just to find out that I have to reset the TiVo box, which could take several hours. I followed the instruction to the tee, but again I could not get the TiVo to communicate with my Dish Network box. I called back (this time I wizened up and I had my three-year-old son who speaks English with a Disney accent say "operator" -- Disney dialect is understood at TiVo), however, after learning that the expected wait time was 45 minutes, I decided to let TiVo go.
Lesson learned: TiVo is a great technology company, but as a stand-alone box, its technology is too complex for the average non-tech-savvy consumer. Unless it is greatly simplified, it may not be economical since it requires a large customer support staff to assist confused consumers. Outsourcing customer service to India maybe a plausible solution -- I would rather talk to somebody in India than be placed on hold for 40 minutes every time I have a question. TiVo Would Benefit From Partnering With a Cable/Satellite System But TiVo's issues run deeper than customer service. Its technology makes so much more sense as part of a cable or satellite box than a stand-alone product. For example, TiVo has to download the programming guides via a telephone line connection. A cable/satellite system like DirectTV or Dish Network or Comcast already has the programming schedule. If TiVo were integrated into one of these systems, the connection would be seamless.
Cable/satellite operators can install and service a unit a lot better than TiVo ever could. Dish Network has a DVR that is far inferior to TiVo which Dish Network installs and services. I bought one of those units for my father several months ago. The satellite guy brought the box, installed it and configured in the matter of minutes without causing any stress to my PhD-holding, but non- tech-savvy father.
TiVo, a $400 million company, would fit in well as a part of Scientific-Atlanta (SFA:NYSE) or Motorola (MOT:NYSE), which could use TiVo's technology to improve their product offering. TiVo is a good software company, but not a great hardware company; its technology would be a great compliment to the satellite or cable box manufacturers.
I really like the idea of being able to watch TV on my terms rather than on the cable company's terms, so TiVo's concept makes total sense. I am seriously considering switching from Dish Network to DirectTV for only one reason -- TiVo comes in the DirectTV receiver and I want a simple, easy-to-use TiVo service.
A Dish Network subscriber, long Disney DVDs and the Disney Channel, Costco member since 1998 Vitaliy N. Katsenelson, CFA Copyright 2004

Sunday, August 08, 2004

Foreign Capital Russian Oil Infrastructure Needs Is Not Coming

August 8, 2004 - Street Insight
In my mind there are two issues that are of concern. First, interruption of much-needed oil flow from Russia (a very valid and important question since Yukos is responsible for 20% of Russian's oil production). Second, the question in my mind that is even more important, is the impact of the Yukos scandal on the future investments in Russia.
It is most likely that in whatever legal form Yukos emerges from this fiasco it will be pumping oil. The more immediate issue here though, since Russian government froze most of Yukos' assets, is that it could potentially cause a stop of oil production. Interruption of oil production for a couple of days, even weeks is not good for the world markets, but they can definitely handle that. The more crucial issue here is would Yukos be able to produce oil at the same level after oil wells were idle for a period of time?
After talking to the old oilman and engineer (and may I mention a hedge fund manager at the same time) Ed Stavetski, I was advised that temperature is a key factor to the resumption of oil production. Currently, temperature in Siberia is about 42-60 degrees Fahrenheit, which is warm enough to make it unlikely for wells to freeze. Ed advised that in case of interruption, additional pressure and heat may be necessary depending on oil viscosity and surface temperature to pump oil to the surface -- all of which cost large amounts of money to supply, thus hindering the profitability of oil wells and requiring additional investment. Also, one needs to understand the Russian psyche. Russians get compensated in two ways: in rubbles and in "hope" (though dollars are preferred). After the collapse of the Soviet Union, hope was the currency of choice for the Russian government; it has experienced such huge budgetary deficits that it delayed paying workers for six months or longer. This currency (not paid on time) is not familiar to western countries where inflation is running in very low single digits. Hope runs deep in Russia. At that time (in the early 90s), inflation was running 20-30% a year. Imagine getting paid six months or a year later and being able to buy a third less with the money than you could when you earned it. Though Yukos' employees under current management have not received "hope" compensation for awhile, they will take it since their options are limited. So even with the funds frozen, it is unlikely that the oil wells will stop producing oil. However, this is where the "positive" story ends. This scandal will have a long-lasting impact on Russian oil production. It is very likely that this scandal will scare foreign investors from Russia. If I was an executive with Exxon, BP Amoco or Royal Dutch, I would think twice about committing any new capital to Russia or I would demand a rate of return that would factor in a significantly higher political risk. So the foreign capital that is much needed to develop oil (especially pipelines) infrastructure, will not be arriving anytime soon. In my opinion, we will not see an increase in oil production from Russia, thus current world supply/demand imbalance may remain where it is.
Vitaliy N. Katsenelson, CFA

Copyright 2004