Tuesday, May 11, 2010


Last Monday Holland's largest financial newspaper published a special on Energy. Using the published data, we could easily derive that the rapid rise of the Emerging Markets and their continued structural advances are easy to explain. Even - or maybe especially - when using the concept of a production function.

Micro Economists came up with this concept. The production function describes the technical relationship between the inputs that are necessary to create products and services on the one hand, and the generated output on the other. For the purpose of this presentation we define four different inputs:
1) Technology
2) Labor
3) Capital
4) Energy

Historically the Western, developed nations had a comparative advantage in Technology and Capital. Recently, we see that Emerging nations are challenging the Western lead in both these areas, especially in Capital. Our Western hunger for cheap Chinese products, Taiwanese cheap technology, Indian textiles, Middle Eastern oil et cetera has generated a money flow from the West to the Emerging nations that has now reached such a level that many of them are now sufficiently capital-rich to consider capital exports, i.e. foreign direct investments. Technology is directly linked to education and information exchange, either through academic journals and/or cross-border study by bright students from various countries. Recently, we do see in this area that Emerging markets do either acquire knowledge or just buy it, using their newly generated financial wealth.

Cheap and efficient labor is currently the prerogative of Asian Emerging Markets. Africa could of course have potential in the future in this area, but its potential is still largely unleashed. Labor productivity in Western countries is still relatively high, but that is mainly because of the usage of advanced machinery. When it comes to skills, management techniques etc. Emerging nations are closing the gap a bit: year by year. And to the extent that certain labor skills are not available in the Emerging nations, they do now also have the financial capital to attract those skills. See for instance one of our earlier contribution to our Tigers and Frontiers blog: one of the success factors behind Singapore's successful shift from Third to First World was related to its acquisition of the necessary skills in various industries through the import of large amounts of skilled foreign workers. Up to a level were almost 50 percent of the population is foreigner.

So with more of a balance in the World's distribution of financial capital, a plus for Emerging countries when it comes to Labor and a declining advantage for the West in terms of Technology, it is clear that Energy will be the crucial production factor of the years to come. In the table below we present the Energy situation in various parts of the world, expressed as years of reserves that a country has based on its energy consumption per 2008.

Energy Reserves per Country
Expressed in years of reserves based on current consumption levels

When comparing the numbers with the equally-weighted averages we see that with the exception of only ONE region-energy source combination developed nations are colored RED, indicating that they suffer from a below-average availability. I.e. they have to be net importers on an even larger scale than they already are.

The only exception is the above average availability of gas reserves in Oceania, when comparing it with the needs of its population. All other areas with above-average availability of Energy are in Emerging Markets! Russia (and Kazakhstan, not included as separate region), the Middle East and Africa are the regions with commodity potential and a relatively large availability of the scarce resource. Remarkable: Emerging Asia is in the same situation as the developed nations, but we believe that its ongoing dominance in Labor will compensate for it.

Of course, international trade theory suggests that there is nothing wrong with one country or region having a larger amount of resources than another. Through trade the country with excess supply can sell to the country with excess demand. Now, and that is our worry: we all know that coal and nuclear energy, the two energy sources that are or could be available in abundance are also politically the least acceptable ones. That is really a pity, because our table does clearly show that without these energy resources price pressure will mount. Price pressure that will further increase the capital flow from the developed nations and Asia into the Middle East and Russia.

Especially the Middle East will therefore be a force to reckon with in the years ahead of us. Remarkable that in all discussions about how the Euro zone nations will solve their Euro crisis or in a broader setting how Western nations will cope with the crisis almost no one talks about the structural growth in the money inflow from Emerging nations. Through investments in Western Europe and the US they will ascertain that their Technology disadvantage and/or lesser skill set in Labor will also be compensated for.

Structurally this will imply a further increase in Globalization, but this time with a shift in money flows. This shift will a) support Western nations at least to some extent; and b) further ensure structural growth in Emerging nations.

Conclusion: this macro analysis shows that it is almost impossible that Western markets will continue to dominate. It also shows that it might be foolish to believe that China and India are the 'ideal' Emerging nations to invest in. In the longer run China and India will definitely be global leaders, for sure. But with everyone focusing on them to such an extent that valuation levels are pushed upward, the Middle East and to a lesser extent Africa seem to be the new top markets for smart money investors. Obviously these markets are also political tricky. But we believe that - using a similar analysis as ours here - growing numbers of politicians in Western countries will understand that the price they have to pay for a tough stand on Middle Eastern nations is simply to high.

The only thing that could harm the opportunities in the Middle East seems to be a rapid development of renewable energy sources at such a scale that the Middle Eastern advantage in fossile fuels is marginalized. We believe that this is almost impossible. First, because of actual developments and prices (renewable energy is often still too expensive compared to fossile fuels) and second, because Middle Eastern nations are not sitting and waiting when it comes to these developments. Actually, the potential in the Middle East for solar energy is huge and be sure that they are the first to act - by that time they definitely have the money! - if renewable energy would pose a threat to their fossile fuel revenues.

When we look at the top-15 in the world when it comes to oil reserves, we see that Iran is a prominent nr 2 after Saudi Arabia. Knowing that the World needs Energy it is also clear from this table that we need Iran's reserves. We believe that the likelihood of some kind of dialogue in the Middle East is therefore still large, notwithstanding today's tensions.

Oil Reserves - Top 15 Countries

But structural long-term stories can only be benefited from when adding a proper risk management layer in which investors manage financial, political and other risks and short-term aberrations from the longer-term trend. This can be done through smart diversification and hedging, but one needs the expertise to evaluate the different countries.

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