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The looming oil shocks: how Japan is going "green"

Japan, Inc., Oct, 2004 by Darrel Whitten

JAPAN remains the favored stock market among foreign investors. Foreign bulls point to a restructured corporate sector in a deflationary environment that is now producing record levels of free cash flow. If deflation ends and top line growth resumes, the operating leverage for earnings will be dramatic.

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THEY HAVE NEVER SEEN such a broad-based earnings recovery across the breadth of the whole market. Japanese corporate profits are now at record levels in nominal terms, even as the Topix remains 61 percent below its peak reached in December 1989. Because of spectacular derating during the Heisei Malaise, the Japanese stock market is now trading at a multiple of some 17x, which is the lowest since 1975, and lower than the US market, a factoid that would be unthinkable in the mid-80s.

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Yet despite all this apparently good news, the Japanese market appears to be at a crossroads. The US markets are looking at a heavy correction, now that chairman Alan Greenspan and the US Federal Reserve are moving to tighten monetary policy. A slowing US economy presents risks for the Japanese economy, which is still largely dependent on external demand for growth. The OECD leading economic indicators, the Tankan diffusion index of large manufacturers and the Cabinet Office's coincidental indicator of business conditions, as well as 10-year JGBs, are giving strong hints that the Japanese economy may be heading for a cyclical peak.

The recent weakness in the Topix and Nikkei 225 is a reflection of this concern, as positive quarterly earnings results have gone largely unnoticed and unremarked upon.

If this is indeed a cyclical peak in the economy, the Nikkei 225 could slip below the 10,000 level again. But Japan does not look as risky on the downside as the US, precisely because it has already suffered such a prolonged deflationary cycle.

What investors seem to be underestimating, however, are the implications of the recent surge in oil prices, despite waning prices of other commodities. Brent crude oil prices have spiked to over $41/barrel, from $24/barrel in the second quarter of 2003. Actually, oil prices have surged three-fold since 1998. The ostensible reasons are many, including geopolitical concerns, a government crack-down on Russian oil companies and other short-term supply interruptions.

Future shock?

However, those who closely follow the global supply-demand balance for oil prices have been warning of the possibility of another oil "shock" for some time. Some suggest this may be as little as five years away.

Oil discovery in the US peaked in the 30s. Peak production came 40 years later. Globally, the peak in oil discovery was in 1964, so it should be no surprise that the corresponding peak in global production is getting close. Doctor Colin Campbell of the London-based Oil Depletion Analysis Center says the global peak could be in 2010. The steady increase in world demand naturally influences the rate of depletion.

In fact, oil prices would have moved higher and faster were it not for the global recession after the bursting of the IT bubble. As the global economies continue to recover, oil demand will rise in parallel until it again hits the falling ceiling of capacity--causing prices to soar.

The major turning point comes from the "swing production" countries (Abu Dhubai, Iran, Iraq, Kuwait and Saudi Arabia). The Middle East's share of world oil supply was 38 percent in 1973, when the first oil shock hit, fell to 18 percent by 1985, and is now again on the rise, surpassing 30 percent. The Middle East's share could reach 50 percent by 2009. By then, the Middle East will also be close to its depletion midpoint, and will be unable to sustain production much longer--regardless of political will or the availability of investment funds.

According to Campbell's base case scenario, a near absence of spare capacity in late 2000 was forcing up the price of oil. Oil prices would have moved higher and faster then were it not for the global economy falling into recession.

The oil shocks of the 70s were traumatic. The nearly 10-fold surge in oil prices between 1970 and 1980 was the root cause of global inflation--and the cause of a global recession, with waning demand and output. With regard to the conventional economic theory, this was an anomaly, a curious combination of inflation and weak economies called "stagflation."

The immediate effect on stock prices was also deleterious. The US market fell 48 percent in 1973, the year of the first oil shock. Japan's Topix took a little longer to adjust, falling some 36 percent from January 1973 to October 1974.

In 1973 and 1974, Japanese wholesale prices surged 15.8 percent and 31.4 percent respectively. Overnight call rates fluctuated wildly from 8.25 percent in 1974, but JGB yields trended fairly steady, between 7.2 percent and 9.1 percent, largely because the JGB market was not liberalized to trading yet. Conversely, Japan's economy stagnated, decelerating from 9.1 percent real GDP growth in 1972 to -0.5 percent in 1974.

Business Services Industry

The looming oil shocks: how Japan is going "green"

Japan, Inc., Oct, 2004 by Darrel Whitten

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