Tuesday, August 13, 2013

Has Charlie Munger gone senile on US Energy Independence?

Charlie Munger is the long-term business partner of Warren Buffett, the legendary chairman and CEO of Berkshire Hathaway (BRK.A) (BRK.B). Munger is the deep thinker who has managed an impressive record with his investment partnership, at Wesco Financial and Daily Journal (DJCO). Munger overcame huge obstacles in his life, including death of his son and divorce to make billions of dollars. Munger is the one who changed Buffett’s perspective on business and investing from cigar butt type investments to buying quality companies trading at fair prices. Munger is a genius and has achieved a lot of wealth in the process.

However, sometimes even accomplished people such as Charlie Munger venture outside their level of expertise, and start making statements that sound weird.

I am referring to his comments on energy independence (source: Morgan Housel & this video)

Oil is absolutely certain to become incredibly short in supply and very high priced .. The imported oil is not your enemy, it's your friend. Every barrel that you use up that comes from somebody else is a barrel of your precious oil which you're going to need to feed your people and maintain your civilization. And what responsible people do with a Confucian ethos is suffer now to benefit themselves and their families and their countrymen later. The way to do that is to go very slow in producing domestic oil and not mind at all if we pay prices that look ruinous for foreign oil. It's going to get way worse later ...

The oil in the ground that you're not producing is a national treasure ... It's not at all clear that there's any substitute [for hydrocarbons]. When the hydrocarbons are gone, I don't think the chemists are going to be able to just mix up a vat and create more hydrocarbons. It's conceivable that they could, I suppose, but it's not the way to bet. We should spend no attention to these silly economists and these silly politicians that tell us to become energy independent.

Let me pose a question for you. It's 1930. Oil in the United States is in glut. We have cartels to get the price up to $0.50 a barrel. Everywhere we drill we find more oil in our own country; everywhere we drill in Arabia we find even more.

What would the correct policy of the United States have been in that time? Well, the correct policy would have been to issue $150 billion of very long-term bonds and cart 150 billion barrels of Middle Eastern oil into the United States and throw it into our salt caverns and leave it there untouched until the current age.
It's easy to see that in retrospect, but who do you see who ever points this out? Zero. We have a brain-block on this issue. We should behave now to do on purpose what we did on accident then.”

I read this statement, and I understand his idea in theory. In reality, it seems very stupid. Of course the risk is that maybe i am so simple minded, that i do not understand the wisdom of those words.

First, the size of the US economy was about $100 billion in 1930. So it would have been tough to borrow 150 billion, which would have been 1.5 times the size of economy. I am sure that if this were done in 1930, many people would have been unhappy about this debt deal. It would have also been difficult for a country to sell a debt issue of that size, without shaking the markets and raising its interest rates. The backlash from voters would have been ever worse, as it would have been seen that this is effectively enslaving future generations with interest payments on oil that won’t be used for years. Remember when everyone proclaimed the end of the US as we know it in 2008, when we had the $700 billion in TARP funds? How would you like it if the US government decided to borrow 15 trillion today and buy oil to be used in 100 years?

Second, this idea is nonsense because it introduces the concept of leverage. Leverage is a dangerous tool, that can lead to total destruction of capital even if you are 100% right. A country that instantly leverages itself by borrowing an amount that is 1.50 times the size of its economy is levering itself, and thus leaving it highly susceptible to short term fluctuations in macroeconomic factors. To put it in simple words, things don’t go up or down in a straight fashion. For example, if you were smart enough to recognize the genius of Buffett in 1972, and bought Berkshire Hathaway on margin that very same year, you might have little to show for your forecast. This is because the price of Berkshire stock fell by more than 50% between its 1972 high and 1975 low. An investor on margin would have been forced to sell at the depths of the market crash of 1974, in order to cover margin loans. Munger should have known better, because his friend Rick Guerin did exactly that leveraged experiment, and sold Berkshire at $40/share in 1974.

So back to the thesis on US taking a $150 billion loan to buy oil in 1930. Even if the country somehow managed to convince creditors that it can afford to take this loan, it would have still bankrupted the country. That’s because GDP fell by 40% between 1930 and 1933, and recovered by 1937. GDP in current dollars was 103.6 billion in 1929 and 91.20 billion in 1930. In 1933, GDP was 56.40 billion, and in 1937 it was 91.90 billion. A country with a GDP of 100 billion, that takes 150 billion loan, has a Debt to GDP ratio of 1.50. A country with a GDP of 50 billion and a 150 billion loan has a Debt to GDP ratio of 3.


Source: Shmoop

If this deal that Munger proposes had been done, the US would have been bankrupt by the depths of the Great Depression. Then the oil would have probably had to be sold for pennies on the dollar, simply to repay the debt.

Even if US withstood the harsh realities of great depression, and kept paying off the debt, it would have been much more difficult to raise money to fight Hitler. Between the end of 1940 and the end of 1946, Federal Debt as a percentage of GDP increased from 44.20% to 108.70%. The increase was because money was needed to fight the enemy. Without winning World War II, the US could have either ended up as a communist country or simply ended up as a Fascist country.


Source: Multpl

Further, the oil booms of early 20th century, created a lot of rich people, and developed US economy. The growth in GDP from that, has created a ripple effect that has made all of us richer. This is due to increase in science and technology, and due to providing work for people and lifting them out of poverty.

Munger sounds like a lot of other smart and accomplished people, who say that something cannot be done any more at end of their careers. I am specifically referring to his comment about scientific progress. Let’s go through some examples of successful people making predictions:

Ben Graham said one cannot profitably research stocks anymore in 1976. This was false as his prodigy Buffett proved him wrong, as he was picking GEICO at rock bottom prices. Buffett has also bought shares in Washington Post (WPO), Interpublic (IPG) and other companies at rock bottom prices a few years earlier, after analyzing them.

Munger is saying that science and technology cannot help in discovering oil. First of all, the current US energy revolution is helped by improvements in tech. High oil prices will provide companies with incentives to invent technologies to drill for oil in far reaching places. If prices go higher, i can bet scientists will find that you can make oil and gas in a lab.

Oil is important for energy. But also for other items like plastics, pharmaceutical and other everyday life uses. We can use energy from sun, but not to make plastics. However, chances are that the scientific and technological progress will identify ways to deliver cheap energy and everyday items at low prices some time in the future. Thus, I am not at all worried that oil will run out or that we will go back to living in caves.

Saving all oil so US can use it 100 years later is similar to what Buffett says" like saving sex for old age".

Munger is still investing legend, and I would likely never reach same level of wealth as him. However, he might be best suited to stick to doing investments, rather than discuss macroeconomics. Of course, if your goal in life is to make money in investments, you might not be the best person to make long-term predictions. If Munger is not senile, then his idea could be meaning that oil companies could be good long term investments.

I am happy to be owning Chevron (CVX), ConocoPhillips (COP) and Royal Dutch (RDS.B) ( ranked in order of my happiness holding these companies). The companies yield 3.20%, 4.10% and 5.30% respectively. The moral of this story is that as individual investor, you are the one ultimately responsible for allocating capital. You should not rely 100% on judgement of others. Outsourcing your investment decisions to others could be costly. Also, if you are an investing legend, stick to being an investing legend.

It is also important to learn another thing about risk. As you grow older, you might end up doing decisions that could be very costly. By not being flexible, you can stick to your Citigroup (C) stock in 2008, because it paid you dividends for many years prior to that. This is the reason why I have the automatic rule to sell after a dividend cut. If I have diminished mental capacities in 2040, it would be easier for someone managing my otherwise long-term investments to follow a rule based guideline. I am also considering whether a low risk index fund wouldn't be a good situation, given the lack of interest in managing investments on the part of my descendants. This is something that came to me, as I was thinking about this article. I need to do a little more thinking, and would try to share my findings with you.

Of course, given the long-term nature of my dividend paying holdings, I am fairly confident that a fun-loving DGI trust-fund baby that only collects dividend checks and doesn't sell anything, will likely do well for the next 50 years. My dividend portfolio is built so that it can generate healthy amounts of cash, with low upkeep required.

In summary, I believe that Munger should be sticking to doing investments, rather than solve economic issues. I still find him of the best investment minds of the past 100 years, and plan to keep learning about his investment style.

Full Disclousre: Long CVX, COP, RDS.B

Relevant Articles:

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How Warren Buffett made his fortune
How to Generate Energy Dividends Despite the Peak Oil Non Sense
Warren Buffett on Dividends: Ideas from his 2013 Letter to Shareholders
Warren Buffett’s Dividend Stock Strategy

10 comments:

  1. I enjoy reading your posts and your investment style. The title of your story is eye catching because if somebody in this world doesnt know who Charlie Munger is then they dont know squat! I hope Mr Munger responds to your story because that would be a lively debate. I read the quotes and you sort of have to read the entire speech or story to fully understand what he meant by it. Your analysis is based just on what he said in the quote and was sound to me.Berkshire does own Mid American which is an energy company so Charlie may have more insight then we know. I know you didnt mean to disrespect Charlie in anyway and you must of enjoyed learning from over the years as I have. Charlie is a true American legend much more greater then The sage of Omaha(Buffett). Charlie took life on full force in many areas that he was interested. He gave a good chunk of his fortune over the years way way before Warren even thought about it. Warren didnt want to deal with it an figured his wife would of outlived him so she would of took care of it. Warren is a deep thinker but lived simplistically. Charlie is a deep thinker but lived multidimensional life. The greatest thing Charlie did for Warren was to open his mind to investing outside of his mentor's teaching. The greatest thing Warren did to Charlie was to convince him to give up his law practice and enter the investing arena full time with him. Both men are giant independent thinkers that always think the same in many respects to investing. Thanks for your article but I do hope Charlie honors you and answers although I would doubt he reads blogs but one never knows.
    Peace

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  2. Perhaps Munger was speaking figuratively and you take him literally.

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  3. Excellent article...... agree with all your points.... Alternative energy sources are and will be developed to replace oil over time... keep up the good work.....enjoy your insight.... gs

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  4. Munger is right and my opinion is you are over analyzing one portion of his statement.

    Paying a little more now and having domestic supplies available in the future is worth the risk.

    How you think for a countries long term survival is different than how individuals think, so "saving sex for old age" doesn't really apply.

    Overall very thought provoking, so nice work!

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    Replies
    1. Agree with you. This blogger should take his own advice that he gave Munger and leave the big ideas to the visionaries.

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  5. Anon,

    If I create a lively debate, that would be awesome.

    I have learned from Charlie a tremendous amount, and I agree he is very smart - he reads a book every day, and changed the mind of Warren Buffett But I do believe he is speaking out of line on energy independence - after all science will be much better 100 years from now both on the production and consumption side.

    Second Anon,

    I am not sure about that. He does certainly speak his mind, as he should - his main goal of attaining FI was simply to get the freedom to do what he wants.

    Third Anon,

    Thank you sir. Oil will be replaced as an energy source one day.. But it would still be needed for a plethora of other items of everyday life... I hope we get to live over the next 4 - 5 decades, and see how it all pans out.

    LAst Anon,

    I am not sure a country can mortgage its future, to pursue something that can or cannot happen 100 years from now. Also, do you think other countries would knowingly let the US use their oil first? Next, I think science will "bail us out". Last, I think we would use about the same amount of oil in the world 30 - 40 years from now, because we would be more efficient in using existing resources.

    I do think however that oil majors should do well for next 30 -40 years. After that, it is up to my descendants to worry about it ;-)




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  6. Perhaps we should buy oil from others on a budget. Buy a certain amount of theirs and save that amount of ours. I have a spending plan, it is a shame our country does not.

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  7. While Mr. Mungers numbers may be off I generally understand his sentiment. Buying goods now in order to reap greater rewards later. It's not so unlike buying a strong stock that will increase in value over time.

    Cheers,
    CD




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  8. Booban,

    If the US had done as Munger suggested in 1930, it would have bankrupted itself. True US could keep buying foreign oil, but back in 2008, public opinion was against spending hundreds of billions of US currency on foreign oil. It was called "the largest redistribution of wealth in US history".

    Stating that science will not improve does not strike me as "visionary". If you think that is "visionary", then be my guest.

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  9. Munger used this example to illustrate the magnitude of the importance of oil and the fact that scarcity will surely become an issue in the future. Its like criticizing me for saying, I should have put every cent into apple 10 years ago, because I would have died of starvation along the way.

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