Heading For The Exit Lane

Vruz sent me a copy of this CIBC research report called "Heading For The Exit Lane." I read it this morning and I’ve been thinking about it for most of today. So I uploaded it to Scribd and reblogged my favorite line in the report on my tumblog. But that didn’t get the report out of my head.

This oil thing sure has legs. Even if we aren’t in a "peak oil" situation (and even the Saudis can’t agree about that), we’ve gotten to a price point where consumer behavior is going to change significantly over the next few years. Over the long term, that’s a good thing. The world economy is addicted to oil, largely because it’s been so cheap for so long. But it’s not cheap anymore and given the pace at which the rest of the world is developing these days, it’s not going to be cheap ever again. Unless we find another source of energy that is a lot cheaper than oil and I am not aware of any developments that will get us there soon.

This has bigtime ramifications for slowing growth and rising prices (inflation). And these impacts will not be limited to the US economy. They will be felt worldwide. The hypergrowth economies of China, India, Brazil, Russia, and other developing economies may not be impacted as much as the more mature economies like Japan, Europe, and most of all the US. Russia, in particular, stands to benefit greatly from the spike in oil prices.

Slower growth and rising prices (inflation) cannot be good for equities. Rising rates, which is what will have to come, will not be good for any kind of financial assets.

Which, of course, leads me to venture capital. The value of your equity in a startup company is a financial asset. It may not be publicly traded but like all other financial assets it is ultimately worth the present value of future cash flows discounted at an interest rate that takes into account market rates of interest plus a risk premium.

We’ve been operating in a world where real interest rates have been hovering around zero (at least in the US). And that has propped up the value of equities and venture capital assets have been part of that prop-up.

All we have to do is look at the 70s to see the effect of low growth and high inflation (stagflation). Here is a chart of the Dow Jones Industrial Average during the 1970s.


Yes, that’s right, the Dow Jones Industrial Average ended the 1970s right about where it started.

I wasn’t in the venture capital business in the 1970s. I was a teenager that decade. I remember Vietnam, Watergate, the oil shocks, the gas lines, Gerald Ford, whip inflation now, Jimmy Carter, the Iran hostage crisis, and Paul Volcker and Ronald Reagan.

The first venture capital firm I worked for, Euclid Partners, was formed in 1971. The two founding partners, Milton and Bliss, raised about $4.5mm in 1971. They didn’t raise another fund until 1983. They strugggled mightily during the 1970s with their portfolio and ultimately made it work when the technology market took off in the early 80s. I heard a bunch of stories from them about that time and it was not an easy time to be an entrepreneur or a VC.

Surely the next 10 years won’t be identical to the 1970s. A lot has changed, particularly the global economic environment. But it’s also clear that the economy we are in (and maybe have been in for the past 18 months) is going to be tougher for owners of financial assets than the past 20 years have been. And I don’t think the startup economy and venture capital is immune to this new reality.

So what should we do about it? Well first, we need to be careful with valuations. If financial assets are going to be subject to downward pressure then inflated valuations will not be sustainable. We need to be careful with the amount of money we invest and burn. Companies that are capital efficient and cash flow positive will fare better in this environment. And we need to be prepared to wait a long time for liquidity.

It’s ironic that the title of the CIBC report is "Heading For The Exit Lane" because I think the exit lane will take longer to find and possibly be less rewarding in the coming years.

A Final Thought: This may mostly be good news for cleantech investors. As oil gets more expensive, cleantech and alt energy technologies can become commercially viable more quickly. But it takes a lot of money, biotech-like capital investments, to get most cleantech investments to profitability. So if the capital markets are going to be more difficult, it’s not all good news for cleantech. And the web clearly has a role to play in all of this too. More on that later.

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Comments (Archived):

  1. Jerry Neumann

    Fred -Not that I’m telling you anything you don’t already know, but in valuing a company, you should either discount with real interest rates (not nominal) or inflate the cash flows per expected inflation. The former is easier. In theory inflation should not have an effect on valuation, because inflation is a purely monetary phenomenon. In practice things are trickier (as your chart shows) but if financial assets did not inflate along with consumer goods, then the chart of the inflation adjusted DJI would be downwards trending over the course of it, not just for the 70s.Here’s a cpi-adjusted chart of the DJI: http://www.itulip.com/reald…The real downward Dow of the 70s actually started in ’64 or thereabouts and lasted until about ’84. This rules out the early ’70s oil shock as a cause. Personally, I think it was a result of the massive destruction of economic value caused by our government’s spending on the Vietnam war and the cold war; materiel can’t be considered an investment once you detonate it.Not that should assuage your pessimism about financial assets.Jerry

    1. gregorylent

      excuse a dumb question, could this be applied to valuing oil?(separately, speculation and dollar devaluation seem more responsible for price rise than asset shortage, imho)

      1. fredwilson

        A lot of people think that speculation, dollar deval, and other financial market forces are to blameI think that’s true to a degree. But as they say, when there is smoke, there’s fireFred

    2. fredwilson

      Agreed on all points jerryI think most of our startups aren’t going to be able to charge more just because there is inflationTheir costs will not go up much nor will their competitors (labor being the likely exception)So I think inflated cash flows and current cash flows may be the same for most web startupsFred

  2. bill_roberts

    Have you seen “Sustainable energy – without the hot air”? (http://www.withouthotair.com/). It makes fascinating reading on the alternatives for getting away from carbon-based energy. The author is a physics professor and he does a great job of explaining the impact and feasibility of different energy generating choices: wind vs nuclear vs solar vs biofuels etc. Investment tip: buy cheap land in sunny places and build solar power stations on it!

    1. fredwilson

      I will go read it.Its interesting to see the second order effects of the oil price increases:Crops and food getting more expensive because of biofuel competitionCertain kinds of land getting more expensiveEtc, etc

  3. jeremystein

    id actually argue that its a great time to be a vc. theres going to be a fundamental shift from buying, leveraging, and selling companies to starting and building companies with real value.

    1. Michael F. Martin

      That should be true, but it depends crucially on investors being able to identify and reach consensus about “real value” over the time-scale relevant to fundraising and growth.I believe that this cannot happen until accounting standards are changed to provide a more realistic picture of how firms work. The current accounting standards were developed with a picture of firms in liquidation as the model. Newer accounting ideas focus more on how firms are like engines, with inputs (including capital) being fuel for future cash-flow.We can’t invest or manage what we don’t measure.

      1. gregorylent

        and what we can measure can still be the angles and inclinations of a house of cards.(i suspect the basic structure of the economic/finanacial/market system in us of a is a bigger threat than oil)

    2. fredwilson

      The former will struggle for sure but I believe there will always be room for both styles of investing

  4. Chris Rossini

    That Dow chart is even worse than it looks on the surface….For $1 in 1970 was worth much less by 1979 because of currency debasement.So even if the Dow broke even over the decade, you lost money because of a depreciated dollar.

  5. MaxS

    > Russia, in particular, stands to benefit greatly from the spike in oil prices.if I may jump in with quick comment: Russia is NOT a beneficiary of ongoing oil madness. In fact that absolutely worst thing that could possibly happen on a country level. As i deal with our RU subsidiaries over last few years its simply horrifing how much Venezuela-style damage is being inflicted. China & India are real winners here, lacking natural reserves many dynamics of post-WWII Japan will come to play here.

    1. fredwilson

      That’s true, long term it doesn’t help themBut they are rolling in money right now

      1. MaxS

        and so are the Saudis. which set a golden “standard” of stagnant patriarchical society going absolutely nowhere. the only difference is that Saudis may not have had any historical choices beside selling oil, Russia [used to have] lots of opportunities. however the tidal flood of oil revenue is breaking all casuality links between perfomance,innovation, personal excelence, rewards for risk-taking, etc etc. today in Russia the choice between “try something” and “join oil patriarchy” is not really a decision – its IQ test with orders of magnitude difference in compensation and career path.

  6. Michael F. Martin

    Fred,I believe your analysis is right on the nose. You should read the following speech by Stanford economics professor John R. Taylor about how Japan was able to avoid the inflation trap that the U.S. fell into during the 1970s. The upshot is that if the Federal Reserve were to raise interest rates dramatically right now, it might avoid some pain and suffering later over the longer term.http://www.stanford.edu/~jo

  7. jackson

    The BRIC countries certainly are ‘drinking our milkshake’, to borrow a term from John Stewart, and coupled with the lousy Dollar – a result of the US borrowing billions from those same countries to fund our nasty war habit has left us in a position where we’re going to have to start changing our habits, much of which is long overdue.Life goes on.Acoustic guitars require no fossil fuels to operate.

  8. Jon

    As oil gets more expensive, cleantech and alt energy technologies can become commercially viable more quickly.The sad news is that the US government is putting a large part of clean tech on hold. Applications for large-scale solar and wind development projects in the desert are officially subject to a 2 year hiatus while the government studies their impact on the environment.http://www.nytimes.com/2008…You’d think this news comes from The Onion, but the geniuses in DC are more worried about the fate of a few desert animals than the fate of worldwide ecosystems affected by global warming. Well, while solar and wind projects are put on hold, more coal power plants can be built. After all, those won’t affect the desert tortoise.

  9. howardlindzon

    rsx (russia) is one way to keep investing if you believe the oil trend is unstoppable. Canada, which I write about all the time is the other.great post.The Dow has basically gone nowhere for 8 years already, so interesting times ahead indeed

    1. Soren Macbeth

      Don’t forget about Venezuela and Mexico.

  10. Dan Conway

    Unfortunately, there’s not much of a difference in the Dow performance so far this decade. We had a spike at the beginning but we’re now back below where we started. December 31, 1999 we closed at 11,497.12. Today, eight and a half years into the decade, we’re at 11,346.51. I would like to believe that we’ll close out the last year and a half strong but at the moment with energy prices, the banking crisis and the correction in real estate there’s not a lot of confidence in that happening.Given the performance of the past eight plus years, it is frightening to think that the value of equities prices are propped up and that real slower growth could just now be beginning.This might go on for awhile. The ’70s market funk carried on until mid-1982.I’m excited by the opportunities and potential rewards in this market environment. Technology, the web, and intelligent social networks help a great deal. Twitter, when it is working,can be an invaluable asset. It was beyond frustrating to seeing the whale or less on Thursday when the market was down 300+. But that too speaks to the value of that web technology.

  11. fakedjs

    I watched Jarheads tonight, again I realize why we throw our weight overseas.

  12. CCjudy

    Union Square Ventures could open another branch focusing on CleanTech. Its value is going to increase. Also can you and your family see Pixar Wall-E there? its a powerful message for a Green World J

    1. fredwilson

      We aren’t going to do cleantech because we don’t have the backgrounds and experience to be among the best at itMore likely is we’ll look for ways that the web can helpFred

      1. CCjudy

        Joseph Campbell said to “follow your bliss” Yours Fred is music – there are many music sites on the New Web. I aggregate new Web Web sites and there are many categories under that umbrella of Music in addition to http://www.strangeglue.com. You could focus on that niche that sector of emerging companies

        1. fredwilson

          I have spent more time than I care to admit playing with, using, and contributing to ‘new music’ services on the webI am a huge fan of many of themBut my assessment of their business prospects is dim. In order to have a viable new music service, you need to have both established and new artists. And you need to be operating legally, not in the grey or black marketUnfortunately the rights holders are extracting very large upfront fees, both cash and equity, to license established artists on these new music servicesThose fees are crowding out innovation, diluting the entrepreneurs, and establishing a difficult risk/reward proposition for investorsSo we will sit that market out and hope that someone else can figure out how to make it workFred

          1. Jake Kaldenbaugh

            Best summary I’ve heard of the opportunities in Digital Music to date. Also, don’t forget that the market is currently dominated by a hardware vendor…

  13. gregorylent

    often lost, it seems to me, is that the market doesn’t measure anything real, it is a manipulated ponzi-scheme mixed in with group psychology … a pov which should get me well and truly ostrracized from all business blogs 🙂

    1. fredwilson

      On this point I will have to disagree gregoryMarkets are the best pricing mechanism over the long runIn the short run, they have issuesFred

      1. kid mercury

        markets only work when market participants have the truth. the further you stray from the truth, the more inaccurate the pricing mechanism becomes.

        1. fredwilson

          But those who have the truth can profit greatly from it

  14. JimHirshfield

    Your points are SO very much in sync with the scary realities outlined in an article in yesterday’s NY Times “Venture Investors Wrap Up an Unusually Bleak Quarter” http://www.nytimes.com/2008

  15. Jim

    2 weeks ago I presented my proposal to grow ethanol (switchgrass) at the MIT Enterprise Forum Whiteboard Challenge. All I had was a whiteboard, a marker, and 5 minutes. No Powerpoints or computers. My idea is to grow ethanol without using any existing farmland. We have currently identified 2.4 million available acres that could produce 2.7 bill gallons of ethanol in a matter of months.The problem is there is not yet economies of scale in refining for swithgrass (cellulosic ethanol). It is not yet at the point for mass production. Until then though, my partner and I are locking up these land deals.We need a portfolio solution to our energy problems. That way if one solution fails the rest can still sustain us. We need a mix of Nuclear, Clean-Coal, Ethanol (algae / Switchgrass), solar, wind, and oil.

  16. michael

    I am not sure you understand inflation.”But inflation is woefully misunderstood, even among financially-sophisticated folks who should know better. I’ve heard Chairmen of the Federal Reserve, elite Wall Street analysts, and countless news-media personalities claim rising prices are inflation. This common misperception is flat-out wrong. Rising prices alone are not necessarily inflation. Inflation is purely and exclusively a monetary phenomenon.”http://www.kitco.com/ind/ha…

    1. michael

      Too good not to share more for those who won’t click through:”If driven solely by a supply-and-demand imbalance, rising prices have absolutely nothing to do with inflation. If gasoline prices rise because supplies decrease relative to demand, this isn’t inflation. It is simply the free markets at work addressing a supply imbalance. Rising prices simultaneously retard existing demand and entice new supplies to market, leading to a new equilibrium level between consumption and production. These simple economics work in everything from hamburgers to houses.All throughout history, inflation has exclusively been rising prices directly driven by growth in money supplies. If you have relatively more money competing to buy relatively fewer goods and services, the only possible outcome is higher prices. And although the meaning of words gradually changes over centuries, if you look in any dictionary, encyclopedia, or economic textbook today you’ll find that inflation is monetary.Dictionary.com defines inflation as “a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency”. American Heritage says inflation is “a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services”. I added the italics for emphasis.So if anyone ever tells you rising prices are inflation, realize they either don’t know what they are talking about or they are intentionally trying to mislead you. Rising prices are only inflation if they are directly caused by an increasing money supply. The problem is rising money supplies often coincide with supply imbalances in specific commodities, so usually both inflation and simple economics are co-drivers.For example, global oil demand is growing as China, India, and the rest of the developing world drive more cars and transport more goods. But supply growth can’t keep pace, as big new oilfields are exceedingly rare. So much of oil’s bull is fundamental, it has nothing at all to do with inflation. But at the same time, oil priced in euros has risen slightly less than half as much as it has in dollars. So about half of the oil bull seen by Americans is largely driven by dollar inflation.So as you live your life in constant sticker shock this summer, realize that varying large fractions of the rising prices you see are purely fundamental. Global demand is straining global supplies. Rice is a great example of this today. But the remaining fractions of price increases we are seeing in the States are the result of true monetary inflation. You can thank the Federal Reserve for this unwelcome development.The Fed is the greatest engine of inflation the world has ever seen. Its only function is to create new US dollars out of thin air, every one of which is pure inflation. Every second of every day, the Fed ramps US money supplies at much faster rates than underlying US or global economic growth. The result is higher prices thanks to relatively more fiat-paper dollars bidding on relatively fewer real goods and services.”Adam Hamilton

      1. gregorylent

        thanks for this… it is very difficult to find truth in the economic arena, probably more cases of vested interests per cubic centimeter than any other profession .. ok, maybe hollywood … smoke and mirrors seem to be something those two have in commonthe disappearance of the m3 data was a bit spooky to me

      2. Thomas

        Actually, I’d argue they are tied together. Supply imbalances lead to outsized profits. Outsized profits leads to entrepreneurs who follow the market and start new businesses attempting to mine some of those profits. This creates growth businesses that seek leverage. Leverage creates more monetary supply. So, in reality trying to separate out the effect of monetary supply from supply/demand imbalances is probably a fool’s errand. These things are inextricably linked and this probably the major philosophical argument between strong monetarists and free-market practitioners.

  17. MJM

    The sky is falling, the sky is falling…….come on. We pay US$8.40 plus per gallon here in Germany and have for some time. You will get used to it and as a result start to conserve energy. The sun will still rise again tomorrow.

  18. Martin Owen

    If you think of companies that got underway in the “bad times” of the 70’s I think you will find there were some fairly good investment opportunities there.It is having a product that has a development trajectory and customers discovering they need it. although I can’t quite remember the name of the company that supplied the 9K `Basic for my home brew computer…. did they ever come to anything?

  19. Geoff

    Whilst you are over in the UK I would strongly recommend meeting up with David Mackay here in Cambridge (author of Without the hot air). His talks and lectures are very interesting indeed. I thought the Jevons paradox fascinating http://en.wikipedia.org/wik

  20. John Sjölander

    I can recommend the documentary A Crude Awakening. It paints a dark picture and puts things in a perspective I hadn’t thought of before. Of course it’s a bit bias, but some of the things can’t be denied.It’s available on iTunes or from your preferred Torrent site.

    1. John Sjölander

      Oh, and I might add that everyone interested in the environment topic should see the excellent documentary “The Planet”. Available free on demand here:http://svt.se/svt/jsp/Cross

  21. Tom Evslin

    Fred:Electrical energy management will be the first great D2D (Device to Device) application on the Internet – an application parallel in importance and opportunity to email and the worldwideweb.This is likely to happen very soon because, while everyone is concentrating on oil used for transportation, we’ve reached a tipping point in the use of oil for home heating. Radiant electric heat generated from electricity at $.15/kWh (the typical cost in Vermont, for example) is cheaper than for home heating than oil at $5.00/gallon. The switch to radiant heat heat can begin with the purchase of a space heater for as little as $20 so no big capital investment is required to start the substitution. Unless the price of oil backs down this winter (which could happen), there’ll be a fairly massive switch to electricity. In 2005 the US used 63 billion gallons of oil for home heating.The sources of energy for baseload electricity in much of the US – hydro, nuclear, coal – are already much cheaper than oil. Wind and solar CAN be cheaper if electricity can be moved efficiently (which requires information flow). But peak electricity is generated mainly from natural gas. It is much more efficient to burn the gas in a furnace than generate electricity with it, transmit it, and then heat electrically.The problem (or opportunity) is that the switch to electricity this winter – which will be huge if oil prices continue to climb – will break both the economics and the distribution systems that we’re used to. Daytime use of electricity for heating is inefficient but encouraged by flat rates. Nighttime use of electricity for heating is currently a great way to displace oil use but needs to be encouraged by lower offpeak rates.The D2D application will be the near real-time communication of low-cost electricity availability from the power grid to smart devices in the home which adjust their behavior accordingly. Space and hot water heaters today; heat storage sinks and heat pumps tomorrow; recharging cars the day after tomorrow.More at http://blog.tomevslin.com/2

  22. Brian

    Fred,Oil prices rising because demand for energy is increasing is not inflation. Inflation has a specific meaning :a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currencyJust because the price of something goes up does not imply that a currency is losing the its value.I am not denying that the US has inflation, but most of the rise in the price of oil is due to supply not meeting demand. If we repealed some of our dumber environmental regulations (not drilling, making it hard to build refineries/power plants, have 50 different blends of gasoline, ethanol requirements) oil and gas prices would drop.If we stopped inflating the dollar, they would drop even more.

    1. fredwilson

      If I suggested that rising oil was creation then I apologizeBut I do think that rising oil prices will feed other inflationary forces

  23. Jesse

    “A Final Thought: This may mostly be good news for cleantech investors. As oil gets more expensive, cleantech and alt energy technologies can become commercially viable more quickly.”Why is everyone thinking like this? Why not invest directly into the oil industry instead? This is what Russia is doing and their economy is booming. We have tons of oil and coal in the US, why not invest in helping these proven and widely used energy sources become more efficient and cleaner instead of trying to create new markets from scratch?

  24. rfreeborn

    I’ve read a number of excellent articles lately on the role of speculators in the oil market and the consensus seems to be that they can’t be playing that much of a role because they aren’t taking delivery of the oil – they are just investing in an appreciating asset in a similar fashion as people are investing in corn and other commodities.Here’s a good article from The Economist – http://www.economist.com/op…I don’t know if anyone else has read about another excellent idea to help boost investment in alternative energy – a non-revenue tax that kicks in when oil goes below, for example, $50 / barrel. If oil was @ $40/barrel, there would be a $10/barrel tax. This “floor” to the price of oil would ensure alternative energy investors a “certainty runway” that would allow them to know if they hit that mark the investment would be profitable.r.

  25. rfreeborn

    In the interest of a fair and open discussion, another interesting link that says there IS a direct relationship between speculation and pricing via academic research done @ HofstraBlog postinghttp://www.salon.com/tech/h…Direct link to paperhttp://papers.ssrn.com/sol3…r.