Friday, November 21, 2008

Energy Markets Explained

Yesterday, the price of oil hit the low end of the price range I’ve predicted would likely be the envelope for long term energy prices. That range, predicted about a year ago, was
$50-75 per barrel, in constant dollars, and yesterday oil closed at about $50. Consequently, perhaps it makes sense to review where we’ve been, where we are headed and what to do about it.

Let’s deal with the most obvious question first-since we are at the bottom of the range, does this mean we should expect a bounce soon? Not necessarily. The events of this past summer illustrate the possibility (likelihood?) that, in the short term, prices can move well outside the long term range. In July, prices spiked about 100% above the top of my projected range. It is quite possible that prices will now oscillate below the bottom of the range by a similar magnitude. I don’t think $25-30 is outside the realm of possibility, although I wouldn’t expect those prices to last long. The point here is that short term pricing can vary widely without affecting the long term trend. In fact, this wild gyration is more typical than exceptional in the history of energy prices.

But, why is this true? Energy prices, like pretty much everything else, are controlled by supply and demand. When prices go up, both conventional and unconventional supplies increase, while demand decreases. High prices promote drilling. They promote development of alternatives. At the same time, they lead to investments in conservation methods such as more fuel efficient cars, homes and factories. And, over time, they lead to attitude adjustments which result in behavioral changes. In severe cases that even leads to recession. An analysis of the viability and break even point of dozens of such factors is what led me to the $50-75 projection.

However, in the short term, both supply and demand in the energy field are very inelastic. Major energy projects typically take 5-10 years to develop. Development timelines for alternatives is long. If you own an inefficient car, it makes little sense to junk it, far short of its expected 10 year life, for a more efficient one. And, it may take ridiculously high prices to quickly change the mentality leading to conservation. Meanwhile, the commodities market, in the short term, may tend to significantly increase price swings-when an investor sees prices moving dramatically up, many will attempt to profit from the trend by buying the commodity, thereby increasing the price. All the same logic applies on the down side. The result is very high volatility in the short term, but relatively straightforward predictions for the longer term.

So, are low energy prices good or bad? Yes…good or bad depending on how you see them. Lower prices, over the long term, are certainly good for the American economy, and for those who consume more energy than they produce. The high prices of last summer removed several hundred billion dollars from our economy, acting as a giant tax which dwarfed any government tax rebates. And the damage did not stop there. Efforts to increase energy production caused inflation in other commodities such as steel, copper, and corn directly. These caused even more generalized inflation. This money didn’t just disappear, of course. It went to OPEC nations and other oil producers such as Russia. There, the greatly reduced revenue could lead to big problems, which could spill over into international events.

Even in the U.S., dropping energy prices can cause temporary problems and disruptions. As oil prices drop, a range of other products decrease in price. Deflation can begin to take hold, leading to a slowdown in the economy. No one wants to buy something today that they expect to be able to buy cheaper tomorrow. As sales slow, profits are reduced. As profits are reduced, stocks fall. Over time, though, this will work its way through the system and result in a better economy.

But, what about alternative energy and conservation investments…do they no longer make sense? Obviously, in general, lower energy prices mean reduced alternative energy and conservation viability, but keep in mind that the high prices of last summer never got built into most energy investments. And a short term drop in prices won’t either. Because of the long term nature of most energy investments, only a perception that either high or low prices are here to stay have a significant effect on these investments.

Incidentally, remember the grilling of big oil executives just a few months ago because they weren’t investing madly to increase production justified by the outrageous prices? At this point, they look a bit brighter than they did then. Then, as now, their investment decisions reflected oil at or below the current price. Perhaps some have learned to resist the urge to invest based on short term price trends, leading to a more stable industry. Meanwhile, the hoarded cash will keep them from having to line up with the rest of the world for a handout. A few smaller companies that looked brilliant at the time, borrowing and investing billions based on the sky high prices, are now in big trouble.

And, what about the investments around the house I’m always talking about? Compact fluorescents? Added insulation? Caulking and better weather stripping? The programmable thermostat? The solar hot water or space heater? The ground source heat pump? Keep investing! Over the lifetime of these investments, the supply/demand curve will continue to, on average, price energy such that these investments are very attractive. Making those investments will be good for both your personal bottom line and the country, not to mention the environment.

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