Toil and Trouble

I read two articles on energy bubbles this week. In the first, Robert J. Samuelson of the Washington Post laid out a strong, logical case explaining why current high oil prices don't fit the classic conditions for a bubble. In the other, Daniel Gross of Slate suggested that the market for alternative energy investments was starting to look like a bubble, and that this might be a good thing. With all due respect, I think both of these gentlemen missed some important aspects of the current situation. If there is a developing bubble in energy, its growth will transfer even more money from consumers to the Middle East, and its ultimate collapse will deal alternative energy another setback from which it could take years to recover. None of that sounds positive to me.

First, let's look at the oil market. Although Mr. Samuelson is right to differentiate the strong influence of supply and demand on oil prices from the "irrational exuberance" that drove tech stocks in the 1990s, he also presents evidence for the influence of speculation in driving prices higher than fundamental factors alone would justify. The missing element is the degree to which speculation isn't just driven by the serious risks he lists, but by the expectation that prices next month or next year will be higher still. That creates demand for the financial instrument--oil futures contracts--that outstrips the demand for the underlying commodity. Because only a small fraction of oil futures are settled by actual physical delivery, there is no practical limit to the degree of this disconnection. And if, as a friend on Wall Street suggested to me recently, oil producing countries are plowing their profits back into oil futures--for lack of better investments--this only serves to inflate the balloon faster. As Mr. Samuelson notes, sooner or later this kind of bubble must pop, either because of the resolution of some major risk or a physical over-supply. That bursting would have serious consequences for the development of alternatives to oil.

Mr. Gross's take on alternative energy stocks is quite different. He points to the involvement of Silicon Valley entrepreneurs and the growing frothiness of some energy tech stocks, such as SunPower, and sees pleasant similarities to the Dot-Com era. While recognizing the catastrophic consequences for investors, he welcomes the green energy technology that he sees surviving a crash, drawing analogies to the recycling of bankrupt fiber-optic assets into new business models. There is a crucial distinction, though, which many other commentators on energy also fail to grasp sufficiently. Alternative energy technology is wonderful, but for it to matter, it must be deployed on a massive scale. The enormous investments necessary for that deployment will only be made, if corporations and investors see the prospect of positive long-term returns. That is the antithesis of boom-and-bust.

Perhaps it seems fanciful to worry about the consequences of a collapse of energy prices or alternative energy equities, when the market for both has never looked stronger. But from my perspective, that's exactly the right time to ponder such an outcome. In the early 1980s industry experts and corporate executives planned for the possibility of $100 oil (in 1980s dollars, no less,) but even as these serious conversations were taking place, the physical seeds of the subsequent market collapse were germinating around them. When the crash finally happened, it derailed most alternative energy projects and guaranteed that our world, 20 years later, would largely resemble the pre-crisis status quo.

I can't be certain that the recent easing of crude oil fundamentals is a harbinger of a similar retrenchment. What I am confident of, however, is that a return to even $40/barrel would severely undermine investor confidence in alternative energy and dry up political support for the subsidies that many of these technologies will require for years. That would be tragic, because our underlying concerns about climate change and an eventual peak in oil production won't have dissipated, even if oil prices return to a level much closer to their long-term average.