Monday, December 29, 2008

Energy Lessons of 2008

A year ago, I looked back on 2007 and ahead to 2008, a year that has defied the predictions of most observers. Although I can't claim to have foreseen the possibility that oil would break $140 and $40--from opposite directions--in the same year, I worried about energy market volatility and cautioned that risk cuts both ways. That seems equally appropriate advice today, when markets are focused on the downside, and "confirmation bias" is such a powerful force. But while we shouldn't expect a repeat of the wild ride of the year now ending, the experience has provided some expensive lessons about energy markets. The following is a non-exhaustive list of those that struck me:
  1. Demand matters as much as supply in determining prices. The difference between oil at $145 per barrel and $40 is only a couple of percent of global demand, or more precisely a swing between steady growth of 1-2% per year and a shrinkage of similar magnitude.

  2. Speculation can amplify prices and market volatility, but it can't override a dramatic shift in the underlying fundamentals of supply or demand. Leverage increases not only the magnitude of speculative gains and losses, but apparently also the speed of the shift from one state to the other.

  3. When prices have been rising steadily, commodity price hedging can look like a sustainable revenue source--almost a perpetual motion machine--until the trend breaks. Then we see that the main benefit of hedging is to smooth out cash flows and enable firms to take on risks they couldn't bear otherwise. Used improperly, it's just an elaborate form of speculation, and as risky at Las Vegas.

  4. Fundamental price imbalances between commodities that are substitutes for each other, however imperfect, don't persist indefinitely. For much of the year, natural gas traded for less than half the energy-equivalent price of oil. As of Friday, this relationship had closed to about an 11% discount for gas vs. oil.

  5. High oil prices don't automatically make alternative energy sources competitive. For the last several years many alternatives faced higher construction costs, as they competed for some of the same inputs (materials and workers) as new oil and gas projects, while alternatives with low "net energy" or Energy Return on Energy Invested (EROEI) saw their operating costs rise in tandem with oil and gas prices.

  6. In particular, investors in corn ethanol production found they were making two bets: one on the difference in price between food and fuel and another on the difference between petroleum products, with which ethanol competes, and natural gas, of which it consumes large amounts, directly and indirectly. (See #4 above.)

  7. Government incentives and mandates can help to create a market for alternative energy, but they cannot guarantee its profitability, particularly when capacity is added faster than mandated targets rise, or than existing infrastructure can accommodate. The recent Chapter 11 filings of VeraSun and several other ethanol producers are evidence of this.

  8. The cost of capital turns out to be as important as the cost of oil for the expansion of all forms of energy, conventional and alternative alike.

I'm sure I've missed some important learnings in this quick tabulation. Next week I'll look at what the coming year might bring, or at least what bears watching. In the meantime, I wish my readers a happy, healthy, and more prosperous New Year. Let's hope the economic consensus is as wrong about the length and severity of the contraction we're in, as it was about the prospects for a soft landing from the bursting housing bubble.

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