Market Outlook Part 2: Energy

April 6, 2008 at 12:48 pm
Contributed by: Chris


Here’s part 2 of my market outlook series. In Part 1, I’m Changing My Name to JPMorgan, I looked at the subprime crisis, the dollar, and how the financial landscape has affected commodity prices. In this part, I dig deeper into each major source of energy, and look at the fundamentals that are driving their skyrocketing costs.

Market Outlook Part 2: Energy

Skyrocketing Fossil Fuel Prices Favor Renewables

By Chris Nelder

In Part 1 of this series, I’m Changing My Name to JPMorgan, we looked at the subprime crisis, the dollar, and how the financial landscape has affected commodity prices.

Today, we dig deeper into each major source of energy, and look at the fundamentals that are driving their skyrocketing costs.


Oil prices have been on everyone’s mind, having spiked 76% over the last year, and 16% in 2008 alone:

Oil price chart

The reasons for the huge rise in oil-and the reasons why gasoline hasn’t kept pace with it, which we will get to in a moment-are complex and interrelated, but we’ll try to sort them out.

Up until about mid-2007, oil prices were mostly about fundamentals: the ever-tightening supply situation that we have chronicled on these pages week after week, terrorist attacks and sabotage of oil facilities and pipelines, geopolitical tensions, and the skyrocketing demand for energy from the world’s developing economies.

But in September, the market dynamics changed. The first Fed rate cut in four years on September 18 set off a flight of capital to commodities seeking a relatively liquid safe haven from the devaluation of the dollar. And oil prices began increasing at a far faster rate.

Most pundits were slow to recognize this key factor, and continued to point to Nigeria, OPEC, and so on. Only in recent weeks have I noticed the dollar cited as a primary reason for oil prices. Apparently, setting new record lows session after session got their attention.

Compare this chart of the dollar vs. the Euro to the oil price chart above. Note the way that both lines sharply change their trajectories in September.:

Dollar vs euro chart

Oil had to increase in price just to maintain its value, since it is predominantly traded in dollars worldwide. In turn, this has led to price increases across the board (that is, inflation), since everything requires energy.

But the dollar’s fall is only part-I would guess around half-of the impetus behind the rising cost of oil. The flight of speculative capital to commodities in general suggests that oil prices have probably gotten ahead of their proper value, as a purer market would find it. I wouldn’t be surprised to see a correction in oil price some time in the next few weeks, particularly as the health of the U.S. economy becomes more dubious. Our main trading partner, China, is already moderating its growth expectations accordingly. Oil fell sharply on Monday and Wednesday of this week, from an all-time high of $111.80 to $102.49 as I write.

Discounting the speculative froth in oil, if the price were to return to the trendline of the last five years or so, it would still be around $85-90 a barrel:

oil price chart 1999-2008

That trendline truly is about the fundamentals, as the supply of oil continues to get tighter, and the world’s already thin spare production capacity gets thinner still. It appears that the raging growth of the world’s red-hot economies-China, India, Russia, and the Middle East-will more than offset declining demand from the U.S. and Europe.

So even if our economy continues to slump, I think oil prices will remain high. My estimated range for this year is $85-150/bbl, but untoward events could cause much higher price spikes, as we saw with Hurricanes Katrina and Rita.

For its part, OPEC has not been inclined to increase production, calling the oil supply adequate and pointing the finger at speculators for high prices. Even if they were to release more oil to the market, they say, it wouldn’t lower prices very much.

In the current environment, I tend to agree with this view. But the amount of actual spare production capacity OPEC has is still shrouded in secrecy, and for all we know their ability to increase production now may be negligible. OECD crude inventories in December (the most recent available data) stood at 52 days of demand cover, which is near the bottom of the December range over the last 10 years.

Worldwide, there is very little reason to be optimistic about crude production. Higher prices for everything from oil to cement are continuing to delay and cast doubt upon the prospects of some impending oil and gas projects, particularly marginal projects like tar sands, and extreme technology projects like deepwater drilling. (See my article on this subject from last year, Receding Horizons Part 1 and Receding Horizons Part 2.) The economic axiom that higher prices always result in greater supply has begun to fail, as the physical realities of finite fossil fuel production trump economic theory.

For the next two years, according to recent forecasts by the IEA and EIA (which were typically optimistic about supply growth, particularly from non-OPEC producers, despite their similar forecasts having been proved wrong for several years running), we will increasingly depend on non-crude oil, primarily natural gas liquids, to fill the supply gap.

In sum, it seems increasingly likely to me that the Association for the Study of Peak Oil (ASPO) forecast of the absolute global peak of “all liquids” by 2010 will be just about on the money. If we should see a worldwide recession over the next two years, the reduced demand might bring us another year or more of production at 2010 levels, forming more of a short plateau of oil production than a sharp peak. But given the many years that it takes to bring new supply online, the production capacity story for the next five years has effectively already been written.

Among the analysts I respect (and more than a few oil company CEOs), the peak oil “debate” is essentially over. There is a growing consensus that we’re staring down the peak within the next two or three years, five tops, and there is nothing short of failing economies that can change that.

The much-anticipated production from relatively new finds in the Gulf of Mexico, Brazil, and elsewhere (including the recent announcement about the potential of the Bakken formation in the center of the U.S.) are all likely to come online some years after the peak, and the production rates they will achieve are unknown. No doubt every last drop of it will be welcome, and fetch a pretty penny, but in terms of the big picture, they can only help to buy us a little more time-a year or three-before global production starts to drop off.

If we use that time to continue to invest heavily in energy after fossil fuels, it will be a good thing. But if we use it to merely crawl a little further out on the limb of petroleum dependence, we’ll just fall that much harder after the peak. Given the recent efforts in Congress to use the occasion of today’s high prices to press once more for drilling in ANWR, and their refusal to demand adequate improvements in fuel efficiency, I’m sorry to say that my money is on the latter scenario.


One of the strangest aspects of the huge run in oil prices has been the fact that gasoline prices haven’t kept pace. The “crack spread,” or the profit on refining a barrel of crude into saleable products, has collapsed from around $22 last spring to less than a buck (or in some cases, even a loss). For pure refiners, like my stalwart favorites Valero (NYSE: VLO) and Tesoro (NYSE: TSO), this has translated into crushing 30 to 50% losses in their share prices over the last six months-a selloff that I continue to believe is very overdone.

This phenomenon is ascribed to the refiners’ belief that if they raise gasoline prices much further, buyers will go elsewhere, cutting into their market share. Integrated oil companies who have profits from other parts of their business are able to take some minor losses from their refining operations for a while and keep selling gasoline. Indeed, lower than expected demand for gasoline has built up inventories to the high end of the average range.

Still, nobody can operate for long at such razor thin margins, let alone losses. If the independent refiners substantially cut back operations in today’s environment, it would lead to higher gasoline prices as the supply cushion is eroded, thus restoring their profitability.

So I do expect the crack spread to return back to a normal range, and along with it, I expect average gasoline prices to approach the $4 range by summer (although official summer prices forecasts have recently been reduced, to account for the economic slump).

Natural Gas and Electricity

Gas prices have been steadily moving up since last summer, pushing to over $10 per thousand cubic feet two weeks ago, with futures prices holding steady in the $9-10 range:


In part, the rise in natural gas prices has been driven by the rising cost of coal, as power plants search for the lowest cost fuel. It has also been supported by a reduction in liquefied natural gas (LNG) imports to the U.S. (as we’ll discuss in Part 3). LNG imports fell to 0.8 Bcf/day in February, down from 1.5 Bcf/day in February of last year, and about 3 Bcf/day last summer. Gas inventories look poised to end the usual withdrawal season on April 1 right about 210 Bcf lower than last year.

Even so, relative to oil prices, gas has been cheap. The historical ratio of oil to gas prices (dollars per barrel of oil divided by dollars per thousand cubic feet of gas) is between 6 and 9, but in February it was over 11. On a BTU equivalent basis, gas is 6 times cheaper than oil. Most analysts expect the ratio to revert to the mean, but they expect the gap to be closed by falling oil prices, whereas I expect it to be closed primarily by rising gas prices. In addition to the abovementioned factors, my view is based on the fact that gas prices are now below that of residual fuel oil from petroleum, which is an alternate to coal and gas for power plant fuel. Power operators will likely take advantage of the disparity by switching fuels to gas, further supporting the price.

Since natural gas has been the fuel of choice for power plant operators for the last many years, thanks to its lower emissions, relatively low cost, and the ability to start up and shut down gas-fired plants at will, grid electricity prices tend to be set at the margin by the spot price of gas. Average electric bills in New England have approximately doubled since 2000, right along with the corresponding cost of gas.

Accordingly, my big three plays on gas, Encana (NYSE: ECA), Chesapeake Energy (NYSE: CHK) and Southwestern Energy (NYSE: SWN) have all gained around 50% over the last year, and from 47% to 106% over the last two years.

Looking a few years out, the outlook for gas is plagued with questions. If new LNG export capacity, particularly from Russia and Qatar, is developed over the next few years, we might continue to see gas prices rise at the relatively slow pace that they have in recent years. We may also see a somewhat significant increase in domestic production from unconventional sources like the Barnett Shale, which we have covered in these pages over the last few months.

On the whole, I expect production to continue to decline in North America, as it has since the 2002 production peak. Global LNG supply may increase, but it will continue to seek higher prices outside the U.S. as long as developing economies maintain their current red-hot growth rates, and as long as it is preferred over coal for its lower emissions. My bet is that gas prices will continue to rise steadily for the next several years, and that grid power cost will continue to keep pace with gas, at least until we have built a great deal more generation capacity from renewables.


Coal prices have varied little for the last three years:

coal price chart

Data source: EIA, “Table 5. Average Price of U.S. Coal Exports and Imports, 2001-2007” 2007 data averaged from Q1-Q3. Chart by Chris Nelder.

According to the EIA, the rising level of exports reached its highest level since 1998 last year because supply in the world’s fastest-growing economies has been limited, and the falling dollar has made it more attractively priced. Russia has halted its exports of metallurgical coal to satisfy its own needs, and Australia, the world’s largest exporter of coal, has faced shipping delays. Global coal demand growth is primarily driven by the steelmaking industries of Asia and South America (particularly Brazil), and by the power plant needs of China. China is both the world’s largest producer and consumer of coal, making it also the world’s greatest producer of greenhouse gas emissions, and became a net importer last year.

The growth in U.S. coal imports, while less dramatic than exports, has been driven by relatively flat domestic production, as shown in the following chart. This caused power plant operators to draw down their inventories (which had been at an historic high) and to seek coal from abroad.


U.S. Coal Production

coal production chart

Source: EIA, “Quarterly Coal Report, July – September 2007”

Having enjoyed two years of rocketing growth in their share prices from 2004-mid 2006, the stocks of major coal producers such as Peabody Energy (NYSE: BTU) and Arch Coal (NYSE: ACI) have moderated (with some notable price spikes) and now stand about where they were at the beginning of 2006. In part, this may be a reflection of the Street’s growing concern about the future of coal usage in the face of increasing public pressure to control greenhouse gases.

While I enjoyed some nice gains from the coal producers during their run-up, I have remained mostly out of the sector for the last two years. There are occasional opportunities to make a quick 20% on the price spikes of these shares, but timing them is tricky, and the greenhouse gas issue adds a level of risk I’m not quite comfortable with.

More to the point, growth in domestic coal demand is primarily driven by electricity generation, which has grown very steadily:

U.S. electricity consumption chart

Source: EIA, Short-Term Energy Outlook, March 2008

However, the political climate is strongly in favor of meeting that growing need from renewables, rather than coal. Indeed, recently introduced legislation threatens to put the kibosh on new coal-fired power plants entirely unless they employ carbon emissions control systems. While coal-consuming power operators have been quick to point out that the technology exists, they have been so far unwilling to deploy it, citing cost concerns.


In stark contrast to the increasingly discouraging outlook for the production of fossil fuels, renewables have been on an absolute tear.

The global solar industry has been growing at nearly 50% per year since 2002, effectively doubling global production every two years. The global market now stands at about $11 billion, with 12,400 MW of deployed capacity. In part, this amazing growth is due to increasing incentive programs, which are succeeding in driving costs down to the point where parity with coal-fired grid power is expected within the new few years.

Likewise, wind power has been growing at the rate of about 25% per year worldwide in recent years. Since 1990, wind generating capacity has doubled roughly every three and a half years. Wind power is already cheaper than power from natural gas, coal and nuclear plants in most cases, ensuring its continued growth. Global wind capacity currently stands at about 94 GW.

Although they are nascent technologies, geothermal and marine energy systems are quickly gaining ground as well, thanks to growing R&D budgets funded by the First World in pursuit of emissions-free power.

The trends are exactly as we have predicted: the cost of traditional fossil fuels is going up, and the cost of renewables is going down. We see no reason to expect those trends to change any time soon.

On the whole, investing in energy for the long term is a no-brainer, as long as the world’s developing economies keep chugging along. The slowing demand of the First World isn’t going to stop this train.

And the recent selloff in commodities presents some excellent buying opportunities.

Next week, we’ll explore the interrelationships between food, energy, and weather, and perhaps illuminate why the price of bread is fomenting violence and protests worldwide.

Until then,

Energy and Capital

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