Don’t make too much of current energy prices; they are disconnected from fundamentals

There is a fair amount of hand-wringing over the recent collapse in energy prices which — while academically interesting — is largely irrelevant to larger macro forces.

Here then a quick observation that is critically important and horribly misunderstood throughout our current energy, environmental, and economic conversation: current energy prices have very little to do with energy fundamentals.

This is a critical point, lost in the pop-economics that pervades most public discussion — which always tends to implicitly assume perfect markets where price is a function only of supply and demand. (No less true of those who claim that we shouldn’t provide tax breaks for hybrid vehicles lest we distort perfect market signals than it is of those who claimed that last year’s run up in oil prices “proved” peak oil.)

Energy Markets Since Last September

Hard as it may be to remember now, the economy was still doing pretty well last August. Crude oil was trading at $100-$120/barrel, natural gas was trading at $8-10/MMBtu and the Dow Jones Average was holding pretty steady in the 11,500 range.

Fast forward to today. Crude oil is down 70 percent. Natural gas is down 50 percent. My 401(k) sucks too, if anyone cares. WTF?

TF was Lehman

In many markets, the wipeout of Lehman brothers accounted for much of this collapse. Lehman had huge trading desks trading electricity, gas, oil, currency and any number of other commodities. When they fell, they left lots of counter-parties holding useless paper. (Useless in the sense that they were valuable only if Lehman delivered on their end of the deal, which suddenly seemed rather unlikely.)

All of a sudden, the price of those commodities on public markets got smacked with a stick called Counter Party Risk. It’s easiest to see this in currency markets:

Let’s say you have an agreement to sell me one million Canadian dollars a year for the next 10 years at parity (e.g., one Canadian dollar per US dollar). Today, one US dollar buys $1.26 Canadian. That means that every time I pay you $1 US and you give me $1 CAD, you’re making $0.26 CAD. As currency prices fluctuate over the next 10 years, sometimes one of us will be up, sometimes the other — but we both benefit by getting certainty about our purchases. In aggregate, all of the collective actions of people like us get translated into the actual exchange rate.

So how much could you sell your contract for? That seems fairly easy: $260,000 CAD/year, right? Post-Lehman, it’s not quite that simple because the person you sell to is going to first ask for some proof that your counter party (me) won’t default on their obligation to deliver those dollars.

This counter-party risk issue is depressing the price of damned near every commodity trading on public markets today. What’s worse, the credit concerns are driving those prices to a much greater degree than the fundamentals of those commodities. (In other words, my credit score has a bigger impact on how much you’re willing to pay me than the underlying foreign exchange risk.)

What does this mean for energy? That’s easy: energy prices today are low for reasons that have little to do with fundamental supply/demand considerations.

Fast-Forward

So what comes next? In many ways, energy markets are now a mirror image of where they were last summer. To be sure, fundamentals still affect price today (e.g., economic slowdowns have certainly reduced demand), just as fundamentals affected price last summer. But whereas last summer there was much — not entirely illegitimate — made of the churn created by commodity traders who were putting unrealistic upward pressure on commodity prices, there is now much downward pressure created by credit concerns. In both cases, these financial pressures are disconnected from fundamentals. But in both cases, they will affect fundamentals in the long-term. Consider:

1. Whether or not crude oil “should” be $120/barrel, the fact that you could sign long-term contracts to sell oil at $120/barrel induced much construction in the tar sands and other high-cost production sites. Thus did financial pressures impact fundamentals by making more oil available.
2. Whether or not natural gas today “should” be $4/MMBtu, gas fields are not investing in well production right now because they cannot lock in contracts to give them their capital recovery. Thus will current financial pressures impact fundamentals by making less gas available.

These fundamentals have a way of coming back to bite you in the ass eventually. If people aren’t building natural gas wells today, we will be supply-constrained come the summer when demand heats up. That will certainly cause an increase in the price of natural gas — even if it isn’t reflected in the current natural gas futures, due to their over-dependence upon counter-party risk in this economy.

What this means for the environment is all rather complicated, but suggests that the dominant theme of the next several years will not be absolute energy price per se, but energy price volatility as credit constraints whip-saw prices back and forth between fundamental constraints. The case for renewables and efficiency always depends to some degree on the competing price of fossil energy. Going forward, it will likely depend to an ever greater degree on the ability of those resources to get energy consumers off the whip-saw. Stay tuned.