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2008 - A Year Like No Other

At Independent Energy Consultants our televisions are always tuned to CNBC and the Weather Channel. As we go about our day we want to hear what others have to say about financial markets and weather conditions that can influence energy prices. In 2008, a long line of energy experts have been seen scratching their heads and offering profound quotes such as "I've never seen anything like this", "This market make's no sense at all", and "It's exactly the opposite of what you would expect to happen". It is, however, another popular TV show that we'll use to make some points in this month's newsletter - MythBusters. Let's look at some of the rationale used in 2008 to explain the roller coaster energy markets and see if the myths are confirmed, busted or plausible.

Energy Myths

Myth: Oil and natural gas prices always increase before and during a hurricane. The key word in this myth is always. As predicted, 2008 has been a very active hurricane season and it's still far from over. Six hurricanes have already approached the U.S. and most have traversed the Gulf of Mexico and made land. Dolly, Gustav, Hanna and now Ike have caused billions of dollars of damage, but the oil and gas infrastructure seems to be fairing well. After hurricanes Katrina and Rita the oil and gas industry developed new tethering standards for offshore rigs. It looks like the those steps have helped, but the pipelines that run along the Gulf floor are still vulnerable and can disrupt flow to the mainland. With the tremendous increase in electronic trading and the recent expansion of trading hours, it appears traders are waiting for damage reports before bidding up prices. In years past, traders had over 60 hours to wait for markets to reopen on weekends and most prepared for the worst. The circumstances that caused prices to rise in advance of major storms may no longer exist. Hurricanes remain a huge threat to oil and gas production, but with the explosion of after-hours trading and markets reopening on Sunday evening it looks as though people want proof of damage before bidding up prices. People could also be worn out by the 24-hour weather industry that cries wolf far too often. Myth - Busted.

Myth: Natural Gas prices are $20/Mcf in Europe and since this is a global commodity that's where the U.S. markets are headed. If imported Liquefied Natural Gas (LNG) had been needed in the U.S., we could have easily seen prices approaching those in Europe. In 2007 LNG met ~3% of U.S. demand and as the "marginal fuel" it helped set market rates. In 2008 LNG imports have been non-existent, because cargo ships have headed to Spain and Japan where the need was greater and prices are much higher. This summer U.S. temperatures have been moderate and the demand for natural gas from electric power plants has been down. That fact, coupled with new "shale gas" finds have helped rebuild storage inventories to above the 5-year average. We have had a string of fortunate events that limited our need for LNG. In future years the demand for natural gas will continue to increase due to environmental regulations. Also, imports from our friends in Canada and Mexico are on the decline. As natural gas becomes more of a global fuel, we suspect it will be influenced by same geopolitical forces that keep crude oil well above its production cost. Myth - Plausible.

Myth: Crude oil will top $100/barrel, approach $150 by July 4th and then may go to $200/barrel. It appeared that self-fulfilling prophecies were coming to pass on weekly basis. Price run ups that had no bearing on market fundamentals were predicted and met with alarming precision. The skyrocketing prices led to Congressional hearings and talks of changing the Nymex rules for non-commercial (speculators) traders. Crude oil prices topped out at $147.27/barrel in early July. Myth - Confirmed

Myth: This is a rare occurrence of a commodities bubble and it will burst at some point. Independent Energy Consultants had been telling all its clients that we were witnessing a rare commodities bubble that was affecting all categories (grains, metals, energy, etc.). No one knew how high prices would go or when the bubble would burst, but we knew it was not sustainable. The bubble that began with the 4th quarter of 2007 for many commodities (Q1 2008 for natural gas) was popped on July 4th. Natural gas prices that had almost doubled in 6 months began a rapid decline and have now given back almost all of its gain. Crude oil began to fall at the same time and has just now dropped below $100/barrel. All of the arguments for why prices had gone so high did not magically change on July 4th, but prices certainly began to drop. This further makes the case that speculators had caused the run up. Myth - Confirmed.

Myth: Crude oil's doubling in price in less than a year was based on increased demand in China and India. Any student of economics knows that business cycles are gradual processes that tend to take 2-5 years to complete. The government subsidies on energy and rapid economic growth in China and India didn't come to a screeching halt on July 4th. The rapid decline in energy prices is not because of demand erosion oversees. As China, India, Mexico and other economies continue to grow, so will their needs for coal, oil and natural gas. That means the U.S. will remain vulnerable to higher energy costs until we correct our reliance on foreign sources. Myth - Busted.

Myth: Drilling in the U.S. won't help because it will take years for that to come online. Even serious talk about the possibility of increased drilling in Alaska and offshore is enough to sway market sentiment. For years we have seen how successful OPEC has been in controlling oil supply to keep prices high. Then when public outcry reaches a peak, they increase supply just enough to lower prices and silence the critics. On the domestic front we may be seeing that already with the "Pickens Plan". T. Boone Pickens, an influential leader in the oil industry, has been touting his alternative energy plan as a means to wean ourselves from foreign oil sources. He has many supporters in Congress and has been received on Capital Hill like a pop star. The discussion surrounding wind power and other renewable resources may be contributing to the decline in oil prices we are currently witnessing. Accepting the logic behind this myth would also lead one to forgo any long-term initiative such as building the much needed new nuclear power plants and refineries. Myth - Busted.

Myth: Changes in the U.S. dollar value are causing the changes in crude oil prices. Throughout the entire wacky year, the one constant appears to have been the inverse correlation between the value of the U.S. dollar and crude oil prices. Since the Nymex crude oil contract trades in U.S. dollars, it makes sense that a falling dollar would cause higher prices and vice versa. Myth - Confirmed.

Outlook and Advice

So what does all this mean to our clients and readers? It means energy prices may remain higher than we would like and will certainly be volatile until the U.S. takes meaningful measures to address our energy independence. Furthermore, none of the rules that allowed the "day-trader" mentality to drive commodity prices to obscene levels in 2008 have been changed. The same cast of characters and conditions could resurface without warning. The crisis we are witnessing on Wall Street is likely to have far reaching and many unknown impacts. If you think doubling energy costs in six months is extreme, take a look at how the market values of these household names have declined in the past year. Here are their per share 52-week hi/low prices. (Each company is currently trading near its low.)

1. AIG $70.13 - $5.82

2. Lehman Brothers $67.73 - $0.18

3. Merrill Lynch $78.66 - $16.60

4. Ford $9.24 - $4.24

5. GM $43.20 - $8.81

6. United Airlines $51.60 - $2.80

It is one thing for speculators to drive Google stock to $750/share, as no one is forced to buy that stock. It is quite another when the commodities we rely on in our daily lives (grains, energy, meats, metals, etc.) double in price in a six-month period. As the equity markets continue to struggle, investors will look elsewhere for investment opportunities. With the emergence of trading technology across the globe, we could see commodities return as a favorite trading target. If that happens, logic and market fundamentals can be tossed out the window and everything we think we know, can become a myth.

Our advice remains the same. We encourage you to develop an energy purchasing policy and have someone watching the markets at all times. If you employ sound risk management techniques, you can obtain acceptable prices without exposing yourself to risks that can drive you out of business.