Energy

It’s been nearly four years since I wrote the article “Could High Oil Prices be Good?” (Hanoch, October 2004) and oil prices went up significantly since then. This article presents the main factors affecting oil prices and the potential implications on your investments.

Causes for higher oil price:

1. Increase in demand: Given the rapid development of various emerging markets, notably China and India, combined with worldwide population growth, oil demand is growing rapidly, mostly by cars for personal use. This is not likely to be a cyclical factor and the trend may continue for many years.
2. Limited Supply:
   1. Declining oil reserves: Oil is a limited resource on earth, and as we come closer to depleting it, prices are likely to go up irreversibly.
   2. Tension in oil producing countries: Tension in the Middle-East, strikes and political instability in Venezuela , and growing instability in West Africa increased oil prices. This factor may have a limited time horizon.
3. Weaker dollar: Since the price of oil is denominated in dollars, the weak dollar made oil artificially more expensive. Given the cyclicality of currencies, next time the dollar strengthens, oil should become cheaper.
4. Speculators: Oil price is determined in the futures market. The futures market is a wonderful tool that helps big oil consumers (like airline companies) hedge the risk of rising prices and set their upcoming oil cost in advance. It is also a place for speculators to bet on higher oil prices. They bid up the price beyond the demand dictated by actual oil consumers and have created a large premium to the price – like a pyramid scheme. Once the price deviates too far, or government regulation addresses this, the bubble may burst and erase the premium, causing a big decline in the price.
5. China‘s managed energy prices: Oil price in China is controlled by the government and held artificially low, resulting in higher demand. Refineries lose their incentives to produce, given their rising cost of input compared to the fixed product price. As a result there are already supply shortages in China . This artificial situation is not likely to be sustainable, and controls are likely to be lifted at some point.

The implications on your life:

Because oil demand is expected to increase in the long run and oil reserves are a finite resource, you cannot expect oil prices to decline to low levels in a natural way in the long run. A bursting speculation bubble or a stronger dollar can have a dampening effect on prices for a limited period, but the lasting effects of accelerated demand around the world and depleting reserves should bring prices back up.

Given these factors, the only way to lower the long-term cost of energy is to use renewable energy alternatives to oil. Unfortunately, implementing these renewable alternatives costs money upfront, and as long as oil price is tolerable, only people that are highly concerned with their long-term well being at the price of a current burden are going to accept this high initial cost.

As the price of oil goes up, the financial benefit of renewable alternatives grows. The result is a clear tradeoff between current comfort and future comfort:

1. Low oil price provides current comfort, making travel, food and many other products cheaper.
2. High oil price provides future comfort by accelerating the development of renewable alternatives that can ultimately completely free us from dependence on the limited oil supply.

A complete departure from the dependence on oil may take many years, but there are already current activities underway given the current price of oil. Here are a few examples:

1. Hybrid cars are being sold in big numbers (over 1,000,000 cars so far) and offer real savings in gas consumption and total costs to their owners.
2. People are reducing their energy consumption by improving the insulation of their homes, buying solar panels and energy-efficient appliances and light bulbs.
3. The once expensive Canadian and Venezuelan tar sands are now highly competitive with conventional crude oil. These massive reserves are estimated to be approximately equal to the world’s total reserves of conventional crude oil. Note that this is not a renewable source of energy, but is an example of how time can be bought for developing renewable alternatives.

The implications on your investments:

Short-Term: As the price of oil goes up, it has two competing impacts on your stock investments:

1. It increases the value of the energy sector in your portfolio.
2. It increases the cost of doing business for other sectors, making them less profitable.

The net effect on your portfolio is slower growth or declines during spurts of oil price appreciation.

Long-Term: As the price of oil goes up, renewable sources of energy are developed and become more competitive with oil and more widely used. It increases the profitability of all companies other than oil related companies, having a positive net effect on your portfolio, with higher growth.

Bottom Line: Stock portfolios are held for long-term growth and income, and as such, they are likely to benefit from the long-term financial benefits of higher oil prices.

Conclusion

If you have the means to withstand the strain of high oil price on your current lifestyle, you can benefit from the potentially nice long-term portfolio growth and improved future lifestyle that high oil prices may bring. The higher the oil prices, the bigger the current pain, but also the sooner the long-term solution will be in place.

Disclosures Including Backtested Performance Data

Oil prices are at a historic peak of over $60 a barrel. Both the individual at the gas pump and the stock market as a whole are affected. During times like these, you realize how dependent we are on other countries.

The ideal world. We should have a strong interest in reducing the dependency on oil for economic and non-economic reasons. Finding alternative sources of energy would make our lives better in many ways:

1. In contrast to oil supplies, which are limited, finding renewable sources of energy would allow for a permanent solution to the energy needs of the world.
2. Energy would be cheaper by avoiding the inflated prices of oil driven by the oil cartel, OPEC (Organization of Petroleum Exporting Countries).
3. The US would not have to be beholden to the countries that produce most of the world’s oil.
4. The US would not have to do business with countries whose governments, policies and/or practices Americans do not agree with.

These are huge incentives for us to find alternative energy sources, even if the initial cost is large.

The real world. In real life, many tend to focus on the short-term. It is hard for the government and corporations to spend so much money on research, with no real results for 10 years or more. Corporations are limited by their cash reserves and governments are elected for periods of 4 years, limiting their horizon.

The real world solution. There is a simple thing that can help us reach a solution, given real-world limitations. Paradoxically, it is high oil prices! The higher the oil prices, the more we will save by using alternative sources of energy, and the bigger the incentive to invest in developing them.

Seeing the magnitude of the current problem, it might be worth suffering from high oil prices in order to reach a sustainable solution. In the 70’s, when oil prices were very high, people came together to create more energy efficient appliances and cars to solve the problem.

The sustainable solution. The improvements of the 70’s weren’t enough. We are still dependent on oil, and the world’s energy consumption keeps rising. A sustainable solution requires using energy that is from renewable resources. A few examples are: wind, solar and hydropower energy. With these technologies, we may never lack energy.

Companies have been working on renewable energy sources for decades. As oil prices are rising, more companies and governments, including shorter-term thinkers, are spending many more resources on developing these alternative energy sources.

The need for a common solution. If we use a variety of energy sources, we would have to build different cars and appliances that can use the different types of energy. In addition, we would have to store energy and transport it in different forms before using it.

Another problem is that many of these sources are not available continuously. The sun does not shine at night and the wind does not always blow.

The common solution – hydrogen! In 1839, Sir William Robert Grove mixed hydrogen and oxygen in the presence of an electrolyte, and produced electricity and water. Later this invention was named fuel cell, and made it possible to transform our energy problem into a much more elegant one. The fuel cell allows us to use two of the most common elements in the world to create energy and pure water as a byproduct. It does not solve the energy problem, because it takes energy to isolate the hydrogen from the water, but it allows us to unify much of the process. Here is how it works:

1. The first group of steps will vary depending on the renewable energy source used:
   1. Generate energy from one of many renewable sources.
   2. Using this energy, isolate hydrogen from water.
2. The remaining three steps are the same regardless of the renewable energy source used:
   1. Store the hydrogen in some form.
   2. Transport the hydrogen to the location where the energy is needed.
   3. Use it to power vehicles and appliances requiring energy.

Now, instead of creating different versions of products for different sources of energy (e.g., solar, wind), we can design the products to accept only one source of energy: hydrogen.

If we use one product to solve the various problems, companies and governments can focus their money and efforts on a single solution to the energy problem. When compared to focusing on many different technologies, this creates a big incentive to join forces and pursue this goal.

Current work. An Internet search on “fuel cell” or “hydrogen energy” yields about 10,000,000 results. Sifting through a few of them would give you some idea about the amount of work currently being done. I was completely overwhelmed! A few links I found:

1. International Association for Hydrogen Energy: http://www.iahe.org/
2. Fuel Cell Europe: http://www.fuelcelleurope.org/
3. US Department of Energy: http://www.eere.energy.gov/hydrogenandfuelcells/
4. US Department of Energy: http://www.fueleconomy.gov/feg/fuelcell.shtml
5. National Renewable Energy Laboratory: http://www.nrel.gov/clean_energy/hydrogen.html
6. California Fuel Cell Partnership: http://www.fuelcellpartnership.org/
7. National Fuel Cell Research Center: http://www.nfcrc.uci.edu/

It is nice to learn that NASA has used liquid hydrogen since 1970 for its space shuttles, and the crew could drink the byproduct – pure water.

Smile. Now you can smile whether oil prices go up or down! If they go down, you can be happy about the immediate financial relief; if they go up, governments and corporations get greater incentives to invest in developing renewable energy sources, which brings the long-term solution closer. It’s a win-win situation.

What does this mean in terms of the future of the stock market?

• If oil prices go down, the stock market may go up rapidly.
• If oil prices go up, the stock market may decline temporarily. In the meantime, the development of alternative energy sources will be accelerated, bringing a recovery that will permanently reduce the impact of oil prices on the stock market and the rest of our lives.

Disclosures Including Backtested Performance Data

Oil prices are rising every day and it is hard to see the end of this trend. The problems in Iraq, Russia and Venezuela combined with the growth in China and India lead to decreased supply and increased demand. It seems like the world is running out of oil, which might bring world economies to a halt. Will it?

The current demand for oil surpasses the supply, but the world is not running out of oil. Oil is a commodity with cyclical behavior. History is full of examples where supply did not keep up with demand, and people believed that the inflated prices would never go down – but they did.

During 1973-1974, oil prices quadrupled in less than 6 months, and reached higher prices than today, when adjusted for inflation. What was the result of the peak in prices?

• More fuel-efficient cars
• Better insulation in homes
• Improved energy efficiency in industrial processes

In the 80’s and 90’s, prices went back to the long-term historical average of around $20 a barrel, measured from 1869 until 2003. What happened to these energy efficiency improvements after the drop in oil prices? They stayed with us and will continue affecting the world throughout the future.

Can you think of possible scenarios resulting from today’s situation? We have gas-guzzling SUVs that will gradually be replaced by hybrid electric cars. In the longer term, hydrogen operated cars will turn one of the most abundant resources in the world into energy. The Environmental Protection Agency (EPA) will establish stricter rules for energy efficiency.

Like any problem that caused stock markets to go down in the past, there is no question of whether there will be a solution to the energy problems in the world – only when it will be. And the bigger the short-term problem, the stronger the long-term solution.

I would like to give special thanks to Jim Williams at WTRG Economics. I could not have compiled this article without his generous help and his detailed article Oil Price History and Analysis. Note that an updated version of his article is expected soon.

Disclosures Including Backtested Performance Data