Optimists and pessimists are converging in part of the energy debate. Despite many disagreements, the two sides have similar investment conclusions, at least for the short term: Develop fossil fuels, research alternative energies, push conservation. What makes some people optimists and pessimists? What are the disagreements? What does their debate imply for investors?
The Optimists vs the Pessimists
The optimist view of energy boils down to a belief that economic incentives will quickly encourage new supply, new technology, and new conservation. Under this view of the world, supply rises, demand falls and energy markets stabilise — with oil prices falling well below recent levels.
The pessimistic view sees the supply constraint as tighter, sooner, and longer, and doubts that economic incentives will work so quickly. Moreover, what-if analysis of sudden discovery of new sources suggests that postponements of oil production peak will be relatively modest — 15 to 20 years. Under this view, the long lead time on research, the uncertainty of outcomes, and surging energy demand from developing countries create long-term shortages and permanently higher real prices.
Some main differences between the two camps are summarised as follows:
Reserves: The pessimists point to geological estimates and models such as the Hubbert’s Peak to suggest that oil supply is peaking now. The optimists counter that reserve estimates are inherently uncertain, that reserve estimates have grown over time due to better extraction technology and more exploration, and thus that a bias toward pessimism is unwarranted. In my view, the points go to the pessimists on this one. To say reserves are unknown is not to say they are sufficient. Moreover, the world has been searching harder and smarter for oil over the last 15 years, and has come up with very little.
Time to Market: Non-conventional sources need to be brought to market. This takes time and money. It faces scientific and environmental hurdles. For example, oil shale has been discussed for 30 years, but little has been exploited. Moreover, major development projects take time, even when geopolical factors are favorable. Environmental problems face virtually every alternative to oil. Financing energy projects faces many risks, and governments have yet to step up support. Advantage pessimists.
Demand Response. Higher prices will reduce demand for current uses, but demand for energy from developing countries (China and India) is growing faster than conservation can save. According to the IMF estimates, world demand for oil will rise from 84 mbpd to 138 mbpd in 2030. Starting from 84 mbpd demand this year, this is exactly the level of demand in 2030 if one assumes 3.5% global growth and a global demand elasticity of 0.6. Herculean efforts would be needed to reduce global elasticity to 0.3 (it is currently about 1.4 in China!), and even then global demand would be 100 mbpd in 2025. The US Geological Survey esitmate of 3.1 trl bbl of total conventional oil (compared with about 2 trl for the pessimists) does not help much, because peak production under the USGS estimate occurs in about 2025, with production of 95 mbpd. The pessimists get this one too.
Energy is energy is energy. Substitutability is a key economic concept, and there has been much substitution out of oil into other fuels, especially for electricity generation. The problem is transportation. Gasoline is one of the few fuels that is light in weight and condenses much releasable energy into a small space. Since the largest part of demand growth for energy comes from transportation, finding a good substitute for gasoline is key. Hydrogen or solar vehicles are a long way in the future, but such alternatives are a major investment opportunity. However, to believe that they will come on-stream quickly is highly optimistic.
Politics. When prices change, behavior changes. However, politicians have great difficulty changing prices for energy, because of the immediate feedback from constituents — note the recent riots in Indonesia when the government raised fuel prices. Few candidates in US elections dare to propose higher gasoline taxes. The unfortunate conclusion is that changes in energy policy will require a crisis large enough to give politicians cover. Even 9/11 in the US did not have this result. Advantage pessimists.
Just Speculation. Another school of thought traces high oil prices to finanical market conditions. Huge amounts have poured into commodity funds in recent years, and these funds are chasing the market. Moreover, oil speculation is abetted by easy monetary conditions around the world. The speculative component in oil prices may drop with a combination of a market reversal (which would scare dabblers) and higher interest rates as the Fed keeps hiking rates. The optimists get this one.
True Final Demand. Some optimists point out correctly that there is no underlying demand for oil itself. Rather, the demand is for transportation, heating, plastics, or other goods based on oil. Hence, if there are bottlenecks, such as refining capacity, then the final price of the product (e.g. gasoline) will include a scarcity premium for refining capacity. Normally, the high prices of the final product will pull up the price of the raw material (oil). The large expansion of crack spreads indicates that there is much truth in this view. The optimists get this one. (That said, it takes time to build new refineries, and skill shortages among plant engineering firms are lengthening delivery dates.)
What Should Investors Do?
For policymakers, the oil market presents a classic case of decision under uncertainty. There are two axes to consider. First, either the optimists are right or wrong. Second, either the world invests in technology/exploration, or it does not. So there are four combinations. (1) Optimists right/Few investments: Civilisation is safe, with little waste. (2) Optimists right/Big investments: Civilisation is safe, but has wasted some resources. (3) Optimists wrong/Few investments: Civilisation is NOT safe. (4) Optimists wrong/Big investments: Civilisation safe, but not as rich as if oil were unlimited. For a policymaker, it is better to spur the investments, because the worst possible outcome is a bit of waste. This waste can likely be absorbed by economic growth.
For individual investors, the problem is different, because investment portfolios are necessarily small and concentrated. From this viewpoint, a more effective mechanism for pooling global energy risks seems advisable. Clearly, individual investments in energy development, technology, and conservation will be a growing part of portfolios over the years to come.
Moreover, a key point is that the disagreement between optimists and pessimists is about prospects in the long term, not short term. Hence, immediate investment implications are not very different. There will likely be more attractiveness in investments in energy technology, exploration, and conservation.
By Robert Alan Feldman, Morgan Stanley economist as published on the Global Economic Forum