Paper Money and Energy Demand, Part 1

It’s a broadly accepted principle that government interference in the private production of resources creates economic consequences. The extent of the interference usually dictates the severity of the consequences. The Soviet Union was notorious for its hopelessly inept price and quota system that led to rationing and shortages. Central planning commissions dictating supply, capital investment, and demand is clearly a fool’s errand in an infinitely complex modern industrialized economy.

How about the establishment of a pure free market to determine energy prices? A “pure” free market cannot exist as long as energy prices are measured in an elastic paper currency. But leaving this complication aside, history teaches that the freer the market, the more efficiently and quickly supply can be developed to satisfy demand.

Other than the headline-grabbing blowup at hedge fund Amaranth Advisors, the free market appears to be functioning rationally. Consumers are just beginning to alter oil-consumption habits ever so slightly in response to their strengthening belief that high prices are here to stay. A few suppliers, particularly consortiums of private exploration and production (E&P) companies that are financing risky deep-water projects, are finally assuming long-term oil prices higher than $20 per barrel in their capital investment projects.

The most aggressive companies are levering up their balance sheets and plunging headlong into the most expensive, risky projects, pursuing reputations as the growth companies of the oil patch, while companies like BP may be left in a state of depleting reserves if its management team continues to delay expansion projects. BP’s management team remains stubborn in its belief that it should not invest in expansion projects that do not guarantee a satisfactory rate of return in a $20-30-per-barrel oil market.

This doesn’t mean that BP stock can’t be a good investment if its board and executives decided to enter “harvest” mode; maintaining production from long-term projects begun 10 or 20 years ago and using the proceeds to pay down debt, buy back stock, and raise dividends are the priorities of their current capital management policy. If this were to occur, BP stock would be a far better 10-year investment than buying a U.S. Treasury note with a 4.7% yield and holding it until maturity. But the market would never assign BP stock a respectable earnings multiple under a scenario of continued high prices. Instead, the most aggressive E&P companies would become the darlings of Wall Street.

The Free Market Is Best, but Not Perfect

Investors in pursuit of high profits have allocated huge sums of money to commodities, particularly energy, as an asset class. By investors, I refer to more than just wealthy individuals; it seems that entities ranging from pension funds to public employee retirement systems to university endowment funds have made room in their portfolios for physical commodities or hedge funds that trade commodity futures.

Some institutional money always “chases” high returns after a big move, but most pension fund managers clearly understand the “price inelasticity of supply” argument. In my opinion, this argument is the single most important factor driving this commodity bull market. “Elasticity” is the term economists use to gauge the reaction of producers and consumers to changes in price. For example, gasoline demand is very price inelastic, because consumers may complain about high prices, but by and large, they have not altered consumption patterns in response to big increases in price.

On the supply side, oil producers can no longer simply turn a nozzle to jack up supply in response to demand surges. OPEC members, including Saudi Arabia, demonstrated that they could do this in the 1980s and 1990s, but are now showing no ability or willingness to flood the market with oil from their stated (but not independently audited) spare production capacity. Even if they could flood the market right now, they would probably be risking irreversible damage to their very old, overstretched, highly stimulated wells. Besides, major producers have become convinced that the global economy can afford and adapt to $60 oil, and OPEC has recently stated its intent to defend this price range with production cuts.

One complication arising from completely free markets is that when they are applied to natural resources, they tend to lead to very long boom-and-bust cycles. Think about this boom-and-bust in the context of the Saudi Arabian oil endowment of the 1950s and 1960s. This is when the “Seven Sisters” (a consortium of Western oil companies) held concessions from the Saudi royal family to produce Saudi oil.

The marginal cost to produce this oil was very low, so the Seven Sisters had every incentive to maximize production and feed growing markets. A combination of geology, exploration efforts, and technology contributed to the rapid expansion of the global oil production apparatus. This allowed new end markets for oil to develop very rapidly without supply or price shocks. It was a booming market for the high-volume, low-cost producers, and it was a great market for consumers, since competition among highly productive, super-giant oil fields around the world kept a lid on prices.

The 1970s are included in this era of geologic abundance — the oil shocks of that decade were political, not geological, in nature. There was plenty of easily expandable supply to meet rapidly growing demand. The advantage of high-volume producers strengthened into the 1980s and 1990s, until they lost most of what they overproduced for their relatively limited Western markets. Their influence over prices waned as a perceived oil glut pushed prices below $20 per barrel in the late 1990s. All oil that is produced is eventually consumed by economic activity — the key variable being “at what price?” China and India were still in the early stages of their transition toward free market economies, so excess oil production was marked down in price until a buyer was willing to take it.

Now, 10 years later, there are many more willing buyers of excess oil production. The chronic state of oversupply had end-users thoroughly convinced that oil production was infinitely scalable. But this situation is over, and now OPEC is showing signs of difficulty expanding production, precisely when it should maximize its future profits. The market is slowly waking up to the fact that there are limits to the rate at which oil can be produced, even with the latest technologies.

A Free Market Pumped up by Fiat Currency

The meteoric rise of many emerging market economies accelerated around the turn of the millennium and added a major new element to the oil demand picture. Oil demand growth is no longer limited to Western population and economic growth, but is now bolstered by the rapid industrialization of China, India, Brazil, and several other emerging consumer economies.

Even in the face of a major slowdown in Western consumption, which would likely cause a temporary panic in these export-oriented economies, it’s hard to believe that government officials (the Chinese in particular) would sit on their hands while the consumption and industrial infrastructure that has been rapidly built began to go bankrupt and liquidate. Social “harmony” is a top Chinese policy objective, and masses of laid-off factory workers do not exactly mesh with this agenda. A transition back toward state-owned enterprises is not difficult to imagine under the circumstances.

Policymakers at the highest levels of every government around the world are familiar with Keynesian remedies to the “deflation liquidity trap” that engulfed the U.S. during the Great Depression. These remedies include injecting reserves into the banking system, intervening in futures markets, and coordinating monetary easing with all major central banks. Treasury Secretary Henry Paulson, the former head of Goldman Sachs, is probably the most qualified individual in the world to implement brand-new economic stimulus policies via the derivatives, credit, and foreign exchange markets (but there would certainly be consequences).

Japan in the 1990s stands out as an example of the failure of such stimulus policies, but the psychology and demographics in that scenario are unique to Japan and are not shared worldwide — at least for the next decade. Many Keynesian academics believe the source of Japan’s deflationary liquidity trap was “deficient demand.” Neither Japan nor any other economy can have “deficient demand,” since the human desire for more consumption has virtually no limit.

The limit of consumption — which is how civilized societies have evolved in order to ration scarce resources peacefully — is defined by an economy’s ability to produce. Japan has a very developed economy, virtually nonexistent immigration, and has long enjoyed high living standards that the rest of Asia is working hard to achieve. The Japanese save a high proportion of their income because they have achieved enormous post-World War II productivity gains and as a group consume far less than they produce and export.

Deficit spending, modern popular democracies, and fiat currency regimes virtually ensure that the price of oil will not be limited to growth in the global economy’s productive capacity. A barrel of oil does not change over time in terms of its utility or energy content, but paper money is ever-depreciating as more and more of it is created every second, at virtually zero cost. The demand side of the oil market, as it is currently set up, is not really a “free market” in the traditional sense of the phrase. Keynesian government policies have had the effect of artificially inflating demand and will be implemented to ensure that demand remains inflated.

Economic growth must remain at a certain level to keep “creating” jobs and servicing enormous debts, and this economic growth is energy intensive. This trend should continue until a collapse of the global monetary system or natural resource scarcity dictates otherwise. A flight away from paper money and assets would overpower Keynesian policies. Peak Oil would drive the fiat currency price of energy so high that virtually no amount of stimulus could offset its depression-inducing consequences. In fact, these policies would have the opposite effect, since those fortunate enough to be sitting on the largest oil reserves are more likely to hoard them in a hyperinflationary environment. But the bond and oil markets are not currently anticipating either of these occurrences in the near future.

A Free Market Adjustment Exacerbated by Myopia and Hubris

Considering the disaster under way at hedge fund Amaranth Advisors, it’s apparent that the free market — when it becomes primarily driven by financial speculation — is not always rational or perfect. In the case of Amaranth, a trader backed his firm into a position where it temporarily became the market for natural gas futures. When Amaranth realized it could not unload its sour bets without imploding its entire asset base, it looked to sell its book of trades to more stable, diversified commodity trading firms.

The Amaranth case reflects how the myopia of short-term trading (with enormous leverage) can exacerbate an already oversold market. The recent 50% decline in natural gas partly reflects high storage levels, and partly reflects the consequences of Amaranth’s myopia. Brian Hunter, a trader with access to too much leverage — and what appears to be a lack of basic risk management procedures — bet the ranch on a very specific spread developing in the natural gas futures market within a specific time frame. Hunter is an irresistible target for finger-wagging about a lack of risk controls. But concentrating on the human error of this event misses the important question we should be asking: What allowed Hunter to make such an enormous specific bet in the natural gas futures market in the first place?

I think one of the most important factors behind this risky trading decision is the pressure that institutional investment managers are under to meet high short-term performance expectations. In the world of hedge funds, portfolio managers must make concentrated and/or leveraged investments to outperform their peers, or they risk becoming extinct within a few quarters as impatient investors redeem their funds. This is especially the case with hedge funds dedicated solely to the commodity futures markets. Commodity prices, especially natural gas, tend to be very volatile over short time frames. When the typical 10% margin requirement is added to the mix, a concentrated one-way bet can magnify a fund’s exposure to price fluctuations 10-fold. Needless to say, traders must be very nimble, with tight stop losses and position size limits, to succeed in this market.

Brian Hunter was very adept at making quick trades in and out of the natural gas market with small amounts of trading capital. In fact, Hunter had established a reputation as one of the best natural gas traders in the world. This reputation undoubtedly attracted the wave of institutional money that tends to “chase” high historical returns, often investing right at the top of a market.

Once this flood of new money came in, the pressure on Hunter to take greater risk certainly ratcheted up a few notches. A multibillion-dollar fund’s sheer size places it at a big disadvantage to smaller, nimbler traders.

The Precedent Set by the Long-Term Capital Management Bailout

This situation would not have been allowed to develop outside of the context of the current financial environment. A wealthy speculator who fully understands the risks of the futures market would never in his right mind gamble with his entire net worth the way Hunter gambled with other people’s money in his final trades. Wall Street firms are riding high on a sea of fiat liquidity, and the Fed stands at attention to bail out whoever makes a bad loan to a hedge fund.

This precedent was set with the 1998 bailout of Long-Term Capital Management (LTCM). Every incentive within the system is now geared toward the production of more credit and the “papering over” all losses. If you were in Hunter’s position — with a choice between making a windfall fortune if you were right and walking away without much personal financial loss if you were wrong — which choice would you make (leaving aside any fiduciary obligation to those who have entrusted you with their capital)? Logically, when the payoff for being right on a 50/50 bet far outweighs the loss for being wrong, the correct choice is to make the bet.

Is a free market in which government authorities consistently bail out, or “paper over,” misallocations of resources really free? The foundation of free market economics rests on Adam Smith’s “invisible hand.” This invisible hand performs its function of allocating scarce resources to their highest-valued uses. Price signals and profits arising from shortages in a particular segment of the economy provide a large incentive for private entrepreneurs to satisfy demand. If too much production capacity is directed toward the booming market, and a great amount of this capacity is built on credit, bankruptcies and liquidations should eventually develop to correct the overinvestment.

But a completely free market cannot exist if the last step in the cycle, where misallocated resources are typically liquidated, is pre-empted. The stewards of the U.S. dollar have allowed an “asset-based” economy to develop, and now have no other choice but to keep the system afloat with ever-higher levels of money and credit. Falling prices and debt defaults are not politically acceptable. If large Wall Street firms were not able to bail out Amaranth, the Fed would intervene to prevent a disorderly contract liquidation that could trigger a systemic financial crisis. Speculators know this and, as a result, employ far more aggressive trades than they would in the absence of this ultimate support.

In essence, the Amaranth episode represents a case of the “tail” of futures trading wagging the “dog” of natural gas supply and demand. Efficient allocation of capital is undoubtedly important and requires active, liquid markets. But it’s not healthy when the best minds and the largest pools of capital in an economy are focused on determining the most efficient price of natural gas in the futures market, rather than directing capital toward the hard physical work of exploration and production. Case in point: There is a major shortage of skilled oil field workers and geologists that is only projected to get far worse. The best and brightest pursue careers on Wall Street, while the compensation that increasingly scarce petroleum geologists will demand will raise the price of several important E&P projects.

A consequence of having a fiat currency-amplified free market economy is far too much focus on the 200-day moving average of the natural gas futures price and far too little focus on long-term investments with far-off payback periods that can meet ever-growing demand. Individual investors who focus on the long term have an incredible advantage over frenetic traders like Amaranth: they don’t have to be right about the price of natural gas this winter down to the decimal point to make money. In fact, the liquidation under way in almost anything natural gas-related is opening up great opportunities for energy investors with patience.

In the latest monthly issue of Strategic Investment, I recommended a natural gas producer that has undergone a significant correction along with the price of gas, but remains nicely positioned in the most promising unconventional basins in the U.S. Production growth from these unconventional basins will be necessary to offset the steep production declines we are seeing in mature basins like the Gulf of Mexico shelf and most conventional onshore wells. This company is generating enormous returns on invested capital by expanding production on its large acreage position, and management has established a clear, achievable plan to maintain its high production growth rate for several more years.

Interesting comparisons can be made between private E&P companies, state-owned E&P companies, and E&P companies that are majority owned by a government and partially owned by private investors. In Part 2 of my essay, I will examine the contribution of PetroChina and Petrobras (two companies from the third category) to the oil and gas supply of the future. These companies must strike a delicate balance between free market incentives and government-mandated initiatives, and therefore present investors with unique opportunities and risks.

Good investing,
Dan Amoss, CFA
October 2, 2006