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What markets are telling us about future energy prices

I am borrowing this shamelessly from an Oil Drum thread (and more specifically from a comment by substr4ct, but it's such a telling graph that it's worth flagging and circulating widely (see below).

Until very recently, and at least since the mid 80s, i.e. basically since we have futures markets in oil, the expectations on long term price of oil were extraordinarily stable - at around 20$/bl.

That meant that, at all times, and whatever the actual spot price was, oil prices were expected to come back (upwards, or downwards, depending on where it would be then) to that level. For instance, in late 1998/early 1999, when spot prices dropped briefly below 10$/bl, the market still epxected them to recover in the medium term (the longest futures available are 5 years forward).

And that price was the central hypothesis used to evaluate oil projects: you'd build your basic retrun on investment scenarios using that price for the life of your project, adjusting, if necessary, the first one or two years to then prevailing prices. And banks, a notoriously conservative bunch, basically used the same numbers to finance oil project over the long term (well, we'd use 18$/bl to be on the safe side).

This graph shows, for every year since 1990, what the markets' expectation of long term oil prices, as represented by the longest date future, was.

So it is actually quite remarkable how quickly the view of the market on future prices of oil has changed in the past 2 years. What the graph says is that as of today, the market expects oil prices to still be around 60-70$/bl 5 years from now, and not to drift down to 20$/bl or somewhere in between.

The market has dumped the orthodoxy of the past 20 years, which is REALLY amazing, considering how deeply these long term expectations remain entrenched, usually.

And the banking market is actually following. Financings that used to be based on 18$/bl oil went to 25$/bl in 2004 and to 35$/bl or more last year. That's also a pretty remarkable change - and, again, an astonishingly rapid one.

You may think that it's silly to argue for 18$/b when oil prices have been above 50$ for the past year or so, but remember that the hypotheses we're talking about in long term financings have to be valid for 15-20 years, and even more if you're talking about the actual investment decisions by oil companies. Prices "always" came back to their 20$ mean in the past, so why think it will be different this time? Why expect prices not to drift back to their "normal" price?

That has required a pretty big shift in overall psychology, which cannot be explained by short term worries on supply or by speculative influxes of "hot money". it's a real, structural change.

It would seem that the markets have accepted the idea, if not of peak oil, at least of the end of cheap oil.

substr4ct provides another graph, which shows the similar evolution of future prices for natural gas:

The worries about long term prices of natural gas have started a bit earlier than for oil (possibly a consequence of the 2000 price peaks created by the Enron/California crisis) - and have so far stayed "ahead" of oil price worries.

As you may have noticed, I have focused increasingly on natural gas in recent "countdown" diaries, as well as on the impact on electricity prices. With natural gas being an industry much more dependent on infrastructure issues, we're likely to see that shortages can come not just from the short term demand-supply balance, but also from short and medium term transport and storage problems. This is a structurally less liquid market, and investment decisions from 5-10 years back (the time of full market liberalisation in a number of places) will come to haunt us unexpectedly.

The markets have taken note, and are (rightly) worried. and yet the irony is that, as mentioned in the Oil Drum thread, buying today the rights to 60$/bl oil in 2010 may well be the best deal ever...

Editorial Notes: This is the latest in Jerome's "Countdown to $100 oil." Links to previous articles in the series are at the original. -BA

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