Irrational Exuberance in Energy Markets:Causes and Consequences

Philip K. Verleger, Jr.

Boulder, CO

April 28, 2016

2

Does This Sound Familiar?

The dimensions of the collapse in the ____ industry during the past

two years have been staggering. Half a million people have lost

their jobs. In that time, the Dow Jones ____ index has dropped 86

percent; the ____ index, 89 percent. These are declines in value

worthy of comparison to the great crash of 1929. Out of the $7

trillion decline in the stock market since its peak, about $2 trillion

have disappeared in the capitalization of ____ companies. Twenty-

three ____ companies have gone bankrupt.

3

The First Mention

…how do we know when irrational exuberance has unduly

escalated asset values, which then become subject to unexpected

and prolonged contractions as they have in Japan over the past

decade?

Federal Reserve Chairman Alan Greenspan, “The Challenge of Central Banking in a Democratic Society,”

remarks at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public

Policy Research, Washington, DC, December 5, 1996.

4

Oil Price Collapse: Third Episodeof IE in the Twenty-First Century

Episode 1: The Dotcom Meltdown

Episode 2: The Housing Price Bubble

Episode 3: The Oil Price Bubble

5

The Oil Bubble Is the Smallest:So Far

The dimensions of the collapse in the telecommunications industry

during the past two years have been staggering. Half a million

people have lost their jobs. In that time, the Dow Jones

communications technology index has dropped 86 percent; the

wireless communications index, 89 percent. These are declines in

value worthy of comparison to the great crash of 1929. Out of the

$7 trillion decline in the stock market since its peak, about $2 trillion

have disappeared in the capitalization of telecom companies.

Twenty-three telecom companies have gone bankrupt.

Paul Starr, “The Great Telecom Implosion,” The

American Prospect, September 8, 2002

6

The Consequence of the Dotcom Bubble

And the storm is not over. Many other firms, including some of the

biggest, are teetering under a heavy load of debt. Altogether, the

industry owes a trillion dollars, “much of which will never be repaid

and will have to be written off by investors.”

Paul Starr quoting Senate testimony of FCC Chairman

Michael Powell, July 30, 2002.

7

“Irrational Exuberance”: The Definition

A situation in which news of price increases spurs investor

enthusiasm, which spreads by psychological contagion from person

to person, in the process amplifying stories that might justify the

price increase and bringing in a large and larger class of investors,

who, despite doubts about the real value of an investment, are

drawn to it partly through envy of others’ success and partly through

a gambler’s excitement.

Robert J. Shiller, Irrational Exuberance (Third Edition,

2016), p. 240.

8

The Shiller Graph:Share Prices vs. Earnings, 1871 to 2016

0

500

1000

1500

2000

2500

1871 1891 1911 1931 1951 1971 1991 2011

Re

al

S&

P C

om

po

sit

e I

nd

ex

0

50

100

150

200

250

300

350

400

450

500

Re

al S

&P

Co

mp

os

ite

Ea

rnin

gs

Share Prices Earnings

Source: Irrrationalexuberance.com.

9

Consequences of Irrational Exuberance

Excess investment in capacity

Low prices for future output

Unwillingness of lenders to advance credit for future

growth

Bankruptcy for traditional providers failing to adjust

10

Telecommunications Illustrates Consequences of Irrational Exuberance

Invention of cell phone and introduction of Internet

created enormous demand for band width.

Massive construction of fiber-optic systems followed.

Much of the fiber-optic system remained dark for

years and is still dark.

However, the availability of networks drove down

communications costs. Bankrupt firms wrote off

investment costs and offered low prices.

Costs of communicating by cell phones fell.

Landline phone companies went bankrupt.

11

Price Index of Cellular Communications vs.Landline (LL) Communications, 1985 to 2015

0

50

100

150

200

250

1985 1990 1995 2000 2005 2010 2015

Ind

ex

Cellular LL Local LL Long Distance

Source: US Bureau of Economic Analysis.

12

Share of Consumer Dollars Allocated toThree Types of Telephone Communications

0

10

20

30

40

50

60

70

80

1985 1990 1995 2000 2005 2010 2015

Perc

en

t

Cellular LL Local LL Long Distance

Source: US Bureau of Economic Analysis.

13

“Ownership Society Boom”Offers Similar Results

The United States benefited from very large financial

flows from China resulting from the trade deficit. The

funds went to banks for lending.

Interest rates fell.

The housing sector was the beneficiary.

– Mortgage rates were cut.

– New home buyers were attracted.

Housing prices surged.

Housing construction surged.

Housing ownership costs rose.

14

Housing Price Irrationality:Case-Shiller Housing Price Index, 1987 to 2015

0

50

100

150

200

250

1987 1991 1995 1999 2003 2007 2011 2015

Ind

ex

(J

an

ua

ry 2

00

0 =

10

0)

20-City Composite San Francisco Detroit

Source: McGraw Hill Financial.

15

0.80

0.85

0.90

0.95

1.00

1.05

1985 1990 1995 2000 2005 2010 2015

Re

lati

ve

Ho

us

ing

Pri

ce

0.0

0.5

1.0

1.5

2.0

2.5

Ho

us

ing

Sta

rts

(Mil

lio

ns

at

An

nu

al

Ra

tes

)

Housing Price Housing Starts

Impact on Housing Costs: Cost of Housingvs. Total Housing Starts, 1985 to 2015

Source: US Bureau of Economic Analysis; US Census Bureau.

16

Factors Causing Irrational Exuberance

Changes in government regulation

Projections

Easy availability of credit

Government incentives

Myopia

Regulatory failures

17

Bubbles Can Sometimes BeAvoided or Popped Early

The housing bubble could have been avoided by prudent regulation.

– The Office of Federal Housing Enterprise Oversight (OFHEO) had been created to prevent future housing bubbles following the 1980 experience. Its officials saw nothing in the rise in prices or mortgage practices to warrant action.

– Federal Reserve officials did not believe housing prices could plunge as they did.

International energy officials missed an opportunity to hold prices around $80 per barrel when production in Libya collapsed.

– Strategic stocks were more than adequate.

– However, many policymakers did not want to intervene in markets.

– Furthermore, high prices were seen as a spur to investment.

18

Major Factors Contributingto the Three Bubbles

Dotcom Housing Petroleum

Change in Government

Regulations

Deregulation of

communications

Mortgage rules on

banks

Low-sulfur

diesel in Europe

Projections Rapid growth Need for housing Peak oil

Easy Credit Banks and

bonds

China cash Banks and

bonds

Government Incentives ??? Demands to lend

to low income

IEA calls for

industry

investment

Myopia Yes Yes Yes

Regulatory Failure None No oversight Failure to use

strategic stocks

19

Irrational Exuberance in Energy Fanned by Regulatory Changes at the Right Time

Bubble caused by irrational exuberance required several elements: optimism, fuel, and myopia.

The energy bubble was fueled by fears of running out.

– The End of Oil (Paul Roberts)

– Twilight in the Desert (Matthew Simmons)

– Fiction published by IEA in various World Energy Outlooks

The EU poured fuel on the fire with a badly timed shift to ultra-low-sulfur diesel.

– Refiners required light sweet crude to make the product.

– A shortage of light sweet crude in 2008 sent crude prices to record levels.

Industry myopia led to excessive investments.

– Pessimists do not build fiber-optic networks, construct large housing developments, or explore for oil.

– Oil industry officials, mostly engineers, by nature believe that prices can only go up.

20

June Refining Margins for Distillate in Rotterdam Illustrate Regulatory Effect

-20

0

20

40

60

80

100

120

140

160

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008Marg

in (

Sp

ot

Gaso

il l

ess B

ren

t; $

/bb

l)

Source: PKVerleger LLC.

21

“One hundred dollars per barrel is becoming

the new $20 in our business.”

John Watson, Chevron CEO, March 2014

22

Episodes of Irrational Exuberance Often, But Not Always, End the Same Way

The 18th century railroad boom after the Civil War

ended when railroads could not pay bondholders.

The dotcom bubble ended when the companies that

had laid the fiber-optics also could not cover their

debt.

The housing bubble ended when consumers could

not meet their mortgage obligations.

The US savings and loan industry, however,

collapsed from deregulation and the end of inflation.

23

Excess Investment Leads to Excess Capacity and the Inability to Cover Debt

Again, too many miles of railroad were built in the

absence of regulation.

Too many miles of fiber-optic cable were laid.

In the case of housing, too much money was made

available to buyers.

24

Technical Change Can Fuel Irrational Exuberance

Disruptive technologies that occur simultaneously with financial

bubbles are a lethal economic combination.

Disruptive technologies are inferior production processes that

accomplish the same task for a much lower cost.

– The 3.5-inch “floppy” disk was disruptive. It was not as good

as standard disk drives but it was good enough.

– The personal computer was inferior to the mainframe, but it,

too, was good enough.

Disruptive technologies can destroy industries and firms by

making existing technologies obsolete and preventing recovery

of investment.

25

Fracking and Futures Markets Have Exacerbated the Energy Price Cycle

Fracking is inferior to drilling in deep water, but it,

too, is good enough to access billions of barrels that

were not counted as reserves.

Fracking can be undertaken by very small firms.

Offshore E&P requires very large firms.

26

Fracking Has Destroyedthe Peak Oil Theory

27

US Natural Gas Prices Providea Preview of Things to Come

Fracking was first applied to develop US natural gas reserves

in Texas and then in the Marcellus Shale.

Increased supplies drove prices lower and lower.

Rigs were withdrawn and drilling was reduced. The pundits

predicted a quick price recovery. On May 19, 2012, Financial

Times published an article titled “US Natural Gas Prices Set to

Double by 2016, Says Shell.”

– The company used a $4 to $6 per million Btu price for 2015.

– Low prices were predicted to boost demand.

– Others predicted lower supply.

28

Weekly Henry Hub Spot Price forUS Natural Gas, 2000 to 2016

0

2

4

6

8

10

12

14

16

2000 2002 2004 2006 2008 2010 2012 2014 2016

Do

llars

per

mm

Btu

Source: NYMEX.

29

New Financial Institutions Promote Competition, Cap Price Increases

Futures markets have always been understood to flatten and lower supply curves.

– Entry by smaller firms is promoted.

– Efficient smaller firms are able to compete with larger, naturally more bureaucratic large companies.

– Counterparties interested in financial returns are attracted.

Futures markets accelerate the forces of “relentless commoditization.”

Investment banks contributed to the process by creating commodity-linked instruments that attracted billions from passive investors.

30

Total Open Interest in Three Principal Crude Oil FuturesContracts, Weekly Data, January 1991 to March 2016

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1991 1994 1997 2000 2003 2006 2009 2012 2015

Th

ou

sa

nd

Co

ntr

ac

ts o

f 1

,00

0 B

arr

els

Source: PKVerleger LLC.

31

Notional Value of Net Long Position of Investors in Commodity Futures, 2008 to 2015

0

50

100

150

200

250

300

Mar-08 Jul-10 May-11 Mar-12 Jan-13 Nov-13 Sep-14 Jul-15

Bil

lio

n D

oll

ars

Source: Commodity Futures Trading Commission.

32

The Oil Price Bubble’s CollapseHas Several Causes

The threat of global warming

The end of regulation

Technical change

Increased competition

33

Pressure to Limit Greenhouse Gas Emissions Is theType of Regulatory Change that Makes or Ends Bubbles

Hotelling’s theory has dominated oil industry thinking for decades.

The late Saudi king Abdullah instructed his oil ministry to save oil for future generations in April 2008.

“Oil in the ground is worth more than money in the bank” has instructed oil ministers since oil-exporting countries took charge of their oil forty years ago.

Today, however, oil producers face the fact that a lot of oil may never be produced.

The new advice to oil ministers is “produce your oil before it is too late.”

Ali Naimi said as much in December 2014.

3434

“There are many things happening in the energy sphere – technology

on the one hand and efficient [sic] on the other, there are politics.

All of these are good for humanity, but they will definitely be a threat

to oil demand in the future. My question to the panel – is there a

black swan that we don’t know about which will come by 2050 and

we will have no demand?”

Ali Naimi. Saudi Arabia’s Oil Minister,

December 2014

35

Threat of Global Warming Limits and Increased Competition Led to a Change in Regulation

Key OPEC producers concluded in 2014 that low-cost

producers should no longer subsidize high-cost producers.

Long-term profits may be maximized by producing at maximum

rates for four to ten years.

– Development of high-cost resources such as Australian

LNG, Venezuelan crude, and Canadian heavy crude could

be stopped.

– Penetration of renewables could be slowed.

National interests of producing countries would no longer be

sacrificed to ungrateful high-cost producers.

36

Technical Change May Keepthe Price Bubble from Returning

Technical change is occurring on the demand and supply sides.

Growth in global demand will be depressed by new technologies and fuel substitution.

– Electric vehicles may have reached a tipping point (EIG).

– Natural gas has become a significant threat in the transportation sector.

– Low economic growth, particularly in developing nations, will slow growth of oil use and give alternatives a chance.

Productivity in exploration and production is driving down costs.

– Fracking is a truly disruptive technology.

– The history of disruptive technologies is that costs keep falling. That seems to be the case with fracking.

37

Increased Competition WillIntensify Price Pressure

The oil industry historically has been characterized by monopolistic competition. The interests of oil-producing countries coincided with the interests of the large oil companies.

– Multinational oil firms had no interest in rocking the boat.

– High prices were in everyone’s interest in the upstream industry.

But the oil and natural gas industries are deintegrated. Mid and downstream firms have no interest in sustaining upstream monopolists.

Independent crude oil producers are proliferating, achieving cost reductions, and boosting supply.

It may well be game/set/match for Big Oil and high-cost oil-exporting nations.

38

US Residential Construction Investment vs.Oil and Gas Drilling Investment, 1986 to 2016*

0

100

200

300

400

500

600

700

800

900

1986 1990 1994 1998 2002 2006 2010 2014 2018 2022

Bil

lio

ns

of

Cu

rre

nt

Do

lla

rs

Drilling Housing Investment Nine Years Earlier

IEA Drilling Target Likely Drilling Trend

* Housing expenditures shifted forward eight years.

Source: US Bureau of Economic Analysis; Barclays; PKVerleger LLC.

Marked Behavior Will Be Very Different

There will be little surplus capacity because it is not

in the economic interest of low-cost producers to

hold surplus capacity.

Investment in high-cost projects will be well below

the levels seen as needed by “experts.”

Prices will thus be very volatile.

– Low when there is surplus capacity

– High when there is no surplus capacity

Oil is the new corn.

39

Price Volatility May Accelerate Penetration of Renewables

The large oil companies want steady, high oil prices

for capital-intensive projects. They will not get them.

High, stable prices seem an ideal way to push oil

into oblivion quickly. The large Middle Eastern

countries will not let this happen.

The consequence: Very volatile oil prices will

complicate renewables’ penetration—but may attract

consumers, especially since renewables offer stable

prices.

40

The Futures Market Will Bethe Clear Winner

Those following oil operated on the absurd theory that Saudi

Arabia was the “central bank of oil.” They expected the

Kingdom to adjust output to stabilize prices, sacrificing income.

Those promoting the idea did not understand the role of central

banks.

Futures markets provide a means by which firms in the oil

business can stabilize prices, making a central bank

unnecessary.

Markets will expand further as the liquidity of futures markets

increases.

41

Oil Prices, 1861 to 2015 andPossible Trend to 2030

0

20

40

60

80

100

120

140

160

180

200

1861 1881 1901 1921 1941 1961 1981 2001 2021

Price Trend Projection

42 Source: BP; PKVerleger LLC.

43