High Gas Prices: Blessing in Disguise?
by Jeremy Siegel, Ph.D.
Annoyed by the rising price of gasoline, a good friend of mine recently asked me in disgust, "Why doesn't the U.S. government have an energy policy to bring prices down?"
"We now have the best long-term energy policy you can have: High Prices," I replied.
High prices are the only proven mechanism that forces Americans to seriously undertake energy conservation, exploration, and production. And they're already working their magic. Sales of gas-guzzling SUVs and trucks at General Motors and Ford were off about 30 percent in September compared to a year ago. And total gasoline consumption dropped more than 5 percent below trend following Katrina.
High prices ensure Americans will economize their use of gas and heating oil and simultaneously encourage investors to fund research and exploration of alternative energy sources. In the long run, this dual response of conservation and innovation will overcome the issues of energy scarcity and reverse skyrocketing prices.
Despite the short-term pain we consumers face today, scarce oil resources will not impede future economic growth. Here's why ...
Hubbert's Peak
An early warning about oil scarcity was given nearly a half century ago by Marion King Hubbert, a Shell geologist who predicted in 1956 that U.S. oil production would peak in the early 1970s.
His theory was dubbed "Hubbert's Peak" and was dismissed by many experts inside and outside the oil industry. But Hubbert was right. Oil production in the U.S. has declined nearly 50 percent since 1970, and after Katrina production slipped to a 62-year low.
The question facing us today is when will world oil production experience Hubbert's Peak? The answer depends on whom you ask. On the downward slope of Hubbert's Peak is Matthew Simmons, an investment banker, Texas energy expert, and author of "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy." Simmons argues passionately that the world's oil will soon be pumped dry. He argues that Saudi Arabia, the world's largest oil supplier, faces declining oil output and overstates their reserves.
On the upward slope of Hubbert's Peak is Daniel Yergin, Chairman of Cambridge Energy Research Associates (CERA) and author of the Pulitzer Prize-winning book "The Prize: The Epic Quest for Oil, Money and Power." Yergin thinks that supplies are plentiful, alternative energy sources will be found, and we will soon have another glut of oil that will push prices downward.
Who's right? I'm no geologist, but the more I analyze the situation, the more clearly I can see the worldwide Hubbert's Peak. Reaching peak world oil production is not the end of the world. (Quite the contrary. In my next column I'll discuss how technological innovation and new energy sources will make oil a non-issue.) But what we need to offset the higher prices today is greatly increased oil supply, and we need it fast. Unfortunately, oil exploration investments are long-term projects, and there still is a high level of resistance in funding major capital projects.
I recently traveled to Calgary, Canada, supposedly one of the most promising locations for future oil extraction. During my visit I constantly tried to get a reading on the huge Athabasca oil sands in Alberta. Many believe Alberta sits atop the equivalent of 175 billion barrels of oil, second to only Saudi Arabia. Unfortunately, this oil remains trapped in a combination of clay and sand that is expensive to extract. Yet at today's oil prices, extraction is not only feasible, but profitable.
By the time I left Calgary I doubted these oil sands would be the full answer to our problems. While some call Calgary a boomtown, many who live there are very cautious. They remember the total collapse that occurred after the last oil boom hit 25 years ago. They don't want to make the same mistakes.
Oil Prices to Remain High
Canadian oil and other oil deposits may be sufficient to put a lid on long-term oil prices, but the emphasis is on "long-term." Optimistic estimates are that by 2030, these Canadian oil sands will produce 6 billion barrels a year, but by that time the U.S. will be consuming nearly four times that amount.
The bottom line: I've found no evidence of an immediate source of additional oil. High prices at the pump will stay that way for some time. Just how long? The oil futures market lets us analyze future price expectations, as crude oil can be bought and sold for delivery many months and even years in advance. In October just one year ago, the market price of crude oil for immediate delivery was $54.00 a barrel. The futures contract for delivery six years later, in December 2010, was under $38. This pattern -- oil for future delivery selling well below the current price -- used to be typical of the oil market.
Today the market looks much different. As I write this column, oil for current delivery selling is just at $64 dollar, about $10 more expensive than a year ago. But oil for delivery in December 2010 is now almost $60 a barrel, more than $20 higher than it was a year ago. Oil traders are now betting that oil will remain in short supply and at these price levels for many, many years.
Investment Implications
What does this mean for the average investor? Energy stocks have been on a tear the last two years, and they certainly could correct downward. The energy sector is now greater than 10 percent of the value of all stocks in the S&P 500 Index, up from just 6 percent a few years ago. But that's still far short of the 30 percent reached during the energy crisis of the 1970s and early 1980s.
Energy won't come close to the 30 percent share again and it shouldn't. Many energy stocks became dramatically overpriced in the 1980s and subsequently collapsed.
Those bearish on energy think that is happening again. This year is on track to be the second straight year that the energy sector has been the best performing sector. One has to go back to 1966 to find another two year top-performing sector (technology) that didn't utterly collapse in the third year.
But I don't believe the whole energy sector will collapse. When the tech sector was the best performer in 1999 and 2000, its valuations became exorbitantly high (two-to-three times greater than market multiples). Energy is not even close to this. Based on current earnings estimates, the price-to-earnings ratio (or "P/E ratio," a critical valuation factor) of the energy sector is now about 11, the lowest of all 10 economy-wide sectors and far below the 17 P/E ratio for the market. And these earnings estimates of oil firms are based on oil falling back to the $50, which is a very conservative price. So it's quite possible for earnings to surprise on the upside.
Outlook for World Growth
The shock from higher oil prices will ultimately benefit the economy. The earlier we confront the reality of a diminishing supply of oil the better off we will be. As a result of the first oil crisis in the 1970s, we developed new technologies that allowed us to reduce the amount of energy we needed to produce one dollar of GDP by 50 percent.
We can and will do that again. Hundreds of billions of dollars are destined to be spent on energy conservation and the exploration and development of new energy sources. High prices will cut the demands for fossil fuels by stimulating energy efficiency, spurring research in alternative energy sources, and revisiting nuclear power options. All this will happen because free markets and capitalism work. People respond to incentives. High energy prices may be painful in the short run, but they will not slow world economic growth.
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