Courtesy of Doug Short.
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The popular perception is a commodity’s price is determined by the market – as participants weigh a variety of different signals, and as they gauge the relative balance between supply and demand. An excess of supply over demand suggests prices will soften, all else being equal. Conversely, an increase in demand relative to supply hints at a rise in price to restore equilibrium to the market. This is the dogma every university student learns in his first economics class.
A commodity is by definition a fungible item; for instance, any cotton bale of the same grade is as good as any other. At a certain level, with suitable adjustments, different commodities may substitute for one another. Wool, cotton or rayon are all fibers which can be spun into thread (or, yarn) to be woven into fabric from which clothing can be sewn. Each has unique attributes which make it more desirable for certain types of apparel, but each fiber is a substitute for the others over a wide range of apparel.
Likewise, all energy forms are different but the same. At its most basic, energy is merely the amount of work a standard unit (a barrel of oil or a metric ton of coal, for example) can perform. A widely used measure of energy is the British thermal unit (Btu). One Btu is the amount of energy needed to heat one pound of water from 39 to 40? Fahrenheit.
Heating water to a temperature high enough produces steam; steam in turn can be made to drive a turbine; the rotating turbine to generate electricity; and, the electricity so generated can power a wide range of tools and appliances. Every energy form can be made to heat water. So every form of energy is fungible. In the short-term, most forms are not readily substitutable ? think of the physical conversion needed to retrofit a natural gas fired plant to use coal. Over longer periods though substitution is feasible.
For these reasons, we believe energy prices should be compared on a Btu basis. Interestingly this is a practice the electric utility industry has used for years. On a Btu basis, petroleum is expensive when compared to coal or natural gas. Currently, petroleum on a Btu basis costs more than seven times coal; versus natural gas, the premium is over three times. This is the reason why utilities have substituted coal or natural gas for petroleum since 1973. Currently, only one percent of the electricity generated in the United States is from oil versus almost seventeen percent in 1973.
This analysis understates the petroleum premium. The petroleum prices used are for residual grades. This is the viscous sludge left over from the distillation process. Prices for distillate grades would increase the premium by roughly thirty percent.
We believe the arguments used to justify recent stratospheric oil prices merit scrutiny and considerable skepticism. Energy may not be cheap, but crude oil, relatively speaking, is perhaps more expensive than is warranted.
Notes:
Based on the cost of various fossil fuels received at electric generating plants in the United States. All costs include taxes and are expressed in Dollars per million Btu.
Petroleum prices are for residual fuel oil (primarily grades nos. 5 and 6).
Electricity net generation comparison based on the total for all sectors (fossil fuel, nuclear, hydroelectric and renewable sources) expressed in billions of kilowatt hours.)
(Source: U.S. Energy Information Administration, Annual Energy Review, 2010 and Monthly Energy Review, Sep 2011.)
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American Independence Financial Services, LLC (“AIFS”) is the investment adviser and administrator for the American Independence Funds and the NestEgg Target Date Funds. The firm is a limited liability company founded in 2004.
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