Tuesday, November 25, 2008

Why Volatility is Here to Stay

The world is a dangerous place these days. Market participants in the stock market, the energy markets, or in agricultural commodities have seen it all - from all time high prices to crashes – in the last year. And inter- and intra-day volatility is increasing – as I mentioned in my previous post, The Vomit Comet.

Volatility makes life difficult to manage. It materially impacts the bottom lines and business plans of households and executive suites alike. I previously quoted Charles Dow in this blog by writing, “The one thing pertaining to all markets is that they will change.” I am going to break that rule in this posting, and put forward an argument as to why volatility is here to stay.

With world supply and world demand in relative equilibrium in the short run, the variables that most drive price are future demand and future supply of oil – since the world needs a lot of it and it is relatively difficult to know with certainty how much we have. (The International Energy Agency actually did a bottom up study of the productivity curves of major known fields in their World Energy Outlook. A summary of this analysis is available here.)

So assuming that the future supply/demand balance is the important metric for calculating oil price, allow me to stagger you with some really big numbers. Let’s talk population. In 1975, world population was estimated at 4.0 billion people. By 2010, world population is expected to be 6.8 billion. This staggering change is causing all sorts of problems for those economists who try to estimate consumption activity. The United Nations predicts there will be 8 billion people in the world by 2030. And the IEA says that in 2030 the world will use 125 million barrels of oil per day. Implicit in that consumption figure is a worldwide growth rate of about 1.8%. If the annual growth rate is inhibited by worldwide recession and instead is 1.6% over this timeframe, the estimate would be 3 million barrels off per day. If the industry builds infrastructure to meet the 125 million barrel forecast, prices will be depressed and bankruptcies will ensure as exploration and production companies will not be able to pay the debt service on their asset loans.

Let’s bring macroeconomics into perspective with an example almost everyone can get their hands around. My wife and I like hosting parties, and we have learned several lessons after hosing parties over the last few years. First, it always seems easier to have enough of everything when there are fewer guests. Second, it is difficult to predict how much of any particular party treat we will need. A few years ago, during the Atkins diet rage, we might have had leftovers from one bag of chips after a party of 30. But at that same party, we might have run out of mixed nuts. As our guest’s tastes have adjusted, we have had to adjust too – for fear of facing the wrath of party goers that have been inappropriately supplied with snacks.

The move from $147 to $48 in crude was based on the realization of decreasing worldwide consumption. And this major price shift affects production plans and capital projects throughout the world. The tremors associated a predicting future behaviors on a growing, crowded earth have just begun.

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