As if tough financing conditions and policy instability weren’t worrying enough for many observers, along comes a crash in global oil prices. One of the US-based Digesterati writes:
“Most of the biofuels projects that I have worked on in the last 5 years have based their proformas on an $80/barrel oil price. With the recent dip and worldwide “power play,” I feel that investors as well as Boards of Directors will be really re-evaluating their business models, with most going overseas to markets that do not have the abundant reserves that we do.
“If we can make biofuels at a competitive price at $60-$70/barrel, they will be the big winners but I don’t see that happening. I feel that chemicals will be the big winners right now. I am working on a couple of feasibility studies around biofuels and it is hard for me to come up with an independent conclusion that will be credible, too much US political risk, economic risk, and international political risk.”
Another of the Digesterati forwarded this summary of an MIT Review article:
“According to Wallace Tyner, an agriculture and energy economist at Purdue University, all cellulosic ethanol plants were planned for oil above $100 a barrel, and since now it’s at US$70, they are no longer profitable and new plants simply won’t get built. Updated requirements are expected from the EPA early next year. If the mandates are repealed, says Tyner, “then cellulosic biofuels and biodiesel would cease to exist.”
Many are asking why are oil prices so low? Is this the new normal an extended period of months, or years, at these levels? Will they return to $100 or so any time soon, when, and what will be the trigger?
Let’s look at the data, and look behind the data, also towards the world of market sentiment and behavior.
Why are oil prices so low?
According to those who believe in orderly, rational markets based on broad and deep consideration of available public information, generally we are seeing commentary around three converging factors:
a. Currency and monetary policy. Succinctly put, the dollar is appreciating fast against world currencies, oil prices are dollarized, meaning that energy prices are rising quickly in local currencies, which softens demand. While, at the same time, producers of energy have costs in (devaluing) local currencies, but see revenues in (revaluing) dollars meaning that they are not always economically incentivized to cut production as fast as you think, as margins can be altered by currency moves.
b. Global growth. China’s growth is slowing, the EU is in rough shape, and the US is somewhere between sluggish and fine put together, the three trigger promoting a downward revision in a number of commodity prices.
c. Supply/demand. While demand drops with a slackening in growth, we’re seeing no cutback in OPEC production, and US production from shale oil has been continuing to accelerate, creating an oil glut.
The “rational market” turnaround timeline? Nothing soon, if you watch futures prices as an indicator of when tightness might return to the oil markets and boost prices.
Today, the WTI Jan 2015 contract is trading at $65.17 and the Jan 2017 contract is trading at $70.88 that’s roughly the impact of inflation. The Jan 2015 Brent contract is trading at $69.07 and the Jan 2017 contract trades at $78.79 not much more than inflation.
What’s the impact for biofuels? 5 Factors to Consider for the Long and Short Term
A. The sweet spot problem. Generally speaking, biofuels work best in a sweet spot that’s somewhere around $80-$95 right now. Much lower as our Digesterati friends expressed, the projects don’t pencil out, can’t compete against oil prices, and it is just tough to get bankers excited . Much higher? Capital heads for unconventional oil plays. But in the $85-$90 range there aren’t quite so many great US shale options, and many biofuels projects can compete on price. That’s the sweet spot argument. Right now, biofuels have been falling off the lower end but, according to this line of thinking, the market doesn’t have to return to the days of $120 Brent for the biofuels outlook to improve.
B. The long-term outlook. The long-range energy outlooks have been less excited about the capability of existing oil technology to meet growing global energy demand, without a robust alternative fuels component. The IEA, for example, sees around 11 million barrels per day in total oil production growth not enough to prevent sharp price increases given the likely global growth over the next 20 years.
Last year, the IEA opined:
The capacity of technologies to unlock new types of resources, such as light tight oil (LTO) and ultra-deepwater fields, and to improve recovery rates in existing fields is pushing up estimates of the amount of oil that remains to be produced. But this does not mean that the world is on the cusp of a new era of oil abundance. An oil price that rises steadily to $128 per barrel (in year-2012 dollars) in 2035 supports the development of these new resources, though no country replicates the level of success with LTO that is making the United States the largest global oil producer…by the mid-2020s, non-OPEC production starts to fall back and countries in the Middle East provide most of the increase in global supply. Overall, national oil companies and their host governments control some 80% of the world’s proven-plus-probable oil reserves.
C. The feedstock problem. Will biofuels feedstocks track the oil market and keep biofuels competitive? Within a limited range of price shift, oil prices and (for example) corn prices are reasonably well correlated but when you have a $30 drop in oil in a short period, there’s a disconnect, and right now biofuels feedstocks such as corn have fundamental food-supply price support that is keeping corn prices near $4.00 and soybean oil prices near $0.32 per pound. So, there’s a fundamental gap between biofuels prices and petroleum prices that is tough to close. And, feedstocks such as MSW which are available at negative cost based on social concerns (e.g. “no more landfills!”), don’t generally track with short-term oil prices.
D. The long-term project challenge. As Abengoa CEO Manuel Sánchez Ortega opined in Kansas in September, Abengoa isn’t looking at short-term prices and demand factors to make decisions about 30-year projects. They are looking at long-term prices and demand.
E. The increasingly short-term nature of RFS targets in the US, and EU 2020 targets. The RFS offered a conceptual 15-year time window for project developers back in 2007 as to market size and growth. Leaving aside the short-term problem that it is December and the EPA has not issued its volume obligations for 2014 yet, we only have a 7 year timeline going forward for advanced biofuels projects. That begins now to seriously impact the ability of companies to see long-term price and demand signals. Shell has been emphatic on the need for longer-range biofuels mandates.
The Conventional Wisdom
So, where are we, in terms of understanding a “rational market” for biofuels? We can see two Storylines the short-term and the long-term. And, o
ne more that lies beyond “rational markets’ that we’ll get to in a minute.
The short-term Storyline was well summed up by our Digesterati friend: the projects don’t pencil out, can’t compete against oil prices, and it is just tough to get bankers excited, and not much will turn around here until at least 2017.
The long-term Storyline is well summed up by Abengoa and Shell. The long-range outlooks show tremendous opportunities across the fuels spectrum demand and price outlooks are strong, particularly in diesel and jet fuel. Unconventional oil growth rates are uncertainties, and RFS2 targets too but overall, the projects will likely be financeable so long as feedstock prices stay in line.
So, what’s the third option? The third option is that what we are seeing is a competition between multiple Storylines not only short-term and long-term outlook, but food vs fuel, indirect land use change, will carbon outcomes be incorporated into energy prices, and the proper risk tolerance for government in commercializing alternative energy, to name a few.
According to that way of thinking, what is far more important to discover is not what the market fundamentals are all about, but how that battle between Storylines will shake out, and when.
For example, you could not have bought a $65 contract for Jan 2015 West Texas Intermediate two years ago conventional wisdom was wrong about late-2014 energy prices, but decisions about projects today are being made on the basis of conventional wisdom about energy prices in 2017-18, and beyond, not the reality. So, we are not looking necessarily at hard markets in commodities; when it comes to project decisions, we are actually looking more at markets in “Conventional Wisdom”.
And Conventional Wisdom has the considerable power to move prices and markets, but it also has the power to be completely wrong, too.
For example, the market did not price in the Global Financial Crisis of 08/09 into energy futures, until the crisis was apparent. Neither did the markets forecast 9/11. Markets do not have to be right about the future to hold power over it.
Game Theory and Biofuels
“In mathematics you don’t understand things. You just get used to them.” ― John von Neumann
Let’s look at the nature and dynamics of Conventional Wisdom via a quick game.
Let’s say that, next year, here at The Digest we offer a prize to all the readers who correctly select the #1 Hottest Company in Biofuels, as voted in our annual rankings. Note, this is not the price for selecting “the best “company, but “the #1 ranked” company
There’s a couple of ways to play the game. First, you could simply make selections based on your perception of merit. A more sophisticated way to maximize your chance of winning a prize would, instead, be to focus your attention of figuring out what most people believe constitutes merit, and base your selection on what most others would believe.
But, then, consider that other voters might be thinking the same thing you are that they are all, at the same time, trying to figure out how to win a prize based on (simultaneously) guessing at everyone’s perceptions.
You may have recognized game theory, here, and in particular Keynes’s “Beauty Contest”. As Keynes wrote in 1936:
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
In his online journal Epsilon Theory, Ben Hunt has applied game theory in general to market behavior and recently to oil prices and here is a recent example of his line of thinking to consider. It’s the best read we’ve had in a month of Sundays. Really fine work, on a number of levels. Where does game theory take us in considering oil prices? Hunt writes:
“When you’re not sure of yourself and you’re trying to figure out what consensus view to adopt, as likely as not everyone else is trying to do the same thing. In these situations it’s Common Knowledge – public signals that we all believe that we all heard, aka Narratives – that largely determines each of our individual behavioral decisions.
“My personal, entirely subjective view is that oil prices over the past 3+ months have been driven by 3 parts monetary policy to 1 part fundamentals…For at least this week and next my personal, entirely subjective view of the ratio of explanatory factors is going to flip to 3 parts fundamentals to 1 part monetary policy.
“That doesn’t mean that I don’t have strong ideas about how the world works, about how both monetary policy and fundamentals impact the price of oil. What it means is that it doesn’t matter what I think about the way the world works. The only thing that matters is what the market thinks about the way the world works, and in times like these the market will think whatever Common Knowledge says it should think. “
Applying this back to advanced biofuels, and recent oil prices.
Right now, the dominant Storyline is oil prices not the fundamentals driving oil prices, but oil prices themselves. The Common Knowledge is that oil prices are low, and that no one exactly knows how low they will go, and so long as that Storyline dominates, it is going to be tough sledding for financing advanced biofuels.
But, take for example the $60M investment by the NZ Superannuation Fund into LanzaTech that was announced on Monday morning.
Clearly, not an investment decision driven by short-term oil prices. The decision was, as likely as not, driven by the very factors that NZ Super gave in their public statements:
a. Expansion capital, while a small part of their investment pie, is a good accelerator of returns for their superannuation fund, and they are committed to it.
b. LanzaTech, being within 24 months of a first commercial, with a global set of committed partners and investors and a good track run in the lab and at the demo plant level , is an appropriate candidate for expansion capital. While keeping in mind that not every Starbucks or Sears ever built with expansion capital was still around 10 years later.
c. The long-term outlook in energy is strong the fundamentals are driven by industrialization in the developing world, and global growth everywhere.
d. Sufficient evidence for a market for alternative fuels a combination of national agendas on security, social agendas on carbon, and the line-up of supply and demand on oil has led experts to conclude that there a long term opportunity for projects that can demonstrate they are competitive with $80-$90 oil in today’s prices.
The Battle of Storyline
At this point, you may find your mind rebelling against the idea that markets are driven by competitions between Storylines. Surely, you say, markets are driven by fundamentals. And you might prove your point by sending to me an elegant explanation of why oil prices have dropped $30+ in recent months, based on currency movements. Or, based on supply and demand fundamentals.
As Ben Hunt explained in his Storyline on oil prices, you’d both be right. There is a Storyline for each, all the way down to $65 oil. In fact, if you added up all the impacts
from all the available (and cogently argued) Storylines to explain the drop in oil prices you’d get easily all the way down to $0 oil.
Free energy! Energy is free! Free Gas! Spread the word!
Whoops. Oil isn’t free, and gasoline isn’t either.
Despite the Reduction in Ukrainian Tension Storyline, the Saudis Killing Off Shale Oil Storyline, the Good Nuclear News from Iran Storyline, the Finally Doing Something About ISIS Storyline, the China Hard Landing Storyline, the EU not Getting Better Anytime Soon Storyline, the Drill Baby Drill Storyline, and the Fracking is Energy Liberation for Everyone Forever Storyline. Not to mention the Ethanol Made it Happen by Capping US Demand Storyline.
Not that there’s anything wrong with any of those Storylines, or the sound economic analysis that often goes with them. They just add up to more than $35.
Which tells you that the oil price isn’t being driven by a Monster Storyline, or the Sum of All Storylines but by the Market in Storylines, where one story dominates the trading sentiment as traders try desperately to understand what the market is thinking.
It is not the Storylines that are changing, but the mix has suddenly shifted from being dominated by the long-term to the short term Storyline.
And we see it here in Digest email.
We are definitely not being inundated with email from traders along the lines of “my thinking has changed to a short-term Storyline.” But we are seeing, as we have shared at the beginning of this column, that we are getting a bunch of communications along the lines of “we think that other people are thinking that other people think that the Storyline has changed to the short-term.”
Generally they replace “what other people are thinking that other people think” with “the market is obsessed with” or a link to a review article about what “the market is saying” and they replace “the Storyline has changed to the short-term” with “the challenges of biofuels in a world of $70 oil”.
So, we get emails roughly saying “the market is obsessed with the challenges of biofuels in a world of $70 oil”.
Who do these shifts occur, and so suddenly?
First ingredient: The mathematics of group realignment. Well, consider how birds communicate in mobbing attacks out of “The Birds” or in flying south for the winter a change in circumstances that can be perceived as a threat, generates an openness to changes in thinking. Two or three birds start flying around, then five or six, then a couple of hundred. Finally a giant flock heads south. What you are seeing is the phenomenon of group thinking and realignment.
Second ingredient: the failure of “business as usual” to explain a new market fact. Example: 1993 Al-Queda bombing of the World Trade Center – explained quickly within the Big Story of Terrorism as understood at the time. Bad people do bad things. Buildings get bombed. But The World Trade Center Does Not Fall Down. That’s Business as Usual.
Then, there’s 9/11. And the dialogue changes, forever.
The Big Story Around Monetary Policy.
Consider this: Easy Money leads to Bad Mortgages Leads to Systemic Collapse of Too Big To Fail Banks, Which Tanks Global Demand, and Commodity Prices Collapse. That’s one way to explain the Storyline of 2008/09 – if not the actual events, and it’s one of the reasons that we didn’t fret over the collapse of oil prices in 2008/09 with respect to biofuels, nearly as much as now. The GFC was seen as the outcome of bad monetary policy – Easy Money.
Believe me, the drop in 2008/09 commodity prices was far more dire than today’s, and tanked a lot of biofuels companies right into bankruptcy. But not so many people fretted about “the end of cellulosic biofuels” then, as now.
Why the Change?
So, let’s turn to the problem of the Storyline of Global Monetary Policy.
Right now, no one can figure out the Fed. The US dollar is rising, despite US long-term focus on a weak dollar, and the interest of the rest of the world in maintain stable energy prices. And maybe you can explain to me the Big Storyline that explains the Downshift in Central Bank Liquidity Operations in the US, vs the Uptick in Central Bank Liquidity Operations in the EU and China.
And, when there’s an uncertainty in the Fed Storyline just as material changes in markets happen, that’s when traders start to think that maybe everyone else’s thinking has shifted. So, are we seeing commodity markets move because there isn’t a dominant way to understand Global Monetary policy at the moment – that the Fed has been struggling to maintain a storyline?
We think so.
Ultimately, the Fed will make its move, and we’ll see the dollar head down, and with that, we’d expect to see pressure on oil prices to rise. And you may find at that point that energy markets get re-focused on the long-term Storyline. Those long-term fundamentals are still out there.
When? Could be a while. A tool for predicting shifts in market sentiment, timing and intensity, doesn’t yet exist. That Might well be the 12th Nobel from a game theorist, when we get that. Between now and then, there’s an arbitrage between the values seen in the marketplace today, and those we will see when the market re-focuses on the long-term energy scenarios. An arb that groups investing for the long-term might well be capturing now.