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mandates are repealed, says Tyner, “then cellulosic biofuels and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
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
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
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
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
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, one 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,
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”
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
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
But, take for example the $60M investment by the NZ
Superannuation Fund into LanzaTech that was announced on Monday
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
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
c. The long-term outlook in
energy is strong — the fundamentals are driven by
industrialization in the developing world, and global growth
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
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
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
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
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, 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.
Jim Lane is editor and publisher of Biofuels Digest where this
was originally published.
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