The price cycle is turning skyward for gas, coal, and crude oil.
These days you don't have to do much searching to find different fuel price forecasts and approaches used in developing them. These different approaches and methods-forward curves, econometric, mean reversion, and random walk models-make it difficult to decide which forecast is likely to be the best. Many of the current long-term fuel price forecasts are constrained by the short-term perspective of the forecaster. After more than 25 years of observing and studying the energy markets, it is highly likely that fuel prices will increase dramatically over the next 10 years. This belief is not based on complex algorithms, but on market fundamentals.
What We Learn from History
When facing an uncertain future, the past can often serve as a guide. Those who look back before they look ahead are often better prepared. Beginning with the last energy crisis in the mid-1970s, Black & Veatch has spent considerable effort in trying to understand and evaluate the underlying factors that influence energy prices.1 This has included an examination of the numerous crude oil and coal price cycles that have occurred since the mid-1800s.
The current consensus is that the rise in fuel prices which occurred during 1999-2000 for crude oil and natural gas, and 2000-01 for coal, was an aberration, and after returning to lower levels, prices will remain relatively level in inflation-adjusted terms through the year 2020 and beyond. However, historical price cycles suggest that this scenario is unlikely.
Figure 1 shows the price of crude oil, natural gas, and coal in real, or constant dollar2 prices since 1860. This graph uses a logarithmic scale; therefore, distances that are equal in the vertical direction represent the same percent change. The illustration in the lower right hand corner of Figure 1 shows the rate of change for the various slopes of lines shown on the graph.
Fuel prices, when expressed in real or constant dollars, exhibit "cyclical" behavior with significant volatility. The low prices for each "price cycle," since the first low in 1861, have been remarkably similar. During the past 140 years, advancements in exploration, drilling, and production technologies appear to have counteracted the effects of increased scarcity (depletion3), as cycle low prices have increased at only a minimal rate since 1861. However, the changes that occur in the cost and price structure during these 15- to 25-year cycles are dramatic.
At price cycle lows it is difficult to attract investment capital. When a new energy price cycle begins from a cycle low, a significant amount of time is required to "recapitalize" the crude oil, natural gas, and coal producing industries. This is also true for the associated suppliers of equipment and services that are required for exploration, development, and production. It then requires an infusion of capital and time to explore for, and develop, new reserve areas. The result is a rapid increase in real energy prices that is sustained for several years, until excess capacity leads to lower prices.
In 1998, crude oil and natural gas prices were at a cyclical low level, similar to historic lows that occurred in 1861, 1892, 1914, 1931, 1945, and 1972. From these lows, prices have dramatically increased. So why are constant dollar prices projected by most forecasters to be anywhere from nearly level to declining for the next 20 years? For many, the long-term view of the future is heavily influenced by the short-term past-generally, what has transpired during the past year. Until January 2002, energy prices were in decline from their highs of the fall and winter of 2000.4
Energy Producers' Response to Long-Term Price Trends
During the downward trend in energy prices between 1981 and 1998 of the last energy price cycle, the productivity of labor and capital improved at crude oil, natural gas, and coal producing facilities. Technological innovations that were relatively expensive during the boom years, between 1972 and 1981, became readily available and more reasonably priced. Additionally, energy producers were more motivated in employing these cost reduction technologies as a way to remain competitive in a marketplace characterized by excess production capacity and declining real prices. Fierce competition and the need to reduce unit costs, by maximizing the level of production for a given amount of invested capital, also aggravated oversupply and forced prices lower.
Near the bottom of an energy price cycle, only the variable or cash costs of production are covered. There is little incentive for the producer to invest additional capital to purchase marginally better technology to improve the productivity of existing operations. Rather, the less competitive fuel producers and suppliers of energy producing equipment and services either voluntarily or involuntarily (via bankruptcy) leave the marketplace. Others seek out merger partners or consolidate production activities to further reduce their administrative and operating cost structure. This was the trend from the mid-1980s through 1999, and is once again taking place in 2002.
To overcome the normal production decline at crude oil and natural gas wells, a considerable number of new wells must be completed each year to maintain production. This level of drilling activity does not accommodate the normal increase in demand and the additional demand spurred by lower prices.
At the price cycle lows, the marginal producers are attempting to avoid bankruptcy and make large reductions in their expenditures for drilling. This occurred in the fall of 1998 and continued through 1999. At such junctures, the media often contributes to an "environment of despair." Energy producers read articles such as "Drowning in Oil," which appeared in the March 6, 1999 issue of ,5 and feared that they were true. That article argued the case for oil prices remaining low. How low? Five dollars per barrel.
Once excess production capacity has been depleted at the price cycle low, additional supply to satisfy a given level of demand can only come from the development of new sources of supply. During the period of increasing energy prices at the start of a new price cycle, suppliers of goods and services throughout the energy supply chain begin marking up their prices. In addition, expansion in the energy producing industries brings a need for new workers,6 training programs, and a demand for higher wages that was foregone during the previous years of declining prices. These factors lead to a decrease in productivity, and contribute to higher costs and prices in the early years of the next price cycle.
Energy Consumers' Response to Long-Term Price Trends
As fuel prices are forced down to their cash cost of production near the bottom of the price cycle, the price differential between crude oil and natural gas (in a free unregulated market) and coal also bottoms. At this time, some electric power generators begin to consider using oil and natural gas instead of coal. These fuels also have a lower capital investment associated with their use in electric power generation. In the transportation sector, the popularity of sport utility vehicles in the late 1990s is comparable to that of the gas-guzzling motor homes during the early 1970s, prior to the last energy crisis.
The fuel consumers' response to rising energy prices is not immediate. It usually takes several years of rising prices for these consumers to realize that they are not experiencing a short-term aberration in the long-term downward trend in prices that has been ongoing for many years. It is often near the top of the energy price cycle when consumers finally react. For example, many utilities began their conversions back to coal in 1980, the year international oil prices peaked and one year before domestic crude oil prices peaked.
Impact of Regulatory Controls
The free movement of prices in any market adjusts supply and demand, allocates resources, and promotes substitution to maximize economic efficiencies. However, prices often have been subject to regulatory controls for long periods of time. For natural gas, regulation began in 1938 with the Natural Gas Act. In 1954, a Supreme Court decision7 interpreted the Natural Gas Act as requiring the Federal Power Commission to regulate natural gas wellhead prices. These regulatory controls often were the cause of large price differentials between competing fuels, contributed to shortages, and led to price spikes in unregulated fuels.
During the energy crisis of the 1970s, price controls led to large price disparities. Natural gas from wells supplying unregulated intrastate markets had prices that could be several times that from a nearby controlled well supplying regulated interstate markets. As seen from Figure 1, the average wellhead price of natural gas was less than the f.o.b. mine price of coal until 1978. The price controls placed on domestic crude oil in 1971 produced a large price disparity between the much higher-priced imported crude oils (see price of landed crude oil in Figure 1) and the regulated lower-priced U.S. domestic crude oils. This restrained domestic natural gas and crude oil production, and ultimately led to much higher prices.
In 1978, Congress passed the Natural Gas Policy Act, which mandated the phased decontrol of natural gas wellhead prices. In the same year, the Fuel Use Act was passed, which required that all electric utilities discontinue using natural gas in generating electricity after 1990. This contributed to an abundance of natural gas and low prices. In 1988, the Fuel Use Act was amended to allow electric utilities again to utilize natural gas for power generation.
During the 1950s and 1960s, there was growing interest in environmental issues. This led to the Clean Air Act of 1955 and its amendments in 1963, 1966, and 1970. These laws, combined with low oil and natural gas prices relative to coal and the lower plant capital cost associated with these fuels, caused electric utilities to switch from coal-fueled alternatives to oil- and natural gas-fueled power plants.
The most recent changes to the Clean Air Act became effective in 1987, 1990, 1997, and 2000. The fuel price differentials between crude oil and coal, and natural gas and coal, reached historic lows in the mid-1990s. Their lower plant capital costs, along with the need to comply with more stringent environmental regulations, contributed to natural gas-fueled power plants again becoming more competitive than coal-fueled plants in generating electricity. In many respects, we are now replaying the experience of the late 1960s and early 1970s, just prior to the energy crisis of the mid-1970s.
Future Price of Crude Oil, Natural Gas, and Coal
Energy price forecasts by the U.S. Energy Information Administration's Annual Energy Outlook (AEO) have been a good proxy for the "consensus" forecast. Annual Energy Outlook 20028 projects that between 2000 and 2010:
- the real or constant dollar wellhead price for crude oil ($4.80/MBtu in 2000) will decline 1.7 percent per year (others say it will decline 0 to 6.2 percent annually9);
- the wellhead price for natural gas ($3.50/MBtu in 2000) will decline 2.3 percent per year; and
- the f.o.b. mine price of coal ($0.80/MBtu in 2000) will decline 1.5 percent per year.
Do such forecasts provide a realistic view of the future? Not likely.
There are strong indications that the long-term trend of declining real energy prices, which began in the early 1980s, ended with the price cycle lows for crude oil and natural gas in 1998 and coal in 1999. These low price levels are indicative of a key turning point in the energy market that occurs every 15 to 25 years. From these low price levels there has always been a rapid and substantial price increase.
Figure 2 shows the trend in the length of contract terms for coal purchases by U.S. electric utilities since 1990. There has been a shift from long-term contracts to the spot market and to short-term contracts with a term of two years or less. At the start of 1990, coal purchase commitments of two years or less amounted to 32 percent of total sales, while contracts with a remaining term exceeding 10 years represented 34 percent. In 2000, commitments of two years or less represented 58 percent, nearly double their share in 1990, and those greater than 10 years only 17 percent of total sales, half their share in 1990. As excess production capacity disappears, price volatility will increase, and the market will again shift from one favoring the buyer to one favoring the seller.
How To Plan For The Future
The trend is your friend until the trend ends. Consumers of energy need to prepare for a market environment that is likely to be quite different from that which they have experienced during the past 20 years. It is not likely to be "business as usual."
There are time-proven ways to deal with market uncertainty, and they do not involve complex derivative transactions. They do require that the energy consumer have a good understanding of the fuel producer's cost structure. In turn, the producer needs to better understand the increasingly competitive market into which the power generator is selling electricity.
In developing and implementing a long-term coal procurement strategy, buyers are often heavily influenced by the trend in prices during the past year. If history is our guide, many will procrastinate before they act. By then it will be too late, and they will be forced to take what a seller's market is willing to offer. This will most likely be what coal buyers have sought to rid themselves of during the past 20 years-a 10- or 15-year long-term contract with terms and provisions favorable to the seller. Why? Because those who provide the capital for developing a new coal mine, such as bankers and investors, will require it.
Long-term contracts are not necessarily good or bad, but their provisions can be economically devastating, if they are not drafted properly. Negotiating a good long-term contract requires that the buyer not focus on the daily changes in the price of fuel, but rather, on realistic provisions that are capable of dealing with the uncertainties of the future. Being able to negotiate good provisions requires that the buyer act now-before tomorrow becomes yesterday.
The opinions expressed in this article are those of the author, not necessarily those of the Energy Sector Consulting Services group of the Energy Services Division at Black & Veatch.
- For example, see "Economic Evaluation of Alternative Coal Supplies," American Power Conference, April, 1980; "Economics of Coal Utilization for Power Generation in Southeast Asia and Pacific Rim Countries," World Energy Conference, March 1986; "Fuel Supply Options-The Economics of Interfuel Competition," PowerGen '89, December 1989; "Considerations in Coal Switching," Utility Coal Conference, February 1993./li>
- Nominal prices are deflated using a broad measure of inflation such as the Gross Domestic Product Implicit Price Deflator.
- Resource depletion is the upward pressure on market-clearing prices over time, relative to what the price would normally be if there were an infinite supply under geological conditions similar to current conditions.
- The peak in coal prices occurred in August 2001 and the most recent low in February 2002.
- "Drowning in Oil," The Economist, March 6, 1999, pp. 19, 23-25.
- For example, between 1981 (crude oil price high) and 1994, the number of people employed in the oil and gas industries declined by 60 percent.
- Phillips Petroleum v. Wisconsin, 347 U.S. 672 (1954).
- Energy Information Administration, U.S. Department of Energy, Annual Energy Outlook 2002 with Projections to 2020, December 2001.
- Other independent forecasts published in Annual Energy Outlook 2002.
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