In an article published Thursday in the Financial Times of London, economist Robert Feldman appealed to what is known as "the hog cycle" to explain the extreme volatility in energy prices, which is likely to continue for at least a decade.[1]  --  Big changes are needed in demand, supply, and government policy if this situation is to abate, but the prospects for positive change in these three areas are, respectively, "bad, worse, and awful," according to Feldman, who is the chief economist of Morgan Stanley Japan Limited....

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THE BAD, WORSE, AND AWFUL NEWS FOR ENERGY PRICES
By Robert Feldman

Financial Times (UK)
July 6, 2006

http://www.ft.com/cms/s/d37799ec-0c8b-11db-8235-0000779e2340.html

Do not look for energy price stability soon. Lessons from fluctuations in pork prices in the 1930s, which became known as the hog cycle, provide an instructive framework for understanding future energy price movements.

The basic economics of the hog cycle were simple. The demand curve was downward-sloping, with demand quantity dependent upon the price at that point in time: there was greater demand for hogs when the price was low.

The supply curve was as usual upward-sloping, but with one difference: because of time lags in production, supply at a particular time depended on the price in earlier periods. In other words, when hog farmers brought their product to market it was based on historical prices. The time lags between supply and demand created imbalances which led to huge price swings. The same type of mechanism is at work today in energy.

In a perfect world, rational suppliers and consumers would see through this cycle. But in the real world, it takes time for consumers and suppliers to respond to higher prices. Buying hybrid cars to replace old gas guzzlers takes time. Finding new energy resources and building refineries takes time. Supply and demand are heavily influenced by government policy and global politics, which adds complexity.

To understand the outlook for energy prices we need to look at whether demand, supply, or policy will change and over what time frame. The news on these three elements is bad, worse, and awful, respectively.

Demand may be the least discouraging part of the story. During the past 30 years, consumers have moved away from low-efficiency cars when petrol prices rose. Conservation has risen, too, as energy prices have increased. That said, the rapid economic growth of China and India will probably offset efficiency improvements elsewhere. An additional impediment to controlling demand is that many developing countries continue to subsidize oil products.

Supply is harder to crack. Even optimists, who see big supply gains around the corner, recognize that it takes 8-10 years for an oil find to get to market. Some estimate that global production capacity can increase to more than 100m barrels a day by 2010, compared with 86m today. However, if demand increases annually at 3.5 per cent, the same rate as global gross domestic product, consumption will rise to 102m barrels. The market would be as tight as today. The optimistic view is also based on growth in refining capacity by 2010. However, much of this is being created in politically unstable places.

Political stability in producing nations and policies to change consumption patterns will be critical if supply and demand are to match. With continuing instability in the Middle East and uncertainty elsewhere, predictability of supply remains a concern. At the same time, weak leadership in energy-consuming countries has stymied aggressive conservation and development of alternative sources.

If oil-consuming countries are going to reduce demand, new policies will be needed, but none are in sight. Leaders of the U.S., Britain, France, and Germany are focused on domestic issues. Rapid change is unlikely to come from China either.

In contrast, leaders of the main oil-producing countries are comfortably positioned. Vladimir Putin, the Russian president, whose term expires in 2008, retains strong support. Mahmoud Ahmadinejad and Hugo Chávez, presidents of Iran and Venezuela, have defined their political identities with populist policies. Mr. Ahmadinejad's term runs to 2009. Mr. Chávez will probably win re-election this year and serve until 2012.

With demand slow to change, even slower change in supply and no change in energy policies in consumer countries, breaking out of the world's energy hog cycle is unlikely soon. The only good news is that investments in alternative energies and conservation are likely to remain attractive.

An optimistic view of oil falling to $40-$50 a barrel requires six "quick" things to happen: a quick discovery of new oil, quick time to market, quick development of alternative energy sources, quick progress in conservation, a quick solution to the Iran problem, and quick reduction in energy demand elasticity around the world. Greater predictability of prices is likely only if there is progress on each of these issues, which is unlikely to occur rapidly. Unfortunately, as a result, energy prices, like hog prices in the 1930s, are likely to remain unstable for some time to come.

--The writer is chief economist of Morgan Stanley Japan Limited.