Energy feeds into almost everything we do or have. It is a vital building block for growth and our modern economy would not exist if not for it. Some historians even surmise that cheap energy was one of the most important factors that helped propel the great accession and development of the United States through history to make it the world’s largest economy. Because of its critical importance in almost all aspects of the economy, directly or indirectly, the call on the future of energy prices is a very important investment decision. Many companies and countries prospects and outlooks rise and fall with changes in the energy complex. What caused the recent dislocation and what will the future bring? That is the million dollar question.

The fall

The rapid fall in crude prices that recently occurred is very rare in history. According to Jeremy Grantham at GMO, except for the crash of 2008 the halving of the price of crude in just a few months has not happened since 1900. The sheer speed of the drop has left many companies flat-footed and reeling: none more than those in the oil patch.

Demand-supply or strategy?

The fall over the last few months is likely a combination of a classic supply-demand response and the Saudis protecting their own interests and market share at the expense of producers in the US, Russia and elsewhere. The supply surplus came about due to the prolific shale production in the US, coupled with the lack of demand growth that was expected in 2014. The industry became overcapitalised as investors were sold on the concept of US energy independence and underspending in the late 1990s was replaced over investment — close to $1 trillion a year, according to Daniel Lacalle (a London based Energy Analyst who has been credited for making a correct call on the recent slump).

Producers over the past few years expected demand growth of roughly 2 to 3 per cent per year but that never materialised. Exploration and production companies as well as national oil companies need to budget years in advance so by the time global demand came in near 92 million barrels per day instead of the 93 to 94 million barrels, the over-investment was firing away.

The main deficit in demand was likely India and China where growth estimates have drifted lower over the years. The last few years have also begun to delink the correlation of energy demand and GDP to some degree. We live in a world where technology has allowed us to do more and grow wealth with less energy spending per GDP.

Opec’s role in refusing to balance of the market and test the marginal cost of production, has helped accelerate the price reduction. High-spec rigs, pressure pumping, seismic, completion — all these costs have fallen between 20 per cent and 45 per cent in the space of two months as overcapacity becomes evident and excess capital expenditure is revised.

Given all this, Opec’s decision not to balance the market through cuts actually makes total sense. It was not Opec who increased production well above demand in the first place, rather it was the explosion in growth of shale production in the US. Opec actually offers the lowest marginal cost of the curve so why would Opec countries cut production to let non-Opec countries grow even further and erode their market share year by year?

Saudi Arabia is simply asserting to world and their citizens that they are the low-cost, efficient producers and that they can sustain a period of oversupply. It is up to the other producers to see whether they can be more efficient or not and they will feel the brunt of the pain.

Lower for longer or upward from here?

Timing the trajectory of energy prices is pretty much a mug’s game. Oil prices today in inflation adjusted terms is back to what it was nearly ten years ago. There can be a strong case that this disinflationary trend could persist, however. Here are a few aspects to consider:

• There are a lot of sunk costs in the energy space. Producers with debt need cash flow regardless of the current investment rates of return they are receiving. Thus the dramatic drop in rigs may not affect production in the short term as the marginal cost of production for producing wells is as low as $15 per barrel. Reductions in investment and new drilling will have an impact on future production. Even with natural decline in US shale (three times faster than traditional wells), it still may take six to 12 months before there is a meaningful impact on production.

• Efficiency and technological advancement continues at a rapid pace. The overall energy intensity of the developed world is not really expanding. Oil demand in the US, for example, is at the same level it was back in 1998 despite the fact that real GDP has grown 40 per cent over that period. Lacalle suggests, improving fuel mileage from 24 to 34 miles per gallon reduces oil demand by about four million barrels per day (“mbpd”) and a 6 per cent penetration of hybrid vehicles in the US and UK can lower demand by 3.5 mbpd. Other aspects in energy efficiency, such as LED light bulbs, also help contribute to lower overall energy demand.

• To work off the excess supply brought about by over-investment, a longer period of lower prices may be needed. The adjustment in the energy market is likely to come from sidelining of capital overtime. Because shale production is so efficient, rigs can come back online very quickly and may halt any major price acceleration with a new surge in supply. One can look at the natural gas market over the last few years to see how most price surges have been short lived.

On the other hand any geopolitical shock that creates a massive supply shock throws longer term fundamentals out the window in the short term. Demand is relatively steady but supply disruptions can really swing prices.

Timing and investing in the energy space over the next year or so will be difficult. Being able to sort out the winners and losers from this dislocation will provide an inordinate effect on the success or failure in future investments both abroad and in Bermuda.

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.