You see, in America, and much of the rest of the world, energy is currency. Without rehashing the standard chain at length: oil is gas, it is jet fuel, and it is used to transport, grow, heat, light, build just about everything.

But you know that.

Here’s the interesting thing that’s happened in the last 15 or so years, the development of the derivatives market (no, not those, these), and along with that, the futures variety.

A future is, quite simply, an obligation to buy X quantiy of Y product (usually a commodity) at Z point in the future. Put in English, a contract (the proper name for futures is futures contract) to by 100Million barrels of Oil for $160 dollars a barrel on 01 September 2008.

So what’s the big deal?

By watching the futures market, you have an indicator of the price at some point in the future of a specific commodity. Classically, in markets, you only had the price of something today and the price it was in the past, not the price in the future. This is a big deal, because as long as the future’s market points to the price of oil in the future going up, the price today will have pressure to move up. (Assuming people don’t think the futures market is wrong–which it can be.)

Speculation!

So while people go on yelling and screaming about speculation in the markets, I have one question for you. If you were betting on the price of oil in the future, wouldn’t you bet on it going up? Sure, the speculators, are driving up the price of oil trying to make money–but it isn’t unwarranted. This isn’t speculation, it’s research. Brazil, India, China, Russia, and several other major countries are now exploding in economic development, and with that comes increased need for oil. We are 4% of the world’s population and yet we consume 25% of the global supply! Surely, this isn’t sustainable. This is why you see ex-big-oil moguls singing a different tune. Oil is a finite resource with extraordinary–and growing–demand. Cold, hard, simple, economics. If you had the money, you’d bet this way too. Do I like that the price of oil, gas, and everything is going up? No! I’m stretched pretty good as it is. But this may be good for the environment.

Alternative Energy

A word on alternative energy. Why hasn’t Solar Power, Wind Power, or other alternative energy taken off? One reason, price. You see, while the newest and best solar panel may be 12% efficient, or whatever it is, (by the way, power plants are horribly inefficient as well), what matters is how that compares to the current infrastructure. So lets say, after you run all the math, a solar power plant will cost $1 per kWH and an existing plant is $0.70 per kWH, there is no reason for power producers to switch I know, I want them to also. After all, there’s more than plenty enough environmental reasons. But it’s still cheaper to burn stuff. What’s more of a shame is that for producers to switch to solar they it needs to be substantially cheaper to make up for the current investment in other, less clean, technologies. Unfortunately, there’s other things that aren’t quite fair, such as tax breaks for existing energy producers that are not there for solar power providers, but these also represent a current investment (in the form of lobbying–oh joy) by energy providers.

This is why I’m excited, though! As oil goes up, the economics of all these pricing scenarios changes. And one can hope that this will price alternative energy into the picture. So the future’s market is helping to accelerate changes in the market at large, and maybe, just maybe, there’ll be enough change before the ocean levels rise and NY finds itself building a wall around Manhattan. (And I am by no means saying “Crisis Averted” on the Global Warming issue!)

Not So Fast

It’s great to huff and puff about how great free markets are and how the ultimately seem to be triumphing– just as they do in theory–but this has one simple cornerstone. Oil is a finite resource. In fact, the classics of economics are finite resources, infinite demand, but what if oil was so plentiful that we wouldn’t face this scenario for 50 years? Would we curb production “just to save the environment” or “satisfy those hippie jerks”? The plain and simple answer is No. Or at least, probably not in time. Why? Because there’s no price applied to economic damage. In fact, the whole process of doing so is called “Shadow Pricing” as if it’s some black art, but there is a real cost to economic damage–it’s just not immediately evident, or easy to quantify. Environmental damage wouldn’t be priced until well after the fact. It’s just human nature, we don’t curb our habits until we feel the shock. This is why things like carbon markets and agreement between countries to curb C02 emissions are important–because they are not priced in the markets.

Luckily for the planet, oil production may have finally peaked.