Too Late to the Oil Party? Consider the Alternative

by: Timothy Kailing posted on: June 23, 2008 | about stocks: ENER / ESLR / FSLR / GEX / JASO / PBW / PUW / PZD / STP / TSL    
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One of the best market proverbs is this: "In the short term the market is a voting machine, in the long term it is a weighing machine."

This line is generally attributed to the legendary Benjamin Graham; occasionally it is attributed to his acolyte, an obscure investor by the last name of Buffett. Regardless of who is actually the source, there is a great deal of wisdom in this simple saying. It clearly shows that the fundamental insights of what is now called behavioral economics have been understood by market players for a very long time. Fads, fashions, and the herding instinct can lead to large disparities, which are exactly what a long-term investor should be looking for.

Recently, the most notable stampede has been the major bull run of commodities, especially the run up in the price of crude oil. One of the easiest ways to make money of late has been to own energy in one form or another. As I read the data (in the good company of M. King Hubbert, Kenneth Deffeyes, and T. Boone Pickens), it is quite clear that we are either at, already past, or within a few years of the peak rate of supply of oil to the market. For those new to peak oil theory, this does not mean that we are about to run out of oil (about half of the planet's conventionally-recoverable oil remains to be pumped), but it does mean we are at the end of the era of cheap oil. And this means that the investment world, along with much of our economy, is in for some very big readjustments.

However, though I am a long-term bull on energy, oil has already more than tripled in the past four years. In my view, after this move, the probability of major price corrections and volatility is currently very high. But a very interesting place for an investor to look is in alternative energy, because the market has been "voting" quite irrationally of late on alternative energy. Specifically, during this most recent spike in oil prices, a disparity between the value of alternative energy companies and conventional energy has reached a large value. To see this, it helps to look at the relationships between alternative energy stocks and oil prices first in the short term and then in the longer term.

The Short Term

Take for example, the market action on the 21st of May, 2008, when oil first charged solidly into the 130 dollar range. Comparing a plot of an alternative energy ETF (PBW) with the SP500 and with the USO oil ETF is quite curious:

click to enlarge images

The "wisdom" of the market crowd on that day concluded that the price of oil and the price of alternative energy stocks should be negatively correlated. And not in a small way, the relative move of PBW and USO, in one day, was over 5%. Since the raison d'être of most alternative energy companies is to compete with oil -- oil is one of the major energy sources to which they are an "alternative", after all -- this is curious indeed. On this day when soaring oil prices dominated the news, the market seems to have concluded that alternative energy should instead be almost perfectly correlated with the justifiably energy-spooked broader market.

Was this day a statistical fluke? I analyzed the correlation of one-day moves of alternative energy (PBW) with both oil prices (USO) and the broader market (SPY) over the last two years and found a strong pattern. Here is the graph of the daily moves of alternative energy vs. oil:

Now, as it turns out, alternative energy's daily market behavior is not generally quite as bizarre as it was on the 21st of May. Generally alternative energy equities are very weakly correlated with oil, but to such a small degree that for most short-term trading interests, they are effectively uncorrelated. (In statistical terms, though the daily relationship of PBW and USO is positive and statistically significant, it explains less than 5% of the variation of PBW price.)

Contrast this with the daily relationship of alternative energy vs. the broad market:

Here the correlation is very strong. Almost exactly half of the daily movement of alternative energy stocks is explained by the movement of the broader market.

Together these two figures speak to a strong pattern: when the market votes in the short term -- that is, when emotions take over -- it collectively decides that alternative energy should be almost uncorrelated with oil prices (indeed, on some days, like the 21st of May mentioned, even anticorrelated) and, instead, alternative energy stocks are quite tightly correlated with the movement of the broad market.

The Longer Term

But things get interesting when we look past the emotional, short-term "voting" behavior of the market and look at the longer-term relationships. At a longer time scale the market approaches the proverbial weighing machine of Ben Graham. At a monthly scale, when we look at the relationship of alternative energy and oil in the last two years we find something much more rational:

Now the correlation of oil and alternative energy on this scale is now quite a strong positive one. In fact the strength of the relationship has quintupled with monthly moves, with over 25% of the movement of alternative energy stocks explained by the movement in oil prices. So as reason would suggest, high oil prices do help alternative energy stocks over the longer term.

Now look at the monthly relationship of alternative energy and the broader market:

At the monthly scale the positive correlation of alternative energy and the broader market does persist -- which makes sense because an energy-triggered recession, for example, would likely be harmful to business-cycle sensitive small alternative energy companies -- but this monthly relationship is only half as strong as the daily correlation, and it is now about the same strength as the relationship with oil.

The Current View

The upshot of all this is that days like the 21st of May, when PBW moved strongly opposite USO, represent inefficiencies that an intelligent market participant can take advantage of. Days like these, when alternative energy is caught fully in the general market swoon as energy prices rise, are days when the market's short-term voting is seriously out of whack.

And sometimes irrational voting can persist for a remarkably long time (anyone remember Pets.com?), and this is where we get back to the title of this contribution. If you are a long-term bull on energy, but are afraid to get in at these prices, where should you consider turning? If you've missed the oil party entirely as an investor, or if you enjoyed the run up but you think the party's over, where might the best "after party" be? Alternative energy looks like the next place to be. Over the last six months oil has outperformed alternative energy by over 50%:

For the chart readers out there, alternative energy stocks also seem to be forming a pretty nice base. If you believe, as I do, that high oil prices will force the economy to eventually move serious capital into alternative energy stocks, then this may represent an unusual opportunity.

I also believe this is a case where investing wisely as an individual will also yield a societal good: the earlier we invest capital in alternative energy the sooner we will help our economy and our society prepare for the epochal challenge of life on the downslope of Hubbert's Peak. This world will be one where energy supply will be crucially dependent on innovation, rather than being primarily dependent on how many holes we poke in the ground and how much ground we have access to in places like the Middle East. And this world will be one where energy conservation and efficiency are not private moral goods, as Dick Cheney would have it (read, something for bleeding-heart suckers to worry about), but are, instead, absolutely essential to economic growth.

Disclosure: As should be unsurprising after reading this, the author is currently (as of June 2008) long alternative energy, through positions in the PBW ETF.
 

This article has 16 comments! Add yours below...

Timothy D. Kailing

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This article has 16 comments:

  •  
    Stockguy456
    Jun 23 01:23 PM
    My Website
    very informative article. Thanks
  •  
    Learning
    Curve
    Jun 23 01:49 PM
    Excellent, thanks.
  •  
    Redwood_12
    Jun 23 03:25 PM
    I'm an alternative energy bull, but I believe it is an incorrect assumption that oil and alternative energy are necessarily linked in any substantive way.

    The vast majority of alternative energy stocks have more to do with electric power than transportation. Oil is and always has been about transportation. Our standard power sources are coal, natural gas, and nuclear, with gas taking up a greater and greater share. Less than 3% of power production is from oil, most of that is peaking or backup generation, and even that is in decline.

    This doesn't discount your analysis as a component of a trading strategy, but as a long term investment strategy it's important to understand that oil is not in fact directly linked in any way to solar, wind, or other distributed generation that make up what we think of as alternative energy.

    (The obvious exception of course is any AE that deals with, influences, or is influenced by transportation, such as batteries or electric vehicles, and of course companies like Energy Conversion Devices do have a dog in that race, but still, it's a small factor relative to the electric power part of the equation).
  •  
    fatcat
    Jun 23 04:58 PM
    Could be profit-taking to cover other position or margin calls..some the solars had some good gains...oil spikes always create some strange reactions!!
  •  
    GrapeApe
    Jun 23 07:29 PM
    My Website
    I was with you all the way until you took a direct stab at Dick Cheney. Was it really necessary to attack a politician in an article like this?
  •  
    solarchampio
    n
    Jun 23 08:59 PM
    My Website
    GrapeApe,

    It is quite appropriate to attack Dick. After all, he did shot his friend during duck hunting.




    beanieville.blogspot.c...
  •  
    thomas728
    Jun 23 11:43 PM
    Mr. User......

    Oil primarily used in transportation ?

    We can add that Lt.Sweet (Nigeria e.g.) cracks to gasoline

    while "sour crude" is used primarily for Home Heating # 2.

    Why bother with pointing out this difference ?

    " 'Cause you ain't seen nothin' yet." Very soon the boys in

    the pits will be looking toward 10/08---etc. and the trasportation

    usuage is not going to simply stop.

    A "Double Dip" is on the way and one of the few places we

    have "friends" is in the UAE.That product is sour.Nigeria ?

    The place could turn into a firestorm tonight for all we know.

    So what now ? Oil Services stocks and the ETFs that so many

    are now discounting.

    Tom
  •  
    Augustus
    Jun 24 12:53 AM
    There, there, my little chicken. The sky is not falling and there is very much oil left to find. Sure, innovation could be great. And there are a few signs of some small progress. With all of the billions of subsidies thrown at the problem, it is quite dishartening to see that nothing yet can compete with plain old OIL.

    You had a fairly interesting article going for a while. Nothing actionable as all you are comparing too is the bubble prices for anything that calls itself "alternative"... energy. Much of it is worse than Petsmart.com on a valuation basis. Take out the subsidies and they would probably crash.

    Great innovative ideas don't need subsidies. Private venture capital will invest and make huge returns. If some project needs a govt. subsidy to compete with $125 oil, I don't want to buy it anyway.

    Your final paragraph gives away your lack of capable analysis. Vice President Cheney is only pointing out what is now obvious to most US citizens. We can and should produce more energy within the USA. More coal, more oil, more natural gas, more nuclear energy, more refined products. It is the those who have promised that "alternative solutions" are available who have let the population down. They have continually blocked expansion of the production avenues which have worked for the country in the past. While promising that everyone will get a cheap majic carpet "real soon now". What a scam that has been. People should be hunting with bloodhounds those with the false promises who created this mess.

    Ah, Yes. Back to the days when it was only possible to get ones hands warmed by rubbing them together. Farming was walking behind a horse or an ox. Very picturesque. That is the future of forced conservation. But, of course, that won't apply to the rulers who are able to get on the allocation boards.
  •  
    lntwo
    Jun 24 01:52 AM
    Not a statistician but dont the R^2 values on the long term scatter plots seem a bit low? Might it indicate a stronger correlation exists elsewhere? Also the sample size seems too small too. Again, not sure but if you know please enlighten.
    Cheers all.

    Long on Alt. Long on oil since 02 (Bush - Cheney one more time suckers) muhahahaha.
  •  
    Itsonlymoney
    Jun 24 11:46 AM
    Just a reminder to Augustus that nuclear power has been highly subsidized in the past and the drum is beating once again for more of the same.

    Oil has been undervalued for so long that nothing could really compete with it. I think the Saudi's intended it that way. They have obviously lost the ability to control oil prices so "alternatives&quo... have a chance to compete for the first time. Lets get on with it because sooner or later we will need all the clean energy sources we can muster. In diversification is strength.
  •  
    Redwood_12
    Jun 24 12:46 PM
    That was my comment about oil linked to transportation but not electric power. The following comment about heating oil is well taken, but still, that's heating, not electric power. Very little heating in the US is from electric power. Fan energy is not insignificant, but electric resisitance heating has been phased out to the point where it is negligible. The analysis in this article doesn't really go into solar thermal, which would compete with heating oil. What's needed is to simplify the analysis and make sure we're comparing apples to apples, and make sure we understand when oranges appear in the bushel.
  •  
    roberte
    Jun 24 03:55 PM
    hey,

    I’ve been trading for a few months now, and I’ve been trying to get a hold of any learning material possible. The problem is, a lot of the
    stuff out there is sh*t. I’ve even spent 5 grand on what were supposedly “Professional” courses, but I probably would’ve been better off just keeping the money to trade with.

    Anyways, my point is before any of you guys waste you’re money take a look at these free tutorial videos. They were recently posted and are excellent quality. I can tell you from experience, that these videos were about 100x better than what I wasted my money on.

    Here’s the site www.epiphanytrader.com... , they’re worth taken a look at; all you have to do is fill out the form. Oh, and the videos range from novice to expert so there’s something for everyone. So yeah… Good luck all.
  •  
    galewhitaker
    Jun 24 09:36 PM
    My Website
    There is no chance that the price of oil is going to drop very much. Oil is a declining resource like gold. Have you ever heard anyone complain about a "gold bubble". The scarcity of oil is common knowledge worldwide. Anyone who owns oil is not going to be stupid enough to sell it cheap. If the prices takes a dip the Saudis will just stop selling. They are already talking about hoarding oil for future princes. Future princes are going to need the money so they can pay for the fine liquor and beautiful women that are required to keep any self respecting prince happy.
  •  
    galewhitaker
    Jun 24 09:53 PM
    My Website
    roberte - I think that anyone who really knows how to make money in the market is keeping it to himself. At any rate they have so much money they don't need to write books or teach courses. I think you need to figure it out for yourself. One thing I know for sure is that the market is being totally manipulated by politicians, institutions and hedge fund managers. I try to figure out what they are up to and then jump on the train. I think the only reason the market dosen't sell off 30% is because Bernanke and Bush are flooding the system with liquidity. This is an effort to try to keep the White House for the Republicans.

    Here are some ideas:
    1. Subscribe to Marty Chanards stocktiming.com web site. Marty will tell you what the insiders are up to.
    2. Only trade options (a gambler's paradise). Strangles and Straddles work best for me.
  •  
    mickel98
    Jun 28 08:48 AM
    Hear Hear!
  •  
    mickel98
    Jun 28 08:49 AM
    Hear Hear
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