McClendon’s Price Lesson at Chesapeake (“Depletable” resources expand)

“[Free energy] markets tend not only to clear, but to clear faster and at lower prices than anticipated.”

The resignation of Aubrey McClendon as CEO of Chesapeake Energy provides a good case to study in corporate strategic planning. Ignoring his financial side deals, for which he has received a good share of criticism, the wisdom of his primary strategy, the aggressive pursuit of shale resources, is an open question to many. Although he has been hailed as a pioneer and risk taker, clearly those risks have gone bad and should be examined.

Higher Prices: A Bad Bet

The core failing was his decision to bet the firm (essentially) on high natural gas prices. From 1997 to 2005, wellhead prices had increased from $3/Mcf to $8/Mcf (2010$), the highest level historically. This, combined with a neo-Malthusian mentality, convinced him and many others that prices would not be mean-reverting, but remain at levels from two to three times the historical average.

In nearly my entire working career, energy executives have complained that prices for energy were too low for them to successfully invest. At one energy economics conference, the moaning about inadequate prices was so frequent that the award winner for contributions to the profession, Richard Gordon of Pennsylvania State University, reminded the audience that markets tend not only to clear, but to clear faster and at lower prices than anticipated.

In a more practical sense, there is a tendency to ignore the fact that mineral and energy prices are both cyclical and mean-reverting, despite being “finite” and thus “running out.” Numerous market analysts have been criticized for excessive bullishness about prices in the past decade, but many have correctly described the situation as one of cyclical behavior, not of a permanent shift to a high price environment.

Compared to other cycles, like the stock market or housing, minerals would seem to be ‘different’. You can’t make them, as neo-Malthusians often say, only extract them. The amounts are determined by nature, not man, and so cannot be improved upon, as housing can be. Although one should recall the Japanese real estate boom, when enthusiasts remarked on the finite amount of land in the islands; or go back to Will Rogers, who said you should buy land because they aren’t making any more of it.

Energy Optimists

And peak oil advocates repeatedly refer to those like M. A. Adelman, Robert Bradley, and myself, as “flat-earth economists” because we seem to think the earth is two-dimensional, arguing for “infinite” resources. Who can forget Paul Ehrlich, in particular, who infamously called the late Julian Simon “an imbecile,” a “flat earther,” and a “fringe character.” [1] After all, in Ehrlich’s estimation, “That we are presently living beyond our means is obvious from the simple fact that we are madly depleting nonreplenishable resources.”

But as the real estate example shows, the point is not about the finite nature of any given resource, but rather about the relative amounts being used and available. They aren’t making more land in the U.S., but there’s an awful lot more not being utilized; even in Japan, more efficient land use improved the ‘supply’ enormously.

Which brings us back to Aubrey McClendon. His embrace of high gas-price forecasts was certainly supported by some, including resource pessimists, but showed a relative ignorance of both resource economics and history.

Natural gas price forecasts have a long record of being wildly optimistic, long predicted to rise 5% a year above inflation. Since much of the research before 2000 was based on analyses of market behavior under price controls (not fully phased out until 1985), it’s hard to see how these projections could be considered reliable, especially in light of their failures. It fooled many CEOs of the time, including Transco Energy’s Jack Bowen, who stated in 1981 before the New York Society of Security Analysts: “Domestic oil and gas will never be in an oversupply position” (Bradley: Edison to Enron, p. 338).

The fact that the North American natural gas market is isolated from the rest of the world by the high cost of liquefaction would seem to support the idea that “gas is different.” But once again, reality is to theory like a windshield is to a bug on the highway.

————

 [1] See Simon’s summary of Ehrlich’s vendetta in “The Special Case of Paul Ehrlich,” The Ultimate Resource 2, pp. 604–609. As late as 1991 Paul and Anne Ehrlich (Healing the Planet, pp. 6, 228) belittled Simon as “an economist specializing in mail-order marketing.” (Among his other notable side ventures and accomplishments, Simon published the leading primer on setting up a mail-order marketing business.) To his credit, Simon never analogously portrayed Ehrlich as a butterfly specialist.