TXU/Energy advisers bankruptcy: Commodity price reality bites

It appears as if the former TXU, a major Texas utility, will become the 10th largest American bankruptcy soon, and the possibility that this was avoidable needs to be considered. Reports indicate that the biggest problem was a 2007 bet that natural gas prices would rise. Sounds rather like Aubrey McClendon at Chesapeake Energy.

It is said that, when J. P. Morgan was asked what the stock market would do, he famously replied, “It will fluctuate.” That line presumably got a laugh then (it still does when I use it, at least sometimes) but those hoping for pearls of wisdom probably failed to recognize it for what it was: a vital truth about market behavior.

There have been numerous efforts to model financial markets and supposedly scientific methods to predict commodity prices (I’ve participated in a couple) and they have tended to fail to the point where some economists argue that prices are “stochastic” (which is a fancy word for “random” which can also be translated as “I can’t explain it”). Indeed, a decade ago, I published a long article analyzing the reasons short-term oil prices are so unpredictable.

Which raises the question of why TXU would make a bet that threatened the future of the company on something like natural gas prices. Arguably, natural gas prices don’t suffer the political interventions that regularly hammer oil prices, which might have given them a false sense of security (especially if they weren’t very cognizant of the history of natural gas price movements).

And in 2007, there were numerous voices proclaiming an end to “cheap” gas prices, as discoveries and drilling productivity declined, and well decline rates soared. The National Petroleum Council, an industry-staffed government advisory group, had produced a multi-volume report in 2003 which foresaw prices rising absent significant government policies to increase supplies (and predicted much higher LNG imports, oops.)

This belief system was also informed by the ‘peak oil’ advocates, who have tended to be pessimistic about supply from nearly every sector, and had a certain amount of credibility in the US oil industry, especially given that natural gas prices had more than doubled in the recent past. Since the Carter Administration, there has been a tendency to predict ever-higher fossil fuel prices—in the long run.

And the industry has long argued that it “needs” higher prices in order to finance drilling, really ever since natural gas price deregulation in 1985 and the price collapse in 1986, so that it became common to predict prices would rise 5% a year above inflation. The 1992 gas price collapse stunned the industry (especially occurring in February, during the peak demand season) but at least made many more cautious in their prognostications.

A 2007 bet on higher natural gas prices would have proved sensible—in 2008, when they rose another 25%. But 2007 prices were already at historic highs, having been exceeded only twice before (admittedly 2005 and 2006) and while mean reversion is a simplistic model of commodity prices, it is also one of the better ones. A wager on lower prices would have been more defensible, but not undertaking a large risk would seem like responsible behavior.

http://www.forbes.com/sites/michaellynch/2014/02/21/txuenergy-advisers-bankruptcy-commodity-price-reality-bites/?ss=business%3Aenergy