Mr. Market, manic-depressive: Is there a cure?

Benjamin Graham, the father of value investing, loved to relate the story of Mr. Market, a partner in a going concern. On some days he would arrive jubilant, ready to take the entire business off the hands of his fellow partners at a rather exorbitant price. Other days he would arrive depressed beyond belief, ready to sell them his portion of the company for a pittance. Graham advised his clients to pay little heed to Mr. Market and form their own opinions based on the facts. Only then should they decide whether Mr. Market's offer was worth taking.

Of course, Graham was concerned with the way stock market investors behave, and he observed that most of them behave very much like Mr. Market. For Graham Mr. Market's roller-coaster mood swings were an opportunity, not a problem.

For society as a whole, however, the manic-depressive nature of markets can have serious and even potentially dangerous consequences. Wild price swings make it difficult for people, companies and governments to plan. It is just such behavior which has characterized the energy markets in recent years. And, there are reasons to believe that we should expect more of the same.

First, queuing theory (essentially, the theory of how lines form) tells us that when a system approaches 100 percent of its capacity, the length of the line to access that system can become highly chaotic, changing from very short to very long in rapid succession. In our case the line is filled by those trying to buy energy, particularly natural gas, oil and coal. (I am indebted to Kenneth Deffeyes for pointing out the relationship between queuing theory and energy prices in his book, Beyond Oil.)

In North America the natural gas system has been operating near capacity for several years. Only warm weather has prevented a serious crisis. For all intents and purposes, North American natural gas supplies have peaked and have been on a long plateau. When Hurricane Katrina hit in 2005, the line of those eager to nail down natural gas deliveries for the coming winter became very long, very quickly. But that line dissipated just as quickly when the winter turned out to be one of the warmest in history. As a result the price of natural gas first rose to almost $15 per thousand cubic feet and then dropped below $5 before rebounding.

Meanwhile, in the oil markets turmoil in the Middle East and fears of hurricanes in the Gulf of Mexico took prices to near $80 a barrel last summer. The price hikes were not merely the result of fear, but also the result of very little spare capacity for producing oil around the world. When those fears subsided, the number of people in line to buy oil suddenly dropped as did the price. This is exactly what queuing theory would predict in an oil market running near capacity. Whether the capacity problem is permanent because we've hit world peak oil production or merely temporary is unknown. But the result for now is wildly swinging oil prices.

Coal has not been immune, either. The coal infrastructure has been operating near capacity. This is despite the fact that everyone acknowledges that coal reserves remain immense. The current infrastructure appeared to be stretched to its limits until recently when coal prices for several major coal grades dove 20 to 50 percent inside of 18 months. In one case a 23 percent decline occurred in a mere two weeks. But, these declines come after the doubling and tripling of prices in the last three years.

A second and widely trumpeted cause of volatility in energy markets is speculation. There is some truth to this as the spectacular losses of one hedge fund in the natural gas market recently illustrated. The fund's accumulation of an enormous position in natural gas undoubtedly helped push prices up. When the market turned down, the fund manager was forced to liquidate that position at fire sale prices. This pushed natural gas prices to extreme lows.

Oil and to a lesser extent coal are subject to the same pressures from large speculators. But, the huge effect of these speculators is only made possible by tight markets. Large speculators can suddenly add considerable length to an already long line of regular energy buyers crowding the market, and those speculators can disappear just as quickly when the market turns down.

There is a third reason as well for the current tightness and volatility of the energy markets. Energy users typically have no quick and easy substitutes for the fuels they need to perform such activities as the extraction of resources; the manufacture and transport of goods; the production of electricity; or the heating of homes. Economists use the term inelastic demand to describe this situation.

All of this might not matter if no harm resulted. But high price volatility in the natural gas, oil and coal markets makes it difficult for alternatives to gain a foothold. First, those seeking to bring alternative energy to market may find buyers for those alternatives reluctant to commit. One month it may seem as if the price of fossil-fuel energy will only escalate for the foreseeable future. The next month severe price declines can make buyers think twice about those alternatives. (Wise planners sometimes regard volatility itself as a risk. But they must believe that the volatility will persist.)

Second, consistently high prices for energy can induce conservation as businesses and consumers perceive that investments in efficiency will be returned quickly in the form of energy savings. But, volatile prices make it difficult to count on quick paybacks for such investments. Consequently, these investments may be put on hold until the picture becomes clearer.

Third, volatility confuses policymakers. High energy prices can summon the necessary public support for needed conservation and efficiency measures and for investments in alternative fuels and public transportation, for example. But politicians can end up looking like fools (even when they've been wise) if prices dip precipitously before election day.

Given the serious questions about our energy future, now may be a good time to address the manic depressive moods of Mr. Market. A floor on natural gas, oil and coal prices would create the kind of stability in the energy markets that would encourage conservation, efficiency and alternative energy development. The floor could be accomplished through sliding taxes that rise as the price of the energy resource falls below an agreed floor. Conversely, those taxes would fall and then disappear as the price rises and eventually breaches the floor price.

The floor could be set well below current prices and still be effective. This is because many alternative energy sources would remain competitive even if the price of oil were $40 a barrel or the price of natural gas were pegged at $5.50 or $6 per thousand cubic feet. With floor prices in place, those working on conservation and efficiency measures; alternative energy; or the expansion of public transportation could be assured that they won't be severely penalized or wiped out during energy's next big swoon.

A floor price offers a clear signal to the market that could help us make steady progress toward a more secure and sustainable energy future. Failing to do something like it will only leave Mr. Market untreated. And, as with real people who go untreated, ignoring the effects of Mr. Market's manic-depression will have serious consequences for our energy future--not only for those in his immediate vicinity such as speculators, utilities, and oil and gas companies, but also for society as a whole.