Too Late to the Oil Party? Consider an Alternative


                   The Current Oil Spike and Alternative Energy:
                    What the Investment Herd May Have Missed

                                      
     Timothy D. Kailing


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:
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:
Elliptical Research Contribution 2008.3:
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. Everyone should, of course, do their own due diligence,
and consider their own unique risk and reward profile before making any investment.
Copyright © 2008 Timothy D. Kailing
Timothy D. Kailing is the principal at
Elliptical Research.

He wears another hat as an
advocate for the benefits of early
literacy in children; in this effort he
authored the book:
Native Reading: How to Teach Your
Child to Read, Easily and Naturally,
Before the Age of Three.