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Why Energy Prices may Drop in the Future

By Ivan Kitov | Tue, 18 December 2012 22:40 | 0

The long-term evolution of energy prices affects the fundamental environment for stock prices. When consumer prices for various goods and services have different but sustainable trends relative to energy prices an opportunity arises for sound investments. Our observations show that some of these sustainable trends have clear turning points which provide investors with invaluable information on buy/sell decision. In this article, we investigate the past and future evolution of the consumer price index (CPI) of energy and demonstrate that it may fall sharply in the near future.   

Four years ago we published a paper on the presence of long-term sustainable trends in the differences between various components of the CPI in the USA. We started with the difference between the core CPI (i.e., the CPI less food and energy) and the overall CPI. Then the consumer price index of energy, which gives approximately 9% of the headline CPI, was analyzed. In the beginning of 2008, we tentatively identified a turning point in the difference between the CPI and the energy index and predicted energy prices to fall relative to the core CPI through the first half of the 2010s. Here we revisit this prediction and demonstrate the turning point timing and the duration was relatively accurate. 

Here we study the relative evolution of the core consumer price index (CPI) and the CPI of energy. Figure 1 displays the difference between the core CPI and the index for energy for the period between 1960 and 2012. All CPIs are seasonally adjusted and borrowed from the BLS.  Before 1980, these two indices had been growing almost in sync with fluctuation around 10 units of price index. Between 1981 and 1999, the difference grew from -10 to almost 80 units. Between 2001 and 2008, a period of intensive growth in the energy index was observed. Qualitatively, one can distinguish three periods of linear trend and three turning periods with a higher volatility. The last turning point was in 2008 and the index of energy is likely on a declining path relative to the core CPI.  However, the extremely high volatility masks the new trend in the difference.

difference between the core CPI and the index
Figure 1. The difference between the core CPI and the index for energy between 1960 and 2012. There are three periods of linear trend and three turning periods. The most recent turning point was in 2008.

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Figure 2 provides a detailed view of the most recent period. The energy index grew much faster than the core CPI between 2001 and 2008. Linear regression gives a slope of -14 for the difference curve. This assumes that the energy index grew by 14 units faster every year than the core CPI.  Since August 2005, the energy price volatility has been at an elevated level and one can likely classify the past seven years as a period of bifurcation. Currently, there is no clear indication of the direction and slope of the next linear trend, however. At the same time, the consumer price index of energy likely reached its peak value in 2007. We expect no further increase in oil price beyond that dictated by the overall price increase. We also expect the current volatility period is close to its natural end and the difference of the core and energy CPI will be growing along the new trend shown by green line in Figure 2. 

difference between the core CPI and the index 1
Figure 2. Same as in Figure 1, for the period after 2002. Linear trends are shown.

We used only absolute difference so far. It is instructive to analyze the difference in relative terms and we have normalized the difference to the core CPI. Figure 3 illustrates the new pattern. In contrast to Figure 1, the amplitudes and periods of long term fluctuations are similar and the overall evolution seems to be repeatable. Figure 4 exercises the assumption of repeatability. We have shifted the original curve by 27 years ahead and obtained a striking similarity in the amplitude and timing of the energy price falls and rises. Figure 5 shows a detailed picture. From the red curve, one can expect an energy cliff any time soon, as it was observed 27 years ago. The energy index may return to the long term sustainable trend stretching into the 2020s. The era of low energy prices is coming.    

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The difference between the core and energy CPIs
Figure 3. The difference between the core and energy CPIs normalized to the core CPI.

The difference between the core and energy CPIs 1
Figure 4. Same as in Figure 3 with red curve representing the original (black) curve shifted 27 years ahead.  

An energy cliff is coming
Figure 5. An energy cliff is coming?

By. Ivan Kitov

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