Present Value and the Price of Oil
In economics, present value is a future amount of money that has been discounted to reflect its current value. In short, money now is worth more than money in the future.
To put the issue in a context that should be familiar to most of us; if you put your house on the market, you have to consider any offer in the context of, should I take what I can get now, or should I wait. If you wait, the longer you wait the higher the final offer would have to be to equal the first offer. Of course, you also run the risk that the next offer may be lower.
This, together with the pricing problems created by excess supply, is the dilemma currently facing energy producers. They have to confront the fact that, even though natural gas prices are near historic lows and the price of oil has dropped some 25% from recent highs, money now is worth more than money in the future. In other words, if you don’t sell oil at the current price, you have to get more in the future, just to break even.
However, curtailing production creates its own problems. The current imbalance between supply and demand is likely to continue for some time. To make production curtailment worthwhile, you have to believe that future oil prices will be considerably higher than current levels. Unfortunately for the oil producers, selling now only further aggravates the excess supply problem.
While predicting future oil prices is difficult and fraught with uncertainty, investors should consider the potential impact of significant changes in energy price on potential investments.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA®
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