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We originally wrote this post in response to a comment on one of our recent articles.

There is no doubt that businesses have tried to become more efficient in the last 20 years, and not carrying excess inventory is a part of that. Ask Ford if high days of inventories is a good thing. We agree that days inventory have not been a predictor of prices over the last 20 years. We do contend, however, that looking at total supply in barrels (rather than days of supply) as some of the bears were doing is an incorrect metric for considering supply/demand balance.

Our belief is that the long-term trend of shrinking inventories was due to the fact that holding oil during that time was a money-losing proposition. As oil prices fell producers, wholesalers and retailers were more willing to hold less inventory, as holding the inventory presented both storage costs and the potential that prices would decline further. For the same reason, companies also underinvested in finding new sources - whether they be new oil fields or alternative sources - there was no business incentive to do so.

Even now, with oil in the range of $70 per barrel, alternative energy sources have major drawbacks. To make a tank of ethanol deprives the world of enough food to feed someone for a year. So in addition to the actual cost there is an opportunity cost that makes ethanol effectively cost something like $350 per tank. Solar? MIT’s Technology Review talks to the inventor of the most efficient solar cell, who says:

A very reputable journal [Photon Consulting] just published predictions for module prices for silicon for the next 10 years, and they go up the first few years. In 10 years, they still will be above three dollars, and that’s not competitive.

Yes, people are trying to make silicon in a different way, but there’s another issue: energy payback. It takes a lot of energy to make silicon out of sand, because sand is very stable. If you want to sustain growth at 40-50 percent, and it takes four or five years to pay all of the energy back [from the solar cells], then all of the energy the silicon cells produce, and more, will be used to fuel the growth.

And mankind doesn’t gain anything. Actually, there’s a negative balance. If the technology needs a long payback, then it will deplete the world of energy resources. Unless you can bring that payback time down to where it is with dye-cells and thin-film cells, then you cannot sustain that big growth. And if you cannot sustain that growth, then the whole technology cannot make a contribution.

With regard to the dye-cells [he invented], silicon has a much higher efficiency; it’s about twice [as much]. But when it comes to real pickup of solar power, our cell has two advantages: it picks up [light] earlier in the morning and later in the evening. And also the temperature effect isn’t there–our cell is as efficient at 65 degrees [Celsius] as it is at 25 degrees, and silicon loses about 20 percent, at least.

If you put all of this together, silicon still has an advantage, but maybe a 20 or 30 percent advantage, not a factor of two. [Meanwhile] a factor of 4 or 5 [lower cost than silicon] is realistic. If it’s building integrated, you get additional advantages because, say you have glass, and replace it [with our cells], you would have had the glass cost anyway.

So realistic solar cell production that are cost-effective without subsidies are still a few years away. In the meantime, we’ll have to dig deeper and deeper for new energy sources.

Meanwhile, demand continues its steady upward march. The last five years have been the wake-up call, saying “Hey, you need some new energy capacity.” Now higher prices are starting to provide the business incentive but it will take years for the new supplies to make it to market. Eventually they will, and when they do they will come in large numbers just as consumers have started switching en masse to more energy-efficient products and prices will plummet for 20 years. That’s the way the free market tends to work in the commodities business.

But for now - we expect higher prices. In the interest of fairness, though, here is the other side: Forbes has the case for oil going to $45. But the Forbes pundit once again says “inventories are at record levels” when justifying his belief - we reiterate that the amount of inventory is only relevant in the context of how much is being used. And while that number too is rising for now, it is at least 20% below record levels.

Crude 2-yr chart:

crude

Source: Why We Continue to Expect Exorbitant Oil Prices