Investment Thesis

Two significant drivers are precipitating change across multiple sectors of the global economy. The first driver is a dramatic increase in energy and commodities costs due to burgeoning demand as highly populated countries industrialize. The second is a pervasive belief that global climate change is real and that carbon emissions must be reduced.

We do not equate “green investing” with socially conscious investing. This report is designed to practically analyze how the economic landscape is changing and how investors may profit from this change.
Economic growth and energy consumption are directly linked. For reasons outlined in this report we believe that a reduction in energy consumption will not be acceptable from an economic viewpoint. We also believe that technology will not reduce our long-term demand for energy. Therefore there must be a focus on alternative technologies for energy generation. For the near-term, we expect traditional sources to remain in demand.
Investment Conclusions

With limited natural resources and rising demand, we believe that prices will continue to trend upward despite efforts at conservation and growth in use of alternatives. Increased prices will drive an accelerating viability of alternatives and economically benefit existing energy producers.

Despite the awareness of carbon emissions, “dirty” fuels such as coal and oil will not see a material near-term reduction in demand. Watch for the unlikely but possible success of liquefied coal and new research for “clean” coal. Scrubber and store-and-capture technologies may be important to reduce CO2 emissions.
Demand for oil will continue increasing until alternatives are a reality. With oil prices above $120 a barrel, oil exploration will see significant investment from producers benefitting companies such as Schlumberger and Transocean. Natural gas growth will continue outpacing coal demand due to its position as the “cleanest” of the fossil fuels. This is positive for natural gas producers such as Chesapeake Energy.
Nuclear power is not only carbon neutral but also a cost effective alternative to coal and natural gas. Uranium, necessary to fuel nuclear reactors, is already scarce however. Investors should focus on uranium and mining stocks particularly if the regulatory environment changes in the U.S. as we believe it may.
Alternative energy sources, particularly solar and wind will expand. We forecast these industries will grow annually more than 30% for the next several years. Solar and wind power companies and suppliers are attractive at appropriate valuations. Examples include polysilicon suppliers such as MEMC Electronics as well as solar manufacturers such as First Solar. Wind energy competitors include General Electric and Vestas Wind Systems.

Ethanol and biodiesel industries will grow, but these fuels are unlikely to power a large number of vehicles except as an additive. If electric cars or other technologies succeed, ethanol will be irrelevant. Ethanol demand will increase near-term as a MTBE replacement and as an additive. We would avoid ethanol producer stocks but believe the trend benefits agricultural suppliers to improve crop yields as well as fertilizer and farm equipment manufacturers. Examples include Monsanto, Potash, Caterpillar and Deere. Even without ethanol and biofuels, growing industrialization and rising food costs are greatly benefiting both farmers and these companies.

Investment Conclusions

• The future of the automobile is electric. We view hybrid vehicles as a compromise of efficiency and range until better solutions emerge. Hydrogen fuel cells are possible and maybe likely, but will require significant infrastructure changes even after they become technologically feasible. Toyota is the best positioned of the large car manufacturers with hybrid dominance.

• Watch for new battery technologies. Lithium-ion and lithium-polymer batteries are already powerful and light enough to make electric cars both possible and practical.

• Light weight materials will become increasingly important. Relative to heavier materials, aluminum and composite manufacture will grow in demand despite their cost premium. There are a few carbon fiber manufacturers that bear watching. These materials will be needed in the automotive industry to realize greater efficiency and are being used now to manufacture wind turbine blades for wind power generation.

• There will likely be a cap-and-trade carbon emission system implemented in the U.S. This will increase the cost to manufacture electricity and will increase the price to the consumer for produced goods in general. If poorly implemented, the possibility of either retarding economic growth or ineffectiveness toward reducing carbon emissions is possible.

Identifying Macro Trends
We are in a continual search for the next investment opportunity. As a money management firm, we investigate, research, and synthesize information in an attempt to identify fads from the lasting trends. Certainly investors, with proper timing, can profit from both, but we thrive on the longer-term opportunity. Catching the timing just wrong on the latest fad can be costly.

Many of our clients are curious as to how we plan to take advantage of the new awareness and concern regarding global warming, the environment, and rising commodity and energy costs. It seems obvious that there ought to be growing investment in these areas and positive returns for investors should follow. Considerably less obvious is where to invest to take advantage of these trends. Now that some of the dust has settled and the hype around global warming has moderated we believe it’s a good time to make a critical analysis of the investment opportunities.

We won’t try to equate “green investing” with socially conscious investing. Each investor needs to make a personal decision in regards to the type of companies to invest in. We do not believe that it is our responsibility to make that decision for you. Our goal here is to lay out the investment landscape as clearly as possible. We believe that the pieces are in place for material change in regards to energy and the environment. While we do not consider coal or nuclear energy to be environmentally “green”, both will continue to be used broadly in the near-term and in the case of nuclear, use will likely be expanded.

There are two fundamental drivers in this cycle of economic change. The first is the groundswell of support for a social reprioritization around the environment. The second driver is an economic shift based on the likely possibility of the end of cheap energy. Together these drivers are causing both consumers and businesses to rethink their practices and both are driving renewed interest and investment in alternative technologies.

From an investment perspective it is practical to simplify and limit our focus to the environmental concerns of global climate change and greenhouse gas emissions (GHG). In our opinion, concern for realities of global warming may have brought about some change on its own, but it is ultimately economics that will drive demand. Only through increased cost of fossil fuels and cheaper, cleaner alternatives will fundamental lasting change occur. With continued population growth, demand for energy will grow and as poorer nations industrialize, demand will accelerate rather than decline.

There are many companies attempting to address elements of the cause of global climate change. Most of these are small, nascent companies trying to tackle large problems with very limited resources. The notion that there should be great investment opportunities in the rapidly developing market for environmentally healthy solutions has quickly become popular. Not unlike the development of the biotech industry in the 1980s or the development of the Internet in the 1990s, we should expect a lot of promise with a lot of disappointment. Venture capitalists expect only a minority of their portfolio investments to be moderately successful but count on one or two big winners to generate significant returns. So, just like the development of the biotech industry or the Internet, the long-term demand for new clean sources of energy will be significant. Today, there are several companies that trade publicly with large market capitalizations and very little, or no profits to speak of. We like to refer to these investments as “public venture”. Our point here is that there is already great investor interest in the companies that are working on solutions for energy alternatives and solutions for global climate change and there are a very limited number of public companies for investors to put money into. Therefore a diversified portfolio is critical and only a portion of any portfolio should be committed to speculative investments. Any emerging market, particularly one with significant media attention, confusion, and one influenced heavily by political machinations, is inherently speculative.

We believe that the real driver for change that investors need to be cognizant of is cost. In a commodity market, the winning technology is the one that produces the end-product the cheapest. Consider that more than 50% of the electricity in the United States is generated by coal and has been for more than 100 years. In the United States coal is plentiful and for the end-user the quality of the electricity delivered to your wall is the same as the electricity generated from an environmentally friendly wind turbine. Consumers are rapidly changing automobile purchasing decisions not based on standards set by congress but based on the record high cost to fill up at the pump. We find it amazing how quickly the media dialogue can shift from environmental awareness to concerns regarding the economy and the cost of energy and food. So much so that several candidates running for President suggested eliminating the gasoline tax for the summer. Environmental concerns have rapidly been extinguished in the face of immediate economic impact. Gasoline consumption is actually down in 2008 for the first time in years. Wasn’t the goal to reduce petroleum consumption? To reduce our demand for oil and to encourage demand for alternative solutions, we suggest, unpopular as it might be, that the gasoline tax be raised.



Change will come either through innovation, making cleaner sources of energy cost effective, or through change in public policy to make the true public cost, including the environmental impact of a process, fully realized by the producer either through tariffs or subsidies. We put little confidence in the ability for government to affect meaningful change in the face of negative economic consequences. That said, with continued growing demand, the limited availability of many commodities is driving up prices, making alternatives more attractive and economically feasible.

Innovations include new battery technologies, thin-film solar cells, new techniques to making traditional fuel sources cleaner and a reexamination of old technologies that are starting to make practical sense. Over the last several years, venture capital has flowed into new ideas and in more than a few cases executives that made fortunes in the Internet boom are starting again in technology to increase performance and efficiency of energy generation and reduce our carbon footprint. Most of the core technologies are not new. Albert Einstein recived the Nobel Prize in 1923 for his 1904 paper explaining photoelectric effect. We’ve been aware of biofuels for as long as we have been burning coal and oil. Many of the first cars ran on electricity. Hydrogen fuel cells are available today and an electric car that accelerates faster than any Ferrari with a range of more than 200 miles is already in production. In most cases it is the application of new technologies that are enabling cleaner use of power at costs that are getting more competitive with existing sources of energy. Yes, consumers are getting more environmentally aware but it is the economics that really start to affect change.

The statistics are now well known. The United States, the wealthiest country in the world, emits more carbon dioxide gas into the atmosphere than any other, a full 25% of the global total. On a per capita basis, we throw off 20 tons per year of carbon dioxide waste for every man, woman and child. Most of Europe, by contrast, emits half this amount, or roughly 10 tons per year per person. Our distinction as the greatest CO2 polluter is a direct by-product of our success. The production, use and transformation of energy have propelled our economy to ever new heights. Our gross domestic product (GDP) in 2007 totaled $13.8 trillion, second only to the European Union


and nearly double China. Consider that the EU has nearly 500 million citizens and China more than 1.3 billion compared to 300 million in the U.S. This monetary measure of our success is a direct result of our ability to generate and use energy. With energy comes innovation, and with new innovation we have developed new products to provide new capabilities which in turn has led to more innovation and the use of more energy. It’s a virtuous cycle that has burned up a lot of carbon-based fuel in the process. Our ever growing demand for energy continues to increase despite significant gains in efficiency. The amount of energy consumed to produce one dollar of GDP has declined from nearly 20 British thermal units (btu) in 1950 to 9 btu in 2005, a increase in efficiency of more than 50%. While the efficiency is great, over the same period our GDP increased 542% adjusted for inflation.



Our growth has continually demanded more fuel, and the problem is not simply America’s largess. China and India, with much greater populations than our own are experiencing a transformation. The economies of these countries are emerging rapidly and with this rise come a middle class of consumers eager for all the trappings Americans generally take for granted, such as televisions, refrigerators, air conditioners and the automobile. Consider that China, with more than 1.3 billion people, now has 160 million motor vehicles. The number of new vehicles increased more than 10% just last year alone. In very short order we will lose our dubious distinction as the greatest consumer of energy as greater numbers of the world’s population have electricity delivered to their doorstep.

The implementation of new technologies to generate material quantities of cleaner energy to sustain economic growth will be exorbitantly expensive for the industrialized nations, and for the developing nations the demand will continue to be for the cheapest solution, which is often the least environmentally friendly. Without substantial R&D investment from the industrialized nations, we cannot anticipate that the appetite for harmful hydrocarbons will be any less from our emerging neighbors than our own. In short, what is quickly becoming a global crisis will in all likelihood get a lot worse before it gets better as the demand for energy is poised to accelerate globally. Unfortunately, it is a competitive advantage to consume more energy, not less, and pronounced economic recession is not a cost any country is willing to pay. In George Monbiot’s book, Heat, he tells the story of a speaking engagement at a conference in London on global warming. After concluding the presentation he fields a question from the audience asking what this country (the United Kingdom) would look like with an 80% cut in greenhouse emissions. A colleague answers the question with the response “a very poor third-world country.” Our point is, significant reduction in carbon emissions through reduced energy generation is untenable from an economic perspective.



The problem of the environment is obviously not new. There have been various environmental crises since the beginning of the industrial revolution, from pollution of water sources to deforestation. For each of us individually it seems inconceivable that we could pollute enough to permanently damage a river, an ocean or alter our climate. The strength is in the numbers, however, and with rising population combined with our insatiability for progress, we cannot avoid an impact on our environment. This is a long-term problem that will take long-term solutions. This same factor affecting our environment, population, is also driving commodity prices higher. Just as it seemed we would never be able to pollute our environment in a material way, many of our natural resources have appeared inexhaustible. Technology has been employed to great success to increase our efficiency in extraction, keeping commodities relatively cheap. With the industrialization of the third world and a higher global standard of living, demand is finally outstripping supply of fossil fuels for good.

Based on this backdrop we draw several macro conclusions. First, any expectation for a reduction in energy consumption is unrealistic on economic grounds. Citizens and governments the world over will not easily sacrifice personal wealth without a truly dire crisis. Second, the problems of high priced commodities and increasing damage to the environment are likely to become more pronounced in the future as demand continues to outstrip supply over the long-term. Third, these trends will drive adoption of alternatives.
 
To support these macro conclusions and determine what ways the energy economy will likely change, we need to take a detailed look at the existing energy landscape in the U.S. Through this analysis, we believe that this short primer will highlight several opportunities for investors to consider. They include both existing energy infrastructure investment as well as clean alternative sources for the future.

The Energy Economy

If we are doing it efficiently, at the end of the day we will end up with more usable fuel to use for other tasks than we burned trying to get to the fuel. The carbon based fuels that we use to power our cars, generate electricity and heat our homes have been essential fuels to create work. James Watt’s steam engine was invented in 1775 and was originally used to pump water from coal mines. We point this out not for a history lesson but to illustrate an important point about the nature of energy. Much of our energy is consumed to access, refine and transport more energy. That first steam pump burned coal to enable greater efficiency in mining coal. The energy we produce is converted to work which is turned right around and used to extract and refine more energy. If we are doing it efficiently, at the end of the day we will end up with more usable fuel to use for other tasks than we burned trying to get to the fuel in the first place.

Prior to the industrial revolution, the global economy operated largely on biofuels to make work. These fuels were wood for heating and food for livestock. The farmer must eat (carbohydrate fuel) to grow crops (more fuel). The ox and horse need food for energy to plow the field and provide transportation to distribute the fuel. In 1910 more than a quarter of U.S. farmland was used to grow hay for horses. These fuels, although renewable, by definition, are less efficient and take massive quantities of space in forests and farmland. Deforestation throughout the globe occurred due to our insatiable need for cost effective energy in the form of wood until we began to use denser forms of energy, in particular, coal and oil.

With innovation, we have created new tools to produce more power, faster. The oil pump consumes some energy to extract the oil, and more energy still is required to transport the fuel, refine it, and transport it again to a gas pump near you. Edison used steam in 1882 to drive the dynamos (generators) at the first electrical generation plant in downtown Manhattan. The steam was generated by burning coal. One form of energy (coal) burned to create a more refined and transportable energy in the form of electricity. Today, most of our electrical power still comes from the burning of coal to generate steam, which drives the turbines that power the U.S.

Every economy is driven by the availability of energy to make work. Unfortunately the resources for power are limited and CO2 emissions are a consequence of all abundant carbon-based fuels. To examine how increased costs and greater environmental awareness may change the landscape, we’ll need to look at our sources and uses of energy.

Uses and the Sources of Energy in the United States

The consumption of power in the U.S. can be divided into four segments. They are, as defined by the U.S. Energy Information Administration; transportation, industrial, residential and commercial, and electrical generation.

Transportation, the sector most discussed in the media, consumed 28% of the total energy generated in the U.S. in 2006, and depends almost entirely on petroleum. In fact, 98% of the power consumed for transportation in the U.S. is fueled by oil. Consumption of power for industrial purposes totals 21% of our total energy. This segment includes manufacturing of cement, chemical manufacturing, steel and metal refineries and other industrial purposes. Residential and commercial consumption totals only 11%, driven largely by the burning of natural gas and oil for heating purposes. The remaining 40% of our power is consumed in the generation of electricity, which is a conversion of energy to a more refined power (electricity) from other sources. Unlike fossil fuels, electricity has the benefit of being easily controlled and distributed across large geographies. The 40% of our power to generate electricity is simply transported back to the other segments, industrial, residential and commercial for an ever growing number of applications.

Four Primary Fuels

There are four primary fuels that power the four sectors of our economy. They are petroleum, natural gas, coal, and nuclear. A fifth category defined as renewable energy is a catch-all for several smaller energy sources including hydro (water), biomass (wood, principally), and a tiny bit of wind and solar.



As sources go, petroleum is the most significant. In 2006 the U.S. consumed a total 100 quadrillion Btu of energy generated from all sources. Of that total, 40 quadrillion Btu, or 40%, was generated burning petroleum. Only 68%, however, went into our cars. Most of the rest, 24%, went for industrial use, primarily manufacturing. Coal and natural gas each provide approximately 23% of our fuel or 23 quadrillion Btu each. Natural gas is more expensive but is more convenient to distribute to homes for heating and for other industrial applications and is somewhat cleaner to burn. A little more than a quarter of the natural gas consumed annually is in the generation of electricity, while 91% of the coal consumed went to the generation of electricity. In the United States, and in China, coal is by far the most abundant fossil fuel and as a result is inexpensive. The fourth largest source of energy is nuclear power, which totals 8% of our energy sources and is used exclusively for the generation of electricity.

Nuclear power is noteworthy because it is a CO2 emission free source of energy. Obviously there are other significant concerns regarding nuclear power and our environment (to say nothing of safety), but the fact is, once a nuclear power facility is up and running, it is efficient and cost effective. Consider that no new facilities have been constructed in the U.S. since 1975 and that a mere 104 nuclear power stations produce 21% of our total electricity after more than 30 years since construction on the last one began.

The final segment of our energy sources is a basket of renewable fuels, which contributes just over 6% of our energy. Not all of the renewable technology is particularly clean, however. Hydroelectric is 45% of the renewable category and is very clean ignoring the ecological impact of damming rivers. Hydro is very efficient and emission neutral, but there are no opportunities for growth. Throughout the world, most of the geographically suitable sites to generate hydro power have already been utilized. The burning of wood is the next largest renewable and half of this is consumed in households for heat. Though wood burning is renewable, it is hardly clean or efficient. We generate approximately 1.25 quadrillion Btu through the burning of wood, although the consumption of wood has been declining for decades.

The popular clean renewable fuels, the ones that will reduce our CO2 emissions and end global warming, barely make a dent as a source of our power. The very low contribution of clean renewable energy makes the threat of climate change all the more daunting. The positive spin is that, from the investor perspective, there’s a lot of room for growth. Biofuels contribute 0.7% of our energy consumption. Wind contributes a scant 0.3% and solar provides even less, contributing less than 0.1% our energy. It’s fair to say that we are starting from scratch.

Climate Change Will Drive Long-Term Change

In this report we use greenhouse gasses (GHG) and carbon dioxide (CO2) somewhat interchangeably. In point of fact, however, GHGs include several other waste gasses that also contribute to global warming. They are methane, nitrous oxide, and a few other pollutants such as hydro fluorocarbons in addition to CO2. We use the two interchangeably simply because the vast majority of waste gas emissions are CO2 and more than 80% of global warming influenced by human activity is attributable directly to rising quantities of CO2.

CO2 emissions are a byproduct of burning carbon based fuels. Despite nearly two centuries of incredible innovation, we still burn much of the same stuff to generate work. Unlike the sulfur dioxide (SO2) toxic emissions that cause acid rain, CO2 is relatively benign (nontoxic) as a pollutant. Your body, with every breath, takes in oxygen and exhales CO2. Plant life throughout the globe requires CO2 for photosynthesis. Carbon dioxide has always been in our atmosphere at various levels through time. This, predictably enough, is the foundation for the principal counter argument against anthropomorphic global warming. The reality is that we emit millions of tons of GHGs into the atmosphere and have been for more than a century and at no time in the Earth’s history has concentrations of CO2 raised as rapidly as it has over the same period. It is difficult not to connect the dots and draw a correlation between our GHG emissions, rising CO2 in the atmosphere and rising global average temperatures.



More problematic, is the fact that the CO2 released into the atmosphere does not simply fall back to Earth or disperse once released. Once in the atmosphere, carbon molecules are estimated to remain for approximately 200 years. So the effects of releasing carbon become cumulative. It’s not as though we can simply reduce our output and the problem goes away. With lower output the problems of GHGs merely become potentially less of a problem over a long period of time. Based on ice core studies, the CO2 concentration in our atmosphere has risen from 280 parts per million (ppm) 150 years ago to 380 ppm today. Slowing the rate of emissions will slow the rate of growth in the concentration, but will not reduce it. The scientific community has accepted the fact that CO2 concentrations will increase from current levels no matter what we do in the near-term. What is debated is what the consequences will be.

An upper-limit of 550 ppm is now commonly used in global policy discussions as a long-term target that may avoid catastrophic problems associated with global warming. Over the last 20 years, carbon building up in the atmosphere has been accelerating, increasing an average 1.9 ppm per year. At this rate we will reach the 550 ppm level in less than 80 years. While it may appear we have plenty of time to develop alternative fuel sources, due to the cumulative effect of carbon in the atmosphere, our CO2 emissions will have to peak and decline in the next 20 years. Our global emissions will have to stabilize at or below year 2000 levels and improve from there over time. The effects are still forecast to be very dire with a long-term forecast temperature increase of 3 degrees Celsius and more than a meter rise in the mean sea level. These targets will be extremely difficult to meet, in our view, making this likely to be a best case scenario. As these realities become more apparent, public policy will have to take into account the environmental cost of using carbon-based fuels. The slow developmental nature of climate change will mute the urgency around the problem slowing action, however over the next several decades, investment in alternatives will grow.

Economics Are Driving Change Today

All three major fuel sources, petroleum, natural gas, and coal produce significant quantities of CO2. Looking into the numbers a little deeper it is readily apparent that on a comparative basis, the burning of coal produces nearly 72% more CO2 than the burning of an equivalent quantity of natural gas, making coal the worst polluter. Petroleum is only marginally better than coal, generating approximately 65 million metric tons of CO2 for every quadrillion Btu generated, which is 23% worse than produced by natural gas. There is no “clean” fossil fuel. In total they generate 99% of the CO2 we emit annually. Unfortunately these fuels are abundant and even after recent increases, they are still inexpensive relative to alternatives. In order for replacement technology to be viable it will have to be cost competitive.

On an adjusted dollar basis, the average consumer cost of gasoline has finally eclipsed the oil crisis of the late 1970s. In March of 1981, the retail price of gasoline per gallon averaged $3.22 adjusted to 2006 for inflation. The average price for 2006 was $2.64 and for 2008 the Energy Information Administration forecasts an average of $3.52. Since the mid-1980s gasoline has been inexpensive encouraging auto manufacturers to focus on increases in power and performance rather than fuel efficiency.


In this country we tend to view cheap gasoline on par with life, liberty, and the pursuit of happiness. Additionally, many seem to believe that demand for petroleum is inelastic. We leave it to Congress to regulate the manufacturers with fuel efficiency targets while the consumer demands faster, larger and more powerful vehicles. The fact is, demand has declined after significant cost spikes and consumers are paying more attention to efficiency today as a direct result of the current costs. Consider that the federal gasoline tax is currently 18.4 cents per gallon. In Europe the taxes on gasoline range an additional $3.00 to $4.00 per gallon. We are not advocating a policy change in regards to gasoline, but seek to point out the fact that demand does decline with higher prices and consumers will seek cost effective alternatives if economically motivated.

In a certain sense the rise in the price of energy, particularly oil, can be viewed favorably if we want to encourage a reduction in consumption, or even better, if we want to make replacement technologies viable. The last time US oil consumption declined was after the record price spike of the 1970s culminating in 1981. In the years that followed, American consumption declined 12%.

With the rise in the price of oil, new fuel economy standards were passed and consumption declined. With the return of the price of oil to relatively low prices by the end of the 80s, further efficiency standards were dropped and fuel economy declined as manufacturers added more size and power rather than fuel efficiency with improvements to the internal combustion engine.