Due to increased prices, we are again beginning to see real declines in gasoline consumption in the U.S.
For the most part, oil reserves globally have been keeping pace with demand and new technology coupled with rising prices has made it possible to tap fields that were previously inaccessible. The rapid rise in oil costs to more than $120 per barrel from a recent average of $20 is changing the economics of car ownership. It is possible that some of the price increase for oil has gotten unsustainably high due to speculation; increasingly analysts are questioning whether the supply and demand picture has fundamentally changed. The weakness of the U.S. dollar in recent years has also been a large contributing factor to the sharp rise in all commodities, particularly those imported. But oil is in limited supply, and discoveries of new oil reserves get smaller every year. Experts forecast that global oil production will peak in the next ten to forty years. With limited supply coupled with accelerating demand as emerging markets such as China and India consume more fuel, we anticipate the cost of oil to remain high. Certainly the higher price of oil will encourage producers to invest in more production capacity which will stabilize and may even reduce the price of oil over the next several years from current highs, but the long term trends for higher oil prices are in place. Expensive gasoline, more than anything else, will drive demand for fuel efficiency and facilitate the development and long-term adoption of new technologies.
Coal, however, is even cheaper and more abundant than oil, particularly here in the United States. So abundant that the U.S. has been described as the “Saudi Arabia” of coal. There are currently more than 100 new coal fuel power stations approved for construction in the United States and China, with the second largest global coal reserves, is finishing a new power plant every week. At current consumption rates it will take us 200 years to consume all the coal deposits that are believed to be in our reserves. Of course by that time the polar ice caps may only be found in history books.
Meanwhile demand for electricity in the United States is estimated to grow 45% between now and 2030 according to the generally conservative estimates of the Energy Information Administration. That demand will have to be met, requiring new power generation facilities.
A Lack of Easy Solutions
Energy costs may moderate from current highs and public focus on global warming may wane, but over the next decade and beyond we suspect that the issues we have highlighted, namely limited supply, growing demand, and a social desire for environmental consciousness will result in long-term change that investors can benefit from. The solutions to the issues of scarcity and carbon-emissions are limited. Broadly speaking the options can be categorized as attempts at conservation, improved efficiency through technologic innovation, development of technologies to clean up after the consumption of traditional fuels, and finally greater use of cleaner alternative fuels.
The Pardox of Conservation
We are not confident that much can be accomplished through conservation. Conservation can reduce carbon emissions at the margin, and reduced demand can briefly ameliorate price shocks, but long term demand for energy will continue to grow. We do expect new regulation to come from governments to encourage conservation and investors need to be cognizant of these regulations because they can have material impact on demand for both alternatives and existing fuels. For example, the German government has been offering huge subsidies for the development of solar in that country. These subsidies are so significant that the price of polysilicon globally has risen due to unprecedented scarcity as more solar cells are shipped to Germany. If these subsidies were to end, the solar market would take an initial hit in demand, followed by likely gains as the price of polysilicon falls, making solar more attractive as a cost competitive competitor to fossil fuels.
Paradoxically, conservation, if successful, would actually hurt demand for clean alternative sources of energy. If global conservation of carbon based fuels were successful on a broad scale it would have the effect of reducing demand, resulting in lower energy costs and subsequently making alternatives too expensive to compete. Due to burgeoning global demand and the nature of energy consumption, we are unlikely to see material conservation gains, except in the case of petroleum as long as prices are sustained at record levels.
Historically conservation has worked in other areas, the most noteworthy is water consumption. Americans reduced water consumption roughly 25% in the 1960s and 1970s through a combination of higher prices, low flow toilets and fixtures and by implementing drip and automatic timer irrigation systems. Unfortunately in the case of energy consumption, the conservation solutions are not as straight forward as installing new fixtures and more importantly, unlike water, we keep coming up with new devices and appliances that require increasing quantities of power. Additionally, in our global economy where fuels like coal, oil and liquefied natural gas are shipped throughout the globe, demand in Asia now has an impact on our prices for energy generating fuels. This dynamic is very different from the economics of water where shortages in Africa, for example, don’t have a direct economic impact on supplies in North America.
At a certain point, a material reduction in energy consumption comes with an economic cost as well. Without plenty of energy, economic growth will stagnate. As a result, where feasible, it is cheaper from an economic perspective to consume more energy and clean up after our consumption than it will be to reduce consumption. Our single greatest use of energy is the discovery, extraction, refining, and delivery of energy. We burn vast amounts of energy in the effort to produce and transport more energy, more efficiently. We are a net beneficiary as long as we produce more energy than we expend in the production process. Since 1950, the U.S. GDP has doubled while the energy consumption has tripled. The energy industry is in a constant search to refine methods to make the discovery, extraction, and transport of energy as efficient as possible. Their profitability depends on it. Our point is, there are constant improvements to efficiency that are being developed and implemented, but there are no easy, neglected solutions for significant reduction in the consumption of energy.
The Efficiency MythThere can and will be some conservation, but the gains will be nominal, finite and will be completely subsumed by new technologies that will require more power. We cannot turn off the spigot without reducing GDP, economic growth and personal wealth. Greater efficiency through technology is also problematic and unreliable as a solution if history is to be our guide. We have grown substantially more efficient at generating energy. The cost to generate one watt of power peaked in about 1920 and has been declining ever since. The problem is that the same technological progress that has enabled greater efficiency has enabled a myriad of new products to consume more energy. Again, as we have pointed out, this process has been the critical driver of our economic growth and our significant wealth. From an economic standpoint the emerging countries of the world have learned our lesson well, energy conservation is anathema to economic growth.
Many had hoped that with technology we would realize significant efficiencies in the use and generation of our energy and that these efficiencies would allow us to do more with less. California energy officials in the 1980s predicted that the demand for electricity would level off and possibly even decline through the end of the 20th century. They could not imagine what we would be using more electricity for. California went so far as to mandate a 10% price cut for electricity, approve no new plants over 20 years and eliminate all long-term contracts to purchase power at fixed prices. Not only did demand not decline, it increased significantly. With increased demand and a lack of supply, prices climbed and without long-term contracts, price shocks had to be passed immediately on to the consumer. Before the crisis ended, it put a California Governor out of office. Today Canada and Arizona supply a quarter of California’s electricity. Historically, demand for energy has only declined for very brief periods. Even before Edison lit the first light bulb we have continuously required more power despite the fact that the devices that we have been powering get more efficient. Technology has indeed succeeded in making our use of energy more efficient, just not in the way many thought it would. The problem is we keep creating new devices and are using more and more of them.
At a Microsoft conference Steve Ballmer, now the CEO of the company, told the following story.
“When I joined Microsoft 26 years ago, the notion that people would have computers was still relatively foreign. I dropped out of business school to come to Microsoft, and my parents, neither of whom went to college, thought that this was a pretty silly idea, that I said I’m going to go work for a company run by a friend of mine that makes software for personal computers. And my father looked at me very earnestly and said, “What’s software?” And my mother looked at me, even more earnestly perhaps, and said, “Why would a person ever want a computer?”
With new technology we have created whole new industries with a staggering array of new products and they all require power.
Another example of how efficiencies from technology often lead not to less consumption but greater consumption can be found today in the general aviation industry. Aircraft have changed very little in the last 50 years. At least until recently. With lightweight composite materials new small aircraft designs are being made commercially available. New capabilities in electronics and specifically GPS have made the job in the cockpit considerably easier. With these technologies new pioneers, notably executives that have transferred themselves from the high-tech industry, are stirring things up. Engine manufacturers such as Honda and Pratt Whitney have designed new small jet engines to be considerably lighter. These engines are the result of new materials which enable the manufacture of the engine using far fewer parts than older models required. As a result they weigh less, are easier to maintain and are more efficient in terms of thrust-to-weight. For all transport, weight savings equals fuel savings, and these planes are far more fuel efficient as a result. Combined with a composite airframe and new electronic capabilities for onboard systems that can be operated by a single pilot, new very light jets are now available. These small aircraft can carry five passengers and a single pilot very quickly to small airports throughout the country. There are several new air taxi services that have placed large orders with the expectation that there will be demand from wealthy travelers and executives looking for cost effective charter services that do not require the removal of your shoes before boading. One significant benefit is that these small jets will be able to get into and out of smaller airports in areas that are not accessible to typical commercial traffic. These new jet aircraft are selling for one to two million dollars, and regardless of whether there is enough demand for air taxi service, there is real demand from owner pilots based on orders.
The engines powering these planes are far more efficient than their predecessors and because of the significantly reduced weight they have to push around, the plane can perform with less thrust. So we have gained in efficiency. Except that we haven’t. Each new jet put in to service will require fuel. Despite the fact that it will burn fuel more efficiently than an older jet, it will still burn fuel. Technology has improved and enabled us to produce small, more capable, less expensive and more efficient devices. Because these new things are so great, however, we build a lot of them and they all take energy to run. Ten small jets at five times the efficiency of a large jet will collectively burn twice as much fuel.
A final example can be found in the semiconductor industry. Using new technologies and new materials, the number of transistors that can be etched into a chip grows every year. The etching processes are able to make the circuits ever tighter, enabling large gains in efficiency. Less voltage is required to be used per transistor, increasing efficiency. However the tighter etching capability also enables a much greater number of transistors, requiring far more power than we saved in efficiency. The resulting processor is far more energy intensive as a whole despite the efficiency gain per transistor. My laptop battery lasts no longer today than it did five years ago. The processor has gained in raw throughput, the battery technology has improved and measured per calculation, the efficiency gains are marvelous, but it uses more power than ever. So if a significant reduction in energy consumption is unsupportable from an economic perspective and efficiency through technology only serves to increase our demand for power then our options are limited. For these reasons the financial success of “dirty” fuel sources will continue. In our investments we will continue to watch oil exploration and coal shipping to China and India, for example. But there are alternative sources of energy and they are rapidly growing creating new investment opportunities. The alternative technologies are not new, but the changing economics are encouraging explosive growth. Rising traditional fuel costs coupled with technological advances to improve the efficiency and reduce the cost of alternatives begin to make them compelling. Add in subsidies and these alternatives are finally economically viable.
A Deeper Look at Electricity
Alternative sources of energy are going to be important despite the fact that they will not contribute a meaningful percentage of our total power generation for decades. The biggest hurdle for clean alternatives has been their cost. As we pointed out, windmills have existed for centuries and solar cells were first developed in the early 20th century. After nearly 60 years of development since the modern solar cell, solar power contributes only 0.0125% of our total electricity generation. But consider, if solar were to provide 1% of the energy consumed in the U.S. by 2010, it would represent a 1,567% increase over current levels. Solar and wind power, will not replace electrical power generation from current sources in a meaningful way anytime soon, but from an investment perspective, growth is accelerating making the sector the single greatest area for alternative energy investment.
While the cost of our traditional fuels to generate electricity has been increasing, the cost to implement solar and wind have been declining with improvements in technology. Yet the cost to generate one kilowatt hour of electricity using solar is still five times more expensive than burning coal. In the right environment wind can fare better, but poorly planned installations can cost as much as solar measured per watt.
Hydro Power
One of the oldest, clean technologies for the generation of electricity is hydroelectric power. Of course there are environmental costs in the form of massive dams that irrevocably change landscapes and ecosystems, but hydro is a mature technology with few options for further growth. The existing facilities generate electricity cost effectively and are competitive with the cheapest fossil fuels. Currently hydroelectric contributes nearly 7% of the total electrical power generated in the U.S. but this number is shrinking as we build more coal and natural gas power plants. Hydro power accounts for nearly 20% of electrical power generation worldwide.
Geothermal and Wave power
There are several less known technologies that are being used to generate electricity that do not burn fossil fuels, though each has its significant hurdles. The capture of ocean wave and tide energy, for example, is being tested in the United Kingdom but the costs currently are prohibitive and the ecological impact is hotly debated. Geothermal power generation is another method that has developed over the last thirty years and reduced costs have made it very cost effective recently. Geothermal can only be implemented in geologically active regions where heat rising from the Earth’s crust can be used to generate electricity. Limitations of geography and geology will curtail widespread expansion of geothermal.
Nuclear Power
Nuclear energy generation is certainly a proven viable alternative to burning fossil fuels. Nuclear requires significant up-front investment but over the life of the facility costs are competitive with coal and about three times cheaper than natural gas. As commodity fuel prices increase nuclear begins to look very attractive. Of course there are safety and environmental issues that have to be addressed. There have been no new nuclear facilities approved in the U.S. since 1975 after Three Mile Island due to safety concerns. Despite this, nearly 20% of our electricity is generated by the 105 facilities we still have operating. France generates approximately 80% of its power from nuclear resulting in a significantly lower carbon footprint. Given the limited options to effectively reduce carbon emissions without reducing electricity demand, we speculate that the current moratorium on new nuclear facilities in the United States may be lifted in the coming years. Even if this happens it will take ten years before newly approved plants can become operational. If it became apparent that nuclear will expand again in the U.S. we would anticipate a short-term reduction in the price of coal and possibly natural gas. We would also anticipate a spike in uranium and a corresponding increase in the valuations of uranium mining stocks such as Cameco and Rio Tinto.
Wind Power
The most significant opportunities for investors are solar and wind technologies. These areas are not without risk, but are proven technologies that are being widely implemented. The implementation of wind power generation is well ahead of solar. In the U.S., wind generates more than 14 billion kilowatt-hours which is roughly 24 times the amount generated by solar but still accounts for only 0.3% of our annual electrical power generation. Like geothermal, wind is somewhat constrained by suitable geography. European countries have been aggressive in the usage of wind power and it does make a large contribution to total electricity generation. Denmark is the global leader with more than a fifth of the country’s electrical power coming from wind energy. Implemented properly, wind can be cost competitive with non-renewable fuels. We expect wind energy investment to grow rapidly but at somewhat slower growth rates than solar. Site locations can be difficult to develop, the capital investment is larger than solar and many residents see wind turbines as a potential eyesore. Lastly, electrical transport infrastructure from remote regions can reduce the cost effectiveness.
Direct investment in wind power is difficult and there are few pure play companies with suitable exposure to growth in wind energy. The largest wind turbine manufacturer is General Electric. As one of the largest companies in the world, wind power is a very small portion of their overall business and any success in the industry is totally subsumed by their other businesses. The leading pure play company is Vestas Wind Systems. The company is based in Denmark, employs over 15,000 people and has installed base of more than 35,000 wind turbines. The ADRs are available under the symbol VWDRY.
Solar Power
On the surface solar appears to be an ideal solution for clean energy, but there are a few problems. The sun transmits a tremendous amount of energy to the earth but the conversion of that energy into electricity is still very inefficient. Solar cells typically only convert about 10% of the energy in sunlight into electricity. In addition to this inefficiency, solar energy generation is confined to daylight hours. Cloudy days and fewer daylight hours in the winter further reduce solar efficiency. Geographies with frequent cloudy weather make solar impractical. In North America, for example, there is on average 4.5 to 6 hours of effective sunlight per day for solar generation. Lastly, the polysilicon used in most solar installations is in limited supply, making it expensive. The cost of polysilicon has been declining over the last few decades making solar more competitive, however recent spikes in demand for silicon has impacted raw material prices. Over the life of an installation the cost to produce a kilowatt hour from solar is in the range of $0.10 to $0.15. Compared to the average consumer cost in 2007 of $0.104 per kWh, solar is still an expensive alternative. Despite the higher cost, investment in solar and solar installations has greatly accelerated due partly to large subsidies from various governments. In 2006, the U.S. generated roughly 500 million kilowatt-hours from solar. While the number sounds impressive, it represents only 0.01% of the nearly 4 trillion megawatts hours produced from all sources. Despite the fact that solar capture capability has been around for more than 100 years, it’s safe to say that solar is still just getting started.
The limited supply and rising demand of polysilicon has driven revenue growth for suppliers such as MEMC Electronics (WFR). We believe that demand will remain strong and supply somewhat constrained for the foreseeable future creating a positive outlook for the company. There are several solar companies that we track including JA Solar (JASO), Suntech (STP), and Sun Power (SPWR).
Most industry experts believe that with increased investment in solar, and improved manufacturing techniques, costs can be reduced to $0.08 to $0.10 per kWh in the next several years. New innovations from companies like First Solar (FSLR) and Nanosolar have potential to significantly change the economics of solar. These companies have developed thin film solar cells that don’t require the use of expensive polysilicon. These new technologies are slightly less efficient, but thin film has the benefit of being able to be incorporated into building materials, including windows, and if costs can be reduced relative to polysilicon implementations, the opportunity is significant.
Despite the limitations, solar does work and can augment supplies from fossil fuel sources. Typical implementations connect a solar installation at a business or a residence to the electrical grid. By connecting to the utility, solar installations can send surplus electricity generated during the day back into the utility system and electricity needed at night, for example, can be drawn from the grid powered by fossil fuels. For an isolated solar installation that is not connected to the grid, batteries are required to provide electrical power when sunlight is not available.
Google has built a solar array on the roof of the buildings at the company’s campus in Mountain View, California. The panels generate up to 1.6 megawatts at peak solar levels and have been projected to reduce the electricity demand at the campus by as much as 30% on sunny days. For companies the government incentives are significant to making solar cost effective. There is a 30% Federal Investment Tax Credit and the IRS provides a five-year accelerated depreciation schedule for the installation.
Currently the use of solar for the consumer is made economical through aggressive rebate programs in states like California and Colorado. In California current electricity rebate incentives require the utilities to pay $2.50 per delivered watt of unused power during the day. In addition there is a rebate for the installation and a $2,000 federal income tax credit. Lastly the state requires that investment in solar power cannot be used in calculations for property tax appraisals. These government subsidies have been critical to making solar economically viable.
Capture and Storage TechnologiesCapture and storage technologies are compelling because they enable us to continue to utilize our existing infrastructure and abundant fuels while eliminating CO2 emissions. Privately funded companies such as Green Fuel Technologies in Cambridge Massachusetts have a process to remove CO2 emissions from coal power plants. The idea is to absorb the carbon emissions and deposit them back in the ground where we got them from.
There are numerous initiatives under development and each has drawbacks. For example, while GreenFuel Technologies has a process that can remove up to 80% of carbon emissions from a coal fired power plant during daylight hours, it requires a significant amount of real estate. Emissions from the power plant are piped into a massive greenhouse growing algae that absorbs carbon gasses through photosynthesis. As a byproduct, the algae can be harvested and converted to biofuel. There are huge discrepancies by the experts on the potential economic cost of carbon capture. The Department of Energy has published estimates of 10% of generation costs while the Intergovernmental Panel on Climate Change has estimated the cost to effectively capture carbon emissions will increase power generation expenses 180%.
An Automobile Obsession
Oil seems to spend a disproportionate amount of time in the headlines relative to other fossil fuels. Our love affair with the automobile, concerns about the limited supply of oil, the cost of gasoline at the pump, and the fact that a significant quantity of our oil is now imported from abroad has assured oil’s position as our most publicized energy source. In the past, high oil prices have put pressure on our economic growth and even started economic recessions. Recently the price of crude oil has increased dramatically with the Energy Information Administration now forecasting crude to average $110 a barrel for 2008. That’s an increase of 51% over 2007 and 400% from 2002. Gasoline is forecast to average $3.52 in 2008, up 25% from 2007. Despite the dramatic increase, it’s only recently that the inflation adjusted price of gasoline has finally eclipsed the highs of 1981. Oil, and as a result gasoline, has been inexpensive for more than 20 years. It has now become apparent that these higher prices are likely to be sustained. The EIA now forecasts a stabilization of prices in 2009 with an average gasoline price of $3.44, this represents only a 2.2% decline from 2008. Increased prices, more than congressional efficiency standards or concern for global warming are shifting consumer demand for greater fuel efficiency and even alternatives to the gasoline powered car.
The global oil supply system is operating near full capacity and demand continues to increase with China leading the growth, adding an estimated demand for 400,000 barrels per day in 2008. Global consumption is projected to grow by 1.2 million barrels per day over 2007 and in the U.S. demand is actually projected to decline marginally due to higher prices. In 2008 the decline in gasoline consumption is projected to be down 0.4% or 330,000 barrels per day.
There have been longstanding concerns that the day we reach peak global production for oil may be in the near future. The thinking is that all of the truly large oil deposits have been found and due to new technologies many of the harder to reach deposits have been tapped. New oil discoveries that add to the global reserves shrink every year despite improved technology to locate deposits. Meanwhile, consumption continues to rise. No one can say for sure when oil production will peak and begin declining but there does seem to be a consensus that the day will be sometime between ten and forty years from now. While that seems like plenty of time, remember that production growth will slow long before it declines and as recent price increases demonstrate demand will outpace supplies.
Although the efficiency of the internal combustion engine is limited by the physics of thermodynamics we have been able to improve the performance of vehicles over the last 100 years. However, over the last 20 years due to cheap gasoline, consumers have demanded size and power over fuel economy. In 1987 the average fuel economy for passenger vehicles was 22 miles per gallon up from 13 mpg in 1975. In 1997 the average declined to 20 mpg as horsepower and weight increased. In 2007 horespower and weight continued to increase while average fuel efficiency remained 20 mpg.
A Personal Experience in Inefficiency
Any gains in efficiency have been used to increase performance, allowing the average vehicle to accelerate to 60 mph in less than 10 seconds instead of the 14 seconds it took back in 1975. We have a 1972 Datsun 240Z in our family. Datsun was the forerunner of Nissan Motor and the 240Z is a small two seat sports car. The car was a stock configuration with 2.4 liter six cylinder motor that produced 151 horsepower and had a top speed of 125 mph. The average fuel consumption was 21 mpg.
The current Nissan 350Z is the present day model derived from the original 240Z and is similar to the original. It is small, sporty, and still has only two seats. Of course the motor is bigger. The displacement has been bumped up to 3.5 liters and with the help of modern electronics and tuning the motor cranks out 300 horsepower, doubling the power of the original. The increase in displacement and power was not solely to provide more power to the consumer’s insatiable demand to accelerate faster, however. Much of the increase was necessary to maintain any performance at all. First of all, there is a lot of new equipment that has been added to the car over the years, much of which is safety related. The original car had only a lap belt with a detachable shoulder strap which was cumbersome to use and few people did. There were no airbags. The bumpers were chrome and looked nice but didn’t do much to protect the occupants. Obviously there was no navigation system, seat heaters, power windows or even factory installed air conditioning. In 1973 California started requiring emissions control equipment which improved the air quality in the Los Angeles basin greatly but sapped some power in the process. All that weight adds up. The 1972 car weighed 2,355 lbs while the 2007 model tips the scale at 3,370 lbs. That is a 43% increase over the original. Add the reduction in performance due to emission control and you need a much bigger motor just to maintain performance. But consumers do not want to merely match the performance of their old car with the new, they want to see improvement. The 2007 model can go from 0-60 in 5.8 seconds versus 8.0 seconds in 1972. It also has a top speed of 155 mph, but that is only because the speed is electronically limited to keep some sense of sanity. Despite all our efficiencies the new car gets an average mpg of 22. With 36 years of innovation and you get a single mile more out of every gallon of gas. Of course the average 22 mph that is achieved in the EPA test does not reflect how most of us will drive the car. We never saw better than 17 mpg driving in the city. Must be our driving.
Rise of the Hybrid
Certainly the purchase of a hybrid vehicle would have been sensible. Hybrid vehicles have recently come into their own. Through April 2008, four of the top ten selling cars are hybrids. Toyota, in particular has dominated the hybrid market with both the Prius and the Camry. Auto sales have slowed dramatically in the U.S. in 2008 except for small passenger cars. The small vehicle segment showed more than 7% growth over 2007 while SUV vehicles declined more than 22% over the same period.
