One of the consequences of working in as esoteric a field as biorenewables is that you don't get many opportunities to write about the larger-than-life figures in finance. I was therefore quite surprised to see Warren Buffett's lesser-known partner and Berkshire Hathaway's (NYSE:BRK.A), (NYSE:BRK.B) Vice-Chairman, Charlie Munger, come out strongly against U.S. energy independence in a recent interview. While the interview is worth reading in full, this statement in particular caught my eye:
"And it is not at all clear that there is any substitute [to petroleum-based hydrocarbons]. When the hydrocarbons are gone, I don't think the chemists will be able to simply mix up a vat and there will be more hydrocarbons. It's conceivable, of course, that they could but it's not the way to bet. I think we should all be quite conservative and we should pay no attention to these silly economics and politicians that tell us to become energy independent."
Let me start by saying that I have nothing but the utmost respect for Mr. Munger. I didn't take a serious interest in investing until reading Benjamin Graham's "The Intelligent Investor," which set me on a course to learning about Buffett and Munger's exploits at Berkshire Hathaway. With that said, Mr. Munger's statement could not be more wrong, particularly when used to justify our continued dependence on foreign petroleum. Michael Fitzsimmons has already done a nice job of considering Mr. Munger's argument from the perspective of U.S. fiscal policy (a stance that was covered at greater length by The Economist in 2009), so I'll limit myself to a discussion of why Mr. Munger's analysis is deeply flawed from a scientific and investment perspective.
The hydrocarbon economy
At first glance, Mr. Munger's logic is strong. The last century witnessed a transformation of transportation fuels from biomass (animal feed) to fossil fuels, particularly petroleum. It didn't take long to discover that the petroleum refining process employed to produce transportation fuel hydrocarbons (primarily alkanes) also yields other hydrocarbons (alkenes and aromatics) that can be converted into a wide variety of useful products. Today these "byproduct" alkenes and aromatics are heavily used to produce fungicides, petrochemicals, plastics, pharmaceuticals, and a number of other products that have become essential to modern life. To say that we live in a "hydrocarbon economy" is a reference to far more than just our use of hydrocarbon-based transportation fuels; I doubt it is an exaggeration to say that virtually nobody in the developed world goes a single day without using at least one hydrocarbon-based non-fuel product that didn't exist prior to the invention of petroleum refining.
For this reason I agree with Mr. Munger's argument that it is unwise to pursue alternative energy sources at a time when petroleum is still widely available (albeit not as inexpensive as in the past). Most of the technologies proposed to replace petroleum today, whether fuel ethanol, hydrogen fuel cells, biodiesel, hybrid vehicles powered by renewable electricity, or CNG/LNG are actually mere substitutes rather than true replacements. In addition to being unable to utilize the existing transportation fuel infrastructure, not one of these alternative pathways is capable of contributing to the hydrocarbon economy. Only a fraction of each barrel of petroleum is refined to produce the blend of hydrocarbons we call gasoline and diesel fuel that these technologies serve as substitutes for (see figure below). The rest is used to produce jet fuel, petrochemicals, asphalt, and a number of other ubiquitous products.
One consequence of using transportation fuel substitutes rather than true replacements is that they ultimately distort the economy. We have already witnessed this in the U.S., as ethanol has displaced a growing percentage of gasoline consumption. Ethanol only substitutes for the gasoline fraction of each barrel of petroleum, but by reducing the refining incentive, displaces the entire barrel. Plastic prices have increased far more than the historical relationship between the prices of petroleum and plastics would indicate; a similar trend has developed between the prices of alkanes and alkenes as well (see chart). This price disparity is the result of ethanol being used in place of 10% of gasoline; a broader switch to one of the aforementioned alternative fuels would cause a much more significant distortion.
Historical ratio of alkane prices to alkene prices. Source: Brown et al. (2012).
Vats of hydrocarbons
One of the primary reasons that hydrocarbons are so useful is that they are generally monomers, or a single molecule, consisting of varying amounts of hydrogen and carbon (hence "hydrocarbon"). Not only can monomeric hydrocarbons of one type be converted to monomeric hydrocarbons of another type -- for example reacting an alkene with hydrogen yields an alkane via a process known as hydrogenation -- but monomeric hydrocarbons are also easily formed from materials that are in abundance throughout nature.
While petroleum refining was quickly identified in the early 20th century as one of the least expensive means of producing the alkanes that are blended to produce transportation fuels, it is far from the only source. After all, hydrogen and carbon are both prevalent both in the Universe and on Earth. The primary component of natural gas is the hydrocarbon methane -- CH4. Biomass is comprised of carbon, hydrogen, and oxygen, so remove the oxygen (either catalytically or via hydroprocessing) and you're left with -- you guessed it -- hydrocarbons. By biomass I'm really referring to just about any living matter. Lipids, whether animal processing fats, waste cooking oils, or dedicated oil crops are already being hydroprocessed to yield diesel fuel on a commercial-scale (not to be confused with biodiesel, which contains oxygen and is thus a fatty ester rather than a hydrocarbon). Woody biomass is being pyrolyzed (i.e., rapidly heated in an oxygen-deprived environment) to produce an intermediate liquid product that is then refined to alkanes, alkenes, and/or aromatics. Microbes have been engineered to convert sugars to monomeric hydrocarbons rather than ethanol, a process that several catalysts have also been identified of being capable of. So when Mr. Munger says "I don't think the chemists will be able to simply mix up a vat and there will be more hydrocarbons," he clearly doesn't realize that thousands of chemists, engineers, and biologists in the U.S. alone are doing so on a daily basis.
The price argument
A common argument against the development of biorenewable hydrocarbon pathways is that technical feasibility and economic feasibility are not one and the same. I cannot (and will not) dispute this. Petroleum attained its dominant position in the hydrocarbon economy due to both plentiful access and low prices; biorenewable hydrocarbons struggle to compete at the current $100/bbl price of petroleum, let alone the much lower prices seen back in 2009 and 2010. Forcing consumers to favor a higher-priced domestic source promotes economic inefficiencies and harms consumer welfare. Autarky has a long and sordid history in the annals of human history and I suspect that this background influences Mr. Munger's position on energy independence.
But is petroleum really the cheapest alternative available to us? This in part depends on how you account for taxes levied on the petroleum industry. The actual tax rates paid by the largest petroleum companies were well below the nominal tax rate for similarly-sized firms in 2011, although these increased in 2012 on the back of large profits. The indirect costs of relying on foreign petroleum must also be accounted for. An older report from the National Defense Council Foundation estimated that accounting for the military outlays spent on protecting the petroleum shipping lanes in the Persian Gulf would add $1.17/gal to the retail price of gasoline. Other analyses have also accounted for the costs of military conflicts in the Middle East, although it is debatable as to whether or not these would have occurred were petroleum not present there. Finally, there are the costs of environmental harm caused by the petroleum industry. All of these costs are externalities in that they are generally paid for by taxpayers rather than consumers. That doesn't mean that they should be ignored; if anything, the current U.S. fiscal situation makes it more important ever to account for them when determining the real cost of imported petroleum.
Conventional petroleum reserves by country. Source: Brown and Brown (2012)
Biorenewable hydrocarbons look far more attractive when viewed from this perspective, with "biorenewable" being the operative word here. Mr. Munger's argument that we should use foreign petroleum as a means of conserving our own (relatively) limited reserves of conventional petroleum is predicated on his belief that the domestic reserves will eventually be needed to keep our hydrocarbon economy going (and as he put it, "running out of hydrocarbons is like running out of civilization"). The very definition of biorenewable hydrocarbons eliminates this concern of finite supply since the feedstock is continuously regenerated. The U.S. has vast reserves of lignocellulosic material that neither compete with conventional agricultural crops nor contribute to atmospheric greenhouse gases on a lifecycle basis. When harvested sustainably these reserves are capable of regenerating themselves ad infinitum. Many of these biorenewable hydrocarbon pathways are competitive at current energy prices, particularly when direct and indirect petroleum subsidies are accounted for in the prices of gasoline and diesel fuel.
Opportunities for investors
As mentioned earlier, a number of universities and companies are pursuing the development of biorenewable hydrocarbon pathways. The largest of the publicly-traded companies doing so is KiOR (KIOR), which uses catalytic pyrolysis and hydrotreating to convert woody biomass to gasoline and diesel fuel. The company began operations at an 11 million gallon per year [MGY] facility employing the pathway late last year and intends to begin constructing a 41 MGY facility in late 2013 or early 2014. KiOR's catalytic pyrolysis pathway is unique because of its flexibility. While the company intends to produce alkanes, which qualify as cellulosic biofuel under the revised Renewable Fuel Standard [RFS2], the catalytic pyrolysis pathway has also been identified as a means of producing both aromatics and alkenes. This flexibility provides the company with a certain amount of security in the face of political and macroeconomic uncertainty. In the event that either the RFS2 is repealed or one of the aforementioned gasoline and diesel fuel substitutes gains traction in the U.S., KiOR will be one of the few biofuel producers employing a pathway that is capable of switching between alkane, alkene, and aromatic products in response to changing market conditions.
Amyris (NASDAQ:AMRS) and Solazyme (NASDAQ:SZYM) are two companies that employ microbes to convert sugars to alkanes. Amyris uses a genetically-engineered microbe to convert sugars directly to farnesene, which in turn can be converted to diesel fuel or jet fuel. Solazyme uses microalgae to convert sugars to lipids, which are then hydroprocessed to yield alkanes. Solazyme can produce gasoline, diesel fuel, and jet fuel, although the latter two products are ideal for its pathway. Both companies produce hydrocarbons that are suited for both fuel and non-fuel products. Furthermore, Solazyme's alkanes can be converted to alkenes, although this comes with both increased costs and efficiency losses. For this reason they are not as suited as KiOR to take advantage of rising alkene prices resulting from an effort to reduce hydrocarbon fuel consumption. An additional disadvantage is that both companies are pursuing production in Brazil to utilize inexpensive sugarcane as feedstock, reducing their ability to claim that they are contributing to U.S. energy independence.
Amyris, KiOR, and Solazyme have all performed poorly over the last year in the face of a challenging market (see chart). KiOR has fared the worst as its cash reserves have recently run low and the company has raised the prospect of financing its 41 MGY facility via the issuance of additional shares. Amyris shares fell from nearly $35 in 2011 to a low of $1.59 in 2012 over scale-up difficulties. Solazyme has fared better since its IPO than Amyris and KiOR but has still fallen by almost 50% from its 2011 highs in the face of a challenging political environment, particularly during the 2012 election cycle. The sharp falls in the prices of all three securities since their IPOs illustrates the dangers of investing in small-cap biorenewable firms. No matter how attractive the pathways and future operating conditions, only those companies that survive both the Valley of Death and Valley of Dearth will ultimately see profits.
Finally, it's worth mentioning the joint ventures that have been set up in the U.S. to produce renewable diesel from lipids. While similar to Solazyme in that all convert the lipids to alkanes via hydroprocessing, they are not capable of utilizing lignocellulosic feedstocks. These JVs are Dynamic Fuels -- a JV between Syntroleum (NASDAQ:SYNM) and Tyson Foods (NYSE:TSN) -- and Diamond Green Diesel -- a JV between Valero Energy (NYSE:VLO) and Darling International (NYSE:DAR). Both JVs operate commercial-scale facilities in the U.S.
Charlie Munger's argument that energy independence is a bad idea is predicated on the mistaken belief that chemists are unable to "simply mix up a vat" of hydrocarbons from sources other than petroleum. As this article demonstrates, biologists, chemists, and engineers across the U.S. (and world) have developed a number of pathways for doing just that. Several of these pathways produce hydrocarbons from plentiful biorenewable sources such as lignocellulose, countering Mr. Munger's argument that energy independence is a bad idea since we need to carefully marshal our own scarce reserves of conventional petroleum. Furthermore, these pathways are also capable of producing hydrocarbons used in a variety of products, both fuel and non-fuel. Not only is it possible to produce hydrocarbons in the U.S. without depleting our domestic petroleum reserves, but such production is already occurring. Investors willing to tolerate a high level of risk have a number of options available to them for taking part.