Seeking Alpha
Richard Shaw, QVM Group (46 clicks)
Profile| Send Message| ()  
In 2006, major corporations, venture capitalists, investment banks, and hedge funds spent a record $71 billion worldwide on renewable energy, according to New Energy Finance, a London research firm. That $71 billion was a 43 percent increase over 2005. They estimate that 1,250 private equity funds target environmental projects.

However, there are significant limits that alternative energy will face that may not be given full consideration today in the headlong rush of politicians promising change, activists demanding change and investors speculating on change . If it were all that easy, you might expect major energy companies to have taken a bigger bite by now.

Fortunes will be made and lost on the new alternative energy theme. Thematic investing suffers from crowd behavior. When a theme is elevated by something like a Presidential speech, the theme is likely to experience short-term benefits elevating both high and low potential companies.

Some companies will prosper and some, perhaps most, will fail or fail to blossom into a big investor wins. Like the dot.com boom-bust cycle, some first movers will become fabulously successful, but most first movers will become failed experiments or footnotes in history.

Bigger is Better: In energy, bigger is better and the biggest of the big are in the action now. The larger companies have the financial strength to surpass the first-mover pioneers when they feel the time is right. They have the time to wait to see what works and what does not, to begin after the pioneers have proved a technology or market concept. The larger companies have the ability to commit the huge capital sums required to be economically efficient. Energy is capital intensive.

Large-cap companies will likely be the dominant players in the final alternative energy markets. Examples may be:

• Archer Daniels Midland (ADM) – the largest ethanol producer
• General Electric (GE) - $1.5 billion invested in renewable energy, mostly wind power
• Total (TOT) – bio-diesel producer

Surviving Pioneers Win Jackpots: Successful pioneers will likely see greater percentage price appreciation due to alternative energy than the very large cap companies whose successes will be diluted by their other traditional lines of business.

If pioneers are your choice, it will be quite difficult to know who will win and who will lose. Losses are always difficult to recover, and the probability and potential severity of losses with new technology is essentially unknown. Therefore, it is probably prudent to find ways to invest in a basket of alternative energy companies through a fund. The result will be less spectacular than selecting the ultimate winners in advance, but the potential for huge losses will be reduced by diversification across alternative energy types and different companies in within each energy category.

Theme Funds Hard to Find:
Currently, you might find more pure theme investing in social responsibility funds focusing on energy, such as New Alternatives Fund (NALFX), than in other investment funds. Regular mutual funds or ETF's, such as, PowerShares WilderHill Clean Energy (PBW), sound like an alternative energy fund they may not be pure plays. PBW, for example, invests in a number of companies with only tangential relevance, such as Applied Materials (AMAT) and Cypress Semiconductor (CY). Alternative energy funds are relatively hard to find at the moment, but wait and they may blossom like mushrooms.

Traditional Energy:

Key traditional fuels in the United States are (example companies in the field in parenthesis):

• flowing water (*),
• coal (Peabody Energy (BTU)),
• oil (Exxon (XOM)),
• natural gas (ConocoPhillips: (COP)),
• nuclear materials (Cameco (CCJ)),
• geothermal heat (*).

* There are smaller companies in flowing water (dams and tidal) and geothermal, but we do not know enough about them to mention names here.

Major Alternative Fuels:

• ethanol (Archer Daniels Midland and VeraSun (VSE)) ,
• bio-diesel (Total),
• wind (General Electric (GE)),
• coal gas (SASOL (SSL), Peabody watching opportunity),
• coal liquefaction (**),
• synthetic crude from oil sands (Suncor Energy (SU), ConocoPhillips and EnCana (ECA))
• synthetic crude from shale (Royal Dutch (RDS.A))

** We aren’t certain, but it appears that the major oil companies such as Royal Dutch Shell are doing more with coal liquefaction than the coals companies.

Bumps in the Road

Traditional Fuels: We know that there are finite resources of oil, natural gas and coal, but just when and how they will run out is a matter of debate. Coal certainly will not run out in an investing timeframe.

Oil seems to be the most limited in terms of actual reserves. Natural gas seems limited in terms of ability to capture and transport it to market economically from many locations. Coal is limited by its ash, heavy metals, radioactivity and sulfur emissions.

Coal on the other hand is in abundant supply in the United States and there are some promising alternative gas and liquid fuel derivatives from coal.

We need to keep in mind also that crude oil is not only used for energy, but also as manufacturing material inputs for such things as plastics, solvents and even as a key ingredient to tar used in road construction. If it were possible to substitute other fuels for crude oil, the impact on the costs of materials made from oil would be favorable.

Ethanol & Bio-Diesel: Similar to the fuel/materials tradeoff with oil, there is currently a fuel/food tradeoff with ethanol and bio-diesel.

Corn is the key feedstock for ethanol in the U.S (sugar cane is the lead feedstock in some other countries), yet corn is also a key feed for animals. As we create duel uses for corn, one for fuel and the other as food for animals and for humans, the food component of the cost of living will rise, perhaps more than the savings in fuel costs. We can see that effect today with a doubled price per bushel of corn.

Mexico has a corn cost problem now with public unrest over tortilla price inflation. China has expressed intent to limit use of edible grains for fuel use to protect their food supply.

One expert in a recent Barron’s article said that there is not enough corn grown in this country to meet the ethanol goal the President articulated in his recent State of the Union address – that's with no corn left to eat. Similar problems with soybeans would likely arise if bio-diesel were to catch on in the U.S.

There is no free lunch with ethanol and bio-diesel. If we do it wrong there may be no lunch at all. There are efforts under way to make waste cellulose into ethanol, but so far the process is experimental and not economic.

Wind Power: Wind has at least two major limitations. First, it can only be generated economically where there are sufficient consistent winds. That makes wind powered electricity location limited as is geothermal and hydro-generated electricity. Second, there are significant problems with “bird-kill”. That bird-kill has the potential to create population changes in birds, particularly migratory birds, that could have great knock-on consequences for all manner of environmental and possibly food chain issues.

Synthetic Crude from Oil Sands: Synthetic crude represents a huge non-renewable energy source in North America – safe from the geopolitical risks of war or effective nationalization found in the major exporting areas of the Middle-East, Nigeria, Venezuela and Russia.

Canada’s oil sands have more oil in them than there is oil in Saudi Arabia. Those sands are under rapid development with the major companies hard at work. The limitation that comes into play is the enormous requirement for natural gas as an input to extracting the oil from the bitumen mined from the oil sands, and the environmentally dangerous levels of CO2 released in the process. While there is hope for ways to either sequester the CO2 or to capture it and use it in traditional oil extraction in older wells, the environmental damage done by the CO2 is of great concern to the Canadian government. Natural gas supplies and CO2 output are current limits on the development of the oil sands.

Synthetic Crude from Oil Shale: Oil shale is a major US asset in the western part of the country. To date no projects have been economic. Royal Dutch has been a leader in that effort. The amount of water and the amount of electricity required to extract the oil from the shale is so great that there is a threat to farmers who need the water to grow crops and to the residences and businesses that need electric power. There is a limit to oil from shale based on water supplies and electricity supplies.

Coals Gas and Coal Gas-to-Liquids: Coal is massively abundant in the US and in its traditional form could meet many of our power needs, but it is highly polluting. Some Chinese cities are literally choking in air polluted by coal. However, coal can be gasified and liquefied to replace natural gas and oil. Those processes have great promise.

During World War II, the Germans used coal liquefaction to produce an oil substitute because their traditional oil supplies from the Middle-East were blocked. Cost was not an issue then, but it is now.

Coal liquefaction and gasification are economic as an oil substitute with crude oil at about $35 per barrel. At current oil prices in the 50’s, coal gas and coal liquid synfuel look attractive.

CONCLUSION:

We will bet our money on established major companies when it comes to both traditional and alternative fuels. We would rather participate in the scarcity premium that petroleum will generate and the general demand growth for coal, while earning reasonable dividends.

Ultimately, we will participate in any shift to alternative fuels through the major companies that we believe will be the key inheritors of control of whatever alternative fuels come into their own. While we aren’t making a current recommendation, we like companies such as ADM, COP, and BTU for long-term alternative fuel plays, rather than unseasoned IPO’s or locked-up venture capital or private equity. Conservative for sure, but less likely to lose hard earned money. Better balance of risk and reward for us.

Source: Alternative Energy Boom Has Its Limits