A Realistic National Energy Policy and What It Means for Investors

Includes: CHK, DVN, GAZ, UNG, XOM
by: Iman Investor

If a picture is worth a thousand words, then the EIA’s illustration of the 2009 U.S. Primary Energy Flow (see below) should be able to give every citizen an instant education on the basic framework of how we supply our domestic economy and our standard of living. It should also be able to stop a significant amount of the ill-informed conversations about our energy problems and the unrealistic “green energy” solutions.

This EIA illustration may be a little confusing at first, but it provides an enormous amount of information for understanding what a realistic energy policy could or should look like. For example, one should be able to see that replacing a meaningful amount of the 35.3 “quads” of petroleum will require a domestic source that has the capacity and scale to do so. Natural gas (“NG”) is the obvious replacement source for some of the 27 quad Btus in “Transportation” demand because it is the only practical fuel source that has the (transportable) energy content to power heavy, mobile equipment (i.e. see The Pickens Plan).

One should also be able to observe from the EIA illustration that the renewable energy quads will have little-to-no impact in solving our energy problems. Unfortunately, it doesn’t matter if you believe man-made CO2 causes global warming or not. Due to low-grade energy content, certain renewable sources are just not meaningfully scalable to replace a material amount of the other quad Btu sources. A closer look at the 7.7 quad Btus of renewable will show why this is true, if your eyes don’t believe the EIA illustration.

Primary Energy Flow by Source and Sector, 2009 (Quadrillion Btu):

TOTAL = 94.6 Quad Btu

After that short introduction, we are now ready to establish a simple, realistic national policy that will provide affordable, domestic energy to power an economy that must compete globally while still having a chance to fund services and entitlements promised to the citizens.

Step 1. Stop all taxpayer subsidies to wind, solar, and ethanol. This may have some people falling out of their chairs and clutching their chests, but we have to be responsible adults about this and recognize that wanting the green energy dream to be true doesn’t make it so. Here is the link.(pdf) to the EIA illustration for renewable energy consumption.

If you go to PDF p2 and look in the lower-right portion of the page, you’ll find a breakdown of the various renewable sources that comprise the 7.7 quad Btu (which is 8% of the total 94.6 quad Btu). The first thing you should notice is the 2.7 quads of hydroelectric power and the 1.9 quads of wood represent 60% of the renewable total. 60%. Surprisingly, wind and solar are only incremental sources within the renewable category at a total of 0.8 quads -- or just 10% of all renewable sources and <1% of all sources. So, after spending billions of taxpayer money, how can anyone seriously think wind and solar will have any real contribution to our supply sources? Are they even worthy of being included in a realistic energy policy?

What about ethanol? According to a 2007 EIA subsidies report, ethanol/biofuels received a subsidy of $5.72/mmbtu. Ironically, the spot price for NG was $3.79/mmbtu on 3/11/11. Putting aside the argument that ethanol is a net user of Btus (i.e. needs more energy than it creates) and contributes to global food inflation, how can it be deemed a renewable source when it requires NG to process/burn the corn into ethanol. Without NG, you can’t have large ethanol output. How can this be considered a sustainable, green energy source? Why spend all that capital on building ethanol processing plants when we could just burn the NG directly in our heavy transportation fleet? Wouldn’t that be a more economical way of reducing imported oil?

The underlying economic fundamentals of certain renewables can be summed up in two words: wasteful duplication. Wind and solar megawatts do not replace the need for dependable fossil fuel megawatts. A simple illustration of how wind turbines are a wasteful duplication would be for the government to force you to buy a car that doesn’t start-up all the time or, when it does, it’s usually in the middle of the night when you’re sleeping. The unpredictable and untimely run-time of this car requires you to buy a second car as a “back-up” so you at least know you have dependable transportation to get to work. In the end, you really only need one car, but the government policy is causing you to buy a second car, which unnecessarily doubles your cost.

Step 2. Convert the heavy transportation fleet to natural gas. 25.4 Quads, or 72%, of the petroleum supply is used for transportation and 7.7 of those Quads come from diesel/distillates. It would take ~7.5Tcf/year in NG to displace all of the 7.7 Quads of distillate fuels used in 2009 and would increase NG demand to ~30Tcf/year. Based on the abundance of NG shale, it seems like this supply source has the scalability to absorb the demand from a diesel-to-NG shift. There are a number of benefits that come from this conversion including the creation of US jobs in the NG-related industries, royalties to landowners, taxes paid to the government, and a net improvement in the US trade deficit.

Step 3. Look to coal and nuclear to supply future increases in electric vehicle demand. Assuming we have a material shift to electric vehicles over the next 20-25 years, the only economically reasonable supply sources that have the capacity and scale to service this new demand would be nuclear/coal-fueled baseload plants. Before you fall out of your chair again, just understand that any material shift to electric vehicles will create material changes in the demand curve for electricity. This is going to be a good thing in terms of capital expenditures and operating costs. For example, overnight demand (i.e. off-peak hours) could someday increase to the levels of demand needed during the day - as more and more cars are recharged at night. This would cause the “demand curve” to flatten out which would mainly require cheaper baseload megawatts to service electricity demand 24/7 versus having extra megawatts built to just service daytime peaks in demand. The increased cost of electric cars will be more manageable if we have an inexpensive fuel source that can offset that cost.

There were 17.1 Quads of petroleum used for passenger cars in 2009. It will be very expensive to shift even 1 Quad to wind and solar considering there were only 0.8 quads from those sources in 2009. So, if we were to shift 7 of the 17.1 Quads from petroleum to electricity, the most economical way would be to work with the existing baseload fleet and repower old coal-fueled sites with new, super-critical boilers that produce 20-30% less CO2. The side benefit would be a reduction in new routes for transmission lines.

The only way we will be able to realistically reduce some of the 35.3 Quads in petroleum demand (24.8 Quads for ground transportation) is to shift to supply sources that can handle it – i.e. NG, coal and nuclear. Believing in the dream of renewable energy while ignoring the realities of our petroleum demand is no way to run the world’s largest economy.

What should an investor do?

First, investors as individuals have little control over how the government intervenes into the energy markets on a state and federal level. So, "Step 1" is out of your hands. As for Step #2, this is where it could get interesting over the near, intermediate, and long term. The logical choice is to invest in the E&Ps that are holding significant NG reserves. Although the NG forward pricing curve looks unattractive in the near-term, the NG-focused E&Ps seem to be dropping NG drilling rigs and moving them to oil-rich regions in the U.S.

In the intermediate and long term, NG is going to be viewed as the "go to" fuel that can fill numerous roles in the energy supply chain. Consequently, demand for NG should continue to increase -- if we are serious about shifting imported oil demand to another domestic supply source that can handle it. Further, in light of the events in Japan, we'll likely see more delays in growing nuclear-fueled electricity. And, with the current political views on coal and CO2, the development of NG-fueled electricity will likely be the path of least resistance.

So, in summary, the current downward trend in NG drilling, coupled with the knowledge that there are limited domestic supply sources that can realistically power our economy (and our mobility) makes E&Ps the most logic place to invest over the near, intermediate, and long term. These companies would include CHK, DVN, and XOM.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.