Energy: The Technology Industry's Newest Sector

Today, there may be more value in viewing energy as a technology rather than a natural resource industry. There is a strong theory, proven by historical events, that energy (and other raw materials) decline inexorably in cost over time. Despite our intuition, natural resources (energy included) are not in any way finite or scarce. Our notions about declining supply and scarcity are deeply rooted in our individual experience of shrinking production from an oil well and sparser lodes of ore from existing mines. However these individual notions are the opposite or our collective experience throughout history. The implications are not only lower energy costs going forward, but also great advances in innovative solutions and new technology.

Julian Simon, noted professor at Maryland University and senior fellow at the Cato Institute, spent several decades researching and documenting these findings, which include the impacts of human population growth on raw materials cost, pollution and bio-diversity. His work, while controversial, has never been disproved. Despite the truth these theories do not garner as much attention from analysts, economists and investors as near-term price fluctuations and old-fashioned notions that black pools of oil left by the dinosaurs will run out and leave us with secular increases in energy costs.

These ideas strike people as objectionable or unsatisfactory because we don’t want to be complacent about our planet. Particularly in areas that inspire emotions like global warming and shrinking bio-diversity, people wrongly take these theories to mean that we should do nothing and the problems will simply go away. Simon’s Law says quite the opposite and acknowledges the collective power of society to focus on and solve problems by applying our best efforts to what is most important. There’s no reason to believe the outcome this time will be any different than it has been during the last few thousand years.

We will spare our readers a pile of statistics on inflation and energy prices but two things should be noted. The first is that the Department of Energy statistics on global supply and demand show that oil is a very orderly market; supply equals demand with very little difference, year after year. The second is that the recent increase in crude prices reflects more of a reversion to the mean from very low prices a few years ago. In 2003 crude was selling about the same price it did in 1983 ($26/bbl) despite the fact that inflation figures would allow crude to trade at more than double that figure and still be well within the envelope of a long-term decline in real energy prices. After four years of major increases (+22%, +41%, +19% and +25%) the 2006 average price of $58/bbl is still not abnormal. However we can’t resist pointing out that since 1949 we have never had four straight years of double-digit price increases and past declines warrant preparation for $30/bbl prices in the next few years.

Today we can already see the forces that Simon outlines beginning to drive the changes that will lead to a larger, more efficient energy industry. First and foremost is the huge wave of financial and intellectual effort now mobilizing into energy. Of course traditional energy companies themselves are stepping up their investments in exploration and production. Increases in extraction rates are coming from the application of newer 3D imaging techniques, steam injection, smarter drills, better pipes and a myriad of other tricks that are worth the effort at current oil prices.

Venture capital investments into innovations around energy more than doubled in 2006 to $1.8B invested in 183 companies. The increase was even greater in the alternative energy sub-segment, which jumped 272% to $727M in 39 companies. It’s easy to foresee another big increase in 2007 based on current levels of activity and enthusiasm for the sector. Thankfully for venture capitalists the virtuous cycle has just received a major boost from the $2B acquisition of Horizon Wind Energy by a Portuguese utility company. Large companies like GE, ADM, the automobile manufacturers and the semiconductor material and equipment providers are also shifting more of their spending on alternative energy sources.

The ultimate success of new innovation in energy depends on the development of a large and viable marketplace. Public attitudes and the political environment for creating incentives and subsidies for new forms of energy supply and conservation has probably never been better. This is necessary now because if one simply runs the numbers on making use of solar panels on a residential property they don’t suggest a very attractive return. Tom Evslin at Fractals of Change has done a complete analysis for his own situation taking account of installation costs as well as the ability to take advantage of higher time-of-day rates which gives solar an edge of wind. After all is said and done the current ROI appears to be about 2% in his circumstances. Of course over time we can expect the initial investment per watt of solar faceplate to decline.

More help is on the way from none other but our favorite financial innovators, the investment banks. In particular Goldman Sachs has created a structure whereby a large commercial customer can switch to solar without having to make any capital investment or worry about ongoing maintenance of the system (handled by a third party). They do have to sign a long-term supply agreement but at rates already lower than what they are paying now. Structures like this are so attractive that they can drive the commercial industry forward into solar with some force.

Local providers are starting to figure out that they can build franchises around this business in the residential sector. There are already emerging providers like Ready Solar springing up that provide a simple kit that can be easily installed by general contractors. Some utilities may enter this market as well as they have done in the past with energy efficient appliances. Small financial services companies are creating a package that includes analysis and financing for homeowners that takes into account the numerous incentives and tax breaks available in many states along with low-cost home equity financing. (What a great way to create jobs for all the unemployed sub-prime mortgage agents!)

There is also an attenuation of demand that comes from a huge number of small improvements from use of LED and fluorescent illumination to replace incandescent lighting, more energy efficient vehicles and hybrids, greater use of geothermal to cut heating and cooling costs and so forth.

Having been convinced that the future opportunities in energy innovation are here to stay and that they have everything to do with technology and investments we hereby plant our flag in the space. As we did with the software space we will be introducing a “Power 20” group of companies that best represent the investment vehicle for this space and will include sector and company reports beginning with solar energy where we have already done a considerable amount of work and then moving most likely to advanced materials and energy related technologies. We’re excited about adding this space.