New Year’s day is a good time for long term thinking and planning. Today I want to relate some fairly visible long term prospects for global energy changes to a few of their more obscure short term investment implications that are actionable.
The great game of the next era in human use of energy is going to be the transition from a petro/electric economy to a fully electric one, motivated by the end of affordable fossil fuels. Transportation is the name of this game because it uses 70% of petroleum products. The crowd is taking its seats for the start of the first inning. The first pitch will occur when we start using – rather than just experimenting with – electric vehicles.
Commercial trucks will probably be the earliest adopters, along with “city cars” intended for short-haul use. The greatest challenge will be cars intended to be driven from point A to Point B without returning to Point A to refuel. That requires commercial electric refueling stations, a substantial challenge in terms of both infrastructure and technology. It won’t happen, I suspect, within the next five years, my investment time horizon. But given the coming scarcity of oil, it will have to happen within the next fifteen years.
Plastics will be the last to go because there is no substitute at this point. I suppose some genius will eventually discover a way to make coal into plastics. Home heating is a relatively easy fix. The financial capacity of millions of consumer to afford to make the change will be the greatest challenge here. In the U.S. and probably many other countries, I foresee home heating tax credits – or some other government support for the transition.
Airplanes and ships will require some sort of synthetic liquid fuel such as ethanol or, better, bio-diesel that will be made in part by using electricity. Some ships may turn to sails and others to nuclear power. Industrial substitution of electricity for liquid fuels is not hard to imagine. It primarily requires better battery technology. Industrial substitution for lubricants may be a lot harder.
With all this future increase in the use of electricity, one obvious investment issue is the adequacy of our electrical generation and distribution capacity. Investors are already concerned with this issue, as indicated by the popularity of such stocks as Ormat Technologies (NYSE:ORA) (geothermal energy), Quanta Services (NYSE:PWR) (electrical infrastructure), wind stocks like Gamesa, and Zoltek (NASDAQ:ZOLT), and all the solar stocks (more later). None of these stocks seem particularly cheap, so we know investors are already on the case.
How will the increased demand for clean renewable electricity be satisfied? I’m not as sanguine as Amory Lovins seems to be, but there are some surprisingly good things happening and about to happen. One is the advent of L.E.D. lighting for home and commercial use. Lightning uses 22% of all electricity generated. L.E.D.s are estimated to use only 5 – 10% of the electricity required of incandescent bulbs, which by the way, were outlawed in the new Energy Bill. So right away we can see that maybe 10% to 15% of all our electricity needs will be obviated within the next 5 – 10 years.
L.E.D.s will become much cheaper and more available within the next couple of years. I think L.E.D. sales will be so huge that the investment opportunity has not been fully discounted yet. Two options are CREE (NASDAQ:CREE) or Lighting Science Group (LSGP), both of which are speculative and not cheap, but I own both in small quantities.
Another potential breakthrough is the use of electric cars to re-balance electricity demand from peak to non-peak times. The idea is that millions of all-electric – or even hybrid-electric – “city cars” will be recharged at home during non-peak evening hours and will be available during peak hours to re-sell the electricity stored in their batteries back to the grid. This would substantially reduce peak demand for electricity and in effect, provide a substantial additional capacity to the grid without adding new generating stations. This idea might sound like science fiction, but if you want to know what the gazillionaire founders of Google are doing with their spare time and spare change – this is what they are working on.
One of my new year’s resolutions is to find good investments that key off growth in electrical infrastructure. One attractive looking candidate is General Cable (NYSE:BGC). This global maker of exactly such products has been growing aggressively through acquisition recently. It seems reasonably priced on a PEG basis (p/e to earnings grown). Of course, everyone is looking for the next new battery company. If anyone has a favorite, I’d like to read about it.
Converting sunlight to electricity using photovoltaic technologies [PV] has been a focus of venture capital for years. Many of the resulting companies have matured and become public and in 2007 solar stocks went on a tear. First Solar, for example, now sells for about 130 times estimated 2008 earnings. Wall Street is convinced that demand growth is virtually endless. I think that could prove a bit optimistic.
Let’s get some perspective. PV is a useful product in large part because various governments – Germany, Japan, California, China (just starting) etc – subsidize it. Why? Not because we are running out of ways to produce electricity but because we are running out of clean ways. In other words, PV is primarily a global climate change driven product.
This is not to say that PV does not have inherent value. Important markets include remote and/or very poor areas of the world that do not have or cannot afford access to centrally generated electricity. Also, with new lower-cost PV becoming available via new technologies from companies like Nanosolar, there will be non-subsidized demand from corporate customers and from some dedicated “green” individuals.
But what if suddenly there appeared a new, cheaper, clean way to centrally generate electricity at costs that are lower than PV and that operate 24 hours a day, not just when the sun is shining? Might not some governmental priorities change? And without government subsidies, might not PV demand slow significantly?
I suspect it might, and more to the point I think such a new development is on the horizon. A private company called Ausra funded by some top Silicon Valley venture investors is building pilot projects with just such technology. Ausra uses the standard concentrating solar power [CSP] idea – mirrors that heat up a liquid to produce steam to drive a generator – that has been operating successfully in the Mojave Desert for 30 years. It then takes much of the up front capital costs out by using flat rather than curved mirrors. Then, most importantly, it adds a clever way to store the heated liquid under pressure inexpensively so that the hot liquid produces electricity even after the sun has gone down.
Here is a summary of the potentially game-changing advantages of the Ausra approach from the Austra website:
This ability to store energy as heat makes solar thermal electric power particularly valuable, because energy can be stored when the sun is shining and released for electricity generation when the power is needed most. Often peak electricity demand extends well into the evening on hot summer days; solar thermal electric power is uniquely able to deliver zero-carbon electric power to meet these demands.
Ausra claims its CSP plants can produce electricity now for 10 cents a megawatt, going down to 8 cents or less in a few years. That’s a pretty attractive price – darn close to coal – in fact, more attractive than coal when you add the coming carbon tax (that I anticipate). A couple of the biggest utilities in the U.S. have ordered sample plants from Ausra.
I’m not saying this is the Model T Ford of solar energy. But it might be. If Ausra’s plan works, I wonder what the appetite of Germany and California will be to continue to subsidize PV once there is a better alternative for clean electricity that does not require a subsidy. I hear California is having budget issues. Do you think they might want to save some money?
The Question of Technology
Here’s another question that bothers me about solar PV companies. How do you control for technology risk? Low cost as measured in cost per watt is what makes a PV producer successful. Low cost per watt is a function of two things, the percentage of sunlight that is converted to electricity by each unit and the production cost per unit. Both of those factors boil down to technology.
There are different opinions about which technology will ultimately prove most successful. Some analysts think silicon, the original and traditional PV building block, is too expensive and not sufficiently available. That idea has made the hot, hot, hot First Solar (NASDAQ:FSLR) very popular based on its spray-on cadmium telluride technology that avoids using silicon. Other companies like Ascent Solar (NASDAQ:ASTI) use a cadmium, indium, gallium, deSelanide [CIGS] formula. Others believe silicon itself can be used much more efficiently than it has been and will ultimately prove the low-cost solution.
If you knew enough about the science and technology – which I certainly do not - you might be able to solve the question of the optimal PV technology between silicon and one or more of the new-comers. This might help you decide whether First Solar – or any of the other existing competitors - is wildly overvalued or not. But such knowledge would not give you the final answer because products with new technologies that you have not yet heard about are being developed behind garage doors somewhere in Silicon Valley – and Tel Aviv. There is no way to start to analyze those. The recent announcement by Nanosolar, a private company, of a 99 cent per watt spray-on CIGS product, an apparent breakthrough, exemplifies this “out of the dark” technology risk.
At this point in the PV market’s development demand is growing so rapidly that virtually any PV company can sell its entire output. It is not critical to have the absolutely top end cost effectiveness. That’s why there is a mania in the market for PV stocks. Wall St. is projecting demand growth into infinity and they are simply not worrying too much about technology risks.
But if new CSP technologies like Austra’s convince governments that PV subsidies are no longer needed in order generate the required growth of clean electricity, and if the elimination of subsidies reduces PV demand, then not all PV makers will be able to sell out their capacity. At that point, the companies with the lowest cost may do okay, but some others may not survive. Ausra estimates that only 8,500 square miles of earth is sufficient, using their CSP plants, to provide all the electricity used in America. Wow.
It seems to me that Wall St. valuation models that use the present value of earnings many years out based on ever- growing PV demand may not hold up. Look, I hardly can tell a watt from a volt. But it just seems to me that it’s a little more likely that First Solar is overvalued here than not. Maybe by many dozens of multiples of earnings. I am short some FSLR shares, not a lot.
Oil and Gas
Of course 80% of the EIS portfolio is invested in companies that would benefit more directly from higher fossil fuel prices than will the electricity-related companies. That’s why I have focused in the past on oil and gas. I don’t have much to add to my recent comments on oil. Natural gas has a feeling of something that is about to happen. But I am usually early.
My newest strategy, owning call options on futures contracts to buy oil, does bear some comment. Recent higher prices of oil have increased the value of those options, so they are now nearly back up to what I paid for them. As you may recall, they are an insurance policy so that if oil prices rise so far and fast that the stock market becomes spooked, the portfolio (which is made up of stocks that will fall if the whole stock market falls) will still do well. If oil prices keep rising relatively slowly and the stock market does not tank, the portfolio should do well and should be helped by this highly leveraged strategy. If the price of oil tanks, the portfolio will not do well and the options will not either. Incidentally, over the next few months the price of oil may well go down, as I discussed in my last letter.
What I mainly want to say about the “futures” strategy is that it may be hard for some investors to understand or to execute. You need to have a background in futures, which I have been trading in small quantities for over 25 years, in order to understand this strategy and to have any sort of feel for it. I cannot convey such experience in a letter and will not try. Moreover, many stock brokerage firms do not offer trading in futures. Even some that do will not offer the longer term options that I bought. In sum, the futures options strategy is really for professionals and people with appropriate experience. Other investors who like the concept of this strategy may want to simply buy long dated options (LEAPs) on an oil-owning ETF such as OIL. Most brokerage firms should be able to offer some product like that.