Future of Energy: FAQ

This post is a follow-up to my earlier note on the future of energy.

 

Q: Why do you put Water in the “plentiful” bucket when it’s becoming a scarce resource for which pricing is likely to increase?

A: There is abundant and free seawater, and we have existing technology to desalinate it. However energy requirements of this technology are high: “Due to relatively high energy consumption, the costs of desalinating sea water are generally higher than the alternatives”. Energy has been a bottleneck, but if energy is abundant and cheap this bottleneck goes away. The inputs are abundant and free (seawater + solar), processing ingredients are cheap (solar power), so the problem is structurally resolved. This is an example of a second order consequence of abundance of energy. The price paid for water delivery would include additional ‘processing fee’ but this is how the utilities work anyway.

And better yet the technology is improving: “Engineers at Lockheed-Martin recently developed and patented a molecular filtration membrane called Perforene which can desalinate seawater using only 1/100th the energy of the best existing desalination systems”

 

Q: What is the source of the mentioned abundance of food? How does cheaper energy help sustainably feed the growing world population?

A: In today’s world poverty and hunger that exist in certain places are not the evidence of humankind running out of food, or any other resource, but rather a result of a lack of proper economic environment in those places enabling people to produce and exchange products.

From the technical point of view there are no visible limitations related to food supply. Hunger only seems a potential problem if people stick to conventional food production as arable land is limited. But we don’t have to stick. Food serves as energy source for humans (hydrocarbons and carbohydrates don’t sound similar by chance), and provides chemical material to build new cells. The same way ‘more fossil fuels’ is not the ultimate solution in industrial energy, ‘more arable land’ is not the ultimate solution in human energy. Technological advancements provide better options. The chemistry (biochemistry) is more complicated when dealing with organic matter but technologies already exist. There is little sacred in what we put in our stomachs and it all can be grown in the laboratory. “Seed” biological ingredients are abundant, “cultivation” technologies exist. The problem has a sustainable structural solution.

 

Q: Who are the main losers in the energy complex? (High cost? Highly pollutive? LNG?)

A: LNG industry is likely to be a big loser. The technology is costly, and is of limited need in the age of distributed and abundant energy. Gas price differences that currently exist between different regional gas markets and that LNG is trying to exploit are not sustainable. The worst case scenario for LNG is this – huge upfront CAPEX is made, then gas price differences go, and gas volumes shrink.

The other ‘assets’ of questionable value are long-dated reserves, high cost reserves (offshore/unconventional), fixed capital that can’t be run down (offshore drilling platforms).

I am not sure on the pollutive producers. Carbon dioxide emissions are slowing down already (global CO2 emissions are flat in 2014 despite 3% growth in the world economy). The governments may have less incentives to intervene (introduce carbon tax, force closure the old facilities, or otherwise) and let the old pollutive facilities to peacefully phase out.

 

Q: Cost per battery calculations look too optimistic.

A: Prevailing prices on the market are indeed closer to 500+ USD/kWh of battery storage capacity, as opposed to (estimated) 250 USD/kWh for Tesla’s battery. But it is always the leaders who shape the future of any industry. Also with all Tesla patents now open to the public their best on the market technology will quickly become a new standard. Further cost improvements will come from economies of scale and general workings of the Moore’s law.

 

Q: Does powerful US oil lobby matter?

A: Incumbents always take defensive positions and call/lobby for no change, but in this situation they are a minority. Energy independence calls for solar. Current account deficit calls for solar. Ecology calls for solar. Most importantly profits call for solar. If profit argument is against you the chances are you are on the wrong side.

 

Q: The question is what can be done with unlimited free energy?

A: What do we do with unlimited water and air? We don’t notice its existence and take it for granted. Generally we should be reviewing all known technologies and processes where energy is an input but where it has been considered a bottleneck. Many things will need to be reconsidered from the basics.

 

Q: Does $40-50/bbl oil reflect the fact that it is a dying fuel source?

A: Not yet. The reason for relatively low oil price today is competition within the oil industry. Conventional oil vs. shale oil / Saudi vs. US. This is still oil vs. oil. A sign of “dying fuel source” would be oil sector shrinking in total volume terms. It is not happening yet, but we may be just a few years away from that point (NB carbon dioxide emissions stopped growing in 2014. Is this a precursor?)

 

Q: Does lower oil price change the marginal economics and lead to fossil fuels staying around a lot longer?

A: Take transportation as an example. Hybrid electric vehicles are more economic than internal combustion engine vehicles at virtually any(!) oil price because electrification is the only way to realise the full potential of regenerative braking (store vehicle motion energy that is currently lost when brakes are applied, and reuse). Such hybrids are already on the market today, they are significantly more efficient than conventional ICE vehicles, and in my view within 5-7 years every new car will be a hybrid. ‘Hybridization’ trend is irrespective of the oil price, and leads to structural reductions in oil usage per vehicle.

Does a full electric vehicle follow? Possibly. But cost competitive, full range EV is yet to be demonstrated (Tesla’s Model S is a luxury sedan that people buy not for economic reasons). Adoption of full EVs is a function of the oil price.

In the previous era of scarce and irreplaceable oil the main resistance factor to the oil price was the global economic growth. Too high oil price was assumed to slow down the economy that would reflect back on the oil price. Now, the total cost of ownership of emerging electric vehicles will put an effective cap on the oil price. The oil volumes that could be profitably extracted at that price would be used in hybrids and chemistry. Such calculation is a matter of a separate exercise but my guess is that the cap price will be low and the total oil volumes that can be extracted profitably at that price are a fraction of today’s oil market. The cap price may even be zero eliminating oil from transportation altogether.

 

Q: Are technological advancements alone enough to eliminate fossil fuels, or we still need governments to step in with regulations around carbon pricing?

A: Last year global GDP grew 3% but CO2 emissions were flat. For the first time in 40 years. Adoption of solar and wind for economic reasons, already a today’s reality, has CO2 reductions as a byproduct. If CO2 emissions had a price the rate of adoption would probably be higher, but regulations around carbon dioxide is not a decisive factor.

I would not be surprised to see attitude to CO2 changing. Currently perceived as a problem CO2 emissions (that needs to be taxed by the government) may soon be regarded as a valuable carbon source in chemical industry (at which point the need for the government to intervene will be gone completely). The technological chain I described in my note (power+water+CO2=>fuels/chemicals), or other competing technologies like this one, will make CO2 (especially concentrated CO2) an asset rather than a liability.

 

Q: Can you expand on the differences between oils and utilities in terms of having to continue investing to harvest cash?

A: Natural decline rate is an essential characteristic of the oil industry. Let’s take a gas utility. If a gas fired electricity generator has a capacity of X and you do your maintenance, its capacity in 10 years will still be X. Oil is different. If you don’t drill new wells (make development CAPEX), as the pressure inside the reservoir naturally falls over time, the annual production will be falling year after year. Running oil company for cash is different from running almost any other business (with ‘stable’ capacity) for cash.

 

Q: Where does 5% market implied EPS growth for oils come from and how does it fit 7% natural decline rate?

A: The US equity market in the 20th century produced 9% / year average USD return. This is with 2 world wars, great depression, great recession, and numerous other crises. I don’t know anyone who in their valuation models (unless valuing a regulated utility business) have required COE in single digit range. Now if your cost of equity is 10%, and dividend yield is 5%, the implication is that the expected by the market EPS / DPS growth rate is 5%. In doesn’t look a realistic assumption for the incumbents who start losing market share to new entrants.

How do you generate the required double digit equity return? You wait for the share price to halve (at which point dividend yield becomes double digit) and provided the actual EPS trend growth is likely to be negative, the overall return (double digit dividend yield + negative growth) can be within required 10% COE.

If an oil company were run for cash, its FCF would be much higher than reported earnings, and the figures would add up differently. Such company could pay 20% initial dividend yield while allowing volumes to fall 7% a year, that could well be the best financial outcome. But it is difficult to find an oil company deciding to stop development capex and admitting it is not a going concern.

 

Q: Somehow I think if one sits down and checks numbers, the transfer to solar would turn out a more distant perspective.

A: It has always been a question of time. The traditional view would also see renewable energy as the ultimate solution, but timing (100+ years) and the nature of transformation were seen differently. Over the 100 years oil price was expected to go up reflecting oil’s scarcity and ever rising costs. Rising oil price would gradually make (structurally expensive) alternative energy resources cost competitive. The alternatives would gradually take market share from oil filling the ‘oil scarcity’ gap.

In reality things developed the other way round. Technological progress made alternatives cost competitive defying ‘structural expensiveness’ argument: two cost trajectories met via alternatives becoming cheaper rather than oil becoming more expensive. One line is set to continue trend down following the workings of the Moore’s law; and the other (after heavy correction letting out political premium, scarcity premium, etc) is set to continue trend up (Arctic oil, deep offshore, etc). After changes in cost leadership market share redistribution normally happen fast.

The most active part of the transformation phase will be shaped by the production ramp up schedules (batteries, EVs, PV panels), and depreciation cycles (10-15 years for cars, 20-25 years for fossil fuel electricity generators).

The full transformation cycle will still take 30+ years but some important milestones are much less distant. I think we are just a few years away from renewables accounting for 100% of the energy market growth at which point fossil fuels enter a structural decline era. And the market is likely to price the tipping point before it is reached (which is anytime from now).