Energy 3.0 At the Cusp or on the Brink – Part 3 Will the Last one off the Planet Please Turn out the Lights?

“You have to go out – but you don’t have to come back!”former, unofficial motto of the US Coast Guard

In Parts 1 and 2 of my series, “Energy 3.0 At the Cusp or on the Brink” I began developing my 7 theses of investing in Energy 3.0. The 7 theses are displayed in Figure 1.

Figure 1. 7 Investment Theses for Energy Investing

Source: Christopher Montaño, CFA

In my posts 1 and 2 I covered the first 4 energy theses; Energy = Life, Energy = Commodity, Energy is Political and Energy is a Mature Market. The results have been fairly dismal. In my discussion we have seen that:

  • energy is critical
  • energy is a commodity -regardless of intellectual property
  • the industry requires political involvement
  • it has regulatory encumbrances
  • it has a low margin structure
  • there is low customer engagement -regardless of technology
  • and if these aren’t enough to discourage you there are “supercompetitors” in the form of regulated monopolies that devour everything in sight in excruciatingly slow fashion.

By now readers may well be asking, “Given your investment theses thus far… what’s the use investing in the energy sector?

Cheer up, it gets worse

This brings me to my 5th investment thesis:

5th Investment Thesis: Sustainability Mandates Investment Capital.

My 5th thesis is that in order to sustain our global economic growth, and sustain our population base, we have to allocate capital investment into energy supply and demand. We simply have no other choice.

Simply put, we do not have detailed understanding about our planetary natural resource limits and our population is getting very large. I also believe that there are major global economic and demographic shifts that will accelerate natural resource consumption during this century.

In 2010, we reached a global population of 7,000 million people. The United Nations projects that during the 21st century, the global population could reach as high as 16,000 million people. (See Figure 2.)

Figure 2. World Population Growth Scenarios

Source: United Nations World Population Prospects:  The 2010 Revision

The truth is that we don’t have a firm idea of how many people that the earth can support on a life sustenance basis, let alone on a growth and consumer based lifestyle basis. From where I sit in 2012, 10,000 million and certainly 16,000 million seem impossibly large numbers of people for the planet to support. I concede that at one time, 7,000 million probably seemed impossible, yet we are managing- for the moment.

Where’s my iPad & iPhone?

The big uncertainty comes in the form of global consumption patterns due to economic development. The good news is that the emerging and developing markets are moving along nicely in their economic development. The bad news is that there is a large population base that’s driving toward consumption patterns like us– the developed economies. There will be significant impacts upon natural resources due to shifts in global consumerism.

There are two waves of population bases that are migrating economically this century. First there are the population in the emerging markets and after that there are the “frontier markets”, the next wave of economically developing countries. Both of these markets represent a large population base that will be attaining a consumer based lifestyles of various levels during this century. This is a large increase in absolute numbers of people that will be consuming natural resources, durable goods, non-durable goods, food, etc…  — and this demographic wave will drive energy demand.

The emerging markets powerhouses “BRIC” (Brazil, Russia, India, China) are already a growth engine for global economic output. When their populations gain greater discretionary income they will begin consuming more along the lines of developed countries via automobiles, housing, clothes, appliances and food- and ultimately energy. How this will impact global stocks of natural resources is unknown. How long will the global stocks of petroleum, natural gas and coal last? This is uncertain and the data are not uniform or estimates closely clustered. Beyond this there is an issue of even if we have fossil fuels to support these new consumers, how do we impact the atmosphere?

Historically there has been about 43% of the world population in the BRIC countries since 1950. These four countries currently have 2,900 million people in them and are projected to peak out in population in 2045 at 3,349 million people (See figure 3.) On an absolute basis this is an increase of 445 million people in 35 years. (For reference, the previous 35 year period saw a growth of 1,160 million people amongst the BRIC countries.)

Figure 3. Population Growth Among the Big Four Emerging Markets, Brazil, Russia, India, and China

Source: United Nations World Population Prospects:  The 2010 Revision

One factor not included in the BRIC countries are their consumption patterns. The number of people moving economically upwards is very large. Common sense suggests if consumption patterns match the current developed world, then this will place a strain on all sorts of natural resources and derivative products. We wonder at what level of annual income does the consumption pattern of a population base enter exponential growth?

The situation becomes more complex as we consider the Frontier Markets. These are the large number of countries that have not been economically developed and are just beginning their economic growth – often based upon human capital arbitrage, global transportation and communications networks. The Frontier Markets include the following countries:

Table 1. Frontier Markets

Within this list are 88 countries that are staged to experience rapid economic growth in the middle and latter portion of this century. These countries are the next wave of consumption behind the traditional emerging markets and also have a large population base. Figure 4 details the middle scenario population growth through this century of the frontier markets. There are currently about 1,700 million people in these countries and the UN expects that number to increase by 1,300 million by 2050 and another 1,000 million by 2100.

Figure 4. Population Growth of Frontier Markets in 21st Century

Source: Source: Christopher Montañ0, CFA, United Nations World Population Prospects:  The 2010 Revision

If we combine the “BRIC” emerging markets with the frontier market populations, then in 2050 we will have a net population of 6,300 million consumers at lesser, but rapidly growing consumption levels than the developed nations. The population by 2100 of these same countries is estimated to be almost 7,000 billion people.

The consumption patterns of economically developing populations may vary from country to country. However it’s clear that fundamental human nature is to move toward ease of existence and actualization. The famous “S-Curve” (Bass diffusion curve) is the most basic of all market demand forecasting tools. New products that people like invariable have exponential demand until a natural level of saturation is achieved. There is no reason to expect that this will be different for the 7,000 million new consumers as they think about cars, televisions, clothes, housing, HVAC, etc… Without diving into excruciatingly deeper data, suffice it to say that sustainability and energy demand will be major, growing issues throughout this century.

How do we provide energy for this growing population group? The answer is likely to be any way possible. While the implications take effort to digest, one is clear. Without massive, global capital investment in all phases of the energy value chain, we will not meet demands during this century for continued economic growth and perhaps, even basic sustainability itself.  It is this fundamental driver of sustainability that I view as a primary thesis for investing in the energy value chain.

The first 4 investment theses dealt with the risk factors in investing in Energy 3.0. In this post, I turned toward a fundamental demand driver- population coupled with global demographics and economic growth. And it is this key factor that investors have responded to in the past 5 years.  However, there are now the challenges that are rearing up in the time period prior to the exponential knee of the growth curve. And it is exactly at this time that patient, wise  investors redouble their efforts in learning how operations and companies succeed in markets. It is also the time where less hardy investors may lose interest or be forced out of a market.


Energy 3.0 At the Cusp or on the Brink – Part 2 Introducing Seven Investment Theses for Energy Investing- First the Bad News

In my first post in this series I looked at the grand theme of “Energy = Life”– fun stuff spanning the scope of human history but not actionable. However, I maintain that context is important when considering investment themes. And given the historical impact of energy on the human condition I thought it merited an entire post to establish the proper level of gravitas this sector holds.

In this post I will transition into more pragmatic comments and lay out some basic investment themes for the Energy 3.0. I will break it up into a series of smaller posts for the sake of brevity. I don’t assume that this list of seven is complete. It would be arrogant to assume that I could capture all important Energy 3.0 investment theses in seven statement but I must somehow be practical in my approach. Feel free to chime in with additional themes. Disclosure- I hold that investment theses aren’t static and reflect the changing markets. These are what I see today with my limited perspective and my theses are subject to change based upon new information and market dynamics.

7 is the Lucky Number for Energy Investors

I have developed 7 fundamental theses on investing in the Energy sector.

Figure 1. 7 Investment Theses for Energy Investing

Source: Chris Montaño, CFA

Thesis 1: Energy=Life

The first thesis, Energy=Life was covered completely in Part 1 of this series and I will refer you to my prior post. Suffice it to say that we need water, air and food to live. However, it takes energy — lots of it, to be a civilization so this is a sector that will be of high importance for a long time. They primary point is that we need to upgrade, renew and invent new ways of creating, delivering and using energy for our civilization to continue its trajectory of population growth, economic and technological progress.

Thesis 2: Energy=Commodity

Almost the direct opposite of Energy=Life thesis is that Energy=Commodity. While this is not exactly true, there are several reasons that an investor in the Energy 3.0 sector needs to understand this concept. Since the basic inputs to our energy system are commodities, it’s unsurprising that downstream products (electricity, gasoline, fuel, etc…)  take on many of the same properties.

One of the most important properties of commodities is that any substitute must be cheaper. The basic properties of commodities aren’t variant so it is really about the economics of substitutes. Any replacement of a hydrocarbon with a renewable source must be driven by cheaper economics. One important implication that has not been lost on the investment community is that we are still a long way off from unsubsidized renewable generation being cost equivalent with hydrocarbons. The fact that there is simply so much technology involved in deploying an alternative energy source leads me to be cautious regarding the time frame when a photovoltaic chip or thin film can compete with geologic time scale processes that produced coal, gas and oil. I consider the current vintage of renewable source energy investments to be experimental and its economics driven by anticipated supply shortfalls and geopolitical concerns rather than renewables working their way down the cost curve.

When you couple the economics of commodities with the perfect substitutability of electrons (or many petroleum based products) it is understandable that customer engagement for energy is very low.  From a customer perspective there is little to no differentiation between electrons or fuel sources.

In fairness to the boldness of alternative source energy entrepreneurs, there is a need for the industry to work down the cost curve and contend for financial viability. There are reasons to persist and push the cost effectiveness envelope. We do not have an accurate understanding of the true level of reserves in the oil, gas and coal global raw stocks. If there are shortfalls then the economic crossover point for alternative energy sources may shift dramatically as prices of hydrocarbon sources increase. There also remains the problem of global climate warming. Even if global raw stocks are sufficient, then it may turn out that we can not burn fuel for 7 billion plus people without accelerating an already perilous atmospheric carbon condition.

Thesis 3: Energy = Politics

On a global basis, governments are deeply involved in energy. This is also true at the state and local level. The energy sector is subject to administrative laws and state, and federal regulations. While the petroleum industry is not a regulated industry as is electrical generation , there is still a high level of government involvement — especially as problems occur. For the investor in energy, regulatory engagement is not optional. Depending on the particular portion of the Industry more or less regulatory engagement is merited. I have identified 3 basic levels of regulatory engagement:

  1. Awareness is the most basic level of engagement and is simply being aware of the applicable rules and regulations impacting the economics of the industry as well as potential regulation under consideration.
  2. Understanding is taking the time to study policy and laws and form views and develop investment theses based upon regulatory policies and laws.
  3. Regulatory Engagement seeks to influence development and implementation of laws and policy. Most industries spend monies seeking to inform, influence and shape markets to benefit them. Figure 2. is data from on lobbying monies spent from 1998-2011 by top spending industries.

Figure 2. Top Sectors Lobbying Spend


From Figure 2. we can see that Energy sectors were among the top investing sectors investing in political capital. I think it’s safe to assume that the majority of the investment is done by the current established base and that renewables is a minor fraction. And what are established competitors receiving for their investment? Subsidies- lots of them (See Figure 3.) The World Energy Outlook for2011 estimated that there were about $409 billion in fossil-fuel consumption subsidies in 2010. For the investor in alternative energy, this is a clear signal that while venture capitalists are plowing limited partner (and general partner) investments into new systems, the incumbents are investing a lot less dollars in political capital for a significant return.

Figure 3. Subsidies for Fossil Fuel Companies

Source: World Energy Outlook 2011

Investment thesis 4: You’re Not Getting Better, You’re Getting Older

The energy markets are mature. In 1891 the first 3-phase ac electrical distribution network was deployed in Frankfurt, Germany. One consequence of this maturity is that there is little economic margin for new entrants with new technology to capture outsized profits while incumbent competitors play catch-up. It is my view that innovation is rewarded by outsized, initial profits for new businesses that deliver new products and services. These initial profits serve to compensate new businesses for the lack of capital in balance sheets as well as provide incentives to investors and entrepreneurs. In mature markets where there is little reward for innovating, it may not be economically rational to invest financial and human capital.  This places an even greater pressure on entrepreneurs as near-zero economic margin translates into near-zero margin for error in the managing the business. Mistakes that may be recoverable in other nascent and developing industries are not likely to be excused in a mature, well understood industry like energy. Investors in energy must be aware that on the job training for first-time entrepreneurs will likely carry very high tuition rates. Also, successful venture investments may have capital returns moderated due to the margin structure of the industry. I believe that there are pockets of higher margin business investments but must be carefully selected to capture these profits.

Another consequence of market maturity is the presence of the “super-competitor” in the form of incumbents. In the oil industry there are the “oligarchs” that are essentially unassailable. Untouched, these behemoths do as they please and have little to no competitive risk profile due to a global transportation infrastructure that is daily dependent upon them. The same forces that propel our Global Economy forward discussed in Part 1 of this series give this group of companies almost unlimited free reign from a competitive standpoint. On the electrical generation side, utilities that transform coal and gas and uranium into electricity are mostly regulated and therefore dominate the channel. The only way to reach the customers is either to make peace with the incumbent or to appeal directly at a grass roots, direct sales channel. With utilities struggling with customer engagement it is a massive task for a start-up company to attract customer interest let alone serve the volume of customers. Should a start-up be fortunate enough to attract the attention of an incumbent, then the sales cycle will likely be long, arduous and invasive. Any investment into an energy company at any level needs a clearly defined channel strategy that steers into the competitive dynamics of the industry.

It’s Always Darkest Before Dawn

For the investor in Energy 3.0, the challenges are large. While energy appears to be a limitless, unquenchable demand curve it also reflects a commodity market structure. On top of this, there is a strong political and regulatory dimension that is very difficult to break into. Not to mention the competitive advantages of large subsidies for the consumption of fossil fuel sources and regulatory barriers for new entrants. On top of this Energy is not a highly profitable business making the process of raising capital even more challenging. Energy 3.0 is a daunting investment environment to say the least.  (Please do not try this at home- these are professional investors in a closed environment.) But before we abandon Energy 3.0 stay tuned. There are still yet 3 more investment theses to review and they offer not only solace to the Energy 3.0 investor but I believe they point to the direction in the near term (1-5 year window)  as well as more general direction for the longer term (10+ years.)

Energy 3.0 – “At the Cusp or on the Brink” Part 1

Introduction to Energy 3.0

I am introducing a new series of posts that are a distillation of my views on the energy market. I recently spent two years working in the energy efficiency industry and formed my perspectives during this time. My understanding of this sector is nascent, dynamic and subject to change. Two years is an incomplete introduction to one of the world’s largest industries and there is much to learn.

Having worked previously in technology, investment research and venture capital, I approach markets with a world view that is a combination of these lenses which are very different than the typical energy industry perspective. At the time I began working in energy I was mildly curious. However, as I learned more about this critical sector, I found my interest growing. As a student of changes and trends from humankind’s interaction with technology, it’s impossible to ignore energy. An examination of the energy industry, its role in our world and economic impact suggest its past and future history is inextricably intertwined with that humankind’s growth and development. Join me in this series and I invite your comments and challenges to my views– I am a data driven analyst and welcome skeptics as friends that ultimately serve to hone my views.

Energy is as Old as Humankind

Energy = Civilization = Population Growth = Economic Growth = Life. While this is a large statement, I believe it is a logical conclusion upon examining the data. It seems hard to ignore that our progress as a species has marched hand in hand with our energy consumption and economic output. Which led? I am not sure, but the data appear reasonably correlated and so I will recognize the relationship and the co-dependency of population, economic growth, technological progress, quality (and quantity) of life and our ability to harness and use energy. Regardless of which developed first, it’s true that our civilization at this time depends upon an abundance of inexpensive energy.

Table 1. The Evolution of Civilization

Source: Chris Montaño; Human Race

I have divided the history of energy into 3 distinct eras and called them Energy 1.0, Energy 2.0 and yes, Energy 3.0. Each era is defined by the energy sources available to humankind during that time. While none of these dates are crisp, they serve as markers where a trend in a new energy source was well established.

Our early history as a civilization was essentially driven by burning things- mostly wood and toward the end of the era, coal. Fire was our first source of energy and it brought us quite far by heating us, providing cooking and eventually leading to the steam engine. However, most work done during Energy 1.0 was performed by muscles- human or livestock. Once we understood hydrocarbons and leveraged them, we were into Energy 2.0 which saw the advent of industrial society, the modern city and work performed mostly by mechanical motors and engines. The ability to change the form factor by which work was delivered and tailor it to specific jobs gave rise to manufacturing and general availability of goods on an unprecedented scale. Motors also changed transportation and introduced autos and airplanes and ships driven by motors rather than wind. This era saw the global economy evolve into the trillions.

Table 1 illustrates the parallel development of energy and humankind. On virtually all measures of civilization’s advances, humankind’s economic growth and energy consumption and population growth have been in lockstep. It is also clear that progress and consumption have been non-linear and exponential. Population grew from ~800M to 2,400M from 1759 to 1944, a period of 185 years but required only another 77 years to reach add more than 4,500M people and reach a global population of 7,000M

Energy 3.0- “On the Cusp or on the Brink”

I am naming this series Energy 3.0 – “At the Cusp… or on the Brink.” As I have looked at energy demands and economic forecasts along with projected population growth through this century, it seems clear that the next era requires significant increases of energy supplies. In essence we are at the “Cusp” of a new wave of demand in energy based upon population, economic and technological growth. However, if we fail to identify significant new supplies or extend current ones, then perhaps we are “on the brink” of deeper, more unpleasant changes for our civilization.

Our growth as a species has been spectacular and I wonder how long it can continue at its current pace. The implication is that we are ultimately hurtling toward some envelope of sustainability in our planet’s ability to provide food, water, and energy for everyone and natural resources for the technology needed for continued growth. Given the exponential growth of all biological populations, I cannot help thinking about the asymptotic limits of what our planet can sustain. Realizing that we have faced similar questions of sustainability in the past yet managed to navigate our way to continued growth and progress as a civilization, I think it’s possible that we will yet again thread the needle. However, I cannot help having the feeling that somehow this time, it is different and the scale is greater than what we have ever faced and the rate of change is ever accelerating.

Driving this situation are a couple of billion people in the developing world that are headed toward middle class economics- and energy consumption in the next 50 years. The World Energy Outlook for 2011 forecasts a 1/3 increase in energy demand between 2010-2035 and 50% of that demand growth coming from India and China. As their consumption patterns match those of the developed nations, it seems reasonable that our resources and infrastructure to meet energy demands will be taxed severely. Economics 101 suggests that increased scarcity of a resource goes lockstep with increase in prices. Of chief concern is the fact that virtually all energy supplies are currently delivered by natural, non-renewable resources. While this is not necessarily a problem in itself, logically there is a limit on what we can expect to extract and use. It seems a prudent step begin developing renewable sources of energy and ensure what energy we do have is developed as economically efficiently as possible.

While renewables have been around since the first wind powered mill was built, modern society has been built upon the energy density of hydrocarbons. There is simply nothing that packs as much energy into a compact form, easily transportable and with an infrastructure that can rapidly translate hydrocarbons into usable energy. There exists no solar or wind powered motor that can drive a container ship across the globe or power an intercontinental flight. The fact remains that the primary drivers of our economy remain gas turbines and diesel motors. These motors power our jets, shipping trucks, container ships and most passenger and military vehicles around the globe.

Renewables electricity generation is at its beginning in being explored in earnest. In fact, in its current state of development it appears to me an economic experiment. It is borne from our reasonable concerns regarding projected energy demands coupled with resource constraints and the nagging worry that we may have already pushed past the tipping point of global climate balance. How this experiment unfolds and the data that it bears will have a profound impact upon our way of life.