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:
- 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.
- Understanding is taking the time to study policy and laws and form views and develop investment theses based upon regulatory policies and laws.
- 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 opensecrets.org 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
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.)