French silver linings

The first round of the French presidential elections held its promises; it showed that opinion polls were no substitutes for actual vote counting and that the second round is more open than ever. 

To begin, voter participation was very strong at 80%.  Second, while Francois Hollande won, his lead over president Sarkozy was smaller than expected, 28.6% vs. 27.2%.  The National Front scored strongly at 17.9% but that was no surprise.  The biggest surprise was that Jean-Luc Melanchon, the candidate from the far Left scored only 11.1%, well below expectations. Finally, Francois Bayrou, the centrist, also disappointed with a 9.1% showing.

Clearly, this first round was a protest vote (massive participation, strong aggregate showing by the non-center parties), but it was not an outright rejection of the current political system as traditional candidates scored 64.9%.  Perhaps political commentators forgot that the median age of the French population is 39.4 years, not 20.

Two factors will determine the ultimate winner: how will the votes of the candidates eliminated after the first round be redistributed, and will there be a clear winner of the forthcoming debate(s).

Marine Le Pen, the Front National candidate, has been a very strong critic of Mr. Sarkozy.  She is highly unlikely to urge her supporters to vote for him.  She will probably prefer to retain the FN’s cohesion to win seats in Congress at a future date.  The FN is not unlike the Tea Party, but with a French flavor.  Immigration, big business, big government, diktats from far away seats of power (Brussels, Washington) are its bugaboos; as such, it is not easy to forecast how FN voters will cast their vote, and whether they will choose to abstain.  Hollande is loath to court them, while Sarkozy is doing it, but in coded language.  What these voters do will be determinant.

Jean-Luc Melanchon measured the limits of French appetite for insurrection (his own words).  In my view, both Hollande and Sarkozy are relieved that he underperformed.  Having declared that it was crucial to stop Sarkozy, he added that his support for Hollande in the second round would only be tactical as he would continue the “uprising” afterwards.  These are not the words that will fire his supporters to massively vote for Hollande.  Some degree of abstenation is likely.

A few weeks ago, Francois Bayrou was seen as a possible king maker, being a moderate centrist.  His low score was quickly noted, and with it, all rumors that he could make a good prime minister were quashed.

At this point, I would expect 60% of the Melanchon votes to go to Hollande and the rest to abstain; 60% of the Bayrou votes to go to Sarkozy and the rest to Hollande; 67% of the Le Pen votes to go to Sarkozy and 33% to Hollande.

This would give us:

Hollande: 28.6 + 6.7 + 3.6 + 6= 44.9 or 50.17%

Sarkozy: 27.2 + 5.5 + 11.9 = 44.6 or 49.83%

Clearly, Sarkozy cannot win unless he can convince a strong majority of FN supporters to vote for him, and even then, he would need extra help.

Which is where the debates come in.  True to form, Mr. Sarkozy asked for 3 debates with Mr. Hollande, while the tradition is for just one.  He may get two if he can pressure Hollande enough by painting him as afraid to debate.  He will then have to be persuasive but restrained, going for the jugular yet gentlemanly.  Mr. Hollande will have to convince voters that he can hold his own, be presidential, and yes, come up with strong arguments as to why he would be a better president than Sarkozy.  We may finally get what has been sorely lacking so far in this election: a serious debate on economic policies.

In sum, this election has tightened considerably and the incumbent could win.  Heavy betting against French stocks and bonds seem premature to me.

YPF

The recent announcement by the Argentine government that it would seize control of both YPF and YPF Gas came as a surprise to many.  Rumors that the move was imminent had been discounted as out of sync with an increasingly progressive Latin America and globalized economic relations.

Yet it did occur, and it was preceded by a seemingly concerted action on the part of some provinces to cancel YPF’s concessions.  As of yet, there is no detail as to how such government control will be instrumented nor how much YPF intends to pay for it. 

Readers may remember that when Bolivia expropriated foreign oil and gas companies, it paid nothing for the assets it took; the expropriation decree specifically stated that only the foreign oil companies that accepted the government action and agreed to stay on and cooperate would receive some share of future revenues to be negotiated.

In retrospect, the Argentine government action was not totally surprising.  After all, in 2005, Argentina basically reneged on its external debt by imposing a 75% haircut.  It also took over some $25 billion of domestic private pension funds and recently appropriated the foreign exchange reserves held by the Central Bank.  Nationalization is within a country’s rights (whether it is a good choice or not) provided that proper compensation is paid.  I do not know what the government will decide in this respect, but if it depends on international pressure, it may be little.

Indeed, the reactions from fellow Latin countries have been mixed and in some regards, surprising.  Quite naturally, “fellow travelers” such as Bolivia and Venezuela applauded the move; the Uruguayan president was on the whole sympathetic without endorsing the decision; his Chilean homologue was non-committal (which is surprising since Chile suffered from the Argentina decision, a few years ago, to renege on its obligations to supply it with natural gas).  Perhaps more unexpected was the reaction from the Mexican president who declared that, after such a move, any foreign investor contemplating putting money in Argentina would need to have his head examined.  Just as startling was the comment by Haroldo Lima, Head of ANP (the Brazilian National Petroleum Agency) that the move was excellent news for Latin America.

What to make of all this?  One conclusion is that bad habits die hard.  This is clearly the case with Argentina, and oil continues to provoke irrational reactions in many quarters.  Another, more controversial perhaps, is that with some notable exceptions, Latin America’s seeming economic miracle has had more to do with huge demand for its raw materials than with profound and durable internal reforms.  I am thinking about Brazil in particular where President Cardoso’s reforms have not been pursued and, in several instances, have been partially reversed.

Chile continues to have the most transparent economy and rule-book, but after some 30 years, it shows some signs of free market fatigue that bear watching.  Peru has achieved the fastest and most consistent growth in large part thanks to its mining industry; but it has also diversified and President Humala has so far surprised the skeptics, me included.

The two most interesting success stories are Mexico and Colombia. 

Having boosted its economy thanks to maquiladoras on the border with the US in the 1980s, Mexico’s industry then suffered from the competition from China.  But the trend has reversed in recent years as the US and Mexican economies integrated ever more.  Indeed, as Argentina nationalized YPF, Mexico may be about to open Pemex to minority investors.

Colombia’s recovery started when President Uribe regained control over the security of the country.  It was then sustained by a large domestic market, the country’s position between North and South America and by intelligent development and monetary policies. 

In a sense, I think that Colombia, barring unforeseen setbacks, is in the third inning of a virtuous economic and political cycle while Chile is late in the sixth.  I am not sure where I would put Brazil (fourth, eighth?) and Peru (second, seventh?).  Mexico is probably in the fifth.

In sum, political and cultural factors continue to be greatly underweighted in assessing sovereign risk and this YPF episode is a vivid example of that.  But the YPF crisis also helps highlight some countries which have been misjudged in my view.

US Energy Realities

 
The recent spike in crude oil prices has made it clear, once again, how much the US are dependent on imported energy. The Solyndra fiasco has shown how illusory the promise of readily available, cheap and clean renewable energy really was, at least for now.

One day perhaps, we will be able to generate wind and solar power effectively, cheaply and reliably enough so that it will become a significant component of our national power infrastructure. By“effectively” I mean without having to cover hundreds of square miles of land with solar panels or wind farms; by “cheaply”I mean without having to offer large subsidies or tax breaks; by “reliably” I mean without having to build backup conventional power plants to make up for the very low capacity factor inherent, so far, in these alternative power sources.

This may take two or three decades before becoming a reality, or it may never happen. Right now, it makes little sense to spend considerable sums of money at a time when federal and local government finances are strapped to promote “new” energy sources that are not ready for prime time. Furthermore, we have two much better (meaning cheaper, more scalable, and environmentally friendlier in my view) sources of energy: natural gas and nuclear.

The US has plentiful reserves of conventional, offshore and shale gas; the US also has great expertise in building and operating nuclear power plants, and Canadian uranium deposits are more secure than Middle Eastern oil and very large.

The following table prepared by the Department of Energy compares the all-in cost/levelized[1]of producing one megawatthour from new plants to be built today and starting operations in 2016. In this first table, the DOE doesn’t differentiate between more favorable and less favorable locations but takes a national average. Alternative energy (wind and solar) are showed at real costs, meaning without the benefit of tax breaks or other incentives.

 

Levelized cost of new generation (2009 US$/mwhr)

 

Plant type	Capacity factor	Total system levelized cost
Advanced coal	85	$109.7
Advanced coal w/CCS[2]	85	$136.5
Natural gas –  Advanced CC	87	$62.2
Nat gas – Adv. CC w/CCS	87	$88.4
Advanced nuclear	90	$114
Wind - offshore	34	$243.7
Wind	34	$96.1
Solar photo-voltaic	25	$269.3
Solar thermal	18	$312.2
Geothermal	91	$99.8

We can draw a few preliminary conclusions from this table:

1. Natural gas is the cheapest option, even after adding the cost of carbon capture and sequestration, with geothermal close behind;

2. Solar is much more expensive than any other option;

3. Wind offshore (where there is little NIMBY opposition) is very expensive while onshore (which carries much higher NIMBY opposition) seems a competitive option;

4. Nuclear is cheaper than coal (and doesn’t pollute) and not so far behind the likes of geothermal, nat gas and onshore wind.

However, it is very important to realize that the above costs are those of the energy produced; they do not include the costs of ensuring that the country is reliably supplied with electricity. When wind farms only produce energy 34% of the time, some other power plant must be built to supply energy during the other 66%. The capacity factors show a very wide difference in the ability of various sources of energy to reliably produce energy.

To assess the true costs of each energy source, we must factor the cost of backup power. We will assume that backup energy is produced by combined cycle power plants equipped with CCS (as it typically is). To compare all options, we will adjust the costs of each plant type so as to reach the equivalent of a 91% capacity factor. We do not include the (high) costs of building extra transmission lines to connect the backup power plants. Nevertheless, the results are telling, as the following table shows:

Levelized and equalized cost of new generation (2009 US$/mwhr)

 

Plant type	Adj. capa. factor	Total system levelized cost
Advanced coal w/CCS[3]	91	$114.9
Nat gas – Adv. CC w/CCS	91	$91.3
Advanced nuclear	91	$114.7
Wind - offshore	91	$348
Wind	91	$200.4
Solar photo-voltaic	91	$433.5
Solar thermal	91	$564.5
Geothermal	91	$99.8

 Once these adjustments are made, it becomes very clear that there are only three types of power plants that are relatively clean, almost always on, and cheap: combined cycle gas turbines with CCS, geothermal and nuclear. As I said earlier, the cost of transmission lines is not included in the above figures, understating the comparative advantages of the three leaders.

While geothermal looks very attractive and is being developed in California and elsewhere, its potential is limited by geology.

Some may argue that, cost-wise, onshore wind is “only” twice as expensive as the leaders. The problem is scalability and land usage. Wind farms occupy huge areas of land compared to natural gas and nuclear plants.  They also pose environmental problems, such as noise, and they have an adverse impact on the value of properties in their vicinities.

As for solar plants, while technology is advancing rapidly, they are still very inefficient and consequently anti-economical.  They also occupy too much land.  Their future may lie at the individual habitat level; but even then, the wide fluctuation in their output would necessitate large investments in smart counters and transmission power lines.

The DOE levelized cost numbers are based on national averages; it is worth mentioning that in the case of wind and solar, location has a much bigger impact on costs than for nuclear or gas-fired. In other words, the gap in levelized costs between the most favorable and unfavorable location/region is much broader. This means that scalability is further constrained.

Range in levelized costs (not equalized)

 

Plant type	Minimum	Average	Maximum	(Max-Min)/Av%
Nat gas – Adv. CC w/CCS	$79.8	$88.4	$102.7	25.9%
Advanced nuclear	$109.8	$114	$121.6	10.4%
Wind - offshore	$187.1	$243.7	$350	66.8%
Wind	$82.3	$96.1	$115.5	34.6%
Solar photo-voltaic	$158.9	$211	$324.4	78.4%
Solar thermal	$192	$312.2	$642.5	144.3%
Geothermal	$85.7	$99.8	$115.8	30.2%

Finally, there is the reality of where we are starting from. In 2011, the name plate capacity of our power plants (not including hydro, oil-fired) was as follows:

 

Name plate capacity in gigawatts

 

Plant type	Capacity
Coal	342.3
Natural gas	467.2
Nuclear	106.7
Wind	39.5
Solar	1
Geothermal	2.4

Given the limited scalability and high levelized costs as well as the dire financial condition of the federal and local governments, it doesn’t make sense to push renewable as hard as we currently are. It is my view that nuclear and natural gas will eventually win the day.

At present, rock-bottom US natural gas prices are wrecking havoc on gassy E&P companies, accelerating the switch from coal to gas-fired power plants and generally compressing the profit margins of merchant power producers. Over time, the price of natural gas is bound to rise for three reasons:

1. Supply will be reduced as it is unprofitable for most E&P companies to drill for more gas; witness the cutbacks already announced by the likes of Chesapeake Energy and Southwestern Energy;

2. Domestic use of gas will increase, be it in the power sector, in some areas of transport or in the chemical industry. To that end, very large investments in plant and equipment have already started; witness Dow Chemical for example;

3. Globally, there is a huge arbitrage opportunity to be exploited: LNG sells in Asia at $13 to $16/mbtu; US gas sells for $2.5 at Henry Hub; the cost of liquefying the gas and transporting it to Asia is about $6. From Louisiana to British Columbia, we see a major drive to build gas liquefaction plants and export terminals. We also see some slowdown in new LNG projects in Australia when these were deemed "no-brainers" a decade ago.

Nuclear power suffers from the fallouts of the Fukushima accident and the past laxity of Tokyo Electric Power (TEPCO), the plants’ operator. But the economics are there for all to see. So are the politics. It makes little sense for Europe to trade some of the energy security afforded by nuclear plants for an increase dependence on Russian imports and volatile crude oil prices[4]. For the US, and with the possible exception of some Californian locations, nuclear power is very safe, and indeed the industry has an excellent safety record, Three Mile Island included.

This is a long game; it could take three years or more before the US nat gas market regains its equilibrium and the specter of Fukushima recedes from collective memories. But besides the objective merits of these energy sources, I feel comforted by American psyche and free markets. In this country, arbitrage opportunities tend to be exploited quickly, and there is abundant capital to be put to work. Indeed, the gap may be closed faster than we think as America often "over-does it" and rushes along. Perhaps the best example of this has been shale gas, while the worst has been financial derivatives.

In my view, the stock price of natural gas and uranium producers is too low; the same is true of merchant power producers that operate natural gas or nuclear plants. I am long these stocks.

 

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[1] The DOE first calculates the costs of building, operating, fuel and maintenance a power plant over a 30 year cycle. It then takes their present value and spreads them equally and annually. Inflation is taken out by expressing these values in real US dollars of 2009. Hence the term “levelized”.

[2] CCS: carbon control and sequestration.

[3] CCS: carbon control and sequestration.

[4] Most natural gas imports from Russia are pegged to crude oil, albeit with a 6 to 9 month lag.