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.

Culture, matches and dark matter

As a value investor who has spent most of his career dealing with emerging markets, I have always felt that the role of culture in risk assessment has consistently been underestimated. 

This is so because national cultures evolve very slowly;  George Kennan famously observed that Custine’s Letters from Russia, written in the 1800s, were the best guide to Stalin’s Soviet Union and still quite relevant to Brezhnev’s.

Another example of this phenomenon is how the culture of conquered nations, over time, prevailed over that of its invaders.  Think of Gaul and the Roman armies, or Mexico and the Spanish conquistadores.

Finally, when assessing sovereign credit risks, it is the willingness as much as the ability to pay that defines which country defaults and which doesn’t.  Some countries, like Argentina and Greece, have had a history of throwing in the towel faster or pushing for deeper haircuts than others.

But culture is also what defines corporations, for better or for worst.  In a sense, it is like the dark matter in the universe, you can’t see it but you can feel its influence.

I thought about that when the Fed disclosed the results of its stress tests on the top 19 banks in the US.  Clearly, the tests were quantitative, the results being produced by some mathematical models or simulations.  Most banks that passed saw their stock prices soar, and in my view rightly so.  Truth be told that I was long JP Morgan, Goldman Sachs and Wells Fargo.  But should we take these results as a license to buy or, in the case of those that failed, to sell?

I would put at least as much weight in corporate culture as I would on the test results.  Why?  Because good culture is the ultimate safety net.  CEOs can say whatever they want, put out “bibles”, codes of conducts and the like, but they can’t vet every employee’s decision, or lack thereof.  Down in the trenches, a strong culture will stop (or limit) wrongdoings, let an employee ask for help or quickly admit to a mistake.

Strong banks exhibit discipline in lending, respect for credit analysis; they also foster a culture of spending restraint, and they pass along their values as much informally (meaning face to face) as they do through formal seminars and written materials.

In banking, financial liabilities in banking are 10 to 15 times as large as capital; that compares with zero to 1 time in industry and commerce.  Consequently, the margin of error is far smaller in banks vs. industrials, and the importance of corporate culture that much greater, in my view.

Warren Buffett likes to tell that he looks to invest in companies that enjoy wide moats, meaning by that companies whose competitive position is well defended.  I think of good culture as a wide moat too, against threats from inside, and sometimes, too a lesser extent, from outside.

But good culture, professional reputation and honor if you will, is easily lost.  As Marcel Pagnol’s character, César, famously said[1], “honor is like matches, you can only use it once”.

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[1] To his son in the play Marius.

Well, punk, do you feel lucky today?

The negotiations for a second bailout of Greece are going to the wire.  Indeed, the goal line seems to be reset further back as some EU countries are wondering whether a Greek default would be less costly than the funds they are supposed to come up with to avoid it.

In retrospect, both the IMF and the Eurozone probably rushed into the first bailout, and the question now is whether they would be throwing good money after bad.

Initially, the ECB committed €45 billion and the IMF together with EU countries and other institutions another €65 billion. In total, €74 billion were disbursed.

What is under consideration now is another €93.7 billion from the EFSF to be applied as follows: €30 billion to help Greece finance part of the private debt restructuring/buyback; €35 billion to help Greece finance the buyback of ECB financing; €5.7 billion to help Greece pay accrued interest; and €23 billion to recapitalize Greek banks.  Net net, the IMF/ECB/EU exposure to Greece would rise to €132.7 billion.

As the clock is about to strike midnight, the wealthier European countries seem to feel like the “punk”, wondering if he should take a chance and reach for his gun, or back off should Dirty Harry have one more bullet in his Magnum .357. “Well, […], do you feel lucky today?”

The key variable in this equation is Italy.  Back in the summer of 2011, markets put Italy and Greece in the same bag, and given the size of the former, a default by the latter would indeed have been very dangerous.  But Italy under Mario Monti has engineered a remarkable reform program, and so far, traditional political parties have cooperated thanks to the Premier’s diplomatic skills (to wit, his handling of the relations with Silvio Berlusconi). 

Spain, the next weakest link, has shown determination in cleaning up its banking system.  Finally, the ECB has hosed the European banks with hundreds of billions of euros, offering three year funding against a relaxed set of eligible collateral.

Confidence in Italy and Spain has increased, bank funding markedly improved.  Do we feel lucky today?  Do we want to face electors and tell them they are on the hook for €100 billion to Greece and counting?  If only we could be sure that Greece would make it.  Alas, that looks very difficult.

Greece would still be highly indebted, and whatever productivity gains it has made look unsustainable.

So far, Greece is experiencing a vicious circle with collapsing demand, investment, employment and tax receipts.  As a result, the fiscal deficit is still growing and the population is revolting.  As I wrote last January in this blog, the risks of political instability are rising in countries under economic stress.  So, further tightening looks counterproductive.

The more serious issues are structural, and therefore do not have short-term solutions.  According to a study published by Natixis, Greek hourly productivity in the manufacturing sector is good, but the value added produced by the manufacturing sector (as a % of GDP) is 40% that of Italy, 30% that of Germany and 26% that of Finland: the manufacturing sector is too small and doesn’t produce enough high value added goods. 

The service sector and particularly the bloated public sector are the real issues.  Yet Greece has done very little to improve this, in particular by going slow on privatizations.  To date, only a few billion euros of publicly-held assets have been sold; this compares with a €50 billion goal and a total base of €300 billion as estimated by former ECB board member Jurgen Stark.

So Greece looks unlikely to be able to grow any time soon.  This makes structural reforms very difficult: privatizations usually result in substantial job cuts, unless the output can be largely increased at a profit.  Think of oil, metals and the like that are sold in US dollars yet produced in devalued local currencies.  This looks unrealistic for Greece; it doesn’t produce these goods and it is in the eurozone.  As to tourism, where the country has both an existing infrastructure and great sites, competing with the likes of Turkey or even Dalmatia looks difficult.

As if it were not enough, ingrained habits, such as skirting the law, operating on a cash basis, avoiding taxes (be they on real estate, income or sales) will be even more difficult to reverse.  They may have had a rational and justifiable basis some time ago, but to the extent they have been absorbed by the culture, they will be that much harder to abandon.

All things considered, the most rational course of action for Greece is to exit the eurozone.  Then, it could follow either one of two models: Russia in 1999 which greatly benefitted from a devaluation of the ruble, political stability and positive economic policies, or Argentina in 2001 which veered to the left and proceeded to distort economic incentives to the point that inflation sky-rocketed, energy surpluses disappeared and the agro-industry declined.

It is also the most rational course for the rest of the eurozone.  Advancing another net €60 billion would achieve little except a short respite, would ratchet up tensions and in the end, destabilize both debtor and creditor countries.

Such a decision would probably cause volatility in the markets, but that could be countered by having the ECB stand behind the sovereign debt of the remaining eurozone members, and by having the latter to commit to better economic policies.

The second shoe to drop

It is remarkable that, so far, the global crisis which started in 2007, has had very few disruptive fallouts in the political domain.  There have been two casualties so far, Prime Ministers Berlusconi and Papandreou in Italy and Greece respectively.  In both cases, traditional parties have rallied behind governments led by technocrats and have approved austerity budgets.  In the US, where it all started, the situation is even more benign:  after causing a stir and some concerns, the Tea Party has overplayed its hand and failed to organize into a potent force, and President Obama, while inspiring faint enthusiasm, may be reelected come November.

Yet this may change.  Indeed, as governments in Europe, and soon in the US, cut spending (including social benefits) and raise taxes in order to reduce public debts and balance their budgets, populations may well revolt and seek alternatives.

In particular, the perception that such sacrifices are demanded by a foreign power, such as Germany, or by faceless financial markets which have been demonized by politicians and the media, combined with the absence of tangible forthcoming benefits may well cause populations to balk, to reject further austerity and loss of purchasing power, and to become receptive to the most demagogic promises of fringe politicians.

Granted this didn’t happen in the US during the Great Depression, but it did in Europe and I would argue that the explosion of media and social electronic networks make such a threat more serious today. Although in a different context, the Arab Spring is the clearest illustration of how a movement can gather irresistible strength.

In particular, what we are witnessing today is the squeezing of the middle-class throughout the West, and such a trend is unlikely to stop any time soon.

In April 1932, the liberal journalist Paul Scheffer of the Berliner Tageblatt wrote a powerful article on Hitler and how he seduced a despondent German middle-class.  This article was reproduced in the January/February issue of Current Affairs, and I am reproducing an extract here.

Hopefully, we will avoid a similar fate. But I do expect that, while the Great Recession mostly impacted financial markets and economies initially, it will have a much larger impact on politics and government in the next few years.