Guest Editorial: "Energy Stocks: The Only Way to Make Any Money"

July 9, 2008 at 8:06 am
Contributed by: Chris

Here is a new guest editorial I wrote for the Wealth Management Exchange site. Original here

Energy Stocks: The Only Way to Make Any Money

By Chris Nelder,
author of Profit from the Peak – The End of Oil and the Greatest Investment Event of the Century

The game has changed. It’s time to throw out the old investing playbook.

Index funds, diversified portfolios, momentum trading strategies, even technical chart analysis are more likely to lose you money than increase it in the coming years.

The reason for this heretical position: peak oil.

The concept of peak oil is simple: Oil production rates generally follow an irregular bell-curve shape. It is simply the nature of petroleum extraction that it ramps up to a peak or short plateau, and then declines. This observation has been made in thousands of oil fields (and oil producing nations) worldwide, and is named “Hubbert’s Peak” in honor of the geologist who first described it, Dr. M. King Hubbert.

Peak oil is not about “running out of oil,” it’s about the peak rate of oil production. It’s not the size of the tank which matters, but the size of the tap.

Living Within A Shrinking Energy Budget

When the production rate of oil reaches its maximum and begins to decline, the world’s economies will be forced to live within a shrinking, not expanding, energy budget. The economic impact of peaking oil production is what concerns us, not the amount of oil yet to produce. We won’t be “running out of oil” for at least 100 years or more, but it will be produced at ever-declining rates.

Right now, the world is producing oil at the rate of about 86 million barrels per day (mbpd), a rate which has been essentially flat since 2005. While geopolitical factors have certainly played a role, the most significant reason that oil production has now plateaued, after decades of steady growth, is the depletion of mature fields.

A majority of the world’s best and largest oil fields have reached maturity, and are either already in decline, or soon will be. In the aggregate, the world’s background depletion rate owing to these mature fields is now about 4.5% per year. Therefore, the world has to manage about 3.8 mbpd of new oil production each year just to keep the global production rate flat-equivalent to finding a new China, or a new Mexico, each year. In order to actually increase global oil production by 1 mbpd a year to meet projected demand, we would have to find the equivalent of a new Iran every year.

After taking into account the significant new oil projects that should come online within the next decade, and the likely pace of depletion and demand, many experts on peak oil believe that we are essentially already at the peak of global oil production. Within the next three to five years, the world will likely reach the end of the plateau at the peak, and go into terminal oil production decline.

Demand Increasing Where Oil Is Subsidized

Although oil production has stagnated, demand for oil has not. Gasoline over $4 a gallon has dampened demand in the U.S., but demand is still increasing in the red-hot economies of the Middle East, China and India, where gasoline and diesel are subsidized. As a result, global demand continues to increase by about 1 mbpd each year.

This imbalance in supply and demand is the primary reason why oil prices keep going higher. Speculation, as everyone from the Department of Energy to the Treasury to oil traders has said, is not really a factor. Even Warren Buffett agrees: “In my lifetime, up until the last year or two, there’s been a huge amount of excess supply available,” he said. “We don’t have excess capacity in the world anymore, and that’s why you’re seeing these oil prices.”

What we are seeing now is simply the market trying to place an appropriate value on a barrel of incredibly useful, energy dense, finite, and diminishing oil.

Oil and the Economy

We have already seen the economic damage caused by oil prices shooting up 40% in the first half of 2008. It has resulted in inflation across the board, because energy is used to make and transport everything. This is particularly true for food: One oft-quoted estimate is that for every calorie of food that comes to your table, it took 10 calories of fossil fuel inputs to grow it, process it, store it, and deliver it to you.

Ironically, the U.S. mandate to produce 36 billion gallons of biofuel a year by 2022 has only exacerbated rising food costs, as food competes with fuel for a limited supply of corn and other feedstocks.

Oil has also reflected the declining value of the dollar, since oil is primarily traded in U.S. dollars worldwide. The decline of the dollar, the sub-prime crisis and an economy on the ropes (in part due to spiking energy costs) has created a vicious cycle. As more and more of one’s income is eaten up by the basic needs of food and energy, it leads to further dependency on credit, which increases the likelihood of credit and mortgage default, which further hurts the financial sector, taking down the broader markets and putting the economy in an increasingly worse position.

Perhaps that is why government economists have cleverly created the Consumer Price Index, or CPI, which specifically excludes food and energy, and thus makes the “core” economy sound healthier than it really is.

At the same time, the loss of discretionary income reduces spending, making economic recovery even more difficult. It’s a classic case of “stagflation.”

Barring a very severe, global recession or depression (which may be inevitable anyway), these problems are bound to get worse. Prices for everything will have to keep going up as long as oil prices do. Prices for grid power will also have to keep going up, because higher prices and faltering supplies of oil put further pressure on coal, natural gas, and nuclear power.

In fact, switching from oil to other traditional fuels might not work at all, and could make our problems even worse.

In my book, Profit from the Peak, I studied all major forms of energy: oil, natural gas, coal, nuclear, biofuels, all renewables, efficiency, the works. In order to determine what the true potential of each fuel is, I examined their relative sizes, their potentials and peaking profiles, and their investing angles.

My research indicates that we are likely at the peak of oil right about now (2008-2010), and that we’ll reach peak natural gas around 2010-2020, peak coal around 2020-2030, and peak nuclear by roughly 2025. All of the sources I consulted are public information, yet few observers seem to have realized that we may be looking at peak energy within the next 17 years!

As for unconventional sources of hydrocarbons, such as tar sands and oil shale, and the currently off-limits reserves of the continental shelf and the Arctic National Wildlife Refuge, they cannot materially affect the basic supply curve of oil. My research suggests that all of the above put together might produce 5 to 6 mpbd at peak, 10 to 20 years from now, but they will only slightly offset the global depletion that will have occurred by then, making a slight bump on the back side of the production curve.

The Impact On Investment

The enormous challenges facing energy production have fundamentally changed the investing game. An uncertain supply outlook combined with a remarkably inelastic demand for energy has driven a stake into the heart of neoclassic economic theory. It appears that this time, things really are different. This time, the Invisible Hand of the market is going to stay in its Invisible Lap, and provide nothing but a diminishing supply and higher prices. It is now an empirical fact that record high oil prices have failed to bring adequate new supply to market.

This is why oil and commodity prices stubbornly refuse to revert back to the mean, as a technical chart analysis says they should.

This is also why a typical broad and “safe” investing strategy based on index funds and diversified portfolios would have delivered somewhere between a zero return and a 15% loss so far this year.

In fact, I believe that commodities, and in particular energy, are really the only sectors that stand to gain as we go deeper into the energy crisis.

This view was echoed in a CNBC interview on May 29 with Matthew Simmons, one of the world’s top energy investment bankers. “I have a very significant portfolio that I’ve built up over the last 25-30 years in energy stocks,” he said, “because I think it’s the only way that anyone’s going to make any money.”

His thesis-and ours-has been well supported by the market. While almost every other sector has been harshly beaten down over the past year or so, energy shares have been going off like a rocket.

After all, the flip side of crisis is opportunity. This is not only the greatest challenge the world has ever seen; it is also the greatest investment opportunity.

Energy: The Investment Opportunity of a Lifetime

The answer to the energy crisis is painfully simple: Reduce demand, and increase supply.

There are hundreds of outstanding investment opportunities in the companies that are focused on providing the solutions we need. I suggested dozens of them in my book, but I also endeavored to equip my readers with a deeper understanding of the whole picture, so that they can find the opportunities that most appeal to them.

For those who like the traditional energy business, there are plenty of excellent plays. Transocean (RIG), the largest offshore drilling rig provider in the world, is a real blue chip investment in oil production, up 44% over the last year. Companies like Chesapeake Energy (CHK) and Southwestern Energy (SWN) are in hot pursuit of natural gas, and are up about 70% YTD. Coal companies like Arch Coal (ACI) and Peabody Energy (BTU) are on fire, up 67% and 43% on the year, respectively.

The renewable energy business is even more exciting. Solar companies like First Solar (FSLR) and Canadian Solar (CSIQ) have tripled or quadrupled over the last year alone. Diversified solar, battery and fuel cell company Energy Conversion Devices (ENER) is up 139% in the last year. Wind turbine manufacturer like Vestas Wind Systems (Denmark: VWS) and Western Wind Energy (Canada: WND) have doubled and tripled, respectively, over the last year.

After wind and solar, however, are potentially even more exciting renewable energy technologies like geothermal power, and marine energy technologies that seek to derive power from waves and tides. The size of these resources is positively vast, many times greater than the total energy the world consumes every day. But unlike wind and solar, which have a solid 30 year history of investment in research and development and real-world trials behind them, geothermal and marine energy are really just getting started. Although both types have been in commercial use since the 1960s, such as The Geysers geothermal plant in California and the Rance River tidal barrage generator in France, a new generation of technologies promises to deliver clean geothermal and marine power in thousands of new locations around the world.

In addition, there are entire new areas of opportunity:

  • Transforming our infrastructures to run on electricity instead of liquid fuels
  • Making everything more efficient, from cars to homes to appliances.
  • Rebuilding the electric grid to be beefier, more distributed, more agile, more tunable, and more resilient.
  • Creating new ways of storing energy, from the micro (batteries) to the macro (overnight thermal storage for concentrating solar plants).
  • Implementing carbon control protocols and carbon capture mechanisms.

Each of these sectors has numerous plays, from big solutions like publicly traded hybrid car manufacturers, to small ones like privately funded grid control devices.

The growth potential for renewable energy, and the associated technologies of the future, seems nearly limitless. After decades of investment and research into renewable energy, it currently accounts for only about 1% of the global energy mix, but by the end of the century, it will have to be closer to 100%.

With a clear understanding of the impending energy crisis, and a realistic grasp of our options going forward, investing in energy and other commodities is a no-brainer. The game has changed, and those who realize it now have an opportunity to jump on the greatest investment event of the century.

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