Chris Nelder - Angel Publishing

Utility Scale Solar Technology Heating Up

Utility scale solar got a big boost this week as Interior Secretary Ken Salazar announced a new plan to designate 24 tracts of public land administered by the Bureau of Land Management (BLM) as study areas for development of solar power plants.

The effort is in support of President Obama's target to generate 10% of U.S. electricity from renewable sources by 2010, and 25% 2025. The nation currently generates more than 1000 megawatts (MW) from photovoltaics, and 600 MW from thermal concentrated solar power (CSP) systems.

The BLM plans to spend $22 million evaluating about 670,000 acres, or more than 1,000 square miles of land, in Nevada, Arizona, California, Colorado, New Mexico and Utah in search of sites with at least three square miles of good solar exposure, favorable slopes, access to roads and transmission lines, and minimal environmental impact.

Salazar estimated that the areas could generate nearly 100,000 MW, and announced his intention to have 13 commercial scale solar power plants under construction by the end of 2010. BLM is already considering environmental reviews for two NextLight Silver State arrays in Nevada, totaling 407 MW. (For comparison, typical coal-fired power plants in the U.S. are 500 to 700 MW in size. One megawatt of coal-fired capacity will power 400 to 900 homes, depending on their location and demand for air conditioning.) The BLM has already begun the process of developing environmental impact statements for three solar projects in California, including two by Stirling Energy Systems totaling 1,600 MW of capacity, and the 400 MW Ivanpah project by BrightSource Energy.

BrightSource Energy CSP plant (pictured on the right), which uses an array of small, flat mirrors on heliostats that track the sun and focus its rays on a central "power tower" where the generator is located.

Applications for 10 MW or larger plants would be fast-tracked under the new program, which will radically streamline the permitting and development process and assume responsibility for one of the most burdensome aspects of getting utility scale solar plants built: environmental reviews.

The BLM has been struggling to process a backlog of pending applications for 470 renewable energy projects, including 158 commercial solar projects totaling some 97,000 MW—enough to power 29 million homes, and equivalent to 29% of the nation's electricity demand, according to the agency.

At present, zero permits have been approved. Progress has been impeded by concerns over species protection, availability of water (primarily for the cooling cycles of the power plants), and a maze of approval processes in multiple government agencies with overlapping jurisdictions.

Projects nearing approval will be expedited under the plan, and existing applications for projects in approved areas will be given priority.

"With coordinated environmental studies, good land use-planning and zoning, and priority processing, we can accelerate responsible solar energy production," Salazar said.

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Minimizing Environmental Risks

Environmental reviews have been especially troublesome, since utility scale solar projects require large (10-15 square mile) areas to be "walled off." But isolating even a five square mile tract can impact wildlife corridors and drainage. Many projects have been put on hold over concerns about endangered and protected species including the Mojave ground squirrel, the desert tortoise, the California kit fox, and the Yuma clapper rail.

In March, California Senator Dianne Feinstein threatened to propose legislation that would designate more than 800,000 acres between the Mojave National Preserve and Joshua Tree National Park as a national monument and off-limits to development, because it contains desert tortoise habitat, wildlife corridors, and endangered cactus. She wrote Salazar, requesting that 12 proposed solar projects in the area be stopped.

At the Concentrating Solar Thermal Power 2009 conference San Francisco, CA last month, I came to understand just how challenging the environmental aspect was in a presentation by Charles Ricker, the Senior Vice President of Business Development for BrightSource Energy. Oakland, California based BrightSource is one of the world's premier CSP developers, with 2.6 gigawatts (GW) of commitments, equivalent to 25% of the world's solar thermal generating capacity.

Ricker related his company's long and torturous slog to build the Ivanpah project. After securing a power purchase agreement (PPA) for 300 MW with California utility PG&E and a 100 MW PPA with Southern California Edison, getting well along in the permitting process with the California Energy Commission (CEC) and BLM, raising capital, securing access to transmission lines, buying a Siemens turbine and a Riley boiler receiver, and negotiating a contract for construction that was to break ground later this year, the discovery of 25 desert tortoises in the area held up the whole works.

Avoiding such deal-killers will be a key focus of the new BLM process. The study will specifically exclude "sensitive lands, wilderness and other high-conservation-value lands as well as lands with conflicting uses" such as mining claims, according to the Department of Interior press release. "Areas with a known density of cultural sites" and those "of known Tribal concerns" will also be excluded.

Once a given area is approved for development, companies applying for projects will be able to incorporate the BLM clearances as part of the environmental impact studies required by the National Environmental Policy Act. Consequently, it should greatly reduce the cost of doing the environment evaluations, as well as the investment risk.

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Fat Incentives

Helping to shoulder the burden of environmental clearing, permitting and approval is a critically important benefit at a time when raising the necessary capital continues to be a major hurdle. Banks are still very reluctant to lend for renewable energy projects. One presenter at the CSP 2009 conference explained that Florida Power & Light had to tap 12 banks to round up a lousy $350 million in financing for what was essentially a no-risk renewable energy utility project!

Another presenter noted that banks will still not finance storage systems for CSP projects because of their lack of a commercial track record. This is extremely unfortunate as thermal storage offers the potential for CSP plants to operate 24/7 and compete head-to-head with coal-fired and nuclear plants, providing round-the-clock "baseload" capacity. Numerous technologies including high pressure concrete, mineral oil, molten salts, and direct steam storage are now available or under development that could crack this all-important limitation and pave the way for utility solar to take over a large part of the nation's electrical supply load. Without storage, solar plants can't function when the sun is down.

In an effort to make utility scale solar projects more attractive to investors, a host of government incentives have been launched.

First, the new BLM process will be funded by $41 million dollars given to the agency under the American Recovery and Reinvestment Act of 2009 "to advance the nation's development and transmission of renewable energy on public lands."

The federal stimulus package also offered a package of incentives designed to further minimize the investment risk for commercial solar plants. A cash grant program from the Treasury covers 30% of the project cost with no limit, and functions like a tax credit. Better yet, Treasury must grant it if a project meets the application requirements.

Congress also appropriated $6 billion for a program administered by the Department of Energy that will subsidize the risk premium (10-15% of the total loan) to backstop the investment risk for projects that are ready to start construction by Sept 30, 2011.

Additional financial incentive programs are available at the state level. Arizona will assess property taxes on a mere 20% of the depreciated property value. New Mexico offers a production tax credit against state taxes for 10 years, capped at 200,000 MWh/year, and a 6% "advanced energy tax credit." Nevada has an abatement incentive that will reduce normal sales taxes of 6.5% - 7.75% to just 2.6%, and reduce property taxes by as much as 55% for CSP projects; the incentives expire in 2049. Colorado offers a permanent property tax assessment that will value solar energy projects at the same level as comparably sized non-renewable facilities, giving them an assessed value that is far lower than the actual value on a sliding scale. Utah offers a sales tax exemption as well.

With policy and financial support at its back and the BLM clearing the path ahead, the future looks bright indeed for utility scale solar, the cheapest solar watts around. It's not easy to find publicly traded stocks that are positioned to benefit from the technology's next wave of expansion, but that's why we're here.

Until next time,

Chris

Energy and Capital

The Renewable Energy Revolution

I have dished out a healthy share of criticism about the paths we are taking into the energy future, so perhaps it's time I offered some paths of my own. I will outline them as simply as possible, since the data and thinking behind them could fill a book.

First we must know where we're going.

Credible models show that by the end of this century, essentially all of the fossil fuels on earth will be consumed—oil, natural gas, and coal. Presumably, whatever fuels do remain at that point will be reserved for their highest and most valuable purposes like making crude oil into plastics and pharmaceuticals, not burning it in 15% efficient internal combustion engines.

Consider the following world model for all fossil fuels:

Source: "Olduvai Revisited 2008," The Oil Drum, by Luís de Sousa and Euan Mearns. Cumulative peak is Data sources: Jean Laherrère for natural gas, Energy Watch Group for coal and The Oil Drum for oil. [This is an exceptional study and I recommend it to my readers!]

By the end of this century then, a mere 90 years from now, we'll need to have an infrastructure that runs exclusively on renewably generated electricity, biofuels, and possibly nuclear energy. That's where we're going.

Fortunately, there is more than enough available renewable energy to meet all of our needs, if we can harness it. Unfortunately, we're starting from a point at which less than 2% of the world's energy comes from renewables like wind, solar and geothermal.

Hydro provides about 6%, and nuclear about 6%, but for reasons too numerous to get into here, some of which my longtime readers have already heard, I don't believe either source will increase much in the future, and both could actually decline.

Our challenge then is to make that 2% fraction grow to replace about 86% of the world's current primary energy, in 90 years or less.

We are currently at peak oil, a short, roughly 5-year plateau which goes into terminal decline around 2012. All fossil fuel energy combined peaks around 2018, less than a decade from now.

All strategies for accommodating the fossil fuel decline require decades to have any significant effect. The now-iconic study "Peaking of World Oil Production: Impacts, Mitigation, & Risk Management" (Hirsch et al., 2005) demonstrated that it would take at least 20 years of intensive, crash-program mitigation efforts to meet the peak oil challenge gracefully. Another study, "Primary Energy Substitution Models: On the Interaction between Energy and Society," (C. Marchetti, 1977) showed that it generally takes decades to substitute one form of primary energy for another, and 100 years for a given source of energy to achieve 50% market penetration.

Therefore, we are going to have to accomplish most of the renewable energy revolution in a scenario of ever-declining fuel supply. In just 50 years, we'll be working with about half our current energy budget. So in fact we may only have about 50 years to build most of the new renewable energy and efficiency capacity we will need to get us through the end of the century.

Another important factor is that exports will fall off much faster than total supply. (See my article on the oil export crisis from last year.) Foucher and Brown (2008) have shown that the world's top five oil exporters could approach zero net oil exports by around 2031. Net energy importers like the US could be increasingly starved for fuel as decline sets in and accelerates, and net energy exporters could wind up shouldering much of the burden of new manufacturing. This factor means that we will have to front-load as much of our development as possible.

The final and most important factor is population. The few population models that actually take fossil fuel depletion into account assume that global population increases roughly out to the global fuel peak, and then stabilizes at that level or declines naturally while economic development promotes lower fertility rates and renewables and energy efficiency increase to fill the gap of declining fossil energy. I understand why this assumption is made—because the alternative is too ghastly to contemplate—and for the immediate purpose of this article I will go along with it. I will note however that history and scientific observation of populations suggest some sharp episodes of decline are more likely, and in my estimation we will end this century with a considerably smaller population than anyone forecasts, at some level well below today's.

How, then, can we replace or offset through efficiency at least 40% of our current energy supply with renewables in the next 50 years, while fuel prices are rising and the global economy is flat or shrinking due to a lack of fuel?

Seven Paths to Our Energy Future

A proper model for achieving this goal would be a very large undertaking, the sort of thing that should be done by a team of experts with a budget. (Is anybody at the Department of Energy listening?) But I can identify some key pathways that are, in my estimation, no-brainers. Because the solutions going forward will be quite different for each country, I will limit my recommendations to the US.

1: Rail. Rail should be Priority 1, and should be granted the largest portion of public funding. We should begin as quickly as possible with light urban rail, and work over the next 40 years to build a comprehensive high-speed long-distance rail system.

Rail is by far the most efficient form of overland transportation we know, and moving people out of their cars and freight off the roads will yield real and immediate savings in liquid fuel consumption. Not only will this help alleviate America's need for rapidly declining oil exports, it is a proven, fairly low-tech, sustainable and workable solution that would allow renewably generated electricity to be phased in over time with minimal disruption.

2: Rooftop Solar PV. Utility scale projects like giant solar farms in the desert and giant wind farms in the Midwest (or offshore) all face serious hurdles in siting, permitting, environmental impact, and transmission capability. Rooftop photovoltaic (PV) solar systems face no such issues and can be deployed right now, building capacity incrementally over time. PV has been proven in the field commercially for over 30 years and, speaking as a former residential and small commercial solar designer, I know that it can provide 50-100% of the needs of most small buildings.

Rooftop PV also has a capital advantage. Whereas utility-scale solar and wind projects need to secure large power purchase agreements in order to raise enormous amounts of capital that will be tied up for decades, small rooftop PV systems are purchased outright by the end-users, assisted by ratepayer-funded incentive systems. Simply getting projects done is considerably easier.

From a funding perspective, rooftop PV is arguably one of the easiest sources we can develop, and options are proliferating. Cities like Berkeley and San Jose are offering municipal bonds to finance local projects, which keeps the financing small, local, and low-risk. Third-party financing companies are springing up all over the country, making it possible for home and business owners to put solar on their roofs with no out-of-pocket expenses and pay them off at the same rates or less than they're already paying to utilities, with nearly zero risk to all parties. End-users enjoy an additional benefit of having a known, fixed cost for their future power, even as fossil fuel prices skyrocket.

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Another very important advantage is that rooftop PV is distributed, which contributes to the resiliency and robustness of the grid. In most modern neighborhoods, no grid upgrading is needed to support rooftop solar systems. More distributed power generation also means fewer points of failure: a cloud over here is compensated by clear sky one mile away. It also enables micro-islanding, which would allow most of the grid to stay up when there is an outage, instead of taking vast chunks of the country's grid down along with it as we have seen in the recent past.

Utilities also win with rooftop PV, because it means they don't have to spend an enormous amount of effort and money in search of enough clean, green kilowatt-hours to meet their renewable portfolio standards, nor spend it on beefing up their grids. It essentially costs utilities zero to take up energy produced this way; in fact it can be a net benefit to them because the homeowner ends up paying for the new smart meters they plan to deploy across their grids anyway (at a cost of tens of millions of dollars).

Feed-in tariffs (FiTs) that pay a premium for kilowatt-hours generated by rooftop PV have been employed with great and immediate success in Germany and Japan, to the point where both programs will be largely phased out within the first decade. Support for a national FiT in the US is still weak, but I believe it could become a reality if the public were educated about the success it has enjoyed elsewhere in the world.

3: Alternative Vehicles. Since reconfiguring our urban topology around transit and deploying light rail will take decades, we will need some transitional solutions that still allow us to get around in cars for a good many years. All-electric and plug-in hybrid electric vehicles are a two-fer: They can take advantage of growing renewable electricity supply, and they can function as a giant, distributed battery for intermittent renewable sources using vehicle-to-grid (V2G) technology. In time, V2G could provide the final link that allows renewable energy to fully displace fossil fuels.

We will need to begin building the electric vehicle charging infrastructure as quickly as possible to accommodate these new vehicles, but it needn't be any more complicated than deploying a new row of parking meters. This I think is a good and proper use of public funding. The automakers themselves should be able to find adequate funding via the private sector, with perhaps a modicum of federal support for research to jump start next-generation development of batteries and propulsion systems.

Compressed natural gas vehicles are another transitional solution that would take advantage of domestic gas supply while cutting demand for imported crude.

Biofuels may also play a role, although I continue to be skeptical about how much they can truly achieve once net energy (EROI) and food-vs.-fuel tradeoffs are taken into account. Corn ethanol fails these tests, but to the extent that cellulosic biofuels pass them, they could take a substantial bite out of our demand for petroleum. Still, it will take a decade or more to scale it up to significant levels.

Before the global economic downturn, our replacement rate was about 14 million new cars and light trucks per year. We have about 250 million such vehicles now. At that rate (we're well down from it now), it would take 18 years to replace the fleet, but we probably won't maintain that rate while the economy shrinks and fuel prices rise. Therefore we should concentrate on a rapid, near term deployment of alternative vehicles, before it gets prohibitively expensive and difficult to do so, even if they wind up having all the sex appeal of a mass produced WWII Jeep.

Ideally, we will only have to replace a fraction of the current fleet, with the rest of the traffic having been moved to rail.

4: Efficiency. Most of the efficiency gains we can make are thermal: reducing the energy it takes to heat and cool buildings. These gains ultimately translate into less coal and natural gas demand, so they will do little to reduce our demand for oil, which must be our first priority. In the long run however, efficiency must make up for any shortfall in renewable energy production, so it must be pursued continually over many decades.

More efficient regular gasoline and diesel vehicles also belong in this category, and may reduce our dependence on oil if they are sufficiently efficient and the gains aren't nullified by the Jevons paradox. In my view, anything under 25 MPG is simply pathetic at this point, and undeserving of any federal support. Incentives for more efficient ICE vehicles should be geared to produce the greatest possible gains in fuel economy, not the watered-down "Cash for Clunkers" bill we got, which will ensure another several years' worth of inefficient SUV production.

5: Utility Scale Renewables. Rooftop PV may be able to fill the short-term supply gap if aggressively pursued, but in the long term we'll need every renewable kilowatt-hour we can get. We'll need large solar plants across the Southwest, and huge wind farms in the Midwest and offshore. Geothermal and marine power can also make major contributions in time, but they're babies now, and will need public guarantees and funding to reach the level where they are commercially viable technologies.

6: A Beefier, Smarter Grid. In order to carry all the new renewable power, we're going to need a bigger, more resilient, and smarter grid. The good news is that we already have most of the technologies we need in this area. All that we lack is the will and the funding to put it in place. In the same way that it took federal funding and initiative to create the interstate highway system, the grid will also probably need to be nationalized and its enhancement funded publicly in order to meet this challenge.

A key element of the new grid will be long-distance high-voltage direct current (HVDC) power lines to transmit the power from the large utility scale projects to the cities where it's needed. This must be on the short- to medium-term agenda since it must be ready to take on real capacity within 20 years and be nearly full-blown within 40 years.

7: Keep Drilling. If we back off too much too soon from oil and gas production, it could leave us without adequate or reasonably priced fuel to accomplish this transformation, and sink the entire effort. I think we'll need as much oil and gas (and to a lesser extent, coal) as we can possibly produce in order to pull it off. Just imagine how difficult it will be to produce a solar panel or a large wind turbine using only renewably generated electricity to mine the raw ores, crush them, transport them, smelt them down and turn them into stock, transport them again and turn them into end-products, then transport them a final time and install them. I think it's safe to say that we have no idea how to do all that without liquid petroleum fuels.

The twilight years of hydrocarbon fuels are essentially upon us, but we'll need them more than ever as they peak out and decline. We will have to keep drilling, and the oil business will have to be able to turn a fair profit.

At the same time, I have long maintained that after a nearly a century of commercial operation, the petroleum businesses should be able to get by on its own, without public subsidies of any kind. If that means the price of fuels goes up, then so be it. We're going to have to start paying a fair value for those finite, rapidly disappearing resources some day, and price increases will only encourage efficiency and alternatives.

Just Do It

Turning these conceptual pathways into action will not be easy, and we may be forced into action before we have perfect clarity about where we're going and what it's all going to cost. Yet I have no doubt that if we move on these seven pathways as quickly as possible, we will make progress in the right direction. There will be time to fine-tune it later.

Over the long term, the economics of energy are clearly in favor of renewables. The costs of producing and burning fossil fuels can only increase, and the costs of renewable energy will fall for decades before stabilizing.

Finding the money to rebuild so much of our infrastructure will no doubt be a challenge. But if we're willing to put a $2.5 trillion debt burden on the future to bail out the financial system, and untold trillions more to provide military protection for the oil resources that remain, perhaps it's just a question of priorities. I have no doubt that the money would be better spent on building an energy infrastructure that will actually sustain us.

The successful pathways are the profitable pathways. Think rail, small solar PV, alt vehicles, efficiency, utility renewables, grid, and drill, baby, drill.

Until next time,

Chris

Energy and Capital

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"Indeflation" and "Compartflation"

A fierce debate now rages among economists, investors, pundits and the puppetmasters of fiscal policy: What's next, inflation or deflation?

Has the most massive money-printing spree in history successfully stimulated the global economy and put it back on an upward course with rising inflation? Or are we still in a global downturn, temporarily masked by the stimulus, with prices, wages and employment still falling?

A comforting 30% gain in the major stock market indexes since the March lows has given renewed confidence to the "green shoots" trumpeters who dominate the airwaves and the press.

But grayer and wiser heads in the investing community—like Dave Rosenberg, John Mauldin, Nouriel Roubini, Gary Shilling, Peter Schiff, and Dave Cohen—have a more bearish view. The financial sector must now deleverage, they argue, which means liquidating assets, repaying debt, saving instead of borrowing, and contracting in general. In their view, the process will take years, not months, and what we have seen since March is a classic bear market rally.

Consider the data Rosenberg offered in a commentary this week in support of his deflationary thesis:

Residential real estate still sports a 12-month supply of unsold inventory, and housing starts have staged a very weak recovery this spring.
Every major industry posted a decline in May. Industrial production had its seventh decline in a row in May, to a level last seen 11 years ago. The Institute of Supply Management (ISM) index, a measure of manufacturing activity and a proxy for tech spending, is still falling.
Employment slid in May to greater depths than were seen in the last two recessions, and "real organic personal income" fell for the second time in the last three months. Ultimately, recessions don't end without rising employment, meaning consumers with money to spend.
Prices are generally still falling. The Producer Price Index (PPI), used to evaluate wholesale price levels, is down 37% year-over-year "to a 50-year deflation low of -5.0."

There are other signs that this spring's green shoots may be browning. The Consumer Price Index (CPI), the Labor Department's key measure of inflation, has fallen 1.3% over the past year, the largest decline in nearly 60 years, mainly due to the 27.3% crash of the energy index component.

Meanwhile, the consumer remains beaten and bruised. As my colleague Steve Christ pointed out this week, U.S. household net worth fell by $1.3 trillion in the first quarter, and household wealth is down 21.6% from its 2007 peak. Commercial real estate is contracting painfully, with prices plunging and vacancies and defaults soaring. Meanwhile, consumer credit defaults are still rising, even as rising interest rates have snuffed out the resurgence in home-buying.

Liquidity in the credit markets remains a problem as well. Banks simply aren't lending out the Fed's forced injection of fantasy capital. Indeed, they are entirely intent on paying it back as quickly as the Fed will let them, on the heels of secondary stock offerings and other measures they have taken to raise capital and reduce their exposure. (For a personal anecdote, I called Discover last week to take advantage of a recent 1.8% promotional offer on balance transfers they had sent me, and was told that they aren't accepting any more balance transfers right now, from anybody, period.)

On the whole, I think the case for deflation and contraction is well made.

Commodity Inflation

At the same time, food and energy prices have been rising rapidly. Oil has rocketed from the low $40s to the low $70s in just four months, a roughly 71% gain. Soybeans rose about 50% over the same period, with most other grains gaining similarly. Normally, this would suggest inflationary fears, and indeed it has apparently drawn hedge fund money off the sidelines, out of bonds, and back into energy and commodities. (Energy analyst Dave Cohen did a great study of speculation in the current commodity cycle this week in "Bad Signs, New Bubbles.")

I don't want to make too much of the commodity resurgence, however. The market continues to price oil inversely to the dollar, and the dollar's fall has been echoed almost perfectly by oil prices:

The dollar's decline can be viewed as the proper result of printing trillions of dollars out of thin air, without new assets to back it—the inflationary thesis.

Indeflation

On the whole this year is looking a great deal like last year across the energy and commodities sector, with the same sort of inflation. But there is an important difference this year: The economy and the consumer are sick, very sick. Gasoline at $3 was a nuisance last year, but this year it really hurts.

Perhaps we should be zooming out on this picture, and considering the affordability of oil. Consider this 60-year chart from the blog of "Mr. Excessive," which tells quite a different story:

The affordability of oil, as measured by the S&P500, peaked in 1999, and has been in decline ever since. Oil prices began rising sharply at that time, as the early effects of peak oil began to be seen. Global conventional oil production has been flat since 2005, despite a tripling of prices.

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So is it inflation or deflation?

My pal Gregor Macdonald argued this question elegantly on his blog in April, and in a conversation earlier this week asserted, I think rightly, that it's not an either-or question. In fact, we're seeing inflation (of prices) and deflation (of assets) simultaneously. Investor guru Doug Fabian has termed this "indeflation" and Izabella Kaminska of FT Alphaville has called it "compartflation."

Instead of just looking at the dollar and inflation, we should consider that, as former International Petroleum Exchange head Chris Cook argued on The Oil Drum, energy is the only real currency. Our fiat money is but a distorted representation of it, and that energy is declining in real terms as oil, natural gas, and coal all become progressively harder to extract and of lower energy content.

Are We At An Inflection Point?

We now appear to be bumping our heads against an invisible ceiling, where the decline in real energy meets our pain tolerance for high prices. When gasoline hit $4 last year, it created real demand destruction because people simply couldn't afford it with their evaporating dollars. Likewise, the spike in natural gas and coal prices ultimately translated into such high prices for basic building materials like cement and steel that demand was curtailed.

It now seems possible that we have reached an inflection point in economic history, where the price at which energy is high enough to sustain new production is the same price at which things become too expensive, leaving us no option but to downsize.

Until we understand this key point, we are going to continue to go through wrenching cycles like we experienced over the last year. Spiking energy and commodity prices lead to destruction of the economy, which then gathers itself at a lower overall level until prices spike again, and back around the wheel we go. As energy declines, the ceiling will get lower and lower, and it will take more and more money to buy the same things.

No amount of tinkering with monetary policy can change that. Unlike money, Btus can't be printed out of thin air.

Unfortunately, neither the Fed nor Congress seems to have learned this lesson.

The Fed still thinks that tweaking interest rates, buying bonds, forcing banks to keep the fantasy money, hiding the stress test results and the like can somehow ease us into a manageable recovery.

A few bright bulbs in Congress suggested this week that we exchange 70 million barrels of light sweet crude oil from the Strategic Petroleum Reserve (SPR) for an equivalent amount of lesser quality heavy sour crude, in an effort to dampen oil prices. Aside from being a fundamentally bad idea, I continue to believe such a move would be utterly ineffectual. The maximum official rate at which the SPR can be drawn down is four million barrels per day, but I suspect the actual rate would be far lower. In any case, the price difference between the two grades of oil is fairly small, and the value of the swap would virtually disappear within a flow of 84 million barrels a day of globally priced oil.

The other bit of new legislation, a "Cash for Clunkers" bill that passed yesterday, also appears to be completely toothless. I supported the idea until I learned the anemic requirements of this bill, which would offer $3,500 vouchers for a mere 2 mpg gain in fuel economy for light trucks and SUVs, and $4,500 for a 5 mpg improvement. Cars would only need to gain 4 to 10 mpg to qualify.

Suffice to say that I still have very low expectations that our national leadership will offer any tangible, effective methods to significantly reduce our consumption of petroleum. I certainly do not see them coming to grips with the near-certainty that by 2012, the world's oil supply will go into terminal and relentless decline.

Looking internationally, finance ministers for the Group of Eight (G8) expressed concern over the influx of capital into the commodity sector after their meeting last weekend. In a communiqué, the group stated, "Excess volatility of commodity prices poses risks to growth. We will consider ways to improve the functioning and transparency of global commodity markets, including considering IOSCO [the International Organisation of Securities Commissions] work on commodity derivative markets." Ministers have asked the International Monetary Fund (IMF) and the International Energy Agency (IEA) to suggest new ways to monitor and regulate the oil markets, in an effort to limit speculation and dampen future volatility.

If done very carefully, such an effort could moderate the boom-bust cycles ahead, and give the world a crucial measure of slack in which we can sustain the long term investment horizon needed to transition to a renewable energy infrastructure. If done hastily or badly, it could starve the energy markets of capital, or cause unintended and probably worse effects.

I think that as it is now constituted, the market is inadequately equipped to face this inflection point of indeflation, and history is no longer a useful guide. We're entering uncharted territory while the risk of peak oil is still priced at approximately zero.

So what does all this mean for investors?

First, it means long-term investing in a diversified portfolio of stocks is probably not going to be a good strategy for a long time to come (if ever); it's time to play defense and look for low-risk yield. Second, it means that investing in oil and commodities will continue to be the name of the game for many years, but investors must watch the signs I have identified here carefully to know when it's time to dive in and time to jump out as we churn through these cycles under a dropping ceiling. And third, it means that we all need to learn to live at a lower level, eliminate debt, build savings, and buckle up for a long and bumpy ride.

There are still profits to be made, however. In fact, my colleague Ian Cooper recently published a detailed report that pinpoints exactly how this period of commodity inflation could hand you dozens of double-digit energy trades. If you're looking for the easiest gains in this market, then I urge you to read it. Just click here.

Until next time,

Chris

Energy and Capital

Arctic Oil and Gas Challenges

Last week, I summarized the new USGS report on the undiscovered oil and gas resources of the Arctic. This week, I'll share with you what I learned at the OTC 2009 conference last month about some of the challenges the industry faces in developing those resources.

Arctic drilling is not new. The first successful well was drilled in March 1968, when ARCO struck oil in the Prudhoe Bay field 250 miles north of the Arctic Circle on the North Slope of Alaska, near the Arctic Ocean. The find was the largest oil field in the U.S., with an estimated 13 billion barrels of recoverable oil (BP), twice the total reserves of the East Texas field, and a flow rate of around 400,000 barrels per day (EIA).

The discovery kicked off an exploration spree throughout the Arctic. By the mid-1970s, offshore drilling was under way as well, but offshore production in the Arctic and sub-Arctic has remained limited due to its difficulty. A mere two million barrels of oil, and no gas, have been produced from the Canadian Arctic offshore since 1985.

ConocoPhillips (NYSE: COP) is the second largest Arctic producer after Russia's Gazprom. Peter Noble, the Chief Naval Architect for ConocoPhillips, ticked off some of the main challenges to Arctic production at the OTC conference.

To begin with, the drillships used in the 70s and 80s are no more. The US hasn't built new icebreakers since the 1970s under Nixon. With a renewed interest in the Arctic, the oil and gas industry is now designing and building a new class of modern drillships and tankers for the Arctic, able to penetrate deeper waters and deeper reservoirs, and break ice continuously. These are highly specialized ships, made by manufacturers such as Finland's Wärtsilä Corporation (HEL:WRTBV).

Submersible drilling rigs can be used in the Arctic, but they can only be moved in open water season, and work best in water depths of less than 30 meters (most of the new prospects in the Arctic are in depths up to 1000 meters). Harsh environment semi-submersibles exist, but none are really capable of surviving months of being locked in ice.

Similarly, collecting 3-D seismic data in 600 to 1000 meters of water today is a much more difficult task than shooting 2-D seismic in 30 meters of water was in the 1980s.

What we need to keep going, said Noble, is drilling solutions that can operate in more than "tens of days" in the warm season. Year-round transportation is needed, instead of platforms being inaccessible to tankers for most of the year, while offshore platforms keep pumping into large and expensive storage tanks.

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Beyond ships and rigs is a much bigger problem: there is no infrastructure or workforce in the Arctic. Marine vessels, airports, road access, municipal support, and all of the conveniences of civilization simply do not yet exist in the frozen north. There are no deepwater ports either, which limits offloading capabilities.

Completely commonplace activities like trenching and laying pipe are a whole different game in ice covered waters. Simply knowing when to expect ice, and how much, is another area that needs improvement.

Evacuation and rescue operations in the Arctic must be self-sufficient, because it's so remote; backline support systems are simply too far away. By the same token, mobilizing fast responses to oil spills requires a local self-sufficiency that currently does not yet exist.

Wildlife protection, cooperation with indigenous tribes, and a "don't spill a drop" ethos mean that oil companies must be extremely careful in the Arctic, and take a holistic view of their activities encompassing the needs of all stockholders in the area, including social needs.

More Than Technical Issues

One such non-technical but crucially important challenge is working successfully with the First Nations (aboriginal tribes) of the Arctic. Many areas under development are the property of Inuit and other natives.

Nick Poushinsky, the Senior Vice President of infrastructure consultancy Stantec (NYSE: STN) explained some of the issues, speaking from his long experience working for the Canadian government in negotiating resource development agreements with aboriginal people. He now works for companies owned by them, which are developing joint venture partnerships with Devon Energy (NYSE: DVN) and ExxonMobil (NYSE: XOM), and working on Beaufort Sea development.

It takes a great deal of effort, he said, to work through issues like royalty regimes, environmental protection, and not interfering with native rights to traditional hunting and fishing. The best time to move ships through the Arctic is in warm, ice-free seasons, which is also when wildlife need to move through it.

Along with environmental concerns and oil spill prevention have come a host of regulatory issues in which conflicts abound; according to Poushinsky, it has "gotten totally out of control." For example, Americans want to protect polar bears, but at $100,000 a head, the Inuit want to hunt them. The US Environmental Protection Agency will not allow testing and research on the water, so those working toward US development of the resources must turn to Norway and other partners for that.

Royal Dutch Shell (ADR: NYSE: RDS.A) and ConocoPhillips are going well outside their domains of expertise, spending $100 million per year on biological and geological research in the Arctic, studying such things as climate change and environmental factors affecting polar bears, seals, walrus, and whales.

Recognizing the importance of their oil and gas resources, aboriginal peoples are starting to feel their oats and demand a piece of the action, exchanging access to their lands for something else. Their aspirations are very high, but they lack the necessary skills and capabilities to participate in building the Arctic infrastructure. At the same time, crews imported from warmer climes often find the conditions unpleasant, and don't come back after their first tours. Manpower and training are desperately needed at the earth's northernmost extremity.

Finally, there are the jurisdictional challenges. Everyone is amused by Russia's planting of a flag at the Arctic, but that was just a publicity stunt. Real oil and gas production can only happen after successful resolution of border disputes. Canada has ongoing border disputes with Denmark, the US and Russia. The US also has its own border conflicts with Russia. Greenland is seeking revenue that will allow it to separate from Denmark, and Iceland is anxious to retain its share of the spoils because one-third of its exports are derived from energy.

The Race Is Afoot

Still, as Mead Treadwell, chair of US Arctic Research Commission noted, if the US does not exercise its visible presence in the Arctic, we cede it. We can't put a ‘keep out" sign on the ocean, she said; it's open to any and all who can get there and develop it.

Nation-states tend to be adversarial in these discussions, Poushinsky observed, taking hardline positions on the issues and refusing to talk to each other. Once the parties sit down and negotiate, results are easier to come by. "We gotta get over this kinda crap," he sighed in a long-suffering tone.

All speakers seemed to agree that a great deal of international cooperation is needed across the board to develop the Arctic. Environmental studies and protection, seismic surveying, spill prevention, protecting the subsistence of indigenous residents, developing drilling and shipping standards, providing infrastructure, and a slew of other crucial areas all transcend borders.

Yet as I said last week, given the pressure of peak oil on supplies, and a global demand for petroleum that has proven to be remarkably resilient in the global recession of the last year, it seems a foregone conclusion that the Arctic's buried hydrocarbons will be developed. It's not a question of if, but when.

And, of course, who will benefit from it.

Until next time,

Chris

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Arctic Oil Reserves

One way to know that the end of the Age of Oil will soon be upon us is the current excitement and chatter about going—literally—to the ends of the earth to find more oil.

The Arctic Circle, which circumscribes about 6% of the earth's total surface, is one of the last regions of any significant size to be explored for oil, and for good reason: It's locked in ice for much of the year, far from support and distribution lines, and is one of the most extreme environments on earth. Whatever oil and gas is extracted from the top cap of our planet will be the most expensive and difficult oil ever produced.

Yet the prospect of new oil production from the Arctic is attracting renewed attention as the world becomes increasingly cognizant of the end of cheap, easy oil, and the security and economic risks associated with the expensive, difficult oil that remains. Exploration opportunities are diminishing every year, as the world continues its 40+-year-long slide down the backside of the exploration bell curve.

With global warming causing the polar ice pack to break up and retreat, it has become possible to sail ships through the Northwest Passage for the first time in recorded human history. (When it was last open is not known, but it could have as recently as the Medieval Warm Period from 1000-1300 AD, when Norse and Icelandic explorers settled Greenland, or distant as the last inter-glacial period, 120,000 years ago.) Thus it now seems at least physically possible to tap the fossil fuel resources of the Arctic.

More specifically, the focus now is upon offshore resources in the Arctic Circle, in continental shelves under less than 500 meters of water. Onshore areas in the region have already been explored, with some 40 billion barrels of oil (BBO), 1136 trillion cubic feet (TCF) of natural gas, and 8 billion barrels of natural gas liquids having been developed, primarily in the West Siberian Basin of Russia and on the North Slope of Alaska. Deepwater basins in the Arctic Circle are considered weak prospects as they lack the appropriate source rock structures.

The important question now is: How much remains to be discovered up there?

In an effort to answer this question, the United States Geological Survey (USGS) in cooperation with an international group of geological experts from Canada, Demark, Greenland, Norway, Russia, and other governmental agencies has just completed an effort to round up the available data on the Arctic region and assess its potential, known as the Circum-Arctic Resource Appraisal (CARA). Their summary report, "Assessment of Undiscovered Oil and Gas in the Arctic," was released last week.

Much of the area is as yet unexplored, so an innovative approach to assessing the area and extrapolating from the limited data available was required. In order to have some way of evaluating the "very sparse geological data" on the area, the evaluators used "analogs" from the real world as comparison samples.

The team divided the area into 69 Assessment Units (AUs) that contained at least 3 km of sedimentary rock, since such source rocks are where the vast majority of oil is found. It limited its assessment to resources thought to contain at least 50 million barrels of oil, or 300 billion cubic feet of gas (50 million barrels of oil equivalent, or MMBOE). According to the report, fields larger than 50 MMBO make up more than 95% of the world's known oil and gas resources by volume, so the limit gives us a good approximation without pretending to more detailed understanding than is warranted by the data. It also considered only conventional oil resources, excluding unconventional resources such as coal bed methane, gas hydrates, oil shales, heavy oil and so on.

Most importantly, it presented its results "without reference to costs of exploration and development."

Maps of the resources reveal their uneven distributions: Sixty percent of the oil is concentrated in just six AUs, predominately in Alaska, and two-thirds of the undiscovered gas is in just four AUs, predominately in Russia.

Figure 1: CARA Assessment of "Mean Estimated Undiscovered Oil" in Arctic Circle
Source: "Assessment of Undiscovered Oil and Gas in the Arctic," Gautier et al., Science, May 2009.

Figure 2: CARA Assessment of "Mean Estimated Undiscovered Gas" in Arctic Circle
Source: "Assessment of Undiscovered Oil and Gas in the Arctic," Gautier et al., Science, May 2009.

A range of probabilistic estimates were developed for the assessment units, which were then aggregated into the summary report. Estimates of undiscovered resources are customarily stated in terms of a range of probabilities. The median, P50 estimates (50% probability) are usually reported in the press, but they're often shown to be optimistic once a given resource is produced.

The USGS report estimates Arctic reserves as follows.

Probability	Oil (BBO - billion barrels)	Gas (TCF - trillion cubic feet)
95%	44	770
50%	83	1547
5%	157	299

Interestingly, an analysis by respected petroleum geologist Jean Laherrère in March 2008 on The Oil Drum estimated that the Arctic would contain 50 billion barrels of oil and 1000 TCF of gas, putting his estimates just above the P95 estimates offered by the USGS. Laherrère is one of the fathers of the modern peak oil study, a man with deep experience in the global oil and gas exploration and production industry, and his estimates are usually quite accurate.

To give a sense of scale to these numbers, world oil consumption is around 30 billion barrels per year, and world gas consumption is about 110 TCF per year. So the Arctic may contain anywhere from a 1-3 year supply of oil and a 7-27 year supply of gas.

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However, these are merely estimates of "original oil and gas in place." Typically, only 25-35% of that amount is economically recoverable using current technology. So the Arctic may in fact have perhaps a 4-month world supply of recoverable oil, and around a 2-year supply of gas.

In reality of course, the resources wouldn't be found or produced all at once, but rather in chunks, over time, and would have far greater implications for the nations that lay claim to it (for example, Greenland) than for the world as a whole. "With respect to oil, there's nothing that we see in the Arctic that suggests this preeminence of oil within and around the Gulf states would be significantly shifted," said geologist Donald Gautier, lead author of the survey.

Given the scarcity of actual drilling data and the reliance on analogs and statistical simulation for this survey, our understanding of the Arctic's hydrocarbon potential will no doubt evolve as fresh prospecting gets under way. In terms of the all-important production rate however, it seems safe to assume that although the Arctic's resources will be most welcome to the nations that possess them, they will amount to little more than a trickle of very expensive hydrocarbons within the context of enormous world demand.

Exploration and development of oil and gas from the Arctic Circle is a foregone conclusion. The world simply needs hydrocarbons too much, and the remaining prospects are few. But to exploit it will require technologies that don't yet exist, enormous amounts of capital, and a high tolerance for risk. In other words, the price of oil will have to be high, and stay high, to make the effort worthwhile.

Next week we'll take a look at some of the companies that are working to explore and develop the Arctic, and the cutting-edge technologies they are developing.

Until next time,

Chris

Investor's Note: While the race for Arctic oil continues, investors need to realize that actual production from this area is years or maybe even decades away. But that doesn't mean you need to wait that long to profit from deepwater drilling. If you're interested in taking some of those offshore profits to the bank, perhaps it's time you joined our success.

Oil Implications for Cleantech Investors

The future price of oil is a vitally important consideration for cleantech and renewable energy investors. When prices are high, it's good for cleantech, and when they're low, it's bad. Yet too few cleantech investors are equipped with the ability to forecast them.

The price of oil is set daily and globally by a complex interaction of many factors, including supply and demand, relative valuations of currency, speculation in oil futures, delayed feedback loops, economic growth rates, money flows of large investors, geological factors, geopolitics, and many more.

Oil shot to $147 in 2008 because of a particular highly leveraged alchemy of those factors, and it fell to the low $40s today as the leverage unwound and global recession took its toll on demand. Such volatility makes for an extremely cloudy investment outlook, particularly when the investment horizon is measured in decades. That volatility is likely to increase in the coming years.

In order for cleantech investors to succeed then, they must have a deep and rigorous understanding of these factors and be able to anticipate oil prices.

Here are a few essential clues to reading the oil markets. (See also my article of last week, "Updated Oil Price Outlook.")

Global Oil Production Has Peaked

The rate of global conventional crude oil production has been stuck at roughly 74 million barrels per day (mbpd) since 2005, despite a tripling of oil prices over that period, ending oil's long history of supply growth. This is predicted by peak oil models, which describe how oil production grows, peaks, and then falls in a rough bell curve shape for any given oil producing region. All increases in "oil" supply since 2005 have come not from regular conventional crude, but from unconventional liquids such as heavy and deepwater oil, oil sands, natural gas liquids, and biofuels, bringing the world supply of "all liquids" to between roughly 84 and 86 mbpd since 2005 (Energy Information Administration, April 2009 International Petroleum Monthly).

Figure 1: World Oil and Gas Production Profiles, 2008 Base Case

Source: Colin Campbell, ASPO Newsletter No. 96, Dec. 2008

A close study of the all liquids peak reveals a bumpy plateau from roughly 2005-2012, after which oil production will go into terminal decline. The absolute peak will likely prove to have been July, 2008.

The International Energy Agency (IEA) projects that under normal circumstances with regular maintenance and investment, simple depletion of mature fields will cut about 5% from the global supply each year, which is far in excess of what new oil projects may hope to offset.

While the world is certainly not "running out of oil," since nearly half of it is yet to produce, the world has definitely run out of cheap and easy oil. From now on the oil we produce will be progressively harder to get, and more expensive. This point has been emphasized in recent years by the CEOs of nearly all major oil companies, as well as the major oil data providers like EIA and IEA.

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Production Cost

The cost of producing oil varies widely between under $20 for old projects in Saudi Arabia, to $100 and up for sources like oil sands and shale. The global average cost of a new barrel of oil production capacity has been estimated at between $60-80.

Figure 2: Oil Production Costs

Source: Cambridge Energy Research Associates

The domestic budgetary needs of producers also play a role, with OPEC producers needing at least $50-60 oil, and Russia needing $70.

Future production costs will be even higher. Credible experts maintain that oil will have to remain above $100/bbl before investors will commit to the expensive and risky marginal projects that will deliver the oil we need over the next several decades.

Figure 3: Oil Production Costs and WTI Price

Source: CIBC World Markets, StrategEcon Jan 23, 2009

Saudi oil minister Ali al-Naimi has warned that the world needs $75 oil to sustain ongoing investment. Current prices "are wreaking havoc on the industry and threatening current and planned investments," he said.

With oil selling for half the new production cost, only older conventional fields are currently profitable. Well-capitalized companies like Chevron and Shell can afford to continue investing with such an uncertain horizon, but marginal producers have been forced to lay down their rigs and cut back on development as credit availability fell along with prices.

Consequently, projected new oil production for 2012 and beyond may not materialize, for a lack of investment now. It typically takes 2-10 years for oil production to commence once a project has broken ground.

Under-investment is precisely what the IEA warned about in its World Energy Outlook 2008, in which they said the world would need to invest over $1 trillion dollars per year for the next 22 years just to maintain current supply levels. Under the current credit crunch and low oil prices, that kind of investment is simply not happening. This is likely to accelerate the global decline rate to 9% and above, according to the IEA.

Oil Is Priced At The Margin Of Supply

A thin, roughly 3% margin in spare production capacity is the prime mover of the oil markets. Supply remained flat while demand grew from 2005 through the first half of 2008, driving spare capacity from over 2 mbpd to less than 1 mbpd, which precipitated a spike in oil prices. When demand fell sharply with the global recession, spare production capacity grew to more than 4 mbpd, and prices overshot well below the production cost.

When the global economy recovers, perhaps in the 2010-2011 time frame, spare production capacity will collapse to a thin margin, and prices will spike again. BP Chief Executive Tony Hayward said in November, "Increased demand will stretch the system to its limits, and this will cause another upward spike in the price."

	2006	2007	2008	2009	2010
World Oil Demand:
OECD	49.6	49.1	47.6	45.4	45.9
-% chg	-0.	-0.9	-3.2	-4.5.	1.0
non-OECD	35.4	36.7	38.0	39.1	40.8
-% chg	3.6	3.5	3.6	2.9	4.3
Total World Demand	85.0	85.9	85.6	84.6	86.7
-% chg	1.2	1.1	-0.1	-1.2	2.5

World Oil Supply	84.5	84.4	85.8	85.5	84.8
-% chg	-0.2	-0.1	1.6	-0.4	-0.8

Excess Supply	-0.5	-1.5	0.2	0.9	-1.9
(+ve)/Demand (-ve)
West Texas Crude, Year-end ($/bbl)	61	96	45	65	100

Table 1: World Oil Supply, Demand and Balance (mbpd)

Source: US Dept of Energy (history), CIBC World Markets (forecast)

Volatility

In the coming decade, we should expect a series of cycles like the one we saw over the last 12 months. As supply remains flat and begins to decline, demand will dictate the price. As global demand increases along with economic recovery, spare production capacity will quickly diminish to almost zero, and prices will spike again, causing demand to crash and prices to fall. As these cycles continue, we may expect volatility to increase.

For cleantech investors, this is both good news and bad news. Poor price visibility will tend to restrict investment capital in the oil patch until such time as the global oil price stabilizes above $70 a barrel. At the same time, the predictability of the renewable energy cost structure will increasingly favor it. For example, investors may come to view a modest 4% return on a third-party solar financing arrangement as a very desirable and stable investment.

For oil investors, current prices are an unquestionable bargain. Oil infrastructure providers and companies with sizable reserves now offer the investment opportunity of a lifetime.

Ultimately, the decline of oil, followed by the peak of natural gas and coal in roughly the 2020 - 2025 time frame, means that renewable energy and energy efficiency technologies probably cannot grow fast enough to fill the gap. Therefore, the growth opportunity for those sectors is essentially unlimited for the foreseeable future.

For detailed data, charts, and analysis on the peaking of fossil fuels and the renewable renaissance, investors may want to explore my exhaustively referenced book, Profit from the Peak (Wiley, 2008). My second book, co-authored with my colleagues Jeff Siegel and Nick Hodge of Green Chip Stocks, is Investing in Renewable Energy (Wiley, 2008) and offers a more detailed focus on renewable energy and cleantech.

Until next time,

Chris

Energy and Capital

Investor's Note: My colleague, Nick Hodge, is using his knowledge of cleantech and oil markets to generate profits for thousands of readers of the Alternative Energy Speculator. In fact, he's already closed 26 winning positions this year, averaging more than one per week. And the next cash-out could come any day. Click here to learn about the stock Nick thinks is the next big cleantech winner.

Updated Oil Price Outlook

"Prediction is very difficult, particularly about the future." - Niels Bohr, winner of the 1922 Nobel Prize for his work on the structure of atoms

In my line of work, nothing is so bedeviling as predicting the price of oil and gas.

Accordingly, most analysts who have been at the study for a few years take pains to avoid making price predictions. Good calls are rarely remembered, and bad calls are rarely forgotten. Price targets become fodder for those who lay in wait for a "gotcha" moment that might stain one's credibility.

Those in the oil industry also try to avoid discussing price. When it takes ten years or more and billions of dollars to develop a large deepwater oil project, the volatility of prices that we saw over the last year makes for a very difficult investment planning horizon. Oil companies must therefore take a long view on their commitments, betting that prices will rise over time.

In a blogger conference call last week with Robert Ryan, Chevron's vice president of global exploration, I asked three questions about how oil prices affect their decisions to pursue new deepwater projects. He declined to comment specifically on all three, emphasizing their long-term strategy. I really couldn't blame him for it. (Chevron just began pumping oil on May 5 from its new Tahiti platform in the Gulf of Mexico, which is operating in 4,100 feet of water and lifting oil from 26,700 feet below the seabed, making it the deepest well in the Gulf. The cost of the first phase of the project is $2.7 billion, and the platform is expected to ramp up to a flow rate of approximately 125,000 barrels of crude oil and 70 million cubic feet of natural gas before the end of the year.)

For oil and gas investors, though, there is no skirting the price question. To get an idea of where prices might be going, we must look at the market from several different angles.

Key Factors Affecting Oil Prices

First, consider the fundamentals of supply and demand. On this point, the data is decidedly bearish. In its monthly Oil Market Report issued last Thursday, the International Energy Agency (IEA) revised its world oil demand number downward by 2.56 million barrels per day (mbpd) to 83.2 mbpd, which would make the sharpest annual decline since 1981

At the same time, worldwide inventories are extremely high, with some 150 million barrels of oil and products estimated to be in storage at sea. An historically long and sharp period of contango in the oil futures curve has encouraged speculators to buy oil while prices were low in Q4 2008 and Q1 2009, and store it until prices returned to normal levels. (For more on this subject, see "EIA's Oil Outlook Report.")

But if demand is still falling and supply is still rising, which should bode lower prices, then what shall we make of the fact that oil hit a 6-month high at $60 last week, after falling into the low $30s?

I tend to agree with the IEA that rather than responding to fundamentals like supply and demand, oil has been following the broader market. Oil prices have followed the major indexes very closely since the market crash last October, and have trended up along with the overall market since the March 9 bottom. In other words, oil has been trading on sentiment about recovery, not fundamentals.

However, there is some indication that the oil trade may be getting back to normal in that it is once again trading inversely to the US dollar. The relationship fell apart from roughly October through February as the markets became singularly focused on the financial and credit crisis, but now appears to have returned:

West Texas Intermediate vs. USD. Source: Bloomberg via RBC Capital

For further reading about this important relationship, see "Oil and the U.S. Dollar."

Another signal of returning normality is in the implied volatility of the oil futures curve, which is now within 3% of its 52-week low:

Source: CurvingFutures.com

This suggests two things: One, that the uncertainty about the future price of oil has diminished, and investors are less interested in insurance against sudden price moves; and two, that the market is probably underestimating the likelihood of future price spikes.

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I think we can safely rule out another factor that was very influential on oil prices last year: that of piracy, sabotage and geopolitical posturing by major oil producers. All of that continues to this day—indeed, the MEND militant group in Nigeria struck a new high note of aggression last week, declaring a civil war against government forces and warning foreign oil workers to evacuate from the Delta immediately—but with global spare production capacity now at least 4 mbpd, it really doesn't have the ability to move the market.

A final important consideration is the production cost of oil, on which I have written frequently since last November. (See: "The Truth Behind Low Oil Prices," "The Looming Energy Crisis," "EIA's Oil Outlook Report," "OPEC Defends Oil Prices," "Oil Prices Are Wrong—Very Wrong," and "The Sleeping Threat of Low Oil Prices.") At under $65 a barrel, the marginal production on which we now depend for future supply simply doesn't make economic sense. Oil really needs to be over $100 to ensure supply a decade from now.

This underpinning factor has prompted the Secretary General of the IEA, Nabuo Tanaka, to warn that oil prices could reach as high as $200 a barrel over the next four years when global demand recovers. Still, while this argues strongly for taking long-term positions in oil, it is a fundamental factor, and as such probably bears little on the short-term price outlook.

Whither Oil Prices Now?

At this point, the outlook is substantially murkier. We're almost up to a good price floor to support renewed drilling, but we're not quite there yet, and rig counts continue to fall. Supply and demand data are bearish, but the broader market's continued move upward is bullish.

Investors seeking a safe haven against the renewed specter of inflation in the wake of quantitative easing are beginning to nibble again at the commodity sector, and hedge fund money appears to be coming off the sidelines and establishing positions again, portending another leg up in prices. At the same time, I think the unwinding of the speculative storage play in oil may be in the cards within the next several months. Should long-dated futures begin to fall, or near term prices reach toward $70, it could unleash a flood of selling of all that oil in storage, and crush spot prices.

Given the uncertainty of the price outlook, I think it's prudent for active investors who are sitting on double-digit gains to take some off the table at this point. Investors who followed my thesis and began accumulating oil since November have enjoyed gains of 50-100%, because oil had been so deeply oversold. It took guts to do that while many pundits were calling for $25 a barrel, but from a fundamental perspective, it was really a no-brainer.

I would advise those who missed the move up since March against taking large positions now, favoring instead a strategy of slow accumulation as a hedge against the broader market selloff that I continue to believe is somewhere in the fog ahead. We're not out of the bear market woods yet, and caution remains the watchword. Should the market give up its recent gains and take oil down along with it, there is little in the way of fundamentals (other than production cost) to support prices through the rest of this year.

At the same time, short-term investors should be able to pocket some quick gains in the oil patch as long as the overall market continues to move up. Financials remain the key sector to watch here.

Finally, for long-term investors willing to hold oil for another year or more, I believe the fundamentals support holding onto to those positions and adding to them on the dips. Likewise, investors who took my suggestion to start accumulating positions on natural gas at the beginning of April (see "Natty Dread") had an opportunity to sell it with a 20% gain one week ago, and are now looking at another buying opportunity as it has descended to under $4 per Mcf again.

Until next time,

Chris

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P.P.S Thanks to options trader and blogger Steven Place (@stevenplace on Twitter) and Jeffrey McLarty of (@jmclarty) for their contributions to this article.

Offshore Oil and Gas Technology

The 2009 Offshore Technology Conference (OTC) in Houston sported the most massive exhibit hall I have ever seen, including huge trucks, enormous steel parts weighing many tons, drilling rigs, giant generators and pumps and other assorted gear that makes offshore drilling possible. This week, I take a look at some of this amazing technology.

Greg Evans, "Offshore Eiffel Tower," Acrylic/Canvas

Reporting from the conference last week, I explained why the oil and gas industry must strive under increasingly challenging conditions to maintain or increase their production rates. The world's largest, cheapest and easiest to produce resources have been exploited, and the best untapped resources that remain are in extreme places like the frozen Arctic, or under a mile of ocean water, or in marginal formations like shale.

The oil and gas industry is constantly in pursuit of new technologies that will allow them to develop these remaining resources, like horizontal drilling and fracturing, advanced seismic modeling, remotely operated devices, and subsea systems.

Nowhere is the technology more advanced than in deepwater drilling and production, with modern hardware incorporating everything from giant versions of low-tech nuts and bolts to the ultimate in high-tech hardware and software.

Modern Marvels

Consider the hardware I saw on our tour of Cameron International Corp (NYSE: CAM), the world's top supplier of subsea components. In search of the elusive "unobtanium," Cameron engineers at the Houston facility perform metallurgical miracles, designing and testing deepwater drilling parts against the most tortuous of conditions—temperatures that fluctuate by 500 degrees, under pressures of up to 30,000 psi (by comparison, your household water supply has about 60 psi)—twisting and bending the steel at up to 5 million foot-pounds of pressure to simulate the real-life conditions of a floating drilling rig, all in an effort to prevent oil spills and blowouts in undersea drilling operations.Everything is double- or quadruple-redundant to guard against dangerous and costly failures.

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Their "blowout preventers," for example, are high-tech marvels, incorporating microprocessors, super high tolerance parts, electric motors, seals and other components in a unit that sits on the seabed under incredible pressure and temperature, waiting to disconnect the wellbore from the production system in seconds without spilling a drop of oil on command from an operator miles away.

Cameron Blow Out Preventer (BOP)

Other Cameron products include "Christmas trees" (stacks of valves and fittings that control the flow of fluids from an oil well and prevent their release into the environment), seals, chokes, compressors, control systems, completion equipment, pipe connections, robotic remotely operated equipment to connect equipment at depths divers can't reach, and subsea systems that can separate salt, water, and gas from oil all on the seabed. Their equipment is routinely deployed today in water depths of over 7,800 feet. Not surprisingly, one of Cameron's top customers is one of our long-term favorites, Transocean LTD (NYSE: RIG) the king of offshore drillers.

I got a glimpse of the software end of advanced drilling technology on a tour of Halliburton's "Real-Time Decision Center and Visualization Center." As a former software engineer and architect, what I saw their systems do took my breath away. Halliburton (NYSE: HAL) engineers and their customers can now plot and steer the path of a drill bit from a half a world away, coordinate petabytes of data from disparate sources in real-time, collaborate with engineers in far-off locations, and examine 3-D models of the rocks they intend to drill. Such technology has enabled Halliburton to drill seven hits out of nine attempts in the most extreme drilling conditions in the world-an impressive success rate.

Other major industrial companies at the conference like industrial giant FMC Corporation (NYSE: FMC) demonstrated the capabilities of their floating production storage and offloading (FPSO) systems, which enable the development of deepwater fields in places like Brazil and the U.S. Gulf of Mexico. These systems can collect the oil from multiple wells on the seabed, connect their output to a central "manifold" system, do the processing to remove the water and gas, pump the oil to the surface, and load it directly onto tankers.

Outlook Solid

With an uncertain outlook on oil and gas for the next few years, one might think that the purveyors of these high-ticket items would be suffering from falling orders, and to be sure they took their hits along with the rest of the equities market through the end of 2008. But all found their bottoms starting in 2009, and have staged an impressive rally in the last two months as they followed the broader market up:

The fact is that deepwater production is now the name of the game in oil and gas. If we want it, we're going to have to go there to get it. Oil producers know this and are still pouring billions into its development annually, in the expectation that over the decades that it will take to develop these fields, their investments will pay off handsomely.

In a technical session at the OTC conference, Baker Hughes Inc. (NYSE: BHI) observed that the drop in oil demand in the last big downturn in 1983 was 24% off the peak, whereas demand has only declined 4% in 2009. "The easy oil has been found," declared BHI CEO Chad Deaton, and when the economy rebounds the supply problem will be more intense than ever. He believes that $100 a barrel pricing is needed to ensure future supply, a point I have emphasized in this column (see "The Sleeping Threat of Low Oil Prices").

Or, as Karen A. Harbert, the Executive Vice President and Managing Director of the Institute for 21st Century Energy (a department within the U.S. Chamber of Commerce) put it, "We're going to be wishing for $4 gas if we don't get our act together."

The oil and gas industry faces numerous challenges in addition to prices that are too low. For one, a lack of qualified personnel plagues the business from end to end. A majority of the personnel are over 50, followed by a 10-year gap before reaching the next tier of 35-40 year olds who could take their places—the result of a sharp decline in petroleum geology students during the 80s and 90s. Technical, regulatory and political challenges, delivery scheduling issues, and cost control are major hurdles for the industry as well.

Taken together, the picture for offshore oil and gas development is clear: demand will remain high, and the prices for oil and gas will have to rise for the industry to meet it.

In future columns, I'll share more insights from the OTC conference, including the technical challenges of drilling in the Arctic, the enormous complexity of developing new oil and gas megaprojects costing billions, and some promising new ideas for storing and delivering energy from far-offshore wind farms.

Until next time,

Chris

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The Great Divide on Energy Policy

When I accepted the invitation of the American Petroleum Institute (API) to attend the 2009 Offshore Technology Conference (OTC) in Houston on their dime, I couldn't resist the offer out of sheer curiosity. But I had little notion of how illuminating it would be, on so many levels.

This isn't your ordinary, bland-slide-decks-with-boring-exhibits conference. It's the cutting edge of the oil and gas business, or perhaps more accurately, the cutting edge of all industry: offshore, particularly deepwater (over 1000 feet of water) drilling. Giant machines, sprawling constructions of pipe and pumps and electronics and incredibly high-tolerance parts litter the sprawling exhibit hall. The speakers are top executives in the oil and gas industry, and policy leaders on energy and climate change. Some 60,000 people from all over the globe will attend this year's conference. In short: It's immense.

I could describe the utterly amazing technology on display here. I could share what I learned about the oil and gas industry's deep commitment to safety and minimizing its environmental impact. I could inundate you with data and names and affiliations.

But that's not what the discussion at this conference is about—not from my perspective.

The top issues of the energy industry revolve around policy more than technology. Should we drill ANWR and the Outer Continental Shelf (OCS)? Can we achieve energy independence? How can we grapple with climate change without destroying the economy, and the sources of energy on which we utterly depend? Can renewables supplant fossil fuels?

As critical as these policy debates are, I see little in the way of progress.

An Ironic Debate

I saw a parade of oil industry representatives plead for a transparent and fact-based public dialogue about our energy options for the future. We should step away from the all-or-nothing debate on fossil fuels vs. renewables, they said, stop demonizing any of our potential energy sources, and get serious about addressing our energy problem before it's too late. As the head of the API said, "The energy issue will intensify until cooler heads prevail," and the debate desperately needs to be depoliticized.

But in the next breath, apparently unaware of the obvious contradiction in it, I saw those same executives complain bitterly about the policymakers who stand in the way of their progress. I heard them discount the potential of wind and solar to meet our energy needs, while trumpeting the much smaller footprint of modern oil and gas production. I heard overblown claims about how technology will continually increase reserves, and how offshore drilling in America could solve our problems if only they were allowed to do it.

One executive decried the "cheap shots" taken at the oil and gas industry by climate change activists, and then a few moments later mentioned how much he liked a print ad that offered a false choice between offshore drilling and high gasoline prices.

I asked a panel of oil company executives how a potential 2 - 3 million barrels per day (mbpd) of new oil production from the OCS by 2030 (according API and EIA data) would figure against the background of steadily declining North American supply. The only response I received was that 2 mbpd is a lot, we'd be happy to have it, and if we don't start drilling for it now, we'll regret it.

I heard not one word suggesting that oil production may have in fact peaked, no mention of decline rates, nor any hint that there might be any limits on supply other than the political will to develop new sources.

The oil and gas industry does acknowledge that the burning of their products probably contributes to climate change. They are resigned to the fact that carbon will soon come with a price, and they are intent on helping to define how that will be done under the rubic that "If you're not at the table, you're going to be on the menu." At the same time, they seem to have a greater appetite for a political approach to the climate change debate than an objective evaluation of the data.

The green side of the debate is, unfortunately, no better. An attendee stood before a panel of major oil company executives and ask how the energy industry could engage more fruitfully with policymakers and the public on climate change, then admitted that she had boycotted a recent local presentation by T. Boone Pickens about his energy plan for the country simply because he was an oil baron. She considered it an act of conscientious objection.

The contradiction of her position apparently escaped her as well, along with the fact that of all the oil barons in America's history, Boone is arguably the most forward-thinking and realistic, and a major proponent of moving beyond oil. Her story offered a classic demonstration of how too-principled positions on energy so quickly lead to stalemates.

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As a longtime advocate for renewable energy and a former solar system designer, I have been to my share of "green" conferences. I have often heard the utterly unrealistic claims of renewable energy advocates, and listened to them vilify the oil industry. They seem to have as little appetite for the facts on fossil fuels as the fossil fuel industry has for objective evaluation of renewables.

So while I agree with the conference speakers who called for a balanced, non-demonizing policy debate, what I see is both sides—the green/climate change side and the fossil fuel side—retreating to their corners, throwing up walls of propaganda, and demonizing the other side.

The middle ground, where truth and progress reside, feels virtually empty.

I am left to ponder, once again, why that is. And once again I come to the conclusion that you can't make policy without politics. What we have here is simply political maneuvering with each side trying to gain an edge by overstating their positions, in hopes that when the dust settles, they'll be left holding something. It is most emphatically not a neutral and balanced dialogue.

In fact, there is no dialogue at all. Cleantech people go to cleantech conferences, and oil and gas industry people go to oil and gas conferences, and rarely do the two crowds mix. In the halls of Congress there is much shouting, but little listening. At the end of the day, it is the art of political compromise, not data, which drives policymaking.

The oil and gas industry remains mired in denial about the peak and decline of its products. Renewable advocates are still lost in a dream about quickly replacing fossil fuels with green energy and an infrastructure that runs on it. Climate change concernists continue to pin their hopes on visions that cannot possibly be realized in the time frames they need. No side trusts the other.

Ten Inconvenient Truths

Allow me then to stake out a bit of middle ground, based on what I believe to be the objective facts, in an effort to bring the parties together and perhaps make some actual progress on the policy front.

We have extracted nearly all of the world's easy, cheap oil and gas, and now we're getting down to the difficult, expensive stuff. The largest untapped resources that remain are in extreme places like deepwater and the Arctic, and marginal formations like shale. As a result, global oil production has for all intents and purposes peaked. Natural gas production will also peak in 10 to 15 years. Neither technology nor high prices will change that. Therefore we must begin to replace those fuels with renewables, and use what remains much more efficiently, with the expectation that most of the world's oil and gas will be gone by the end of this century.
Drilling for oil and gas drilling in the OCS and ANWR must and will be done; our need for those fuels is simply too great to pass them up. An additional 2-3 mbpd will put a dent in the roughly 12 mbpd we now import, but if we drill for it now, it won't come to market for 10 years or more. By that time, it probably won't even compensate for the depletion of conventional oil in North America, nor will it do much to reduce prices. But it will be crucially necessary, and producing it won't make an ugly mess of the environment.
Renewables are clearly the long-term answer, as is an all-electric infrastructure that runs on its clean power. However, it will likely take over 30 years for renewables to ramp up from a less than 2% share of primary energy today to 20% or more. They probably won't even be able to fill the gap created by the decline of fossil fuels. Oil and gas currently provide about 58% of the world's primary energy, and they will remain our primary fuels for a long time to come.
It will take many decades to reconfigure out transportation systems to run on electricity. It will take decades to fix our wasteful, leaky built environment so that it doesn't need as much energy to begin with. None of the solutions will come quickly or easily.
Neither renewables nor fossil fuels nor nuclear power alone can bring "energy independence." Indeed, if independence means isolating ourselves from the rest of the world's energy commerce, it might not even be desirable.
We must pursue all sources of energy immediately and aggressively if we hope to meet our future needs, and pitting one against another is counterproductive.
Nuclear power will not grow significantly in the next several decades, as nearly all of the existing reactors will need to be decommissioned within the next 20 years, and a new generation of reactors must be built to replace them. After we do that, a renaissance for next-generation nuclear energy may be a possibility but it will only happen after we have confronted the crises of peak oil and peak gas. It may produce no net reduction in emissions at all.
It is quite possible that even our best efforts on all fronts will not achieve the carbon emission targets we have set. Climate change must be confronted via a unified policy on emissions and energy supply, which is to say that in our zeal to control emissions, we take care not to squelch the production of the oil and gas that constitutes the majority of our energy supply, at least until we have something to replace it. To do so could have unintended and paradoxical consequences, like impeding the manufacture of renewable energy devices, and contributing to tight supply situations that once again cause fossil fuel prices to skyrocket and further damage the economy. Rather than emphasizing the uncertainty on climate change data, and fomenting fear about the cost of mitigation, all sides must come together in a depoliticized dialogue strictly based on neutral scientific analysis.
We should use accurate and unbiased models of the future growth and decline curves of all forms of energy for policymaking—models based on historical data, not faith. If the data says we're likely to recover another 1.2 trillion barrels of oil worldwide and no more, then we should not assume that future drilling and technological progress will somehow turn that into 3 trillion barrels of recoverable oil.
Carbon emissions will soon come with a price. Drilling the remaining prospects for oil and gas will be expensive: From the decision to invest until first oil is produced, it can take 10 years and $100 million dollars to drill the first well in a new deepwater resource, using rigs that cost $1 million a day to run, and the production platform can cost as much as $5 billion. Deploying thousands of wind turbines and square miles of solar will be expensive, slow, and difficult. Replacing millions of inefficient internal combustion engine vehicles with electric and plug-in hybrids will be expensive. Rebuilding the nation's rail system will be hugely expensive. In short, the good ol' days of cheap electricity and gasoline are likely gone forever, and all the solutions going forward will be expensive.

I share the industry's concern about energy illiteracy, but it cuts both ways. It's true that as long as oil and gas provide the majority of our energy supply, we must continue to invest and drill for it, and the industry must work hard to educate the public and policymakers about that. But to claim that limits on drilling are the only problem, or that renewables cannot provide the energy we need in time, exploits that illiteracy and deliberately confuses the debate.

The fact is that there are good people and good intentions on all sides of the issues, and none of them wants to destroy the environment or the economy.

As I see it, neither the fossil fuel industry nor renewable boosters are yet willing to come out of their corners and work with each other in an honest fashion to develop a truly viable path forward on energy. Until both sides put aside their exaggerated claims and partisan bickering, the public will remain confused about the true options and continue to use politics, not neutral data, as their guide. That cannot produce good policy, and it does all of us a grave disservice.

Such unhelpful contentiousness, denial, and cheating on the numbers is a luxury we can no longer afford. Our energy and climate change problems are real, they're urgent, and they're getting more so every day. It's time to set the tactics of the last war aside, wring politics out of the dialogue, and start grappling in an honest and direct way with real solutions. Nothing else will do.

Next week, I'll dive back into energy data, and share some observations about the impressive technology and the potential of offshore drilling.

Until next time,

Chris

Energy and Capital

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Facts and Myths About Offshore Oil

A new battle is brewing over offshore oil drilling. Nine months ago, President Bush lifted a ban on new oil and gas leases off the nation's coastlines, and the congressional moratorium on offshore leasing expired last September.

Now Obama's Department of Interior officials are considering reopening the Outer Continental Shelf (OCS) to leasing, and once again the oil industry is pitted against environmentalists, as well as California residents who remember the ugly mess that a 200,000 gallon crude spill made of the Santa Barbara coast in 1969 after an offshore rig blowout.

I remember that mess. Some time in the mid-70s, when I was 10 years old or so, my family took a trip to California to visit relatives. After nine long hours in the car from our home in the Arizona desert, I wanted nothing except to frolic on the beach when we finally got there, and I wasn't about to let my uncle talk me out of going there no matter how bad it was.

It was nasty. The beach was covered in globs of black goo—so much of it you couldn't avoid stepping in it—and the whole place reeked. (If you haven't ever smelled crude oil, it's smells like exactly what it is: a combination of asphalt and gasoline and everything in between.) We had our fun on the beach, but when we got home, we had to endure a good scrubbing down with turpentine (or maybe it was gasoline) to get the gunk off of our skin.

So I have sympathy for those who don't want to see that sort of thing happen ever again. I've also been an environmentalist all my life.

On the other hand, I believe our energy predicament is shaping up to be so dire as to render all such ideology moot. Taking a principled stance on environmental grounds may soon seem like a luxury of a far-gone age.

Outer Continental Shelf Potential

Let's take a look at the numbers.

According to the EIA (2007 data rounded to billions), total US proven reserves of conventional oil are about 21 billion barrels, of which 4 billion are proved offshore reserves.

US demand is currently about 6.7 billion barrels per year, so if we relied solely upon our proven reserves and were able to produce it as quickly as we like, we'd only have about a three-year supply. Fortunately, we are able to import more than two-thirds of our oil consumption from elsewhere. Nature limits the rate at which we can pump our domestic oil, a rate which has been in steady decline since US domestic oil production peaked in 1970.

Three years' worth isn't much, so we have turned to the difficult and expensive stuff that remains, some of which isn't even oil: low-grade tar sands from Canada, thin seams of shale in the Midwest, and the OCS.

Energy and Capital readers are no doubt familiar with our articles on tar sands and the shales (Bakken, Barnett, Marcellus, and others), but an update on the OCS is probably in order.

The EIA estimates that "technically recoverable undiscovered" offshore oil in the US is in the range of 59 billion barrels—nearly three times as much as our remaining "proved reserves." Most of it, about 45 billion barrels, is expected to lie in the Gulf of Mexico.

The remaining 31% is what was unavailable under the Congressional moratorium, but according to a testimony before the House last month by acting EIA administrator Dr. Howard Gruenspecht, only about 20% of the total technically recoverable oil in the OCS has been under moratoria.

The United States Geological Survey (USGS) numbers are considerably larger, suggesting that some 85 billion barrels of technically recoverable undiscovered oil may remain offshore. (For the present article, I will avoid delving into the murky details of probabilistic reserve estimates and why they differ from source to source.)

In any case, it's clear that the remaining oil prize in the US is offshore. So why aren't we producing it?

Partisans like Sen. Kay Bailey Hutchison (R-TX) would have us believe that it is simply the politics of overzealous environmentalism, banging the drum loudly for offshore drilling and complaining that 85% of the OCS has been off-limits "leaving some of our greatest energy reserves untapped." Indeed, the "Drill Baby Drill" crowd claims that if only we'd drill the OCS everywhere, we could achieve "energy independence."

But if only 20-31% of the OCS has been off-limits, why hasn't the rest been drilled yet?

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Risky Business

One part of the answer is that there simply isn't any oil in some of those areas. Last July, John Hoffmeister, former CEO and president of Shell Oil's US operations, told CNBC "The industry is pursuing the leases it has, but to be blunt, the prospective nature of many of those leases is very low. And you don't go drill oil where you know it doesn't exist."

The second part of the answer is also simple: poor economics.

Offshore oil is expensive, and deepwater oil—wells drilled in more than 1000 feet of water—is more expensive still. Leasing rates for high specification drillships able to produce oil from deepwater formations have run as high as $600,000 per day, which is why we have liked our deepwater drilling players for a long time now.

Consider the economics of the Mars field as an example. At a water depth of 2,940 feet, it is believed to contain 500 million barrels of oil equivalent. The platform produces some 220,000 barrels per day, at a reported development cost of $100 million. Prior to the development of BPs Thunder Horse platform, it was the most advanced platform in the deepwater Gulf of Mexico, where the best prospects for new US oil production are. The Mars platform was destroyed by Hurricane Katrina, and rebuilt by Shell at a reported cost of $200 million. (By comparison, the Thunder Horse platform produces oil at about the same rate, but has a total cost of around $5 billion.)

Deepwater oil also remains a very risky enterprise, even with modern seismic imaging technology. This week Contango Oil & Gas Co. (AMEX: MCF) reported that it would take a $12.5 million write-off for drilling a dry hole in the Gulf of Mexico. It takes a fluid and committed credit market to sustain that kind of risk, but the world is still in the grips of a credit market freeze.

Morgan Stanley recently reported that enough deepwater projects have been scrapped in the global economic downturn to reduce future crude supplies by as much as 2.4 million barrels per day (mbpd) by 2011, a substantial chunk of anticipated supply. Since August 2008, the company reported that no new lease contracts had been awarded, but 11 orders were canceled and 46 more were delayed.

Perhaps the largest project to be delayed recently is the Manifa project in Saudi Arabia. With a $9 billion price tag and a possible 900,000 barrel per day flow rate, it would be the country's largest offshore oil development, but progress has been delayed by six months, probably to take advantage of lower construction costs.

How Do We Reach Energy Independence?

Finally, we must also address the flow rate of any new domestic oil. True "energy independence" would mean producing 18 to 20 mbpd, not the roughly 5.5 mbpd we are producing today. Could we do that?

Through drilling alone, the answer is "not even close." In total, I estimate that if all limits on drilling were removed, including the OCS and ANWR, we could only increase US oil production by a maximum of 2-3 mbpd. That new production would come online slowly, and the additional flow would be hardly noticeable as it compensated for the loss in conventional oil production due to sheer depletion. If it lowered prices at all, it would be by a few pennies per gallon, at best.

Now I have no doubt that Sen. Hutchison understands this, but within the parameters of politics, she must state her case as strongly as possible and try to overcome the resistance to offshore drilling.

Nor do I have any doubt that the hearts of anti-drilling environmentalists are in the right place. Why continue down the doomed path of oil dependency when renewables appear to be right around the corner? Why would the good people of Florida want to court the disaster of oil spills, or look at oil rigs in the distance of their beautiful beaches?

Both sides of the issue, unfortunately, are wrong-headed, and would lead to poor policy. If the public were successfully convinced that we could drill our way out of our energy dilemma, it would stifle development of a renewable-powered infrastructure that will survive in a future of declining oil. Conversely, large oil spills from offshore drilling are a thing of the past, and if we do not drill our remaining reserves with all possible haste we will undoubtedly find ourselves without sufficient oil at an acceptable price within just a few years.

The IEA's warning in February should remain foremost in our minds: If oil demand recovers in 2010, global spare capacity would fall to zero by 2013. And as the world's largest nation dependent on imported oil, we could be in for a very difficult time. The last thing we should do is pull the plug on the majority of our energy supply, which is oil, before we have new forms of energy to replace it. To do so would have terrible consequences on the economy, and hamstring our capability to continue evolving to a new energy regime.

Our only real path to energy independence is to pursue all options, within acceptable emissions limits, and gradually phase out fossil fuels as we ramp up renewables and the electric infrastructure to support them. But while renewables remain less than two percent of our energy mix, we should be careful not to expect too much of them. We will need oil and natural gas for decades to come, and in time we will need to develop our offshore resources or face the prospect of shortages.

Until next time,

Chris

Energy and Capital

Editor's Note: Next week, I will be attending the 2009 Offshore Technology Conference in Houston, by invitation and sponsorship of the American Petroleum Institute. Check in then for my impressions on the cutting edge of offshore drilling technology, and the industry's next great challenges, like drilling the deepwater of Mexico and the Arctic.

A Macro Look at Green Energy

I love Earth Day. I have celebrated it for decades, by planting my garden or going for a hike or attending an event. (This year I'll be spending it as I have spent the last 10 days, staying put and nursing a nice case of poison oak I picked up while getting up close and personal with nature the weekend before last.)

This year it seems to have achieved a whole new level of popularity with a flourish of local celebrations. Everywhere I turn, I see messages encouraging people to plant a vegetable garden, reduce their energy and water consumption, install a solar system, buy "green" stuff...even offering "five ways to green up your sex life."

The media are saturated with ads applying a fresh coat of green paint to corporate images and logos, and the news has never been greener.

As I write, the FORTUNE Brainstorm: Green 2009 conference is under way, featuring an impressive lineup of business leaders and visionaries who are working on everything from electric cars to energy to emissions control to green business strategy. (Check out the Twitter feed from the conference.) The best and brightest in the tech and environment worlds, bringing a wide array of ideas and technologies, are finally engaging directly with business to make progress on the most important challenges of our time.

Simultaneously, at the Dow Jones Alternative Energy Innovations south of San Francisco, startups are pitching their inventions to investors, including new technologies in efficiency, solar, electrical storage and water.

Putting an end to a long-fought battle, the EPA finally agreed last week that "greenhouse gas pollution is a serious problem now and for future generations," threatening public health and triggering climate change. This paves the way for policy action and significantly clears up the investing horizon for clean energy technologies.

In the House, debate commenced yesterday on the "American Clean Energy and Security Act," a bill submitted by House Energy and Commerce Committee Chairman Henry Waxman and Edward Markey (D-MA) that would cut greenhouse gases more than 80% by 2050 through a cap-and-trade mechanism, and propose new standards for energy generation and use. It would be the most sweeping climate change legislation ever attempted.

A slew of great news from the renewable energy world also crossed my desk this week.

Sempra Energy announced plans to build a 48 megawatt (MW) expansion of its existing photovoltaic (PV) power plant in Nevada. When completed, the 58 MW installation will be the largest PV solar plant in North America.

First Solar (NASDAQ: FLSR) secured financing for a 53 MW solar power plant, which would be the largest in Germany and provide enough power to run 14,000 homes.

The Vatican announced plans to build a 100 MW, $660 million solar plant that would generate six times as much power as the tiny nation uses, with the excess exported to Italy. It's a great investment under Italy's generous feed-in tariff program, which pays up to €0.49 per kilowatt hour for the clean power when the retail price of grid electricity is about €0.16.

Most exciting to me was a new $1 billion, 200 MW solar project announced for Arizona, the sunshine-blessed state where I grew up. This plant would be in addition to a 280 MW CSP plant now being built near Phoenix by Spanish energy technology giant Abengoa SA (MCE: ABG). Together, the two plants will provide enough power for 130,000 homes.

Other impressive, utility-scale solar projects have been securing approvals and production agreements, including a planned 600 MW solar thermal project in Nevada, and a 1,300 MW plant in Southern California, both built by BrightSource Energy.

Geothermal power is also finally taking off. A new report from Emerging Energy Research identified over 9,000 MW of new geothermal generating capacity now in the global pipeline, which would nearly double the current 10,500 MW of global geothermal capacity. Of the new capacity, 4,400 MW are from US projects.

The news has been equally encouraging on the demand side. Electric car manufacturers are racing to bring their products to market, and engineers are making fast strides in obtaining a 60 to 100 mile range on a charge. Within the next two years, consumers should have an exciting array of choices for electric and plug-in cars.

Smart Grid: The $2 Trillion Market

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Smart grid technology appears to be the hottest focus of investment capital and media attention, and was reportedly the subject of the only over-capacity session at the FORTUNE conference.

Efficiency projects are likewise popping up, like wildflowers in spring.

As an energy analyst keenly interested in renewable energy and sustainability, I have never been more encouraged about the progress being made in both the business and political spheres. These announcements are particularly impressive in light of the fact that the world is still suffering from a serious credit crunch.

But as an individual investor, the outlook is somewhat less rosy.

It's (Still) All About the Financials

As I worked over some charts this week, looking for profitable investments in a market that remains chaotic, I had a stunning realization: Every chart had basically the same line!

Consider this six-month chart of ETFs for the real estate, financial, oil, Dow Jones industrial, and retail sectors:

While some sectors have clearly performed better than others, it's basically the same line in every sector, plus or minus 20%. Year-to-date, the correlation is even clearer.

Within the energy sector, the correlation is stronger still, with coal, oil, natural gas, solar, wind, and geothermal stocks all moving together in a tight-knit group.

Try it yourself. Plot a few of your favorite sectors together and play with the time frames. I think you'll find largely the same patterns since the market meltdown began last summer. Only traditional hedges like gold, tobacco and food plays run counter to the overall market trends.

That told me one thing: The markets are still all about the financials, which in turn have been all about real estate.

That was a sobering thought, because I don't believe the market rally of the last six weeks for a minute. It was led by the financials, and frankly they have cooked the books.

I have nearly lost track of all the ways that the Fed, Treasury, and SEC have attempted to stave off the inevitable realization that the banks are insolvent. TARP. TALF. PPIP. (Collectively, they mean "printing of trillions of dollars out of thin air.") Refusing to disclose who received those trillions. Suspending mark-to-market. Taking the banks' word at the result of their self-administered "stress tests," and then forbidding them to share those results with the public until May. And so on.

Only in a game that has been rigged and re-rigged repeatedly could the banks pull off the hallucination that they were profitable in Q1, especially to the point of claiming record quarterly profits! But that's exactly what they did, and the market followed their rally.

Let me be unequivocal about this: What we have witnessed in these vain attempts to sustain a fundamentally unsustainable financial system is a sham, an insult to our intelligence, and the biggest heist in history.

When this flood of taxpayer money recedes, the truth will be known, just as graveyard corpses float up to the surface after a New Orleans flood.

I don't know when that will happen; after all, that is the entire point of these games, isn't it? To give the big money just enough time to get away clean before the house of cards falls on the taxpayers' heads?

But I have little doubt that eventually, it will. It could happen in three weeks, when the stress test results are made public. Perhaps it could happen this summer, when scuttlebutt has it that a number of damning insiders will blow their whistles. Perhaps we will have to wait until China starts dumping dollars. I just can't say.

When it does though, the market will undergo another bone-shuddering meltdown, and everything will fall again—potentially marking the true bottom of the recession.

The lesson here is clear: traditional fundamental analysis is useless. It's been useless since real estate started dragging down the financials and took the whole market with them nine months ago. Even technical analysis is useless for long-term investors (although it remains the bread and butter of day traders). So you can stop looking at the financial statements and evaluating sectors and drawing lines on your charts.

Until the financial mess is finally washed up and hung out to dry, you can throw a dart at a dartboard to pick your long term investments, and get roughly the same returns.

Energy investments are, unfortunately, no exception. Renewable energy simply can't continue to attract the large amounts of capital needed to sustain unprecedented growth until the banks are straightened out. Fossil fuel producers can't keep drilling and mining into progressively marginal deposits until the prices of their commodities recover, which can't happen until the economy recovers (for signs of the recovery, watch Asia).

So by all means, get your reusable shopping bag, swear off bottled water forever, turn off anything that isn't in use, install a solar system, and plant your vegetable garden. With my sincere blessing.

Just don't let a rigged market make a chump out of you.

Until next time,

Chris

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Space Based Solar Power

I didn't have to wait long for confirmation on my thesis of last week: "How to Profit from Energy Illiteracy."

Two new energy technologies were widely and breathlessly lauded in the media since then, both of which set my bullshit detector to clanging loudly.

The first was about a new type of insulated heater cable that could be used for in situ retorting of oil from the "vast" oil shale deposits of the American West, which hold "three times as much crude oil as the whole of Saudi Arabia."

All of the articles I found gushed about the potential of unlocking this hidden treasure by heating the rock underground to turn it into liquid crude, a less destructive method than surface mining. A few attempted to explain that the source rock contains not crude but kerogen, a solid, low-grade, high-ash precursor to oil, which must be heated to turn it into an upgraded form of synthetic crude. Essentially, the process attempts to do what nature did when it made crude oil, only in a much accelerated way.

None of the articles said anything however about the potential net energy of the process, its actual scale, its flow rate, or how long it might take to scale. That is, none of them said anything about anything that actually matters.

Here's the real deal on oil shale.

After four decades and five major fully authorized, commercial, even subsidized attempts to develop oil shale into a usable liquid fuel, no one has ever been able to make it economically feasible.

The nearest thing to a serious oil shale project in the country is a small, football field sized pilot project in northwest Colorado operated by Shell. Their plan is to drill several hundred holes into the rock, into which the heating elements are inserted. They will heat up the "pay zone" of hydrocarbons, which is often buried 2000-4000 feet deep, to temperatures up to 700 degrees F, and keep it there for three to four years in order to cook the kerogen into a liquid.

Obviously, that takes a great deal of energy input, but there's more. In order to keep the heated zone from leaking oil into the surrounding water table, a "freeze wall" is built around it, which will freeze the ground with giant chillers!

The net energy of this process isn't yet known (and the estimates provided so far are highly questionable), but it's so energy-intensive that I am intensely skeptical of the technology ever producing more than a long-lived trickle of extremely expensive synthetic oil. A path to American energy independence it will never be.

ASPO's Randy Udall puts it this way: "Suppose you owned $100 million dollars, but the bank would only allow you to withdraw $100,000/year. You would be rich...sort of."

But boy, those sure are some sexy cables, huh, you techno-utopians?

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The Space Based Solar Fantasy

The second story that got my blood boiling was on so-called space based solar power (SBSP).

The excitement was over a report that the California utility PG&E had sought permission from state regulators to sign a 15-year contract with California based Solaren Corp. to purchase up to 200 megawatts of solar power (850 gigwatt-hours in the first year) that would be collected in space and beamed to earth.

Again, the press gushed about the "next frontier" of solar power, which would collect power "24 hours a day" from the far brighter solar radiation available above earth's atmosphere from a low-orbit solar satellite 240 times bigger than the International Space Station. The energy would be transmitted to a receiver based in Fresno, California via microwave or radio waves (reports differed).

To my dismay, even the Wall Street Journal got into the SBSP act, albeit with a few allusions to the unknowns of the deal.

Let's take a look at a few of those unknowns.

First, Solaren hasn't even determined what sort of solar cells the project would use, yet the company asserted that it is sure the project will be economically viable.

Second, according to chief executive Gary Spirnak, the company is seeking funding "in the billions of dollars" just to develop the design and launch a pilot project. Neither Solaren nor PG&E has disclosed the expected cost of the project nor the terms of the power production contract.

To get an idea of what kind of bang for the buck SBSP might deliver, the Journal quoted a Pentagon report estimating that a 10 megawatt pilot satellite would run about $10 billion, or about $1 million per kilowatt of capacity.

By comparison, an off-the-shelf solar photovoltaic (PV) system for the home runs about $8,850 per kilowatt, for a commercial system about $6,720 per kilowatt, and for an industrial sized system, about $4,850 per kilowatt (source). Even after quadrupling those costs to account for the fact that PV systems generally produce power for only about 6 hours a day, it's still a tiny, tiny fraction of the cost of SBSP, and uses technology that is in commercially operation today, not fantasy technology of the future.

A more apt comparison would be concentrating solar power (CSP) plants, which are utility-scale systems that can run 24 hours a day with internal heat-storage technology. These plants generate power for $3,000 to $3,500 per kilowatt and likewise use current, commercially available technology (source). At 11 to 12 cents per kilowatt-hour (kWh) of production today, on its way to 7 cents per kWh for next generation plants, CSP systems will soon be economically competitive with coal-fired and nuclear electrical generation.

Why would anyone be interested in space-based solar power when commercial utility scale solar technology on the ground today costs 0.3% of its price?

Wild Claims And Hard Realities

Then there are all the other niggling questions about how exactly the power transmission to earth works without, for example, inadvertently frying a plane that happened across its path, or running the risk of destruction on the ground should anything go awry with the system.

Or how the company is so confident that we can deploy as-yet unproven technology at a scale far beyond man's most ambitious space program to date, and do it by 2016.

Oh and I almost forgot to mention: Solaren's director of energy services Cal Boerman claims that after four rocket launches to place the equipment into space, it would not require assembly by astronauts, but instead would unfold on its own. Anyone who has watched the evolution of cutting edge space projects like the Hubble Telescope and indeed, the International Space Station itself, knows of the many problems they have faced with systems that didn't work according to plan. Now Solaren wants us to believe that they can make something 240 times bigger than the ISS with no astronauts needed?

The best comment I found on the Solaren project was from the Motley Fool: "As far as technology commercialization timelines go, space-based solar is likely somewhat ahead of nuclear fusion powered by a rare fuel that's mined on the moon."

The whole plan is pure fantasy as far as I'm concerned. But it's sexy space energy technology, so people just gobble it up.

Those inclined to excitement about such developments view PG&E's proposed contract as verification that there is something real about the project. But I have an alternate interpretation.

PG&E is desperate to contract for enough renewable energy to meet the state's renewable portfolio standard, which currently requires it to produce 20% of its electricity from clean sources by 2010, with a possible new standard of 33% by 2020 in the offing. However, the available supply of renewable energy is nowhere close to that, nor is it growing nearly quickly enough to meet such an ambitious target in an environment of tight credit.

My guess is the utility would be willing to sign a contract with space aliens in pink tutus at this point, if they would guarantee in writing that they would deliver megawatt-hours of clean power before 2020. Mark Toney, head of The Utility Reform Network watchdog group, called the Solaren announcement "remote" and "an act of desperation," preferring that PG&E spend "more time on proven technologies closer to home that we can really count on."

For all the doubts surrounding it, there are a few things about space based solar power that I can virtually guarantee.

One, if the Solaren project fails to round up financing, which is already a problem for earth-based utility-scale systems, or is deployed but fails to meet expectations, no one will publish its failure in big, bold headlines.

Two, it will never scale or be cost-effective on par with existing ground-based solar technology.

Three, if it ever gets off the ground, it will be plagued with technical problems, and in a post-fossil fuel world, it will become impossible to maintain.

Four, the net energy of the whole project will be ridiculously low, and the energy payback period on it will be measured in decades.

Five, it will consume a vast amount of gullible techno-utopian capital.

The Profitable Solar Reality

While that capital is chasing pipe dreams with visions of solar satellites dancing in their heads, the real money will be made by those who have the savvy to invest in the most realistic, functional, scalable, cheap, and high net energy systems on the ground today.

I'm talking about companies like Phoenix Solar AG (FRA: PS4), an international systems integrator of PV systems who builds and operates large solar plants and wholesales specialized parts for power plants. Or Acciona SA (MCE: ANA), a Spanish holding company whose subsidiary Acciona Energy deployed a 46-MW solar PV power plant in Portugal last December for $348 million ($7,565 per kW). Or privately-held Ausra, Inc. of Palo Alto, California, a pioneering provider of utility-scale CSP plants with operations in the US and Australia.

Companies like these will be the real contenders in our race against time to scale up renewable energy and leave fossil fuels behind before they leave us. While the SBSP dreamers are still working on their first hundred megawatts, these leaders will be working on their next hundred gigawatts.

Until next time,

Chris

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How to Profit from Energy Illiteracy

Politics is a painfully slow and inadequate way to go about forming an energy strategy, but it seems to be the only way we have.

A new bill submitted by Rep Henry Waxman (D-CA) and Edward Markey (D-MA), the American Clean Energy and Security Act, would aim to reduce emissions of carbon dioxide and other greenhouse gases by 20% from 2005 levels by 2020 (vs. the 15% proposed by President Obama), and by 80% by 2050.

The new emission targets are particularly interesting in that it would bring federal law nearly into line with California's landmark Global Warming Solutions Act of 2006 (also known as AB 32) which would reduce greenhouse gas emissions to 1990 levels by 2020 (a 30% drop) and 80% by 2050.

The proposal includes some requirements to modernize the electrical grid, produce electric vehicles and improve energy efficiency, all of which are crucially important steps toward meeting our energy challenge.

But it is also based on a cap-and-trade market approach to emissions, which I fear could prove a disastrous boondoggle. There is ample evidence that such programs have been a failure in Europe and elsewhere as traders exploited loopholes, and the programs did not produce the expected reductions in emissions.

A simpler, fairer, and virtually exploitation-proof approach to emission controls is a carbon tax. Assigning a price to carbon emissions across the board and raising it gradually would give the market the information it needs to progressively choose cleaner primary energy sources, improve efficiency, and get us where we need to go.

The word "tax" is politically unsaleable, however, and so we carry on doing some of the right things for mostly the wrong reasons.

Instead of worrying about CO2 targets, we should be worrying about how to live within a shrinking budget of fossil fueled energy. As I have mentioned before, studies by professor Kjell Aleklett (Uppsala University) and professor David Rutledge (Caltech) have called into question whether we can even burn enough fossil fuel to reach the 450 ppm target on CO2, given their models of the peaking and depletion of oil, gas, and coal.

Still, there is something encouraging about seeing our ambitions to fight climate change starting to converge with what our energy goals need to be. Climate change, energy, national security, and our overall economic health are deeply intertwined issues, and they must be addressed together if we want real, sustainable solutions.

When 20 Years Is "Imminent"

My study suggests that we will have to live with 25% less energy by around 2025, and 50% less energy by 2050. Starting with peak oil (a flattened peak from 2005-2012), then peak natural gas (around 2010-2020), then peak coal (2020-2030) we are facing the imminent decline of 85% of US primary energy sources.

By the end of this century, most fossil fuels will be kaput, and we'll be relying exclusively on renewable energy (which currently supplies less than 2% of our primary energy), and whatever nuclear energy capacity we can maintain without fossil fuels.

Some may object to my characterization of a 20-year-off peak as "imminent," but in fact, it is.

According to Joseph Romm, the editor of Climate Progress, oil company Royal Dutch Shell claimed in 2001 that it takes 25 years for a primary energy source to reach a 1% share of the global market after its commercial introduction. Based on the histories of solar and wind energy and the fossil fuels, that seems about right.

Once an energy source reaches 1% penetration, we can start making some predictions. A fascinating paper I recently came across (C. Marchetti, "Primary Energy Substitution Models: On the Interaction between Energy and Society," 1977) used statistical analysis to make some startlingly accurate forecasts about oil, natural gas, coal, and nuclear energy 30 years into the future. According to the model, once a given fuel source reaches 1% penetration its success over the next 30 years is essentially "baked in."

Significantly, Marchetti found that it generally takes 100 years for a given source of energy to achieve 50% market penetration. While he did not model renewables in his 1977 study, he did realize that solar and other nascent energy sources could not achieve a significant enough fraction to fill the gap of older fuels by 2050. His conclusion? "Go nuclear or bust."

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We may rightly take issue with Marchetti's analysis on several points: It does not model renewables or efficiency, nor does it take into account any limits on resource reserves. But his paper was not an attempt to forecast the future of energy; it was simply a statistical model showing how energy sources are progressively exploited and substituted. As such, the implications are sobering for renewable energy and our future energy budget as a whole.

If it takes 25 years for a given primary energy source to reach 1%, and another 100 years to reach 50%, we should be forming our energy policy on at least 50-year time horizons.

We don't, I suspect, for several reasons.

Politics Always Trumps Science

First, 50 years is much too long a period for the political process to contemplate. Thousands of scientific papers have accurately projected the future of various energy sources, and made recommendations accordingly, but they don't survive the process of making policy when elected leaders have short terms in office and constituents who demand results in two years or less. In short, politics always trumps science, to our eternal detriment.

Consider the case of corn ethanol. Before federal subsidies arrived and produced the boom and bust of corn ethanol producers in 2006-2008, scientific research had concluded that with an EROI (energy return on investment, or "net energy") of perhaps 1.2, corn ethanol was an obvious non-starter. There's no way a fuel production process that only returns a 20% net gain can be sustainable (research by Dr. Charles Hall et al. suggests that the EROI needs to be at least 3, if not 5 once all indirect costs are accounted for). Yet their research was ignored, and their pleas to Congress fell on deaf ears; politics trumped science. Only now, after the bust, are people starting to look at the EROI of fuels as an important consideration in policy formulation.

Second, we are simply too afraid of the conclusions to think about them. But this fear is almost never directly acknowledged; we prefer to express it in high-minded pronouncements on the wisdom of free markets, or denial couched in weak science, or faith in human ingenuity.

Third, we have a serious problem of energy illiteracy. A new report from the nonpartisan, nonprofit research group Public Agenda titled "The Energy Learning Curve" reports some stunningly discouraging data from its January 2009 survey of over 1000 American adults:

39% of respondents couldn't name a single fossil fuel.
51% couldn't name an alternative energy source.
65% thought that most of our oil imports come from the Middle East.
56% believe that nuclear energy contributes to global warming, and 31% believe that solar energy contributes to global warming.
68% believe that "The main cause for increases in gas prices is speculators who drive up the price of oil."
More than half don't know that less than 10% of the United States' energy comes from renewable sources. [If you rule out hydro and biomass, neither of which are likely to scale up, and restrict "renewable" to mean only solar, wind, and geothermal, it's less than 2%.]
17% are classified as "Climate Change Doubters." Nearly two-thirds of this group, and 44% of the entire sample, believe that drilling the Outer Continental Shelf and Alaska would eliminate our need for imported oil.
19% are classified as "Disengaged," meaning they don't know and don't care about energy much at all.

I would certainly hope that readers of my column would do much better than this sample. (And if not, they need to pick up a copy of my book Profit from the Peak and study up.)

But our problem isn't just the "dumb public." Congress is chronically full of bad ideas about energy, which I have frequently chronicled in this column, as have been most presidents in recent memory. Even our new Secretary of Energy Steven Chu appears to be desperately mistaken about the potential of biofuels, and the time frame he has to address the peak oil crisis.

The media is little help either, regularly gushing about the trillions of barrels of oil in shales, or the latest "breakthroughs" in cold fusion or water-powered cars, without giving a moment's thought to the flow rates (that is, the only thing that matters) of unconventional oil, or retracting their previous stories when the latest breakthroughs turn out to be mistakes and canards.

Even most cleantech investors know little to nothing about peak oil, or any of the fossil fuels for that matter. Conversely, most oil and gas industry types are broadly ignorant about renewable energy and efficiency, and view it as a threat.

In the face of such ignorance, how much hope can we place in the political process to form sensible energy policy? Even if we did have hope, how much do we really think we can accomplish in the next 40 years, given the conclusions of Marchetti's model?

Forget "Energy Independence"

Right now, our spending on energy research and development, and developing new energy and efficiency measures is less than one-tenth of what sober analysts calculate we would need to spend to make a reasonable transition to the energy regime of the future.

We're also about 20 years too late to begin making that investment if we want the transition to be better than a chaotic, very bumpy ride marked by shortages and horrendous price swings.

An intelligent, sensible approach to our energy future would concentrate first on efficiency and conservation, but it's deemed politically unacceptable to ask Americans to make any sacrifices.

It would support continued drilling and careful stewardship of our remaining domestic oil and gas reserves, but that quickly runs afoul of the green and environmental lobbies that are now in control.

It would put rail and transit oriented development at the top of our infrastructure agenda, but those objectives were too long-range and not "shovel ready" enough to gain any serious traction in the recent federal stimulus package.

It would put a tax on all sources of carbon emissions, and would require the US to reduce its oil consumption each year by the same percentage that global oil production is declining; both suggestions would arouse righteous ire from free market advocates. The "Energy Learning Curve" report found that "Anything that increases the cost of driving is soundly rejected by the public."

It would forget about "energy independence" as a goal (if it were possible at all, it would be at least 70 years in the future) and start thinking instead about how to reconfigure our cities, suburbs, transportation, food supply, energy distribution, economics, and...well, everything...so that it becomes truly sustainable. It would reject the idea of growth completely and start thinking about how to manage the Great Contraction. But I'd wager there isn't a politician in America who would begin to try to sell that.

I don't know how to escape politics and still make policy. Despite my cautious optimism about the new direction the Obama team is taking on energy, their first moves will accomplish little to address the peak oil threat. It looks to me like the impending energy crisis is already a foregone conclusion.

What I do know is that those who do understand energy—who know where it comes from and what our future options really are—may not be able to rise above the din of ignorance to chart us a clear path forward, but they can profit from it. They know that oil under $50 and natural gas under $4 is such a ridiculous giveaway, it might as well be free. They know that renewable energy has a virtually endless upside potential, but that the right technologies to invest in will be ones with a high EROI, a short time to market, and the ability to scale quickly.

Until next time,

Chris

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How To Invest in Natural Gas

As oil prices descended into the $50s, then the $40s in December, I knew that they had overshot any sort of sustainable level. Careful research showed me that oil needed to average at least $65 a barrel to sustain current supply levels, and needed to be closer to $100 to ensure production capacity five years or more into the future.

The price of oil had simply rendered too much production uneconomical, guaranteeing that supply would be quickly constrained when demand picked up again. When that happened, I anticipated that prices would once again spike. I believed that the steep contango of the oil futures curve, pricing oil for delivery in future months at a high premium over the near term, was confirmation that prices would soon begin to move up again.

I suggested that investors should begin to slowly accumulate long positions in oil up through early March (see "The Sleeping Threat of Low Oil Prices"). Those who did were lucky enough to even pick some up in the $30s in February.

My patience was rewarded as prices rebounded to around $55 by the end of the month. That was probably too much, too fast, so it was no surprise to me to see it pull back to the $50 range this week. Again, I view this as a golden opportunity to add a little more to my positions.

The Gas Air Pocket Sets Up

Now I am seeing the same pattern in natural gas (or as traders sometimes call it, "natty"), only the danger of constrained supply is possibly even greater, since about 84% of US natural gas consumed is produced domestically and there is very little storage throughout the system.

Gas prices have plunged 72% from their record of over $13 per Mcf¹ to $3.75 on Monday, taking it all the way back to 2002 pricing. (The spot price for natural gas has only fallen below $4 once since 2002, in September 2006.)

Figure 1 NYMEX Henry Hub prices, 2-year chart

Source: Trading Charts

As with oil, the collapse in prices has forced many drillers, especially marginal producers, to lay down their rigs. According to data from Baker Hughes, natural gas exploration rigs in the United States have fallen steadily from a record 1,606 in September to 884 as of March 13, a more than 45% decline in active rigs.

Theresa Gusman, head of equity research for Deutsche Bank AG's (DB) DB Advisors unit, has estimated that spending on U.S. exploration and production will drop 40% to $22.5 billion this year.

According to a Bloomberg report, the sharp cutback in drilling could produce as much as a 5% loss in gas production in the fourth quarter of this year, even more than the decline projected by the Department of Energy.

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Costs Are Key

Beyond the general decline in drilling, there is another factor that augurs higher prices. Nearly all of the increase in domestic natural gas production we have enjoyed for the last several years has come from the unconventional shale plays we have frequently discussed in these pages, like the Barnett, Haynesville, and Marcellus formations.

Unfortunately, unconventional shale gas is more expensive to produce than conventional gas, and only a small fraction of the potential makes economic sense when gas is selling for $3.75 per Mcf. According to global energy advisory firm Tristone Capital Inc., the average cost of production in the top nine North American shale plays is around $4.50 per Mcf.

Yet there are some producers who can still make a profit at these levels. For example, Atlas Energy reports its drilling costs in the Marcellus Shale—the most profitable of the shale plays, in New York and Pennsylvania—as running $1.49 per Mcf, so drilling continues there, albeit at a slower pace. The Haynesville formation is still profitable as well, but drilling in the Barnett and Fayetteville formations has all but stopped, as the cost of production there is too high. Barnett producers claim they need gas back in the $6-8 range before they'll resume drilling.

This chart of the production cost for major US natural gas producers tells the story plainly:

Figure 2 Natural gas production costs of major US producers

Chart by Chris Nelder. Sum of lifting cost and finding and development data from Southwestern Energy Company SEC Filing, attributed to John S. Herold database, "All data as of December 31, 2005, 2006 and 2007." "Drillbit F&D Cost per Mcfe defined as three-year sum of total costs incurred less the three-year sum of proved acquisitions cost divided by the three-year sum of reserve additions from extensions and discoveries."

At under $4 per Mcf, only about half the producers can break even, let alone show a decent profit.

As the chart shows, Chesapeake Energy Corp., the largest independent natural gas producer in the nation, is suffering for the higher cost of its production. The company has slashed its conventional drilling by 75% over the last six months, and expects to increase its cuts to 85% in the next 60 days. Speaking at an energy conference last week, CEO Aubrey McClendon said, "You simply cannot make money in a sub-$7-and-$8 environment."

Presumably by "you" he doesn't mean ultra-low cost Ultra Petroleum Corp. (NYSE: UPL), or Southwestern (NYSE: SWN), which remains one of my personal favorites as a "pure play" on gas.

In sum, what we're seeing is the destruction of the marginal supply that gave us this surplus. We're cutting back to the bone, and the longer it takes for prices to rise again, the less slack there will be, and the sharper the curve of the price spike. Like oil, we're setting up an air pocket in the fuel line, which we'll hit the minute we step on the gas.

Larry Nichols, chief executive officer of natural gas producer Devon Energy Corp. (NYSE: DVN), also sees the air pocket forming. "When the recession ends and the economy starts booming, we're going to have less natural gas than we do today and prices are going to spike back up," he said two weeks ago. "The drop in supply will be so steep, it could easily catch up to where demand has dropped to before the recession ends."

Supply Nearly Back in Balance

The obvious questions now are: Why is the price of gas so low, and when will it pick up again?

Gas prices are dragging the bottom in part due to an abnormally warm winter in the Northeast, but mostly due to the recession.

Gas consumption in the US is split roughly in thirds between commercial and residential demand (which is fairly constant), electricity demand (which grows at about 5% each year) and industrial demand. It's the latter category which has dropped off sharply in the economic downturn, and which has been most responsible for gas demand destruction. According to the Department of Energy, industrial demand declined 5 percent in the fourth quarter of 2008 from a year earlier, or about 1 Bcf/d (billion cubic feet per day).

As one may expect, this has produced a temporary glut in supply. But if you look at the historical chart of the relationship between gas supply and price, you see that inventory levels generally presage price moves. At this point, we're heading into a slight deficit, and if it continues down under the combined pressure of reduced drilling and increasing demand, we should see the next spike in gas prices.

Figure 3 Natural gas prices and storage deviation from 5 yr norms

Source: Guiness Atkinson Energy Brief March 2009, citing Bloomberg, EIA (March 2009)

US gas consumption varies greatly from month to month, with peaks during winter heating and summer air conditioning months, and valleys around the equinox months. In 2008 it ranged from 50 Bcf/d to over 80 Bcf/d, and averaged about 64 Bcf/d over the year (EIA).

The current oversupply is estimated at about 4 Bcf/d, and will probably fall to 1 Bcf/d by the end of the year as a result of laying down drilling rigs². Remember, 1 Bcf/d is equal to the recession-induced loss in industrial demand, or about 1.6% of average demand.

When industrial demand returns, our marginal supply capacity will disappear, and we'll be back in the danger zone for price spikes and possible shortages. . . potentially by the end of this year!

Prices Rising by End of 2009

Chesapeake anticipates the same turning point, issuing a statement on March 2 saying, "U.S. natural gas production will begin to dramatically decline before the end of 2009 and consequently natural gas markets will regain better supply/demand balance by the end of 2009, if not sooner."

Like oil, the futures curve for natural gas is in a steep contango, suggesting that the market thinks gas is going higher too:

Figure 4 NYMEX Henry Hub futures, 2009-2018

Another factor in favor of higher prices is that on a Btu basis—the actual energy contained in the fuel—natural gas is selling for less than half the price of oil, a very rare disparity. In normal times, the potential for fuel switching ensures that the two trade in a fairly equivalent way, but the last year has been anything but normal times. It's a safe bet that in time, that equivalence will be restored, with the floor probably set by oil.

Another often overlooked, yet potentially important factor for natural gas demand is that the ongoing cleantech revolution could cause us to switch loads from fossil fuels to electric power, particularly in transportation, faster than we build renewable energy capacity to power them. That additional demand will fall on natural gas before it falls on coal. This may seem an outlier price factor now, but it could be a potent one in a few years' time.

When prices do make their next run, they'll probably stay high, as renewed drilling lags the price by six months to a year. Again, gas is mostly a domestic market; imports are limited in size and LNG growth is very slow. You can't just order up tankers of imported natural gas like you can with oil.

A Golden Window of Opportunity

The time it takes to raise capital for new drilling, deploy rigs, and start producing again after gas prices rise is a golden window of opportunity for investors. As long as marginal capacity remains in a razor-thin range, prices will stay high and low-cost producers will be rolling in profits again.

While it's impossible to say when the US economy will recover and bring natural gas prices back into sustainable territory, I am confident that for those with at least a one-year investing horizon, there is no better time than now to begin accumulating those positions.

A stake in one of the low-cost producers shown in Figure 2 would be a fine way to play it, but for now I like getting natural gas exposure not through the producers, whose hedging strategies and rising and falling rig counts will cause their stock prices to moderate and lag significantly behind the price of gas, but by buying into the United States Natural Gas Fund (NYSE: UNG). It invests directly in the near-month futures contracts, so it will respond to rising gas prices fairly quickly.

I realize this is a contrary call. Most pundits, including Cramer two days ago, see little to be excited about in natural gas and expect further selling. The aforementioned analyst at Tristone is actually worried about gas falling to zero, as it did briefly in 2002.

They may be right about further declines over the next few months, but a few analysts like me are expecting gas in the $7-8 range by 2010. With a potential upside of more than 300% within the next two years, I see no excuse for not beginning to accumulate positions now into the cleanest fossil fuel around. I was right about crude four months ago, and I think I'll be proved right about gas a few months from now.

Until next time,

Chris

Energy and Capital

P.S. The price collapse of natural gas may be devastating to some producers, but a few, particularly those operating in Canada and the lower-cost US shales, are veritable gold mines with fat reserves and profitability even at today's low prices. To discover more about them, check out the Pure Energy Trader

1 Units in natural gas vary and can be confusing. For this article I used the more-or-less standard notations Mcf for thousand cubic feet, MMcf for million cubic feet and Bcf for billion cubic feet. (MM represents "thousand thousand"...hey don't blame me, I didn't come up with it). 1 Mcf is roughly equal to 1,000 MMBtu. Gas is often priced in MMBtu, or millions of Btus.

2 Credit to a study by Jon Friese on The Oil Drum, "Natural Gas Supply and Demand Balance," for his excellent analysis.

How to Protect Your Portfolio from the Fed

For energy investors, the market is starting to look like 2008 all over again.

The Fed is printing money like it's going out of style (and it is). The dollar is falling. Oil and other commodities, particularly metals, are rising steadily.

On March 18 the Fed announced a potential $1.15 trillion expansion of its balance sheet to buy up Treasuries and toxic assets. And on Sunday night, Treasury Secretary Tim Geithner threw a Hail Mary pass, begging the private capital community to step up and buy $1 trillion of bad mortgages using mostly FDIC financing.

The debasement of the dollar has reached truly frightening proportions. The government's commitment to solving the financial crisis is now pushing $12 trillion by my calculation—nearly as much as the US GDP.

Put another way, that's enough to pay off every mortgage in the country. Had the money been spent that way, it would surely have cured the fundamental ills of our economic backbone, and put us on a solid path to recovery.

Unfortunately, it wasn't. Nearly all of it is designed to cure the banks' problems and restore confidence in the credit markets, not to help consumers with mortgages and credit card debt and a shrinking job market. Worse, the Fed and FDIC have refused to even disclose who the recipients of the bailout money are. What we do know is that they are overwhelmingly the large banks (and their counterparties in credit default swaps, like AIG), that is, the very characters whose egregious excesses got us into this mess, whose CEOs know Hank Paulson personally. Regional and local banks who had the good sense and restraint to not participate in the subprime Ponzi scheme to begin with are still waiting for a response to their TARP funds applications.

Normally, such a frenzy of money printing would cause the dollar to fall, but these haven't been normal times. The global recession has hurt the rest of the world's currencies even more, and the dollar has appreciated steadily in its status as the "tallest midget."

But with this latest drop from Helicopter Ben, and the desperate Treasury proposal, our currency may have finally jumped the shark. It certainly feels that way to me. On Monday the dollar posted its largest one-day drop since 1971, falling to 83.35 on the Dollar Index, where it is measured against a basket of world currencies.

The End of ‘Rome' on the Potomac

Bloomberg quoted Alan Ruskin, head of international currency strategy in North America at RBS Greenwich Capital Markets Inc., as saying "This is a historic moment — the start of debasement of the world's reserve currency. It feels to many participants that in the grand sweep of history we are witnessing the end of ‘Rome' on the Potomac."

The depreciation of the dollar is desirable, from the Fed's perspective, because inflation reduces the burden of our debt, and makes US exports more competitive on the world market. Reinflation is now the name of the game, as a deliberate tactic to arrest the contraction of the US economy. Indeed, Fed chairman Ben Bernanke has indicated that he would like to see the US inflation rate in the 3-4% per year range.

Conversely, dollar depreciation is a major concern for holders of US debt, particularly China, which holds the most: about $1.3 trillion of it, mostly in short-term Treasury bills. Rapid inflation of the dollar would quickly destroy the value of their holdings.

Consequently, China has indicated that it is losing its appetite for T-bills, which is one factor motivating the Fed to begin buying back US debt (to support its market). At the same time, China is rapidly investing its dollars in hard assets, particularly miners and oil producers, and making further moves to reduce its exposure to the dollar.

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This week, Chinese central bank Governor Zhou Xiaochuan even urged the International Monetary Fund to create a new "super-sovereign reserve currency" based on a large basket of currencies, which would replace the dollar as the world's reserve currency. China is also working to conduct more of its foreign trade in its native yuan, or in other non-dollar denominated currencies.

Whether the notion of a new global reserve currency has legs or not, we should recognize these shots across our bow as clear indications that dollar inflation is the new big fear, and that it could zip past Bernanke's targets, possibly even sending the US into a deadly hyperinflationary spiral.

We should not concern ourselves just yet with the dollar's demise, reports of which are premature to be sure. What we should be aware of is the anti-dollar sentiment.

And that means that the anti-inflationary trade that put the wind in the sails of commodities last year is coming back. With extraordinarily large sums of capital sidelined by the deepening recession, funds holding cash are anxious to put it someplace—any place—where it will at least retain its value while inflation trashes the dollar.

Inflationary Safe Havens

So it should come as no surprise that the dollar's fall this month was attended by a surge in commodity prices, despite a lack of clear indication that global demand is on the uptick. Oil has climbed steadily from the low $40s to over $53. Silver, gold, copper and lead prices have gained 20-30% in the last two months. Wheat, corn, soybeans, and barley have all gained steadily since their last bottom at the beginning of March. Fertilizer stocks and agricultural ETFs have been back in play as well, posting 15-25% gains for the month.

Does that mean that the bottom is in? Should investors start piling back into the sector, lest they miss out on the easiest gains and best valuations they might ever see in their lifetimes?

My gut says no.

Monday's 7%, nearly 500-point rally in the Dow was indeed impressive and historic, and capped off the largest 10-day rally since 1938. But we should not forget that such sharp moves are precisely what bear market rallies are made of. Since 1928, the Dow has had 28 days with 7+% gains, including Monday's, and 24 of those days occurred between 1929 and 1933. The market didn't put in the true bottom until 1932.

Still, while the threat of reflation gone wild is hanging out there, and continuing to increase under "QE3" (the third round of "quantitative easing," which is simply genuine Wall Street gibberish for printing money out of thin air), it's prudent to put some money to work in commodities now. The steady gains in crude and minerals signal that the smart money is coming off the sidelines and getting some exposure to the sector again.

So how do you play it?

For those with a taste for adventure, there are the ETFs/ETNs that short the financial sector, like the double-leveraged ProShares UltraShort Financials (NYSE: SKF) and the triple-leveraged Direxion Financial Bear 3X (NYSE: FAZ). For those who remember Captain Contrarian, he has been on the sidelines for more than a year and is more bullish on gold than ever, and just went into SKF in size. These are riskier plays with sharp daily movements, however, and are not appropriate for most investors.

For broad, basic exposure to the commodities sector, I like the PowerShares DB Commodity Index Tracking Fund (AMEX: DBC). And in ag, I still like the PowerShares DB Agriculture Fund (NYSE: DBA), and the fertilizer plays The Mosaic Company (NYSE: MOS) and Potash Corp. (NYSE:POT). For many other suggestions, see the Related Articles below.

Another simple way to play oil directly is the ETF United States Oil Fund (NYSE: USO), among others. They all track the futures curve in different ways and are imperfect instruments that don't echo the daily performance of oil prices very well, but over the medium term they work well enough.

Until next time,

Chris

Energy and Capital

P.S. As oil prices continue to recover, the standout gains will be made by oil producers with good reserves in Canada and the US, and healthy balance sheets. To get your hands on these gains, all you have to do is become a member Ian Cooper's red-hot advisory, Pure Energy Trader. Fact is, Ian's hit it big on his last 4 trades, with closed gains of 62% and 64%... and two still open with gains of 15% and 20%.

The Vision Thing

Twenty-one years ago, President George H. W. Bush admitted that he lacked "the vision thing," but when it comes to energy and transportation policy, nearly all of our leaders since him have been equally impaired.

Despite having lived through the oil shock of the early 1970s, only to see our oil imports since then rise steadily to two-thirds of our consumption today...

Despite increasingly urgent warnings from agencies such as the IEA, who warned one month ago that if oil demand recovers in 2010, global spare oil production capacity would fall to zero by 2013, sending oil prices skyrocketing...

Despite ample evidence and clear mathematics that the world could be down to 75% of today's energy budget in 20 years, down to less than 50% in 40 years, and down to less than 10% in 80 years...

The US still has no plan whatsoever to deal with the impending energy crisis, a crisis that threatens to drastically shrink our economy and change our way of life forever. Nobody is driving this bus; we're all passengers.

After nearly 40 years of evidence that finite energy supplies inexorably reach a point of diminishing returns, I can only ask: Why do we still not have a plan? Any plan?

The Pickens Plan

One plan that we do have on the table is the Pickens Plan, T. Boone Pickens' proposal for making a dent in foreign oil consumption. It imagines a corridor of large wind turbines stretching through the windy heartland from Texas to North Dakota, which would replace the 22% of our current electricity supply that is generated from natural gas. Then we would use the natural gas to run commercial and fleet vehicles, offsetting 38% of our demand for foreign oil.

Pickens critics were quick to sling mud on the plan, alleging that he is only trying to line his own pockets with taxpayer money, despite the obvious fact that at the age of 80, he's unlikely to see the fruition of his plan, let alone realize the fortune that it might bring to its investors. Pickens himself has said as much, indicating that his real motivation is to leave a legacy that will put the country on a more sustainable path. (Pickens is a strong proponent of peak oil and probably understands the oil business as well as anyone else alive.)

I have voiced a number of important questions about the Pickens Plan, including how and when the natural gas fired power plants will be decommissioned, the cost and the time-to-market for natural gas powered vehicles, how the project will be financed, and whether our domestic natural gas resources are up to the job. (See "Will Arctic Oil, Natural Gas, MIT, Paris and Pickens Save the Day?" for more on that.)

Although those questions remain unanswered, we at Energy and Capital and Green Chip Stocks have written a fair bit on the Pickens Plan, not because it's perfect, but because it's a plan. Something is better than nothing. At the very least, to the extent that the wind and natural gas parts of it work out, it would make a dent in our oil imports.

The Better Place Plan

I can only think of one other serious plan that excites me, which seems truly pragmatic and sensible: Better Place, a company with a plan to replace oil-burning cars with all-electric cars.

Better Place starts with a simple objective: How do you run an entire country without oil? (Which immediately makes me wonder: Why are none of our elected leaders asking themselves that question?)

At a Brookings Institute presentation last summer, CEO Shai Agassi ticked off the key elements that will allow his plan to succeed.

The first element is policy. Last year, Israel set a goal to get off oil entirely within a decade. By a simple mechanism that would gradually raise taxes on gasoline-based cars over the decade, consumers would be driven toward zero-oil cars. With Israel's leadership, later joined by Denmark, Australia, California, and Hawaii, there is a bona fide market for the vehicles.

The second element was a commitment by automakers Renault and Nissan to build all-electric cars in partnership with Better Place that would go 100 miles on a single charge. For the majority of users, such a range is more than adequate for a daily commute and errands, and the cars would be recharged from the grid at public parking spaces and at home. For longer distance travel, Better Place envisions that one would be able to drive up to a device like a car wash, and have the battery pack replaced in about the same amount of time that it takes to fill up with gasoline today.

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The Institute for the Analysis of Global Security has stated that if all cars on the road were hybrids, and half were Plug-In Hybrids by 2025 -- U.S. imports would be reduced by 8 million barrels per day. That's about 80% of our daily consumption!

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(There may be an even better option. New research from MIT published in the March 12 issue of the journal Nature found that by coating lithium iron phosphate particles with a thin film of lithium pyrophosphate, they could allow a lithium ion battery to be charged and discharged hundreds of times faster than normal, potentially eliminating the need for battery-swapping stations.)

A third element to the Better Place plan is to deploy a charging infrastructure. A half a million charging parking spots will be established initially, which can recharge the car automatically, billing via a built-in ID chip. The company has already obtained $200 in private seed capital to built the charging stations in Denmark and Israel.

The fourth element is the business model itself. Agassi compares it to that of the cell phone business: Instead of charging consumers for the car, it will essentially lend the cars to consumer for free when they sign up for a four-year plan. Consumers will pay only for miles driven and for access to charging stations, which will cost them no more than they already pay for gasoline Agassi claims, and will be sheltered from the risk of owning an expensive, cutting-edge battery pack.

A final benefit of the Better Place strategy is that enlarging the overall fleet of electric vehicles has a multiplier effect. By enabling vehicle-to-grid (V2G) technologies that can use plugged-in electric vehicles as temporary storage, V2G holds great promise as a way to help solve the storage problem of intermittent renewable energy sources like wind and solar, which further enables their growth. At the same time, it creates demand for renewable electric power.

Cars created under the Better Place program are slated for mass production by 2011. By comparison, Chevy will bring just 10,000 units of its new electric Volt to market in 2010, which will do only 40 miles on a charge, at a cost of $40,000. Remember, the Better Place cars will be essentially free to own.

Agassi estimates that under the Better Place plan, at a cost of $500 per car, or about $100 billion, the US could get its 200 million cars off oil entirely. At $45 a barrel and 20 million barrels per day of consumption, that's equivalent to what the US now spends on oil in only four months!

The German Plan

It's not a serious plan to get off oil, but I should mention a curious program Germany has begun which will give a $3,250 rebate to anyone who will scrap an automobile at least nine years old, provide proof that it has been destroyed, and buy a new or slightly used car. It's mainly a stimulus package for the automobile industry, but if it replaces a potential 1.2 million old cars (out of a fleet of over 40 million) with more efficient ones, it would certainly reduce their import needs.

Again: at least it's a plan.

Congress' Plan

Against the brilliant Better Place plan and the pragmatic Pickens Plan, Congress' plan, as embodied in the $800 billion stimulus package signed into law last month, looks downright shabby.

The $100 billion that Agassi would need to achieve his vision is about one-eighth the price of the stimulus package. Although the latter includes $150 billion in public works projects for transportation, energy and technology, it would only put one million electric vehicles on the road—that's 0.5% of our current fleet—in six years, and there is little else in it that would actually reduce our use of transportation fuel any time soon. It's a start, but it's really far too little, too late. In six years, we'll be about three years past the global oil peak and clawing for solutions.

For another comparison, $100 billion is a mere 4% of the $2.5 trillion that we're spending to shore up the fundamentally insolvent banking system. That includes $175 billion to extend the life of the terminally ill AIG, some of which is going to bail out its default-swap counterparties, including Goldman Sachs.

Even the portion of the stimulus package dedicated to rail—the most obvious, tried-and-true transportation technology we possess—is a mere $12 billion or so. The repair backlog for Amtrak's northeast corridor alone is $10 billion. Just $1.1 billion will be spent on improving Amtrak and intercity passenger rail, and another $1 billion is designated for new commuter and light rail.

At this point, the hopes I once had for a rail renaissance in the 2009 funding spree have all but faded.

(For his part, President George W. Bush proposed eliminating the budget for Amtrak entirely in 2006. Apparently he inherited his father's lack of "the vision thing.")

Meanwhile about $30 billion of the stimulus package is targeted for road-building, a painfully stupid investment on a dead end street. In the wake of the most destructive spike and crash of commodity prices in recent history, Congress still doesn't understand that oil prices will spike again, and that our days of importing 13 million barrels per day of oil are numbered.

Now, I'm not saying that the Better Place vision can be achieved exactly as advertised, because it's a bit too early to say. But at least it's a plan—a plan that absolutely can be implemented with today's technology, that's scalable, and that comes at a very attractive price.

America desperately needs serious energy leaders who will not flinch at telling the truth about the future of energy, and who are willing to figure out how in the world we're going to navigate it. Clearly, presidents and Congressmen are not those people. We can only hope that the visions of business leaders like Pickens and Agassi will succeed despite them.

Until next time,

Chris

P.S. Vehicles that run on natural gas and electricity, and their components, are nothing new to investors who subscribe to the Alternative Energy Speculator. We've been following these companies for years, and know exactly which ones are ripe for the picking. Sign up today and start profiting from the transportation revolution!

Mexico's Troubles Are Our Troubles

A new contender now tops my long list of worries: Mexico.

I have been keenly aware of Mexico's troubles for most of my life. I lived in Mexico City for a short while as a kid, and saw its crushing poverty firsthand. I vividly remember certain formative experiences, like seeing kids my age dressed in rags and panhandling for centavos, or eight full-grown men riding a single motorcycle, or a rural cave dwelling with a TV antenna sticking out of the top, powered by an illegal tap on a nearby power line. I also grew up in Tucson, where shopping excursions to the border town of Nogales 60 miles away was standard fare when we had visitors.

But I have written about Mexico's oil production repeatedly in this column primarily because it is so essential to US supply. Mexico is our #3 source of imports, providing 1.3 million barrels per day (mbpd), or about 6% of our total petroleum supply (EIA, Dec 2008 data).

Yet Mexico's days as a top oil producer, and possibly its days as a democratic nation, are numbered.

Mexico's largest oil field, Cantarell, is one of the four largest "supergiant" oil fields in the world, and was once the world's second-largest producer (after Saudi Arabia's Ghawar field). It peaked in 2003 at 2.1 mbpd, but thanks to a program of nitrogen injection that was pursued to maximize the rate of production (probably at the expense of long-term production), its production is crashing at an accelerating rate, currently about 38% per year. It is now producing about 0.77 mbpd, and will probably fall to 0.5 mbpd before tailing off at a gentler rate (or so Pemex hopes).

Mexico's largest producing region is now the Ku-Maloob-Zaap (KMZ) complex, adjacent to the Cantarell complex. It's a much smaller complex than Cantarell, and at 0.78 mbpd it is near its planned maximum production rate. Nitrogen injection was initiated from the beginning, which we could take as an indication that Mexico would rather maximize its revenue now than worry about tomorrow.

One doesn't have to look too far to see why that might be.

Oil is Mexico's number-one export. With its oil revenues in decline, the state is finding it increasingly difficult to fund operations-including operations against one of its other top exports: illegal drugs.

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"A State of Undeclared War"

Drug cartels have grown in power and wealth in Mexico, and have now taken to open war with the authorities, who are finding themselves increasingly outgunned against better funded and supplied adversaries sporting military-grade weaponry.

An estimated 10,000 people have died in the violence since Mexico's president Felipe Calderón took office in 2006 and began a campaign against organized crime. Over 6,000 died last year alone, of which about four-fifths were criminals killing criminals, plus about 800 police, soldiers, prosecutors and other officials who dared to fight organized crime. Another 1000 have already died in 2009.

The atrocities committed are brazen and horrific, including torture, beheadings, and public displays of mutilated corpses. Gangs hang banners in the streets announcing their views, make public threats against officials, and make YouTube videos of their executions. Extortion and protection rackets are proliferating as the federal crackdown has splintered the cartels into warring factions. The nation's framework of 32 independent states, a decrepit judicial process, and an ineffective and disorganized federal police force have left the nation with a corrupt law enforcement system that is ill-equipped to control the cartels.

The violence is primarily concentrated in the Sinaloa region, and along the border with the US, as gangs fight with one another for market share and try to smuggle their goods north, and guns and cash south. Consequently, the border cities of the US are fighting an escalating battle of their own.

Phoenix is now the kidnapping capitol of the US, with 366 abductions last year, mostly conducted by and against cartel members for financial gain and displays of power, but increasingly also against innocent civilians and even against anti-kidnapping authorities. Phoenix is now also the top gateway city where illegal drugs enter the US. Other US cities along Mexican borders of California, Arizona and Texas are contending with increased violence and trade in weapons.

The reach of the cartels now extends to every corner of the US, from distribution of marijuana and cocaine in major cities, to guerilla pot farms in national parks and the mountains of Northern California. Mexican drug cartels are now the major criminal force in America, surpassing the Mafia.

In a congressional hearing with the Department of Homeland Security yesterday, Rep. John Culberson of Texas called the conflict "a state of undeclared war on the southern border."

Strangely, Mexico's troubles have remained mostly off the radar in the US, until the State Department issued a warning on February 20 urging American travelers—particularly students on spring break—to avoid going there for their own safety.

So what does the estimated $20 billion trade in illegal drugs from Mexico have to do with energy, you ask?

Oil Exports Are Crucial

Mexico's exports of oil and gas to the US account for over one-third of the government's revenues, and their decline is expected to widen the country's current-account deficit to an average 3.6% of GDP in 2009-13. Its economy is projected to contract by 2% this year as its exports to the US fall due to the recession, which has weakened the peso badly; around a third of its value relative to the dollar has eroded since last August.

The declining production of Cantarell alone will deprive Mexico's economy of roughly $5 billion, or half a percent of its approximately $1 trillion GDP.

At the same time, a large number of migrant workers in the US are going back home as their work here dries up. (On a trip to Oregon a few weeks ago, I visited a commercial farmer who put a sign up at the end of his driveway saying "No Trabajo" after being hounded by up to five worker gangs per day looking for field work.) The loss of that income to the workers' families back home will be keenly felt.

Add to that declining tourism revenues—my family doesn't take shopping trips to Mexico anymore, due to poor security and other problems—and a loss of income due to the falling price of oil, and you have an economy that is truly on the ropes.

It will be very difficult for the Mexican government to maintain order, keep its people fed and sheltered, and fight the drug cartels under such severe pressures. Some experienced analysts of Mexico have even speculated that the country will not survive as a nation-state for more than another few years.

It will also make it very difficult for Pemex, under whose sole domain the Mexican petroleum industry operates, to raise the necessary capital to expand its oil and gas production. Mexican law prohibits foreign companies from owning its petroleum resources, so it relies heavily on debt backed by foreign issuers to fund its operations.

Given the increasing uncertainty of Mexico's future, the inability of its law enforcement to maintain security, the crippling of its currency, declining tourism, and a possible downgrading of its investment grade on the horizon, I find it hard to imagine how Pemex will continue to invest at the necessary levels—$20 billion in capital expenditures are planned for this year—to keep its oil and gas flowing to US markets.

On current trends, Mexico's oil and gas exports to the US will cease entirely within seven years.

How will the US adjust to a 6% loss in its oil supply from Mexico alone, when all of its other major suppliers are also in decline, and foreign competitors are able and willing to pay hefty sums for the last, marginal barrel of exported oil?

It won't be easy, but our remaining reserves right here at home will become an increasingly important answer to that challenge, and those barrels will sell for much higher prices than they do today. Not only is Mexico my number-one worry, it's also my number-one reason to invest in domestic oil and gas producers with significant reserves.

Much of our unconventional oil reserves are too expensive to produce at a profit while oil is still in the $40s. But that might turn out to be a good thing. If we were to leave them in the ground for another three years, they could be worth three times as much when we do produce them, and make a crucial contribution to our national security.

Until next time,

Chris

Energy and Capital

P.S. The best remaining domestic oil reserves in the nation are precisely the kinds of investments that are making Pure Energy Trader members a fortune, despite the tumultuous volatility in the financial markets. Sign up today and find out which plays are best positioned to profit now while oil prices are still dirt cheap. Simply click here to learn more about the Pure Energy Trader.

The Sleeping Threat of Low Oil Prices

If you need any more proof that the markets are not an efficient discounting mechanism, look no further than the price of oil.

Oil prices in the high $30s to low $40s are nothing short of a ticking time bomb under the world economy, but you wouldn't know it from watching the commodity markets. Once the global downturn slashed $100 off the price of a barrel, the issue of oil supply seemed to simply fall off the radar of market observers. Falling oil demand is all that anyone seems to care about, but we may pay dearly for taking our eye off the ball of supply.

Marvin Odum, the US President of Royal Dutch Shell worried aloud on Bloomberg television yesterday about the loss of policy focus on oil, as renewables and electric infrastructure upstaged it. "The big risk that I see here is what happens to the energy that runs our economy today, that gives us energy that we can afford, and that is primarily oil and gas." According to Bloomberg, the company has delayed investment decisions on expanding its Athabascan tar sands project in Alberta, and upgrading its Mars project in the Gulf of Mexico.

I could scarcely agree more.

While the price of oil has crashed from its highs last summer, the costs of production—including labor, steel, rig leasing, and so on—have not declined nearly as much, and their future prices depend heavily on the health of the world economy. One month ago, Shell chief executive Jeroen van der Veer told the Wall Street Journal that while crude prices have rolled back to levels last seen five years ago, the company's costs have doubled since then. The costs will eventually fall too, he said, but would lag by 12 to 18 months.

Shell's budget for capital spending this year is roughly $31 billion, a huge sum. Under a barrage of news reports showing that economic activity is still declining, it's only prudent to hold off on further spending if a delay could save them billions. It also makes sense to delay production if the same oil could be sold in a year or two at twice the price it would fetch today.

Consider the economics of the Mars field as an example. At a water depth of 2,940 feet, it is believed to contain 500 million barrels of oil equivalent. The platform produces some 220,000 barrels per day, at a reported development cost of $100 million. Prior to the development of BPs Thunder Horse platform, it was the most advanced platform in the deepwater Gulf of Mexico, where the best prospects for new US oil production are. The Mars platform was destroyed by Hurricane Katrina, and rebuilt by Shell at a reported cost of $200 million. Assuming those numbers are still correct, at a $300 million total cost the project would pay for itself in 34 years at $40 a barrel, but in only 14 years at $100 a barrel. (By comparison, the Thunder Horse platform produces oil at about the same rate, but has a total cost of around $5 billion.)

Shell is one of the few companies in the oil patch who are increasing their capital spending and increasing dividends in the current uncertain environment. Revenues are off sharply across the industry, and most companies are taking write-downs on revenue, and cutting costs. Occidental Petroleum has announced a 25% cut in its capital spending for this year. ConocoPhillips has sharply cut back on its spending and staff. Chevron is only maintaining last year's level of investment. Schlumberger has slashed its worldwide workforce by 6%.

The most recent data from Baker Hughes indicates that rotary rigs drilling for oil in the US—an indicator of oil exploration activity—are down 22% from last year to 260 rigs, comprising just 23% of total drilling activity (the rest are drilling for gas). The Canadian rig count is down 38% from last year.

Production from Mexico, our number-three source of imports, is in serious trouble. Its oil output fell 9.2% in January to its lowest level since 1995, but its exports are falling much faster, at a 20% decline, according to Pemex. (As I explained last June in "The Impending Oil Export Crisis," exports fall faster than overall production.) The decline of Cantarell, one of the four "supergiant" oil fields in the world, has accelerated to 38% per year. At the current rate, Mexico's oil exports will cease altogether in seven years or less. Widespread civil unrest already plagues our southern neighbor, where drug cartels have taken to open war with the government, and the crashing of its top export is sure to make matters worse.

Things are no better in the Middle East. OPEC reports delays of more than 35 of 150 planned upstream projects, with some postponed until after 2013. Additional project delays are expected.

Too Cheap to Lift

Simply put, the biggest threat to supply is that oil is now too cheap to increase its production. While it's true that lifting costs for older, mature projects range from $10 a barrel in Saudi Arabia to about $15 a barrel in Russia, Alaska, Norway and the UK, all of those areas are past their peaks and into decline. It's the cost of new oil that we should be worried about.

With the world's oldest, largest, and cheapest fields either already in decline or soon to be, we are now depending completely on difficult, unconventional oil projects like deepwater, tar sands, and oil shales to manage any increase at all in supply. My research suggests that oil needs to be at least $65/bbl to sustain investment in these incredibly capital-intensive projects.

According to a new study by Deutsche Bank, the cost of new oil projects in the world's remaining growth areas—namely, the Gulf of Mexico, Brazil, Nigeria and Angola—plus a 15% rate of return ranges from $60-$68 a barrel.

According to a recent study by Brad Setser for the Council on Foreign Relations using data from the IMF and other sources, Saudi Arabia, Kuwait, Algeria and Libya all need $50-60, and Russia needs $70, to break even on production and meet their budgetary needs. (These numbers are averages across many different kinds of reservoirs with different cost structures, but do reflect the real forward production cost.)

Saudi oil minister Ali al-Naimi has warned that the world needs $75 oil to ensure future supply, and that current prices "are wreaking havoc on the industry and threatening current and planned investments."

The real bar is probably even higher. Credible experts maintain that oil will have to remain above $100/bbl for a good length of time before oil companies are willing to commit enormous amounts of capital to the expensive, risky, and decades-long projects that remain to be developed.

Clearly, no one is going to step up to spend billions of dollars to develop new oil projects until oil is holding firmly above $60.

Without those projects, we are headed for a quick slip down the back side of Hubbert's Curve. Deutsche Bank calculates the global loss of oil production due to poor economics at 700,000 barrels per day with oil at $30 a barrel, of which more than half would be lost production from tar sands. At $20 a barrel, fully 3.5 million barrels per day (mbpd) would be uneconomical to produce.

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Tar Sands Troubled Too

The Canadian tar sands were until recently the great black hope for non-OPEC supply, with a production cost for older projects in the range of $28 a barrel. However, Shell chief financial officer Peter Voser says the company's current cost is around $38 per barrel. But the cost of new tar sands projects is much higher: According to an analysis by Merrill Lynch, it doesn't pay to invest in new tar sands projects until oil sells for about $80 a barrel. I have seen other recent estimates putting the cost at closer to $90 a barrel. More than $90 billion worth of projects in the tar sands have been postponed since oil prices started their sharp decline.

Accordingly, the government of Alberta just announced a one-year repeal of its revised royalty structure, which went into effect at the beginning of this year. The royalty rate will be cut from the current 15%-25% to a maximum of 5% as an incentive to encourage junior oil and gas explorers to resume their investments.

This is no surprise to me, as the Stelmach provincial government has twiddled with the royalty rates no less than four times in the last two years, much to the dismay of tar sands producers seeking a clear investment outlook. As I wrote a year and a half ago in "Tar Sands: The Oil Junkie's Last Fix," "If the royalties on the tar sands were allowed to rise to anywhere near the normal levels for oil—around 40%, not 1%—the entire industry would cease to be. The profit would vanish, simple as that."

The slowdown in tar sand production casts further doubt on the expectation that it will ever rise from the current 1.5 mbpd to 5 mbpd by 2030. I have estimated that it might peak at 3.5 mbpd by 2030, but the confluence of macro factors now pointing to serious energy shortfalls and a global economy on the brink in the 2012-2013 time frame makes me doubt we'll reach even that.

Scary Decline Rates

The rate of decline from mature older fields is now of paramount concern, as new investment has faltered.

The most recent accepted estimates on decline rates are from the International Energy Agency (IEA), which puts the average global rate of decline at 5.1% (a somewhat squishy number; see here for details) for "observed decline rates." The agency's "natural decline rates," which is what you get without continued investment, now average 9% and will increase to 10.5% per year by 2030.

At a 9% rate of decline, the world would lose 7.6 million barrels per day of supply each year—roughly double the world's current spare production capacity!

Continued reports of oil project cancellations and postponements have prompted the IEA to intensify its drumbeat of alarms about future supply. Last week the agency warned that if oil demand recovers in 2010, global spare capacity would fall to zero by 2013. "That is our concern. Investment, investment, investment, that is what we are asking," Executive Director Nabuo Tanaka said at a conference in Lisbon. The agency estimates that the world will need 45 million barrels per day of new capacity—the equivalent of four Saudi Arabias—just to meet decline by 2030. That's right: just to keep production flat!

As my regular readers know, I believe even that is a conservative estimate. Using the IEA's own most recent numbers on oil decline rates, I calculate that if world demand grows at a projected average of 1.6% per year, the world will need to add the equivalent of six new Saudi Arabias by 2030. (See "IEA Oil Report: ‘Time is Running Out'") To accomplish that impossible feat, the world would need to spend over $1 trillion per year between now and 2030, an equally unlikely prospect.

The natural decline of oil fields is a relentless force, and it requires continued investment and vigilance to keep up production rates. There are many historical examples of older oil fields that were shut down or starved of maintenance due to poor economics, which failed to return to their previous production levels once investment returned due to irreparable damage. Deutsche Bank's study of such fields found that decline rates increased sharply during times of past price collapses. The bank estimates that the accelerated decline of mature non-OPEC fields alone could cut as much as 1.5 million barrels per day from global supply.

By my calculations, the world will likely be down to three-quarters of today's energy budget in 20 years, and down to less than half in 40 years.

Get Long and Stay Long

Despite all the evidence on crimped supply and the warnings of the IEA, the action in oil prices has remained extremely volatile, flip-flopping as much as 10% in a day in recent weeks. This is pure insanity when you realize how crucial it is to essentially all economic activity. Would it make sense to you if the GDP fluctuated 10% from day to day?

Traders are still firmly in control of the oil market, and we should be skeptical of detecting too much signal in all that noise. But I do see prices firming around the $40 a barrel point now, as supply falls and existing stockpiles are gradually depleted. OPEC members are nearly fully in compliance with existing cuts, according to Algerian Oil Minister Chakib Khelil in an interview in Madrid on Monday, and the cartel is considering further cuts at its meeting two weeks from now.

As I have said repeatedly in this column, oil in the $40s is setting up an air pocket in the global fuel line. Once the trade settles down a little and starts reflecting fundamentals again, the name of the game will once again be spare production capacity.

It's a hard number to pin down, but the current global spare production capacity is probably now in the 3-4 mbpd range. (OPEC claims to have 8 mbpd of spare capacity, but I don't believe it, for reasons too numerous to get into here.) Even after all the dire reports about demand lost to economic malaise and shut-in supply from OPEC cuts, that's still only 3-4% of total supply capacity. I think the IEA is right: we could easily blow through that spare capacity by 2013.

This is why I have also said that oil at today's prices is only adding tension to the price slingshot. As we witnessed last year when spare capacity dropped for the first time to roughly less than 1%, prices go parabolic the closer we get to zero spare capacity. When global oil demand recovers—likely led by China—it will send oil prices skyrocketing in two shakes of a lamb's tail. It's impossible to say what that price might be, but I would certainly expect it to surpass last summer's high of $147. I wouldn't say that $300 a barrel was out of the question by 2013.

Non-OPEC conventional crude supply has been essentially flat since 2002, fluctuating between 39 to 41 mbpd, and whatever spare capacity they may now have due to depressed prices is of negligible importance. "All liquids" non-OPEC production has increased from 46 to 49 mbpd since 2002, but most of that gain was from biofuels, tar sands, and natural gas liquids, none of which seem poised for any great expansion at this point. We may reasonably expect that only OPEC might be able to provide extra capacity now. But how confident is OPEC?

In a stunningly blunt February address to a Middle East energy conference in London, OPEC Secretary General Abdalla Salem El-Badri made most of the same points I have made here. "Current prices will not sustain the industry," he said. "They are at about half the level required to attract investments to the industry and ensure sufficient production capacity to meet future demand...Uncertain future demand has put this planned spare capacity—as well as the long-term availability of crude—at risk."

Given the increasing tension in the price slingshot, and the increasingly bad outlook for coming anywhere near the level of investment we would have to make over the next few decades in order to compensate for decline, I am now pretty comfortable with getting long on oil and staying there. If oil does go any lower from here, it can't stay there without seriously reducing production, which would restore the price.

I still recommend being mostly in cash while the market is so fearful and volatile and utterly out of touch with the fundamentals, but for those who are inclined to put a small stake into oil and leave it there for a few years, there is no time like the present to start scaling into those positions.

Until next time,

Chris

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Cleantech's Week in the Sun

There has never been a better time to be a cleantech investor.

Witnessing the scale of the effort being mobilized in Washington right now is nothing short of astonishing to a long-time observer like me.

I have never seen a time that was so favorable for green technology. As I write, the largest annual conference of cleantech investors and businesses is going on in San Francisco, at the Cleantech Forum XXI. With 800 of the world's leaders in the sector representing over $3 trillion in capital meeting to work on green jobs, renewable energy, climate change and resource scarcity, visions are being laid out and deals are being made.

On the other coast, the PowerShift '09 conference will get under way on Friday, where 10,000 young people will meet in Washington D.C. to push for bold action on an energy plan that addresses climate change. An array of elected officials and activists will appear at the conference and offer workshops on lobbying and organizing.

On Monday of this week, another major summit meeting was held in D.C., as the Center for American Progress Action Fund and Senate Majority Leader Harry Reid hosted a forum entitled "National Clean Energy Project: Building the New Economy." Featuring comments by President Clinton, Vice President Al Gore, Energy Secretary Steven Chu, Interior Secretary Ken Salazar, House Speaker Nancy Pelosi, Senator Jeff Bingaman, Representative Ed Markey, and energy baron T. Boone Pickens, it made clear that our leaders are deeply committed to a clean energy future, and that they aren't letting the opposition slow them down.

Pickens and Gore offered some political anecdotes about how some people always resist change, but then appreciate it when it comes. Similarly, at the TED (Technology, Entertainment and Design) conference earlier this month green auto pioneer Shai Agassi (of Better Place) derided arguments against getting transportation off oil as comparable to arguments against "getting off slavery" in 1800s Britain.

Also on Monday of this week, the Supreme Court dismissed an appeal to a lower court ruling that the Environmental Protection Agency acted improperly under the Bush administration in attempting to except coal-fired power plants from the requirements of the Clean Air Act. In essence, the dismissal paves the way for the EPA to regulate the emissions of mercury, lead, arsenic and other pollutants from coal plants.

For his part, the President made it clear in his address to Congress on Tuesday night that carbon will soon come with a price, calling for "market-based carbon" caps and renewable energy.

All of this in just one week. This isn't just a cleantech wave; it's a tsunami.

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Cleantech Investors Eager but Cautious

The investing community is eager to capitalize on the new wave of political support and stimulus dollars coming to cleantech, but they're also cautious about the risks of rounding up capital while much of the credit market is still only communicating with the outside world via smoke signals.

At the Cleantech Forum XXI, Chuck McDermott of RockPort Capital quipped "Washington has made the pitch, now you have to figure out the catch." Dispersing hundreds of billions of dollars quickly will be a challenge for the federal government, and rounding up matching capital from the private sector may remain a challenge for investors and businesses.

Energy Secretary Steven Chu is working hard on his end of the deal. One week ago, he announced a reorganization to streamline the government's process for dispersing and guaranteeing loans for energy and climate change projects. The reforms will simplify the application process, speed up review, defer application fees and amortize up-front costs, and evangelize within the cleantech industry to try to attract and shepherd projects through the process.

Industry is working hard too. Solar darling First Solar (NASDAQ: FSLR) reported yesterday that it had finally broken the $1-a-watt barrier for manufacturing solar panels. At that price, solar can be competitive with coal-fired grid power, and has been long considered a critical milestone in making widespread solar economical. The stock rose 10% on the news.

Damn the Torpedoes!

Despite the enormous enthusiasm for the cleantech sector, the broader market continues to be extremely volatile, and without a real solution for the fundamental problems of insolvent banks and illiquid credit markets, it will likely continue to sell off. With a 12-year-old support level of the Dow now violated, some technical analysts are saying "Look out below!"

The volatility in the energy sector has been particularly crazy, especially with renewable stocks that have been bashed down to pink sheet prices in the widespread selling of the last eight months. Oil has been getting hammered too (although as I have written repeatedly, selling at this point only adds more tension to the price slingshot).

Even the smart grid stocks I mentioned last week were hit hard in the selloff of the four sessions from last Wednesday to Monday, falling 10-15% as a group. But on Thursday, as the market rallied, they gained 6-14% back.

On the whole, most equities are still trading along with the broader market, reacting to the latest news on the bank bailouts, monetary policy and the stimulus package. What the market wants is confidence, and the trade has been mostly about sentiment straight across the board, not fundamentals. For long investors, it has been a nauseating ride.

Does that mean that investing in cleantech, which is still considered a speculative sector, is dangerous?

If you're a long-term investor, the answer is no.

I say, "Damn the torpedoes, full speed ahead!" Once we swallow the bitter pill of nationalizing the banks and taking the hit to the national balance sheet that apparently everybody but Tim Geithner understands is necessary to restore confidence in the markets, the cleantech and renewable energy sectors are going to absolutely explode.

[Being a stickler for accuracy, I checked and discovered that the actual quote was probably "Damn the torpedoes! Four bells! Captain Crayton, go ahead! Joucett, full speed!" uttered by the first admiral of the US Navy, David Glasgow Farragut at the Battle of Mobile Bay (Alabama) on August 5, 1864. And the "torpedoes" were tethered mines. But I digress.]

For example, one of my favorite geothermal plays, U.S. Geothermal Inc. (AMEX:HTM) was up 40% on the day yesterday to $0.84, and its next resistance level, set just two weeks ago, is $1.07. Two weeks ago, the company signed an interconnection agreement with the Idaho Power Company for its Neal Hot Springs project, where drilling began only last May. Test results indicate that the first 286º F source well could produce five to six megawatts of power. Permits to drill three more wells have been filed, and the project is moving ahead.

Geothermal energy is still just barely on the radar of most investors, even though it's one of the cheapest, at about five cents per kWh (about half the average price of grid power). It's also one of the cleanest, and most abundant. According to the US Department of Energy, there is enough recoverable geothermal energy under American soil to meet our annual energy consumption 140,000 times over!

For the last several years, the geothermal industry has been in a land-grab phase, securing leases for the best geothermal sources. Now they're beginning to develop the projects, and soon the cash will flow. Let these companies prove their profitability for a year or two, and the venture capital will be waiting in line for a piece of the action.

The technology we needed for a renewable energy revolution is now here. We now have solar, wind, and geothermal technology that can go head-to-head with fossil fuels on price. All we need now is willing capital, a smarter and beefier grid, and some vehicle-to-grid technology or other storage systems—all of which we seem certain to have within just a few years. When that happens, the sector is going to take off like a rocket, and never look back.

Until next time,

Chris

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Smart Profits on the Smart Grid

It's not every day that you see an opportunity to get in on the ground floor of a whole new industry, but smart grid technology is just that.

The "smart grid" term has come to encompass a whole array of different technologies, creating some confusion about exactly what it is. It doesn't help that the publicly-traded companies in the sector are mostly young, with cheap stocks regarded as speculative.

What investors should not be confused about is the outlook for this sector, which is nothing short of spectacular.

In the U.S., it took only 25 years for commercial mobile phone technology to evolve from mainly business users of Motorola's "brick" to everyone over the age of four owning one. In the same way, the early trial programs of smart grid technologies today will become ubiquitous, only it will happen much more quickly.

The reason is simple: The cheapest watt is the watt you don't have to produce. Eliminating waste is by far the low-hanging fruit in the energy sector.

The waste in our electrical grid is enormous. According to the U.S. Energy Information Administration, over half of the energy we generate is wasted in generation and transmission. For example, coal and nuclear power plants need to keep running even when demand is lower than their generation, because it takes days to start plants up and shut them down.

Worse, everyday waste from unused but running lights and appliances can force utilities to start up "peaking" power plants (usually powered by natural gas) in order to meet peak demand loads that could be met without them if the waste were eliminated.

Energy is wasted from one end of the electrical grid to the other. Inefficient generator turbines, wasted heat from power plant cooling cycles, transmission lines, inefficient motors using the power, and dumb appliances all contribute to the losses.

In many ways, the smart grid is about reducing wasted energy. That's not just good policy; it's also good business. Deploying energy saving technologies usually pays for itself quickly, and always pays for itself in the long term. It also cuts down on greenhouse gas emissions from generating unneeded power.

Smart grid technologies are going to receive a nice boost from the U.S. stimulus package as well. The Senate bill includes $11 billion to improve the electric grid.

Between the cost benefits, the lower emissions, and federal funding, investing in smart grid technologies now is a no-brainer.

I fully expect that within 20 years, today's electrical grid architecture will seem unbelievably wasteful, and all of our end-user devices incredibly dumb. The smart grid renaissance has only just begun, and investing in it will be a long-term home run.

Let's take a look at a few of the companies that will profit from the smart grid transformation.

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Utilities Getting Smart

The utilities' efforts to make the grid smarter began in the US around 2003, when several operators began replacing their old mechanical meters with electronic "smart meters" which communicate with the utility's head office, a technology known as Advanced Metering Infrastructure (AMI).

Smart metering can give customers immediate feedback on their own energy consumption, letting them know when power is expensive and in short supply, and when it's cheap and in excess. By moderating their usage of it accordingly—say, doing laundry at 9 pm instead of in the middle of a hot, high-demand day—customers will save themselves money.

At the same time, the utility will save money by not having to produce more peak demand power than necessary. Smart meters can allow utilities to shut down part or all of a customer's power consumption when grid demand is high, and customers agree to do without the power in exchange for lower rates.

Smart meters communicate usage data to the utility electronically, eliminating the need for "meter maids" to physically visit each meter, or the need to estimate usage when the meter maid couldn't get to the meter.

But that's just the beginning. Smart meters also enable a host of other technologies. Smart appliances can take orders from smart meters about when and how to run, and when not to run. Likewise, smart sockets can control the usage of dumb devices plugged into them. The utility can quickly pinpoint service outages, and restore service more quickly.

Smart meters also allow customers with solar, wind, and micro-hydro systems to sell power back to the grid, thus enabling the deployment of more distributed generation. As plug-in hybrid vehicles become more common, smart meters will be able to use them as distributed storage, drawing down a small part of their battery power by agreement of the vehicles' owners. In time, such "vehicle-to-grid" power technologies could be the "holy grail" of renewable energy, by giving the grid a way to store energy from intermittent sources like wind, then use it later when it's needed.

Utility operators in Austin, San Francisco, and Boulder have all embarked on long term programs to replace their meters, with other cities soon to follow.

California utility operator PG&E has the nation's most ambitious program. Currently deploying new meters at the rate of 10,000 per day, the company aims to install 10.3 million new meters at the nearly 6 million homes and businesses across its entire grid by 2011. The utility estimates that roughly 90% of the $1.7 billion cost of the project will be offset in savings over its 20-year life, of which over half will owe to meter-reading savings.

The rest of the country is watching PG&E closely. If their rollout is successful and the cost benefits are clear, we should expect the rest of the country's utilities to soon follow suit.

Smart Players in Smart Grids

There aren't many real "pure plays" in the smart meters themselves. The meters deployed by PG&E are made by diversified giant General Electric (NYSE: GE) and privately-held Swiss company Landis+Gyr.

But there are some side plays on the PG&E rollout, such as utility infrastructure company Esco Technologies (NYSE: ESE) whose subsidiary Aclara RF Systems Inc. provides a secure radio transmission network for the smart meters to communicate with the utility's head office.

Another smart metering company is Green Chip Stocks favorite Itron, Inc. (NASDAQ: ITRI) which provides metering, data and software for automated meter reading. Itron recently announced a deal to use communications technology by Digi International (NASDAQ: DGII) in its advanced metering network.

There are also the smart grid companies whose technologies will ride on top of the smart metering networks. Echelon Corporation (NASDAQ: ELON) makes a variety of devices that will put the "smarts" into everything from air conditioners to light switches, enabling them to communicate with each other and with the grid operator. Comverge, Inc. (NASDAQ: COMV) provides demand-response and energy management technology that allows grid operators to better manage peak and baseload capacity. A similar play is EnerNOC Inc. (NASDAQ: ENOC) whose technology allows utilities to remotely manage and reduce electricity consumption across their networks.

Even Google (NASDAQ: GOOG) is getting into the smart grid act, with a new iGoogle gadget called PowerMeter. The application will display power usage per appliance in real time, so that customers can see where their power is going. The company cites research that indicates the feedback to consumers encourages them to cut 5-15% of their energy usage by changing their behaviors. Google is offering an open-source standard for collecting and reporting that data over the Internet, and encouraging companies in the smart grid sector to conform to their standard.

Smart grid companies were punished along with everybody else in the market meltdown, but have stabilized and started working their way back upward. Over the last four months, most of the above-mentioned companies have gained 20-50%, while the rest of the market continued to struggle and fall. The time is now to jump on the smart grid and start picking up some smart profits!

Until next time,

Chris

Energy and Capital

P.S. The Alternative Energy Speculator has been tracking smart grid stocks since its inception, and Nick Hodge tells me he's been "playing them like a fiddle" as the stimulus bill took shape. Don't miss your opportunity to discover the very best plays in smart grid technology, sign up now!