Tuesday, December 7, 2010

Peak Oil vs. Global Warming

"Peak Oil" and "Global Warming" are often discussed together as two of the most difficult energy challenges that our society faces over the coming decades.  Both challenges have the potential to lead us to catastrophic societal outcomes if we fail to address them properly.  The "worst case scenario" for each challenge reads like an apocalyptic movie plot - for peak oil, we could see resource wars, economic collapse and worldwide starvation; for global warming, there could be "climate wars", harsher storms, desertification, and sea level rise.  Both have the potential to kill millions of the poorest people who are currently living on the margins of our global society.

As we enter a post-peak oil world, we will begin to switch to alternative energy sources to compensate for the shortfall in oil production from the aggregate depletion of worldwide conventional oil fields.  The forms of alternative energy we use will be largely dependent on whether or not we place restrictions on carbon dioxide emissions.

Peak Oil means we'll either emit far less CO2 or far more - it all depends on whether we tax it.
If we don't place any restrictions on carbon dioxide emissions, the liquid fuel alternatives we will choose to make up for our post-peak-oil production shortfall will be completely based on the return on investment that can be achieved from these alternatives.  Companies will invest in the sources of alternative liquid fuels which will be the most profitable.  Alternatives with the highest energy return on energy invested (EROEI) will receive the investment up to their upper limit of scalability.  The "waterfall of investment" will occur in the following order, based on EROEI:
  1. Increased traditional land drilling for conventional oil in politically unstable regions
    1. EROEI: between 20:1 and 40:1
    2. Scale is limited by political turmoil and field peaks; Iraq has the potential to increase production from 3 mbpd to 12 mbpd (nearly 15% of world oil demand!)
    3. Water Intensity: 0-60 gal/MMBTU
    4. Carbon Intensity: 25 g C eq. per MJ of fuel
  2. Increased use of enhanced oil recovery methods in existing fields
    1. Water injection, gas injection, hydraulic fracturing, pumpjacks, etc.
    2. EROEI - between 1:1 and 20:1
    3. Scale is limited by water & gas availability; enhanced oil recovery technology often only prolongs a fields peak and causes a more rapid decline thereafter
    4. Water Intensity: 40-100 gal/MMBTU 
    5. Carbon Intensity: 25-30 g C eq. per MJ of fuel 
  3. More deepwater offshore drilling of conventional oil
    1. EROEI = 10:1
    2. Scale is limited by the number of new fields found.  Brazil's Tupi field, the largest oil discovery of the preceding 20 years, has a maximum possible daily production of 1 mbpd (4% of world demand)
  4. Arctic land and offshore drilling of conventional oil
    1. EROEI = 10:1
    2. Scale is limited due to harsh climate - limited drilling period and difficult transportation; ANWR maximum possible daily production is 780,000 barrels per day (<1% of world demand)
  5. Canadian Tar Sands
    1. EROEI = 7.2:1 
    2. Scale is politically limited by water usage and water pollution; Canada currently produces 1 million barrels per day; maximum possible daily production is 3.6 mbpd (4% of world demand)
    3. Water Intensity: 15-35 gal/MMBTU
    4. Carbon Intensity: 30-35 g C eq. per MJ of fuel 
  6. Natural Gas-to-Liquids
    1. EROEI = Between 3:1 and 10:1
    2. Scale is limited by the expense of infrastructure and availability of natural gas; Shell's Pearl GTL plant cost $19 Billion and can only produce a maximum of 140,000 barrels per day (1/10th of 1% of the world's oil demand)
    3. Water Intensity: 20-90 gal/MMBTU
    4. Carbon Intensity: 30 g C eq. per MJ of fuel
  7. Coal Liquefaction
    1. EROEI = 6:1
    2. Water Intensity: 40-70 gal/MMBTU  
    3. Carbon Intensity: 40-50 g C eq. per MJ of fuel 
  8. In-situ shale oil production
    1. EROEI = Between 2.5:1 and 6.9:1
    2. Water Intensity: 10-40 gal/MMBTU 
    3. Carbon Intensity: 30-70 g C eq. per MJ of fuel

The problem is, as you can see above, each source of alternative liquid fuels has a higher carbon intensity than our current conventional oil production does.  Meaning that not only will our worldwide carbon emissions increase as the world's energy demands increase, but they will increase at an increasing rate as we move to more carbon-intensive alternatives.

If the government does place restrictions on carbon dioxide emissions, our energy investments will look completely different.  Oil from tar sands, coal-to-liquids, natural-gas-to-liquids will become even more expensive than they currently are - rendering them less competitive against renewable liquid fuel alternatives such as biofuels.  Biofuels, however, are themselves quite energy intensive - requiring natural-gas-based fertilizers and pesticides, diesel-fueled tractors and trucks and high-energy bio-refineries to convert crops into fuel.  Biofuels are also limited in scale - if we wanted to get all of our current US fuel demand from biofuels, we'd have to stop eating food and devote every single acre of cropland in America to biofuel production.

In a high-carbon-price environment, therefore, cellulosic ethanol may offer the greatest hope for renewable liquid fuels.  Cellulosic ethanol wouldn't compete with our food supply and is far less carbon-intense than gasoline derived from traditional oil.  It is, however, still a long way off from commercialization.

Wind and solar power are not direct substitutes for oil as they provide electricity, not liquid transportation fuel.  In a high-carbon-price environment, peak oil and carbon taxes would combine to greatly increase the price of traditional gasoline.  Carbon taxes would also make electricity more expensive in the US, since we get most of our power from coal.  With carbon taxes, however, these coal power plants would not need to compete as vigorously with coal liquefaction and the price of electricity would likely not increase as much as the price of gasoline.  Carbon taxes may make unconventional oil (such as oil derived from tar sands) so expensive that transportation methods would begin to shift from fossil-fuel-based modes to electrified modes.  Freight transportation would shift from truck to train - possibly with more electrified rail.  Personal transportation would shift from traditional automobiles and SUVs to plug-in-hybrids and electric cars.  Air travel would become dramatically more expensive - increasing the incentive to build more high-speed rail in the US.

Coal power plants would pass on the cost of the carbon tax to their customers and natural gas power plants would become more cost competitive against coal since natural gas releases about half the CO2 per megawatt hour that coal does.  Carbon sequestration at coal power plants may slow this shift away from coal.  More wind power would come online as these projects become more cost competitive against natural gas, but more natural gas plants would likely need to be built to provide the necessary increase in base load capacity to offset the wind power's intermittency and lack of dispatchability.  Depending on the price of carbon, nuclear power may replace these natural gas plants for increased base-load capacity.  More pumped water storage would be needed as more wind power comes online - to help smooth out intermittency.

The path we follow (traditional transportation infrastructure w/ carbon-intensive unconventional oil vs. electrification of transportation w/ renewable energy) will largely depend on the societal and political choices made by a number of disparate groups.  Our society could begin to demand less carbon-intensive forms of energy.  On an individual basis, we can choose to go down this path by buying carbon credits, paying a premium to our utilities for renewable energy and switching our personal modes of transportation to those which emit less carbon - such as hybrids, electric vehicles and mass transportation.  This "bottom-up" change is already happening, with early-adopters buying hybrids and electric cars and installing solar panels on their houses.  But it is a slow and economically inefficient way to move the world towards a less carbon-intensive and peak-oil-proof world.  Due to the complex and uncertain nature of peak oil and global warming, it may take a very long time before mainstream society "gets it" and begins taking personal steps in this direction.  Also, due to the economic pain of taking these steps, this "tipping point" of societal opinions and behaviors may not occur until well after the negative consequences of peak oil and/or global warming are upon us.

One interesting "bottom-up" approach is General Electric's announced intention to purchase 25,00 electric vehicles by 2015.  As the world's second largest manufacturer of wind turbines, GE certainly has some skin in the game when it comes to the imposition of a carbon tax, and the announcement is likely designed to help encourage further adoption of these electric cars, moving the electrification of personal transportation further into mainstream society.  At the same time, GE's CEO Jeff Immelt has been actively lobbying in Washington for a carbon cap-and-trade scheme.  If more companies take steps like these, it may sway public opinion enough for politicians to implement climate change legislation.

A government-imposed carbon tax would quickly move us in the direction of sustainable transportation, but such a tax can only happen with the political will of the majority of Americans behind it.  In the current political environment it seems impossible that a carbon tax could be implemented.  A carbon tax would have the net effect of immediately raising fossil fuel prices.  When even the FED chairman admits that we're teetering on the edge of a double-dip recession, saying "We’re not very far from the level where the economy is not self-sustaining", all politicians are wary of implementing measures which would put additional burdens on the economy.

In a post-peak-oil environment (which, according to the International Energy Agency's 2010 World Energy Outlook, we entered in 2006), a carbon tax may be even more politically impossible.  As American citizens have to live with higher and higher oil prices, and in the absence of any catastrophic events linked with global warming, they may demand that the government not impose any carbon taxation.  We've seen this before during the 2008 presidential campaign with people shouting "drill, baby, drill" as the price of oil skyrocketed to all-time highs.  As political polls show, the immediate economic concerns of the average voter always trump their long-term environmental concerns - particularly during a recession or when gas prices are high and rising.

So while the solutions to both problems overlap in the realm of renewable energy (wind, solar, biofuels, etc.), the movement towards these alternatives will only happen with a tax on carbon.  In the absence of a tax, we will transition to more carbon-intensive oil alternatives as we enter a post-peak-oil world.

As an investor, you should be setting yourself up to profit from this transition.  The largest international oil companies (IOCs) will win in either case - since they're all currently investing in unconventional oil as well as renewable energy alternatives.  For example, Exxon (XOM) is investing in algae-based biofuels, Shell (RDS) is investing in tar sands and gas-to-liquids, and Chevron (CVX) is investing in geothermal energy.  In order for the IOCs to pursue more deepwater offshore drilling, enhanced oil recovery, gas-to-liquids and other unconventional oil plays, they will require the assistance of oil equipment and supply companies such as Schlumberger (SLB) and Halliburton (HAL).

The best way to invest in this sector of companies, as I recommended in the Peak Oil Proof Portfolio, is to diversify your holdings through an ETF, such as VDE.  I also recommend in the portfolio that you hold coal (KOL) and a renewable energy ETF (PBD).  In a post-peak-oil world without any carbon taxation, the price of coal will increase significantly.  With a carbon tax, renewable energy companies will grow significantly.  Either way, as an investor, you will come out ahead.

Tuesday, November 9, 2010

Demand Destruction from Peak Oil

Demand Destruction is a term used to describe a series of economic actions that occur when oil prices become too high for the global economy to absorb them.  In this environment, the economy goes into a recession and the price of oil correspondingly crashes.

Oil's primary use is as a transportation fuel - 81% of the world's oil is refined into liquid transportation fuels (46% for gasoline, 9% for jet fuel and 26% for diesel and other liquid transportation fuels).  The remaining 19% of the world's crude oil production goes into heating oil, electricity generation, plastics, synthetic rubber, asphalt and tar, wax, lubricants, adhesives, solvents, explosives, paints, sealants, corrosion inhibitors, cosmetics, fragrances, pharmaceuticals, fertilizer, pesticides, food flavorings, food additives and other industrial and commercial products.

As oil prices increase, the input prices for the variety of goods listed above (including food) increases.  These increased input prices, along with the increased transportation cost for these goods from higher fuel prices are normally passed on to the consumer.  This increase in consumer goods prices is pure oil-price-induced inflation.  While consumers must stomach these increased consumer goods prices, they must also pay more of their budget for gasoline.  As the price of gasoline goes up, consumers will use less gasoline (which is what most economists are referring to when they talk about demand destruction in oil), but at the same time, the consumer will also be using more of their disposable income on gasoline, which leaves less money to spend on consumer goods (which are now more expensive due to oil-induced inflation).  This creates a secondary (and more significant) oil demand destruction as the economy shrinks from lower consumer spending.

One way to visualize demand destruction is to look at the average American consumer.  The average American consumer lives on a tight budget.  As the price of gasoline increases, the consumer begins to drive less.  They will likely still drive to work every day (what we could consider their "base level" of oil demand), but they may cut back on their other driving - such as going out to eat during the week or driving to see family on the weekends.  They might postpone that family vacation to Hawaii.  All of these actions decrease their overall oil consumption.  If the consumer is on a particularly tight budget, they may start carpooling or taking the bus to work - further reducing their oil demand.  Meanwhile, the price of everything they purchase, from groceries to prescription drugs, has increased - cutting in to their discretionary consumer spending budget and further reducing their overall spending on non-essential travel and non-essential purchases.

Because 75% of Americans live paycheck-to-paycheck (the vast majority of whom are also being squeezed by significant credit card debt) and 70% of the US economy is dependent on consumer spending, when you aggregate the drop in consumer demand from one person across all the consumers in an economy, the economy goes into a recession.

Globally, we can aggregate the effect on consumer spending across the world economy.  The UK, Germany and many other developed countries are very similar to the US in that their economies are extremely dependent on consumer spending.  In China, consumer spending only accounts for 40% of the country's economy, but because it is a large exporter of consumer goods to developed economies, China's economy is extremely dependent on consumer spending in the developed world.

Research has shown that the primary way in which oil price shocks affect the economy is through a reduction in consumer spending.  At a certain price of oil, consumer spending falls off sharply; the world economies reach a "tipping point" and enter a recession.

Of course this is a very simplistic way to look at the world economy, and obviously there are many other factors at play.  There is evidence that the world's developed economies have become less dependent on oil over the last few decades.  As a result, oil price spikes may not have as damaging an effect on the world economies as they have had in the past.  There remains a great deal of uncertainty over how oil price spikes effect the macro economy, but one way to look at the problem is as follows:

As the world economy grows, the short-run demand curve for oil shifts to the right.  Normally the short-run oil supply curve would shift to the right as OPEC increases production and previously-uneconomical oil fields come back online in the rest of the world.  But in a post-peak-oil world, OPEC's ability to increase production is limited and this short-run demand curve cannot move any further to the right.
As you can see, in a peak-oil world, short-run quantity supplied hits a wall and the price of oil keeps increasing.  This is the economic mechanism that causes a "price spike".

When the price of oil become too high, the economies of the world can't afford the additional oil cost; the world economy goes into a recession and the short-run demand curve for oil shifts back to the left.  Since oil production is inelastic in the short-run, the price of oil plummets.  This is the core of "demand destruction".

As the oil price drops due to lower oil demand, the low oil price helps the economy slowly recover.  This economic recovery brings more demand for oil and the cycle continues.

This cycle of oil price spikes, recession and oil demand destruction is referred to as the "bumpy plateau".  This mechanism may hide the true peak of world oil production for a number of years as oil price spikes and recessions cause the daily world oil production rate to vary significantly as we get close to and pass the point of world peak oil.

(Source: Colin Campbell – Association for the Study of Peak Oil)

In the long run, as the worldwide oil production rate moves down the far side of Hubbert's Peak, the supply curve will shift to the left at the global aggregate depletion rate, further increasing prices.  In the long-run, high oil prices should help encourage increased investment in additional oil drilling as well as increased investment in oil alternatives such as shale oil and tar sands projects.  However, due to the rapid nature of price movements and demand destruction, the market sends mixed price signals, hindering the investments needed to shift the long-run demand curve to the right.

In the long run, people will trade their SUVs for hybrids or move closer to work and companies will increase the fuel efficiency of their operations, and purchase more fuel efficient trucks and airplanes, etc.  All of these efficiency improvements that would shift the long-run demand curve to the left, however, take a long time to implement and are particularly difficult to justify when the price of oil plummets along with the economy due to demand destruction.  The average consumer will be feeling financial pain during the recessions and when they see that the price of oil has plummeted (due to demand destruction) they may not see the need (or be able to) trade in their vehicle for a more fuel efficient model.  The average consumer "trade cycle" for cars is 52 months, far longer than the duration of a typical price spike and demand destruction cycle, meaning our society will be slow to increase vehicle fuel efficiency.  Indeed, even now with oil prices rising nearly 15% over the last 6 months, sales of SUVs and pickup trucks are outpacing sales of cars in America by the widest margin in 5 years.  Consumers simply don't understand the price signals.

These mixed price signals and economic volatility also make financial modeling difficult for firms.  This, combined with the difficulty in justifying capital expenditures during a recession, means the implementation of efficiency projects in firms (which would help them become more resilient to future price spikes) may be slow.  This will further reduce the ability of our society to shift the long-run demand curve to the left.

For oil companies, these periods of low oil prices due to demand destruction also make it difficult to finance new oil projects which would help offset the global depletion rate.  This prevents the long-run supply curve from shifting to the right against the leftward shift caused by the global aggregate oil depletion rate, the net result of which is increasing oil prices.

Large-scale shifts in transportation infrastructure (high-speed rail, electric cars, renewable electricity generation, etc.) will likely only be possible with extreme government involvement.  Given the history of partisan government gridlock during recessions (as we are seeing now), these fundamental infrastructure changes may take a significantly long time to implement, thereby prolonging the bumpy plateau.

The last oil price spike we had was in 2008, when crude oil reached an all-time high of $147 per barrel.  It would appear then, that $150/bbl is the upper limit in price of what economies can afford without tipping into a recession. This price, however, is based 2008 dollars and because the US government has injected trillions of dollars into the economy through bailouts and quantitative easing since then, it isn't known what the trigger will be in dollar terms the next time around.

A better way to find the demand-destruction-inducing price of oil is to look at oil prices as a ratio to other commodities or indices.

After analyzing 25 years of data, I found the following ratios:

Gold/Oil Ratio ($/troy ounce : $/bbl)
Average over 25 years - 16:1
Ratio when Oil hit $147/bbl (July '08) - 6.5:1
Ratio when Oil crashed to $30/bbl (Dec '08) - 27:1
Ratio when Oil hit at multi-decade low in 1998 - 27:1
Ratio today - 16:1

S&P500/Oil Ratio (Index in $ : $/bbl)
Average over 25 years - 29:1
Ratio when Oil hit $147/bbl (July '08) - 8.5:1
Ratio when Oil crashed to $30/bbl (Dec '08) - 29:1
Ratio when Oil hit at multi-decade low in 1998 - 107:1
Ratio today - 14:1

After running the data through a statistical trading model, I found the optimal trading triggers, based on these ratios.

If the S&P/Oil ratio goes below 12, oil is about to become so expensive that it will "break the system", in this case, Sell Oil, Short the S&P 500.

When the economy crashes, if the Gold/Oil ratio goes above 20, oil is too cheap compared to gold, in that case, Buy Oil.

We're currently seeing an upward swing in commodities prices.  You should be holding oil and other commodities at this point.  The best trigger to keep an eye on for the next few months is the S&P/Oil ratio - if oil prices begin to spike and this ratio drops below 12, Sell Oil, Short the S&P 500.

Tuesday, October 26, 2010

ETF Spotlight: Norway and Scandinavia - GXF

This week's ETF spotlight focuses on the Global X FTSE Nordic 30 ETF (GXF).  Scandinavia is one of the world's most energy secure regions, with large Norwegian oil reserves, wide renewable energy adoption, and broad social and government efforts to reduce energy consumption.  The Nordic countries are are also some of the world's most economically and politically stable economies and stand to benefit greatly from peak oil.

The village of Reine in Lofoten, Norway
(Credit: Petr Šmerkl)

Norway is the world's 5th largest oil exporter and 3rd largest gas exporter - ahead of Kuwait and behind Iran, the UAE, Russia and Saudi Arabia.  Western Europe gets much of their oil from Norway's offshore fields in the North Sea and this resource has provided an incredible source of wealth for Norway - accounting for approximately 50% of all exports.

Starting in 1996, the Norwegian government started funneling the excess proceeds from its oil exports into The Government Pension Fund of Norway.  In 2010, the fund topped half a trillion dollars, and currently holds 1 percent of the global equity markets.  The incredible size of Norway's sovereign wealth fund has greatly increased the country's resilience to the possible harmful effects of peak oil.

Norway's North Sea oil production peaked in 2001 at 3.4 million b/d and has been declining at a rapid 13% rate since.  The decline rate is a cautionary tale for anyone who thinks that enhanced oil recovery technology will save the world from peak oil; Norway is a world leader in such technology and rather than postponing the country's production peak, it has merely allowed it to continue to produce oil for a longer period time at production rates that are still declining from their peak.

While Norway's oil production peak might, on the surface, make it in an unattractive peak-oil investment play, there are a number of reasons why Norway could benefit greatly from peak oil - including the country's large existing oil reserves, energy independence, potential arctic oil reserves, position as an oil technology leader, societal push for energy efficiency, large existing renewable energy infrastructure and political and economic stability relative to other oil exporters.

Despite Norway's oil field depletion rate, the large size of the existing oil reserves and the government and societal push for energy efficiency make it unlikely that the country will become a net oil importer in the near future.  This leaves it in the enviable position of being one of the few energy independent nations on earth.  This should allow Norway to not only ride out any oil shocks, but also to profit from them.  Additionally there's some research which shows that energy independence allows economies to continue to grow during worldwide recessions.

Norway is also actively pursuing the exploitation of new sources of oil in the Arctic Ocean.  Oil companies are extremely optimistic about the potential for vast quantities of oil in the Arctic, with some experts saying that reserves could total 25-50% of the world's undiscovered oil.  Norway, along with the United States, Russia, Denmark and Canada, stand to benefit greatly from this "final frontier" of oil exploration.

Norway is a worldwide leader in offshore oil rig technology, due largely to the fact that the North Sea is one of the harshest drilling environments on earth.  Winter temperatures are frequently below freezing and waves can regularly exceed heights of 10 meters - with one instance of a 25 meter wave hitting an oil platform in 1995.  In overcoming these unprecedented technological hurdles, Norway has developed some of the world's most advanced offshore oil drilling technology, and stands to benefit from exporting it to companies which wish to drill in even harsher environments, such as in the Arctic.

Additionally, Norway is a technology leader in advanced oil recovery from carbon sequestration.  Statoil currently operates the world's largest carbon sequestration facility and should be able to easily export its technology and expertise to other oil companies wishing to increase oil production and reduce carbon emissions - both major economic issues for oil companies in the future.  Additionally, this carbon sequestration technology could potentially be combined with underground coal gasification technology to carbon-neutrally harness the 3 trillion tons of coal which lie off Norway's coastline (a reserve 3 times larger than the entire world's onshore coal reserves).

Norway has also long been a leader in offshore oil rig safety standards, with its Det Norske Veritas classification being one of the world's toughest regulation standards for offshore vessels.  As a result, Norway stands to benefit from the current push to retrofit existing offshore oil rigs to higher safety standards, due to new government regulations resulting from the Deepwater Horizon oil spill in the Gulf of Mexico.

Scandinavia has significant existing renewable energy infrastructure.  Norway, due to its vast network of hydroelectric dams, generates 99% of its electricity from renewable energy.  It is also the first country to commercialize tidal power.  Finland generates about a quarter of its electricity from renewable sources.  Denmark, long known for its windmills, generates about 20% of its electricity from wind power and manufactures a significant portion of the world's wind turbines.  Scandinavia's large renewable energy infrastructure, combined with a current push for electric car adoption, will greatly reduce the region's exposure to the negative effects of peak oil in the future.

In addition to its renewable energy sources, Scandinavia is leading the world in an effort to reduce its oil consumption.  Major Scandinavian cities like Stockholm, Copenhagen and Oslo are extremely walkable, have readily available public transportation and lead the western world in bicycle use.  In Copenhagen, 36% of all citizens commute by bicycle and the city has set a target for 50% of citizens to do so by 2015.  In Sweden, 43% of the country's electricity comes from renewable sources and the government has drawn up plans to make the country oil-free by 2020.

The Scandinavian countries have robust economies with stable currencies.  The Norwegian Krone has even been called "the world's safest currency" - a distinction which is particularly salient during the current currency wars, with the world's largest economies in a race to the bottom to devalue their currencies.  The Scandinavian countries are some of the wealthiest on earth; all rank in the top 20 for gross domestic product at purchasing power parity per capita, with Norway holding the 3rd spot, behind only Qatar and Luxembourg.  They are also some of the most productive, with GDP-PPP per hour worked ranking Norway as the most productive country on earth.  Sweden, Finland and Denmark also all rank within the top ten of the world's most competitive economies.

On its own fundamental merits for currency stability, government stability, economic stability and potential for economic growth, the Scandinavian countries make an ideal investment target.  When combined with their focus on energy independence and the vast resource wealth of Norway, investing in the Global X FTSE Nordic 30 ETF (GXF) is a great way to protect your portfolio from peak oil.

GXF Top 10 Holdings:
  1. Novo Nordisk - Danish Pharmaceutical Company
  2. Nordea Bank - Nordic Banking Conglomerate
  3. Ericsson - Swedish Telecommunications Company
  4. Nokia - Finnish Mobile Phone Company
  5. Statoil - Norwegian Oil Company
    • Operates in 34 countries worldwide
    • Technology leader in harsh-environment offshore drilling
    • Offshore safety leader
    • Technology leader in carbon sequestration
  6. H&M - Swedish Clothing Company
  7. Svenska Handelsbanken - Swedish Bank
  8. Volvo - Swedish commecial truck Manufactuer
    • Produces some of the world's most fuel-efficient commercial trucks
    • Volvo Cars is owned by the Chinese Geely car company
  9. Sandvik - Swedish Materials, Mining & Construction Company
    • Large upside potential from increase in commodities prices
  10. Danske Bank - Danish Bank

Saturday, October 16, 2010

Book Report - The Impending World Energy Mess

Robert Hirsch is perhaps most well known for writing the famous "Hirsch Report" in 2005, which was the first official US Government report, written for the US Department of Energy, which publicly acknowledged the threat of peak oil and the potential catastrophic effects it could have on the US economy.  Along with the two co-authors of the Hirsch Report, Dr. Hirsch recently published a book aimed at the general public entitled "The Impending World Energy Mess".

Generally the book does a very good job synthesizing all of the various complexities associated with peak oil, from the overestimation of OPEC reserves (pg. 33), to the summary of current peak date forecasts (ch. 7), the challenges to mitigation strategies (pg. 130), the Energy Return on Energy Invested of alternatives (ch. 13), and the obstacles to scaling up alternatives (ch. 14).  It is very comprehensive in the way it takes each alternative, one by one, and analyzes their market potential and the challenges and risks of their adoption.

One criticism of the book is that the authors chose to treat climate change with a good deal of skepticism.  Obviously the "climategate" scandal shed a lot of negative light on the way scientists build their climate models.  Correlation of temperature changes to greenhouse gas emissions does not necessarily imply causation and anyone who's familiar with modeling - for example, financial modeling - knows that the modeler can adjust the countless assumptions to make their model come to pretty much whatever conclusion they desire.  So while there may be a great deal of skepticism (much of it funded by the largest greenhouse gas emitters) about the anthropogenic roots of global climate change, there is little doubt about the basic scientific measurements confirming global warming since the beginning of the industrial revolution.  So the problem comes down to the simple question: "are you confident enough with your skepticism of the anthropogenic roots of global climate change to risk doing nothing and potentially endanger all future generations of life on earth?".  Which brings us to the "precautionary principle".  For a group of authors who so competently apply the precautionary principle to the problem of peak oil, it's disheartening to see them completely ignore it for climate change.  Certainly, the militaries of the world (including the United States, Canada, Germany, China, & Russia) understand the issue and have been actively building contingency plans for wars resulting from global warming and peak oil.  If our militaries are taking the two problems seriously, perhaps we should as well.  After all, the solutions to our energy security problem, our peak oil problem and our climate change problem are the same: become more efficient in our use of energy, transition our transportation infrastructure to be less dependent on fossil fuels, and build massive new sources of renewable energy.

In chapter 16, the authors name specific countries as peak oil winners and losers, and their conclusions largely mirror the Peak Oil Proof Portfolio:
  • Winners: Oil Exporting Countries
    • Russia
      • I recommend RSX in the Peak Oil Proof Portfolio
    • Canada
      • I recommend EWC in the Peak Oil Proof Portfolio
    • Saudi Arabia
    • Mexico
      •  Hirsch fails to recognize Mexico's 2006 peak and massive 13% decline rate since
    • Norway
      • I recommend GXF in the Peak Oil Proof Portfolio
  • Losers: Oil Importing Countries
    • United States
      • Major economic downside potential as China spends US dollar reserves on oil
    • China
      • Massive recent oil investments (in US Dollars) may help mitigate problem
    • Japan
    • India
    • South Korea
    • Most of Europe - specifically Germany, France and Spain

    On a side note, I had the opportunity to sit in on a discussion panel two nights ago with Michael Nash, the director of the new movie "Climate Refugees".  He told a story of a night he had in China a few years ago where he had a few drinks with some Chinese officials after randomly sharing a cab with them.  He asked them what they really thought of the way the United States was handling its energy security and climate change policy.  The officials responded that they would love nothing more than for the US to have another 10 years of political impasse over energy policy - that while the US has been squabbling over building an energy bill, China has gone from being a developing country to the world's largest consumer of energy and the world's largest producer of wind turbines and solar panels.  The Chinese officials rightly deduced that if the United States waits any longer to get serious about its energy problem, that not only will the US be in severe economic trouble, but that it will be buying the solutions to its problems from the Chinese rather than building them domestically.  As Dr. Hirsch accurately surmises in the book, "the risk of widespread economic disaster is so great that immediate action is mandatory."  If the US politicians don't get serious about creating a comprehensive energy plan to transition the US economy towards energy alternatives, the United States could end up as the "biggest loser" of the above list.

    Additional investment advice is given in chapter 18, including:
    • Avoid holding long-term bonds
    • Consider investing in inflation-protected TIPS bonds
    • Invest in commodities as a hedge against energy-induced inflation
      • I recommend GLD and SLV in the Peak Oil Proof Portfolio
    • Avoid investment in consumer goods companies
    • Consider short sales of stocks
    • Invest in countries which are energy secure
    In chapter 11, the authors also recommend their preferred technologies which countries could adopt in an Apollo-style "crash program" to mitigate the effects of a worldwide oil production decline.  Since each technology carries with it significant technical and political risk, I believe it's best to invest broadly in oil (VDE) and alternatives (PBD) and avoid trying to pick technology winners and losers.

    As for the Peak Oil Proof Portfolio, it's up 4.16% since its inception, vs. 3.07% for S&P 500.

    Saturday, October 9, 2010

    ETF Spotlight: Brazil - EWZ

    I've created a mock portfolio to track the progress of the Peak Oil Proof Portfolio.  For the past week, the portfolio has gained 2.95%, while the S&P500 gained 2.10% - mostly due to poor US unemployment figures raising expectations that the Fed will issue a second round of quantitative easing.  In the event of "QE2", we could expect that US energy demand will increase, buoyed by more readily-available money.  Loose US monetary policy should generally benefit the entire portfolio.

    Sunday, October 3, 2010

    Peak Oil Proof Your Portfolio

    I decided to start this blog to help people adjust their portfolio and their financial lives to make them more resilient to the potential effects of global peak oil.

    For the purposes herein, I'll define peak oil as the point at which global conventional oil reaches a daily production peak (in millions of barrels per day) and begins to decline thereafter.  An easier way to think about this definition is - the point at which all of the "easy oil" is in a state of terminal decline.

    I'm not here to convince you that peak oil will eventually happen - dozens of people have written books and reports detailing the geological reasons for global peak oil, with empirical regional depletion data extrapolated up to the global level. Nor am I here to try to convince you that the global peak is imminent or has already happened - nobody knows the exact timing of peak oil, and it could be a number of years before it arrives.

    Rather, the purpose of this blog is to help you bolster your portfolio, following the precautionary principle - you're better off being safe than sorry, and frankly it'd be financially reckless to not diversify your portfolio holdings against a financial threat with such far-reaching implications.

    I believe an "ideal portfolio" would be invested in the following areas:
    1. Broad market ETFs in countries with good energy security, good existing industry and good growth potential
    2. Commodity ETFs - as a store of value, hedge against stocks and hedge against oil-price-induced inflation
    3. Energy ETFs - both conventional oil and alternative energy - to directly profit from price increases
    ETFs are the ideal way to diversify a portfolio - they provide the ability to own diversified stocks and commodities at a very low cost and they are extremely liquid. It makes much more sense for an individual investor to buy an ETF than to buy a number of individual company stocks. With ETFs, you can easily reduce your risk to poor performance in individual companies; your risk is far lower if you own a broad energy ETF (like VDE) than if you own individual company stocks - just imagine if you had owned BP or Enron as your sole "energy play".

    Countries with good energy security are those which are currently net oil exporters and those which have the potential to increase their oil production. Canada, Russia and Brazil all fit into this category. Norway is a net exporter, and although oil production from the North Sea peaked in 1999, I think Norway and the Scandinavian countries are well ahead of the rest of the world in terms of energy security due to their access to large existing reserves of oil, their access to potential new sources of Arctic oil, their successful efforts to reduce energy consumption, and their heavy investment in alternative energy.

    Pre-Peak Oil Exporters

    Canada and Norway both have large, stable, industrial economies. Australia is a major exporter of industrial commodities. Brazil and Russia make up the B and R of the BRIC countries, and have huge economic growth potential. The other two BRIC countries, India and China, are net importers of oil and both have terrible energy security.

    The United States, while currently the 3rd largest producer of oil, is also the world's largest consumer of oil and a net importer. Oil production in the United States peaked in 1970 and the US has been jockeying for oil security ever since. Obviously the United States is a huge industrial economy, but I believe its economic growth potential could become limited by global peak oil, and therefore, there are better investments to be made in other countries.

    Commodities will benefit in a number of ways from peak global oil. Firstly, commodities themselves are a store of value. Uncertainty over the future value of the US Dollar has been driving many investors into precious metals recently and in the event of a peak-oil-induced global economic collapse, commodities will hold their value much better than stocks or currency. Commodities also provide a hedge against inflation. Energy prices are one of the key factors in inflation - as prices of energy go up, so do prices for agricultural commodities, metals and all industrial inputs. During periods of high inflation, someone holding $100 in gold is going to be much better off from a purchasing-power standpoint, than someone holding $100 in US Dollars or $100 in US company stock.

    Lastly, investing directly into energy is the best way to benefit from higher energy prices. There are two ways to invest in energy - by purchasing oil directly as a commodity (through futures contracts or via an oil-futures ETF) - or by purchasing stock in companies that produce oil or provide equipment and service to the oil producers. I believe the latter method is better for a number of reasons. Holding futures contracts is risky and buying ETFs which hold oil futures is costly, since most are rebalanced on a daily basis. Oil company ETFs, on the other hand, are far less risky, less costly and provide steady dividends. You can think of the choice as: "would you rather own a loaf of bread or own the bakery?"

    Investing in alternative energy is also a good hedge against the political risk of owning oil companies. The political environment during an oil price spike (especially a sustained price spike) is extremely unpredictable. In an effort to punish a scapegoat, politicians could impose irrational (and economically damaging) windfall taxes on oil companies. Oil rationing and oil company nationalizations certainly aren't off the table either. The elimination of subsidies and tax-breaks for oil producers and the implementation of massive subsidies for alternatives energy could also certainly happen, and it would pay to own alternative energy stocks in such an environment. Additionally, as we start sliding down the far side of the peak oil curve, we will need to transition our world from a hydrocarbon-based society to a renewable-energy based society. Renewable energy companies stand to benefit handsomely from this transition.

    So to put all of these recommendations together, I believe an ideal "peak oil proof portfolio" would look something like this:

    • Country ETFs - 50%
      • Australia - 10% - EWA
      • Brazil - 10% - EWZ
      • Canada - 10% - EWC
      • Norway and Scandinavia - 10% - GXF
      • Russia - 10% - RSX
    • Commodity ETFs - 20%
      • Agriculture - 5% - DBA
      • Metals
        • Gold - 5% - GLD
        • Silver - 5% - SLV
        • Industrial Metals - 5% - RJZ
    • Energy ETFs - 30%
      • Oil - 20% - VDE
      • Coal - 5% - KOL
      • Renewable Energy - 5% - PBD