Friday, November 1, 2013

Harvard's Fossil Fuel Divestment Statement

Harvard University has been under pressure since last November when 72% of the student body voted in favor of divesting fossil fuels from the school's $32 Billion endowment.

This month the president of Harvard, Drew Faust, responded to this divestment request with a loud "NO."  Her letter can be read here, but I thought I would include it here and add in some of my own "translations":

Dear Members of the Harvard Community,
Climate change represents one of the world’s most consequential challenges.  I very much respect the concern and commitment shown by the many members of our community who are working to confront this problem.  I, as well as members of our Corporation Committee on Shareholder Responsibility, have benefited from a number of conversations in recent months with students who advocate divestment from fossil fuel companies.  While I share their belief in the importance of addressing climate change, I do not believe, nor do my colleagues on the Corporation, that university divestment from the fossil fuel industry is warranted or wise.
Harvard is an academic institution.  It exists to serve an academic mission — to carry out the best possible programs of education and research.  We hold our endowment funds in trust to advance that mission, which is the University’s distinctive way of serving society.  The funds in the endowment have been given to us by generous benefactors over many years to advance academic aims, not to serve other purposes, however worthy.  As such, we maintain a strong presumption against divesting investment assets for reasons unrelated to the endowment’s financial strength and its ability to advance our academic goals. 
Translation: The people who gave us money for our endowment don't necessarily agree with divesting fossil fuels.  Moreover, if we make divestment of fossil fuels a permanent policy, we may alienate future donors.
We should, moreover, be very wary of steps intended to instrumentalize our endowment in ways that would appear to position the University as a political actor rather than an academic institution.  Conceiving of the endowment not as an economic resource, but as a tool to inject the University into the political process or as a lever to exert economic pressure for social purposes, can entail serious risks to the independence of the academic enterprise.  The endowment is a resource, not an instrument to impel social or political change.
Translation: We are an educational institution, not a political advocacy organization.
We should also be clear-sighted about the risks that divestment could pose to the endowment’s capacity to propel our important research and teaching mission.  Significantly constraining investment options risks significantly constraining investment returns.  The endowment provides more than one-third of the funds we expend on University activities each year.  Its strength and growth are crucial to our institutional ambitions — to the support we can offer students and faculty, to the intellectual opportunities we can provide, to the research we can advance.  Despite some assertions to the contrary, logic and experience indicate that barring investments in a major, integral sector of the global economy would — especially for a large endowment reliant on sophisticated investment techniques, pooled funds, and broad diversification — come at a substantial economic cost.
Translation: Fossil fuel companies account for about 10% of the global equity market.  Cutting yourself off from such a large percentage of available asset classes will limit the number of portfolio combinations near the "efficient frontier," which would push down our endowment's risk-adjusted returns.
Because I am deeply concerned about climate change, I also feel compelled to ask whether a focus on divestment does not in fact distract us from more effective measures, better aligned with our institutional capacities.  Universities own a very small fraction of the market capitalization of fossil fuel companies.  If we and others were to sell our shares, those shares would no doubt find other willing buyers.  Divestment is likely to have negligible financial impact on the affected companies.  And such a strategy would diminish the influence or voice we might have with this industry.  Divestment pits concerned citizens and institutions against companies that have enormous capacity and responsibility to promote progress toward a more sustainable future.
I also find a troubling inconsistency in the notion that, as an investor, we should boycott a whole class of companies at the same time that, as individuals and as a community, we are extensively relying on those companies’ products and services for so much of what we do every day.  Given our pervasive dependence on these companies for the energy to heat and light our buildings, to fuel our transportation, and to run our computers and appliances, it is hard for me to reconcile that reliance with a refusal to countenance any relationship with these companies through our investments.
Translation: Divestment of companies that produce products you don't like is hypocritical if you continue to use those products.  You wouldn't take someone seriously if they were telling you to divest from cigarette company stocks while they had a cigarette in their mouth.  This also hits on the fact currently there is no scalable alternative to fossil fuels.  Over 80% of our global energy consumption comes from fossil fuels.  It is not feasible in the near term to ramp up renewable energy to offset this production in the face of increasing demand.
I believe there are a number of more effective ways for Harvard both to address climate change and to enhance our commitment to sustainable investment. 
Our teaching and research on environmental and climate issues is significant and growing, and it is a priority in The Harvard Campaign.
We offer some 250 courses in the broad domain encompassing environmental studies and energy.  We support some 225 faculty who work in the area, as well as a graduate consortium that involves more than 100 students and seven Schools.
We have a thriving University Center for the Environment.  Outstanding faculty in chemistry, biology, earth and planetary sciences, engineering, and beyond are making profoundly important contributions to envisioning the future of energy and shaping the relevant science and technology.  The Kennedy School’s Belfer Center has won international acclaim for its influential work on climate change economics and policy.  Harvard scholars in design are on the frontier of thinking about sustainable cities; scholars in law, business, economics, and public policy are leaders in addressing regulatory, commercial, and economic aspects of energy and the environment; scholars in public health do vital research on environmental health and its relation to energy use.  Indeed, the foundation of our current national clean air regulations was a study undertaken more than two decades ago by faculty at the Harvard School of Public Health.
We also have a strong institutional commitment to sustainability in how we live and work.  Our Office for Sustainability is doing outstanding work.  We are making substantial progress in reducing our greenhouse gas emissions.  We have become much more conscious of sustainable design principles in all of our physical planning and construction.  We have created awards to recognize “heroes” who are helping to make Harvard green.  And Harvard has earned an array of honors to recognize various sustainability efforts.  I am very proud of all that our students and faculty and staff are doing on this front, and those efforts will continue and grow. 
Translation: We are an educational institution, not a political advocacy organization.  As such, we are already doing a lot to address environmental issues in the capacity of an educational institution.
As a long-term investor, we need to strengthen and further develop our approach to sustainable investment.  This is no small undertaking, and it will present challenges along the way.  Especially given our long-term investment horizon, we are naturally concerned about environmental, social, and governance factors that may affect the performance of our investments now and in the future.  Such risks are complex, often global in nature, and addressing them effectively often entails collaborative approaches.  Generally, as shareholders, I believe we should favor engagement over withdrawal.  In the case of fossil fuel companies, we should think about how we might use our voice not to ostracize such companies but to encourage them to be a positive force both in meeting society’s long-term energy needs while addressing pressing environmental imperatives.  And, like other investors, we should consider how to obtain further, better information on how companies not only in the energy industry but across all sectors take account of sustainability risks and opportunities as part of their business strategies and practices.
Translation: Companies listen to shareholders more than they listen to outsiders.  Since there is currently no scalable alternative to fossil fuels, we are better off continuing to holding our fossil fuel investments and trying to steer fossil fuel companies towards sustainability.
To help us pursue this path, Harvard Management Company has recently brought on its first-ever vice president for sustainable investing.  She will help us think in more nuanced, forward-looking ways about sustainable investment, including the consideration of environmental, social, and governance factors.  And, in concert with colleagues, she will play a central role in considering how Harvard can achieve superior investment returns as it fulfills a university’s distinctive responsibilities to society.
Harvard has a strong interest in marshaling its academic resources to help meet society’s most important and vexing challenges, and there is no question that climate change must be prominent among them.  We will continue to do so, through the energy and ideas of our faculty, students, and staff, in ways that are true to the purposes of our endowment and that best take advantage of the University’s distinctive capacities as an academic institution.
Drew Faust

Tuesday, October 22, 2013

Peak Global Energy Efficiency

Fossil fuels are finite and eventually their global production will peak and decline.  Since our global economic growth has a nearly perfect correlation with global energy consumption, a decline in global fossil fuel energy availability could mean "the end of growth."  The argument on the other side is that we will simply become more efficient with our use of energy.  The argument goes that we will become less energy-intensive consumers and the energy intensity of our global economy will decline.

So are we on the right track?  Are we becoming more energy efficient with our global economy?

To answer this question, I took data from the World Bank and from BP's Statistical Review of World Energy.

First, we see that on an absolute energy basis (in Joules) our global fossil fuel consumption continues to increase.

Once we multiply this consumption by the nominal price of each fuel, we can get a global "fuel bill" and compare it to the value of global trade each year.

Finally, when we take our global fuel bill and divide it by our value of global trade we get an estimate for how much value of trade we get for each dollar we spend on fossil fuels.

Unfortunately, this analysis shows us that the value of global trade we get for each dollar spent on fossil fuels peaked in 1998 and has been declining since. In essence, we are becoming less and less efficient in our use of fossil fuels at a time when we should be getting more and more efficient.  This is bad news for cornucopian economists who believe that energy efficiency will save our global economy from peak oil.  Despite ever-higher oil prices over the last decade, it seems that we have become unable to increase the energy efficiency of global trade.  If we can't increase our global trade per barrel in the face of higher oil prices, perhaps this shows that reaching "peak everything" will indeed lead to "the end of growth."

Monday, July 22, 2013

Global Oil Dashboard - Q2 2013

Here is the second installment of the of the "global oil dashboard" for Q2 2013. I created this tool to help me track the key quantitative indicators of peak oil. Oil is a finite resource and peak oil will happen eventually. Because some experts, such as the Energy Watch Group, believe that peak oil is happening right now, I want to keep track of these indicators on a real-time basis to determine whether we are indeed passing peak oil. I designed this dashboard to be mostly automated, in order to allow me to easily update it on a quarterly basis. This dashboard also allows me to keep track of the performance of various "peak oil proof" investments to determine whether my investment hypotheses are correct.  The dashboard is best viewed as a PDF - Click here to download the PDF.

The text of the PDF is as follows:

Page 1: Global Peak Oil Summary

The global rate of oil production is up slightly year-over-year.  However, during the same period global net exports of oil declined.  Production gains in Russia, the US and Canada are just barely offsetting production declines in Norway, UK, Latin America and the Middle East.  Global supermajor production continues to fall.  Based on this data, we are likely still on the "bumpy plateau" of peak oil and have likely passed "peak oil exports."

Global oil consumption was up slightly year-over-year with almost growth coming from the developing world.  The developed world continues to fall from its "peak oil demand" peak.  The economies of the developed world are shrinking on a relative basis to the global economy.  Europe is officially in a double-dip recession.  GDP growth remains strong in Asia and the developing world.  In Q1 2013 China overtook the US as the world's largest oil importer - the first time the top spot has changed hands in 41 years.

The price of Brent crude oil has been volatile and fell nearly 10% year-over-year, but remained well above historical averages.  Prices in futures and options markets seem to indicate a belief that oil prices will continue to fall, possibly due to slowing global economic growth.  The global money supply rose over 6% year-over-year as central banks pumped more money into their economies, but a falling velocity of money from economic stagnation has so far kept inflation from pushing up oil prices in real terms.

Page 2: Oil Supply: Global Oil Production Rates

The global oil production rate is up slightly year-over-year but has slowed since Q1 2013.  The growth rate of the global oil production rate has been declining for nearly 30 years and is well below its 1986 peak.  Major improvments in production rates in the past year have occured in the United States, Canada, Russia, China and West Africa.  US oil production increased dramatically due to shale fracking, helping to offset the decline in production from Alaska and the Gulf of Mexico.  Lybia experienced major production rate gains as it ramped back up following the Arab Spring.

Page 3: Oil Supply: Export Supply

The Top 10 Oil Exporting Countries Represent 81% of World Oil Export Supply
Global oil exports remain relatively flat year-on-year but are still down about 3 MMBPD from their peak in 2004.  Six of the top 10 oil exporting nations are now experiencing 5-year net export rate declines.  Saudi Arabia, Nigeria, Venezuela, Norway and Libya are all seeing lower rates of net exports.  This decline has been somewhat offset by huge increases in oil exports from Iraq and Canada.  Total liquid production rates continue to decline for the Supermajors.  Overall, global net oil exports do not appear to be responding to record-high oil prices, signaling that we may be on the "bumpy plateau" of peak oil and may have passed the point of "peak oil exports.

Page 4: Oil Supply: Export Supply: News Summaries

Russia Q2 2013 News
In Q2, Russian oil production continued past its a post-Soviet record achieved in Q1 2013.  Russia is now the worlds largest oil producer and world largest oil exporter.
In Q1 China passed Europe to become Russia’s number one oil market.  In Q2, the Sino-Russian energy relationship grew even stronger.  Russia announced that China National Petroleum Corp will begin exploring for Arctic oil in Russian waters alongside Rosneft.  Rosneft then signed a 25 year agreement to deliver 365 million tons of oil to China - one of the largest oil deals in history.
Russia gave temporary asylum to US whistleblower Edward Snowden -  harming US-Russian relations.

Saudi Arabia Q2 2013 News
Export cannibalization continues to grow in Saudi Arabia.  The Saudis have 3 new refineries under construction that will reduce net exports by 1.2 million BPD in 2017.  In Q2, Saudi Arabia passed Germany in total oil consumption.
Perhaps indicating Saudi Peak Oil is imminent, Saudi Arabia's Oil Minister Ali Al-Naimi was quoted as saying ""We don’t really see a need to build a capacity beyond what we have today.""
Stability remains precarious: oil revenue accounts for 93% of revenue for the Saudi government, which now needs $94/bbl oil to balance their budget.  Based on actuarial tables, the 88-year old King Abdullah has a 15% chance of dying in the next year.

Iraq Q2 2013 News
1/2 of Iraqi oil exports now go to China.  Chinese oil companies are increasingly displacing US ones.
Chaos continued in many parts of the country with car bombs going off on an almost daily basis.  1000 Iraqis were killed in attacks in May.  Southern Iraq is on the verge of a Sunni-Shiite civil war.
Kurdistan began exporting oil directly to Turkey, bypassing the federal Iraqi government completely.  In Q2 a brigade of Iraq’s Kurdish troops defected to Kurdistan, further hurting relations.  Turkey recently completed a new pipeline to Northern Iraq and signed an agreement Turkey to develop Iraqi oil fields.

United Arab Emirates Q2 2013 News
In Q2 UAE oil minister Suhail Al Mazrouei declared that the ""Days of Easy, Cheap Oil are Gone"" and announced that the country would begin constructing nuclear power plants to provide 25% of its electricity by 2021.
In Q1 the UAE opened the world’s largest solar plant, named Shams 1.

Kuwait Q2 2013 News
Kuwait announced that it plans to spend $56 billion over the next 5 years to raise production by 650,000 bpd by 2020.

The Kuwaiti central bank announced that its economy would likely grow at just 1.9% in 2013 – slowing oil export cannibalization.

Nigeria Q2 2013 News
Nigeria’s oil production continues to fall, mostly as the result of vandalism and oil theft. Crude oil theft now costs the country $7 billion annually.  Attacks on pipelines and offshore rigs and hijackings of tankers continues.  A nationwide blackout hit the country in May.  Nigeria's rebel MEND group, which frequently attacks oil infrastructure, announced it would begin attacking mosques.

Nigeria's government continues to fight Islamist militants in the Northern provinces.  Nigeria’s four main opposition parties formed a coalition, threatening President Goodluck Jonathan's hold on power.

Venezuela Q2 2013 News
In Q2 Nicolas Maduro was sworn in as president, following the death of  Hugo Chávez on March 5th, 2013.  Maduro will continue the oil industry policies of Chávez.  Maduro's oil minister, Rafael Ramirez, repeated his assertion that $100/bbl should be the floor for oil prices.
Venezuela announced a major currency devaluation in Q1.  As of Q2, the country is on the brink of hyperinflation, with annualized inflation topping 20%.  The government has begun rationing everything from toilet paper to chickens.  Blackouts are becoming more common and hyperinflation could collapse Venezuela's economy, forcing down oil production rates.

Norway Q2 2013 News
Norway proves how relentless peak oil can be.  Oil production continues to plummet; passing a 25-year low this year.  The state of Texas now produces more oil than the country of Norway.  Over the past 11 years, Norway has fallen from the world's 7th largest oil  exporter to the world's 14th largest today.

The oil ministry announced that it expects production to continue to decline in 2013 and bottom out next year as new projects come online.

Libya Q2 2013 News
Oil production hit 70% of its pre-Arab Spring levels.

Bombings, kidnappings and assassinations continue to make the prospects of stability uncertain.  Protests continue in Benghazi.  In Q2 NATO sent a contingent of soldiers to help train Libyan government forces against militants aligning themselves with Al Qaeda.

Canada Q2 2013 News
Canadian oil production is up dramatically year-over-year.  In Q2 Canada accounted for 38.7% of U.S. crude imports, the most ever by a single nation.

Oil sands production rose 13% during 2012 despite cost increases of more than 10% per year.  Oil sands production could rise from 1.8 MMBPD today to 5.2 MMBPD by 2030  if it isn't hampered by climate change legislation or lower prices.

In March, 5,000 barrels of tar sands oil being delivered from Canada spilled from Exxon's Pegasus pipeline into a residential neighborhood in Arkansas.

Page 5: Oil Supply: Production Costs and Operating Profits

Production costs continue to increase for oil drilling.  Despite record-high oil prices, these increasing costs are resulting in declining profits for oil majors

Page 6: Oil Supply: Global Oil Consumption Rates

Global oil consumption is up slightly year-over-year.  Most consumption gains came from China, India, Japan, Brazil & Thailand.  Consumption in the United States and Europe fell over the same period.

Page 7: Oil Demand: World Relative GDP Growth Rates

The global economy grew slightly in real terms year-over-year.  As measured in oil or gold (as opposed to Dollars) the world's economy is growing strongly.  Most of this growth came from the developing world and in particular from Asia.  The GDP of the developed world fell in relative terms, as measured by its share of total world GDP.  All of Europe  and North America experienced negative real GDP growth year-over-year.

Page 8: Oil Demand: Global Oil Import Demand

The Top 5 Countries/Regions (US, EU, China, Japan & India) Represent 52% of World Oil Import Demand
For the top oil importing countries, GDP continues to increase but at a slowing rate.  Almost all of Europe is now in a recession.  Some countries, such as Greece and Portugal are in a severe recession.  The economies of the United States and Japan are both growing on a real basis but shrinking on a relative basis to the rest of the world.  Economic growth remains robust in China and India, propping up global oil import demand, pushing the date of global peak oil closer.

Page 9: Oil Demand: Global Oil Import Demand: News Summaries

China Q2 2013 News
In 2013 China overtook the US as the world’s largest net oil importer - a spot the US had held since 1972.  Chinese car sales rose 20% year-over-year, but China’s economy grew at its slowest rate in 13 years as exports fell.  In April, a short-lived cash crisis hit the country.

China signed a major gas deal with Russia to import natural gas from Russian fields.  Russia also announced that it would double its exports of oil to China.  China awarded contracts to 16 companies to drill in China’s shale gas reserves, but not a single one has ever drilled a gas well before.  So far China has drilled 60 shale wells and they have all come up dry.

China is the world's largest emitter of carbon dioxide and at current pace will produce 4 times more CO2 than the US by 2020.  Air pollution levels in Beijing went literally off the scale in Q1 2013.  Not coincidentally, China’s coal consumption levels reached a record high.  China now burns as much coal as the rest of the world combined.  It is estimated that 1.2 million Chinese die a year from the horrendous air pollution.  In March 16,000 dead pigs were found floating down the river that supplies drinking water to Shanghai.
In Q1 Chinese Premier Wen Jiabao called for action to alleviate the pollution and tax minister Jia Chen announced that China would introduce a carbon tax.   In Q2, China announced it will begin setting up a carbon trading market.  China continued to pull ahead as the world leader in renewable energy.  Wind power overtook nuclear power in China, producing 2% more electricity overall.  For 2013, China announced it will install more than 5 times more wind power than nuclear power and more than 3 times more solar power than nuclear power.  China now installs three times more solar each year as the United States – accounting for a third of the total world solar panels installed each year.

China announced plans to build a second aircraft carrier and Hong Kong, a Chinese protectorate, gave temporary asylum to US whistleblower Edward Snowden -  harming US-China relations.

United States Q2 2013 News
In Q1 US oil production reached a 20-year high, hitting 7 million bpd for the first time since March 1993.  Meanwhile, the US has almost certainly passed “peak oil demand.”  US oil demand dropped to an 18-year low and us oil imports fell to their lowest level in 25 years.  Gasoline consumption is at its lowest level since 2004.  In Q1 Obama’s State of the Union address specifically endorsed the McCain/Lieberman cap and trade bill; If climate change legislation is enacted, US oil demand would drop further.
While shale oil production rose dramatically, all other forms of US oil fell.  US Gulf of Mexico oil production continued to decline off its 2009 peak.  Production from Alaska’s North Slope continues to fall from its 2002 peak and was down 8% year-over-year.  Shell Oil gave up on the 2013 Arctic drilling season after its oil rig, the Kulluk, ran aground in Alaska.  Worryingly, the Bakken shale oil boom in North Dakota may be slowing down, with the initial productivity of new wells dropping.  Companies are shifting their focus to California’s Monterey shale, where they may face heavy environmentalist opposition.

In Q2 Obama announced a series of executive actions designed to address Climate Change, including limitations on carbon emissions from existing power plants, increased appliance efficiency standards and promotion of renewable energy development on public lands.  Renewable energy in the US continues to grow with solar capacity increasing 76% year-over-year.  Obama announced Ernest Moniz, a supporter of fracking, as his nomination for Secretary of Energy.  Obama also announced Gina McCarthy, a former Mitt Romney aide, as his pick to head the EPA.  In Q2 the EPA announced its new ""Tier 3"" gasoline regulations which will bring US sulfur requirements in line with California's.

The Federal Reserve has keep interest rates near 0% for four years and has tripled its balance sheet by continuing pump $85 billion each month into the economy.  In Q2 FED Chairman Ben Bernanke announced plans to "taper" such money printing; the market reacted swiftly to the negative and Bernanke quickly reversed his rhetoric.

European Union Q2 2013 News
Europe was officially in a double-dip recession in Q1 2013, shrinking by 0.6%.  Greece’s economy shrunk by 6.4% year-over-year.  Unemployment in the Eurozone rose to 12% - the highest level since the Eurozone was created in 1999.  Europe has passed “peak oil demand”, with oil demand now down 2 million BPD from 7 years ago.  In Q2 US exports of diesel to Europe hit a 23 year high.  The EU now produces 13% of its energy from renewable sources.

In Q1 Cyprus announced a one-time bank levy on all Cypriot bank accounts on March 15th as part of a €10 billion bailout.  A panicked bank run ensued and the government was forced to close all banks for 12 days.  The government reopened its banks after it promised not to confiscate money from accounts smaller than €100,000.

In Italy, the government will likely remain in political gridlock after parliamentary elections split three ways, leaving no party in a position to govern.

Japan Q2 2013 News
Japan remained in a recession, with its economy contracting for the third straight quarter.  The escalating rhetoric between Japan and China over the Senkaku islands cooled when Japan’s new prime minister Shinzō Abe send a letter to Chinese president Xi Jinping, expressing his interest in a peaceful resolution.  The new prime minister also announced he would approve the construction of new nuclear reactors – a complete 180 from former Prime Minister Yoshihiko Noda, who planned to shut down all Japanese nuclear power plants by 2040.  Japan announced it would begin restarting its idled nuclear power plants by the end of 2013 but in Q2 announced it would be impossible to restart the plants on schedule.  New safety regulations are expected to shut down 10 more nuclear reactors.

In Q1 2013, after spending $700 million on the decade-long project, Japanese scientists announced that they had successfully extracted natural gas from subsea methane hydrates.

India Q2 2013 News
In Q1 India became the 4th largest oil consumer after China, the US and Russia.  Meanwhile, India’s oil production rate fell 4% year-over-year.  Amidst continued electricity shortages, Indian coal imports fell 11% year-over-year.  In Q1 the Indian government announced that it would raise gasoline and diesel prices as it continues to slowly phase out fuel subsidies.

In Q2 Prime Minister Manmohan Singh announced plans to double India's renewable energy generation by 2017.

Page 10: Oil Prices

Global oil pries are down year-over-year.  This 1-year and 2-year trend of declining oil prices has reversed the 5-year and 10-year trends of rising oil prices.  Both Brent and WTI crude oil futures are in backwardation, indicating that traders expect the price of oil to fall in the future.  This backwardation benefits investors who take long positions in futures ETFs (like DBO & OIL), as there is no negative “roll yield,"  like when oil is in congtango.  The commitment of speculative traders and the difference in expected payoffs from put and call options contracts, however, tell us that traders believe that a price drop is le3ss likely than a price rise over the long term.

Page 11: Oil Demand: Money Supply Growth Rates

While supply and demand fundamentals affect the real price of oil, currency fluctuations affect its nominal price.  The money supply for most countries continues to grow at unprecidented rates as central banks attempt to prop up their economies.  For countries in the midst of severe recessions, such as Portugal and Ireland, the money supply is shrinking significanty, risking a deflationary spiral.  Venezuela is in the opposite position, on the brink of hyperinflation, which could collapse the country's economy and severely harm the global oil export market.  The global money supply is up over 6% year-over-year.  This increase in money supply, however, has not resulted in severe inflation, as the velocity of money continues to shrink by over 3% per year.

Page 12: Peak Oil Proof Portfolio Investments

The Peak Oil Proof Portfolio rose in value year-over-year but underperformed the overall equity market.  This could be expected as the global oil production rate has not yet peaked.  The biggest winners were timber, industrials,  health care, media, global real estate.  Clean Energy gained significantly year-over-year but is still down on a 5-year basis.  The biggest losers were precious metals and zero-coupon bonds.  Q2 2013 saw a major crash in gold prices and rising interest rates (spured on by FED talk of "tapering") caused bond prices to fall.  Outside of the portfolio, railroads, car sharing and bitcoins all has dramatic gains.  Bitcoins had a dramatic bubble and bust in Q2 2013, but are still up over 1000% year-over-year.

Thursday, June 13, 2013

Chasing Yields

Baby boomers who are retired or close to retirement are finding themselves without a lot of options for "safe" income-generating investments these days. Over the past 60 years the classic 50%/50% stock/bond portfolio has yielded a combined annual income from dividends and bond coupons of about 4%. A retiree with a $1 million portfolio could look forward to a comfortable $41,000 a year in income before any drawdowns to their portfolio. Over the past 15 years, however, the situation has changed dramatically. Today, that same portfolio would yield just $19,800 per year - half what most retirees had been expecting. When the returns are charted out, it becomes blatantly obvious why retirees today are desperately chasing yields: 

The Bond Bubble
Thanks to the Federal Reserve's Zero Interest Rate Policy (ZIRP), treasury bonds are now returning their lowest yields in history. Bond prices and bond yields are inversely proportional. With interest rates having nowhere to go but up, bond prices have nowhere to go but down. Retirees holding a majority of their wealth in bonds could see their principle cut by a significant amount as interest rates rise. This bond bubble could continue on for years, but eventually it will burst.

The rise in bond rates could occur in a few ways. First, the Federal Reserve could raise rates if they believe that the economy is on a sustainable recovery. Fed Chairman Ben Bernanke's recent allusion to this caused bond rates to immediately surge.

A second way that bond rate could rise is through reduced confidence in the ability of the US government to pay their debt. On August 5, 2011, Standard & Poor's, one of the "big three" ratings firm, downgraded the US Government's credit rating for the first time in history. Ratings firm Egan-Jones has cut the US government's credit rating three times over the past few years over concerns with the Federal Reserve's quantitative easing.

A third way that bond rates could rise is if China decides to stop buying US debt. China is currently the largest foreign buyer of treasury securities and has $1.2 trillion in holdings. If China began cutting back on its purchases, or worse, began selling its existing holdings of US bonds, interest rates would rise significantly.

This combination of historically low interest rates and the inevitability of lower future bond prices has caused many analysis to begin calling US treasury bonds "return free risk" (a play on "risk free return" - the role that treasury bonds have historically played). Clearly it doesn't pay to be in bonds right now.

The Search for Yield
As treasury yields have plummeted to historic lows, investors have set out on a quest for higher yields in fixed income securities.

The first methods for finding higher yields is investing in longer maturity bonds. Instead of buying 10-year treasury bonds with a 2.25% interest rate, retirees may now be investing in 30-year treasury bonds with a 3.37% interest rate. The problem with this approach is that the prices of longer maturity bonds are more highly leveraged against interest rates. When interest rates rise, as they inevitably will, people holding 30-year bonds will get burned far worse than people holding 10-year bonds.

A second method of finding higher bond yields is to move into riskier bonds. Instead of buying treasury bonds, retirees may park their money in corporate bonds, municipal bonds or even junk bonds. While the yields of these bonds may be higher, the risk of default is higher as well. If the economy enters into another severe downturn, many companies and cities could enter bankruptcy, leaving bond holders with nothing.

A third path to higher bond yields it to look internationally. Just as with the other options, this one carries increased risk. Buying foreign bonds exposes the investor not only to the sovereign default risk of the country they are buying from but also to risk of currency fluctuations between their home currency and the currency that the bond is denominated in. Nevertheless, many investors are beginning to look overseas for increased bond yields. For investors worried about peak oil, it is possible to buy government bonds from 5 of the top 10 oil exporting nations: RussiaNigeriaVenezuelaNorway, and Canada. As we pass peak oil and oil continues to get more expensive, government revenues should continue to increase for these countries, ensuring that they can avoid sovereign default while oil importing nations like Japan and the United States struggle. Buying Nigerian 10-year government bonds, for example, can land you a whopping 14.4% yield today. For investors simply wishing to reduce their exposure to US default risk, Canada and Norway 10-year bonds have about the same return as US treasury bonds but with arguably a much lower risk of default.

The Need for Yield
While the income from a typical 50/50 stock/bond portfolio has fallen by half over the past 20 years ago, many retirees are also finding that the cost of living in retirement has risen sharply over the same period. The price of gasoline, for example, has doubled over the past decade.

If you wanted to hedge against the cost of driving, you could buy 1300 shares of ExxonMobil stock and over the past 20 years the dividends you would have received would have almost perfectly offset the increases in the price of the gasoline you purchased each year. The problem is, it would have cost you just $12,000 in 1993 to buy 1300 shares of ExxonMobil stock, but in 2013 you'd have to spend nearly $110,000!

We may not be at peak oil yet, but we are certainly feeling the effects.

Food prices have also doubled over the past decade. Because each calorie of food we eat requires 10 calories of hydrocarbon energy to produce, it is no wonder that the rise in oil prices nearly is nearly perfectly correlated to the rise in food prices.

Combined with declining investment income, these rising costs of living are pushing retirees further in search of investment yields.

A Stock Bubble?
Without any good option in bonds, many investors have sought out yields in other asset classes, like annuities, royalty trusts, master limited partnerships and real estate investment trusts. All of these asset classes, however, usually carry increased risk of default and price volatility. In the case of annuities, investors face serious counter-party risks -- people holding Lehman Brothers annuities before the last crisis are lucky if they got anything following the bankruptcy.

This leaves investors with just one place left to go for increase yields: stocks. With retirees desperate for income and the value of treasury bonds certain to plunge at some point in the future, it is no wonder that investors are pouring their money into equities in the hope of receiving dividend income. By doing so, however, these investors are simply piling on more risk. Not only does the underlying value of stocks tend to swing far more wildly than bonds, but unlike the coupon of a bond, which you're guaranteed to get as long as the bond issuer doesn't default, continued high dividends from companies are far from a sure bet. If we enter another downturn, dividends could fall as companies try to shore up their balance sheets. 

Despite these risk, investors continue to pile into stocks in the quest for higher yields.  I believe that this reality helps explain why the stock market continues to hit record highs as the real economy continues to drag along with high unemployment and near zero real growth. I certainly don't have a crystal ball, but I do have an uneasy feeling about the current "recovery" here in the United States.

Thursday, May 23, 2013

The Core Peak Oil Debate: Speed and Scale

I just got finished reading Ramez Naam's new book "The Infinite Resource." The first part of the book is a great overview of peak oil and climate change. He accurately describes the gigantic nature of a both problems and the potentially massive negative consequences we face as a society from them. He's clearly done his homework and gives a lot of examples of how these issues are affecting us all right now.

He also does a good job framing the climate change debate and walking through the real issues that are currently being debated (like whether peak oil will stop climate change and what level of atmospheric carbon dioxide we should consider "safe") while knocking down the "red herring" debating points (like whether humans are causing climate change).

On page 96 he finally gives us his main thesis: that we can solve the issues of peak oil and climate change with technology, innovation and substitution. He goes on to back up this assertion by showing many different ways in which technology is improving renewable energy, food production and sea water desalination.

On page 175 he finally addresses the main issue of the peak oil debate: Speed and Scale. His whole thesis (that the issues of peak oil and climate change will be solved by technology, innovation and substitution) is dependent on innovation improving renewable energy technology at a fast enough rate to allow us to offset the energy lost through fossil fuel depletion at a speed and scale necessary to avoid collapse. That is the core issue of the peak oil debate: will we be able to substitute renewable energy fast enough to make up for declining rates of fossil fuel production?

Naam is supremely confident that technological innovation in renewable energy will occur at a fast enough pace to allow us to both overcome the pace of fossil fuel depletion once we pass peak oil, peak gas and peak coal, but also that the rate of technological innovation will occur fast enough to allow renewable energy technologies to continue to ramp up to tremendous scale in the face of other limits like the limits of available "high potential" locations for wind and solar, the limits to speed and scale of the required electrical transportation infrastructure, the limits of available skilled manpower to build out that infrastructure at a fast enough pace, the depletion of required resources (peak rare earth metals, peak copper, peak silver) required to build out that infrastructure, the backlash of Jevon's Paradox to increases in efficiency, the potential decline in available capital should peak oil push us into another recession through another oil price spike and the potential social backlash (NIMBYism) to the massively ramped up scale of renewable energy infrastructure.

My argument is because of all of these limits, it is unlikely that we will be able to ramp up renewable energy generation and the electrification of transportation fast enough to offset the decline in available energy once we pass peak oil. The consequences of this shortfall are what worry me most. Naam's optimism that "technology" will solve the problems of peak oil and climate change by allowing us to seamlessly switch from from fossil fuels to renewables is, in my opinion, dangerous. Optimism breeds complacency. By telling readers that "innovation" will solve all of our problems, people can put down the book and go back to their normal lives without making the dramatic changes required to make themselves more resilient and to move us all towards a more sustainable future. This kind of optimism causes people to say "well this guy says there are some smart scientists out there working to fix the problem, so I guess I don't have to worry about peak oil and climate change."

Perhaps our difference in opinions comes from the fact that my professional experience is in the energy industry -- where projects take billions of dollars and years to ramp up to scale -- and Naam's professional experience is in the technology industry (specifically at Microsoft) -- where new software can be developed overnight on a shoestring budget and ramp up to infinite scale with little cost and few "real world" obstacles. Unfortunately, our global energy infrastructure isn't made out of bits and bytes, it's made out of iron and steel (and copper and rare earth metals). Energy projects can't be ramped up overnight. Engineering lead times for renewable energy projects can take a decade. We have trillions of dollars of capital stock (cars, airplanes, trains, farming machinery) locked up in technologies that are dependent on oil. Every car, every airplane, every train and every farm tractor has a usable life. In the case of a farm tractor, that usable life may be in the decades. Rolling over this multi-trillion-dollar capital stock is going to be an extremely slow process. It will take decades and trillions of dollars to switch our transportation infrastructure away from oil and on to renewable electricity and biofuels. Unfortunately, with peak oil staring us in the face, we do not have decades to solve the problem. With atmospheric carbon dioxide levels passing 400 ppm this month and with China now burning more coal than the rest of the world combined (making any carbon reduction the developed world does a moot point), we certainly don't have decades to fix our climate change problem. You can't simply wish away these problems with optimism about "innovation."

The consequences of this kind of unhinged optimism are perhaps more serious in the investing world. When deciding how to invest in the future of energy, we need to balance our optimism for technological innovation with our pessimism that the limits to innovation won't allow us to substitute away from fossil fuels fast enough to avoid collapse as we begin seeing a post peak oil decline. The key here is deciding how much optimism we should have. With most activities in life, it pays to be an optimist: sports, love, friendships, philanthropy, work, etc. But with investing, it arguably pays to be a pessimist, or at least to walk the line between pessimism and optimism. Optimists ignore investment risks and get burned. Pessimists see those investment risks, weigh them and decide to invest in ways that expose their portfolios to the upside while hedging the downside risk. In the world of peak oil, all of these risks will increase dramatically.

Friday, May 17, 2013

Global Oil Dashboard - Q1 2013

Introducing the "global oil dashboard."  I created this tool to help me track the key quantitative indicators of peak oil.  Oil is a finite resource and peak oil will happen eventually.  Because some experts, such as the Energy Watch Group, believe that peak oil is happening right now, I want to keep track of these indicators on a real-time basis to determine whether we are indeed passing peak oil.  I designed this dashboard to be mostly automated, in order to allow me to easily update it on a quarterly basis.  This dashboard also allows me to keep track of the performance of various "peak oil proof" investments to determine whether my investment hypotheses are correct.