A Blood-and-Gore Forecast for Carbon
“There is consensus within the scientific community that increasing the global temperature by more than 2°C will likely cause devastating and irreversible damage to the planet. Reliable measurements make it clear that we will easily cross this threshold in the near term at our current rate of CO2 emissions. So in an effort to avoid it, the International Energy Agency has calculated a global “Carbon Budget” that accommodates the burning of merely one-third of existing fossil fuel reserves by 2050. Put differently, at least two-thirds of fossil fuel reserves will not be monetized if we are to stay below 2°C of warming — creating “stranded carbon assets.”
A stranded asset is one that loses economic value well ahead of its anticipated useful life. Stranded carbon assets include fossil fuels, as well as those assets which, given their dependence on fossil fuels, are also CO2-emissions intensive. Not all carbon-intensive assets are created equal, and it is reasonable to assume that in carbon-constrained scenarios the projects with the highest break-even costs and emissions profile (e.g., tar sands and coal) will be stranded first.”
This is an argument that is certain to raise an eyebrow if you invest in any fossil fuel companies. But is it valid?
Set aside your prejudices about climate change for a moment. I understand that some readers may still be skeptical that carbon emissions from human activity can have a significant impact on the climate. As an engineer who spent a lot of time on risk management issues, I view the problem as one of risk and potential consequence. My take is that increasing carbon emissions pose a climate risk in which the ultimate outcome is uncertain, but potentially severe. Such a risk must be mitigated.
But it doesn’t really matter much what I think should happen, unless I can somehow influence policy in that direction. What matters is what I think will happen and how investors should position themselves accordingly. Even if I happened to be a climate change skeptic, if I thought Al Gore’s argument will result in policy changes I would advise investors to react accordingly. On the other hand, if I thought oil consumption was going to increase, I would likewise have to advise investors to react accordingly even if I thought we needed to take immediate steps to limit carbon emissions.
So what do I think will happen? A 2012 paper by Neil C. Swart and Andrew J. Weaver from the University of Victoria that was published in Nature Climate Change is instructive. That paper contained a graphic that shows the relative potential warming contributions of various fossil fuel resources:
What this graphic shows is that according to the computer models, if all of the total fossil fuel resource base is burned, it could cause the average global temperature to increase by nearly 19°C. But the resource refers to all of the oil, natural gas, and coal in place. The reserve — which is a much smaller subset of the resource — is the portion that is technically and economically viable to extract. (The red vertical line at just above 1.5°C represents a 2°C warming from preindustrial times).
To put this in perspective, the bottom category of the graphic refers to burning the entire 1.8 trillion barrels of oil-in-place (OIP) in Alberta’s oil sands. Burning all of the oil sands (mind you, this is not possible, but just a thought exercise) would raise the global temperature an estimated 0.36°C. But burning the 170 billion barrels of oil sands that are classified as reserves would only raise the temperature an estimated 0.03°C (represented by the tiny red sliver at the end of the “unconventional oil” bar). That small change would not be measurable against the background noise. Further, even if the Alberta oil sands operations scaled up to rival the size of Saudi Arabia’s oil production, it would take until near the end of this century to consume the 170 billion barrels and contribute this undetectable temperature change.
The 2°C number referenced in Gore’s editorial was agreed to in the Copenhagen Accord as the maximum allowable global temperature rise from preindustrial times to avoid the worst impacts of climate change. There is nothing magical about 2°C; this was a negotiated number designed to get the most people in agreement. Some argue that even 1°C is too much, while others don’t believe 2°C poses a grave threat.
But let’s use 2°C as the agreed upon target. Looking back at the graphic, the world could burn through the entire conventional oil and gas resource (remember, the reserve is a much smaller subset of this) and those two combined wouldn’t even contribute 1°C according to the models. Add the unconventional oil resource to conventional oil and gas resources, and you just reach 2°C.
Now look at the coal resource. It alone could raise global temperatures by 15°C — over 15 times the combined conventional oil and gas resource. So if you are prioritizing the sources we need to limit, coal is the runaway choice. Now, many will argue “We have to limit them all.” Sure, every little bit counts. But consider that coal can single-handedly blast right past the 2°C target, while conventional oil and gas can make only a relatively minor contribution. In other words, stop coal and the target is within reach, but stop conventional oil and natural gas and you still have to stop coal. (I don’t mention unconventional gas, because the vast majority of this resource isn’t close to commercial viability).
Gore and Blood argue “it is reasonable to assume that in carbon-constrained scenarios the projects with the highest break-even costs and emissions profile (e.g., tar sands and coal) will be stranded first.” Is that a reasonable assumption? No, because resources aren’t used on the basis of their emissions profile. They are used on the basis of their costs relative to their selling price, which is also a function of competition.
This leads to another reason why oil is unlikely to be one of the stranded assets that Gore describes. Coal has lots of competitors for producing electricity. Over the past three years in the US, the shale gas revolution depressed gas prices and resulted in a swing away from coal for power producers. Some of that demand has swung back this year as gas prices recovered, but coal consumption in the US has fallen in four of the past five years, and is down 24 percent since 2007.
Coal has to contend with natural gas, nuclear power, geothermal, hydropower, and various renewables like wind and solar power. If coal is the most serious threat to the global climate, not only is it the most likely to suffer from legislation that discourages coal consumption (as the new EPA power plant regulations would do), but it would also be more easily displaced by competitors.
Oil is different. It has a far more dominant place among liquid fuels than coal does among the other power options, because there isn’t a serious competitor to oil. Biofuels contribute a very small amount to the liquid fuels pool, but that pool is overwhelmingly made up oil, and it will continue to be overwhelmingly made up of oil, despite the recent inroads made by natural gas as transport fuel. Humans aspire to be mobile, and oil will continue to satisfy that need for mobility at the lowest cost and greatest convenience. There won’t be any real legislative successes at seriously reducing global oil consumption as long as few economical and scalable alternatives exist.
Thus, I think Gore’s argument has some validity when it comes to coal consumption, and coal will remain under siege as a result. I have felt this way for several years, which is why I generally steer investors away from investments in the coal sector.
But oil isn’t in the same category. The fact that its relative contribution to potential warming is a small fraction of coal’s — plus the fact that few suitable alternatives exist — minimizes the risk that oil will wind up being a stranded asset.
What about Gore’s contention that the oil sands will be one of the first stranded assets? It just so happens that I am presently en route to Fort McMurray, Alberta where I will get a firsthand look at the situation in Alberta’s oil sands. I am going at the invitation of Canada’s Consulate General to get an up close look at the full range of topics (e.g., economic, environmental, social) related to the oil sands. I will be reporting my findings in next week’s Energy Letter and Energy Strategist.
The Energy Strategist Portfolio UpdateFirst Solar Goes Supernova
Home runs don’t come easily in this business, in part because of the natural temptation to lock in quick gains. This strategy for coping with good fortune, known in scholarly work as disposition bias, can be quite costly, because it rids portfolios of the best-performing, highest-momentum stocks soon after their merits have become more apparent. It’s a great way to turn home runs into doubles.
Don’t make that mistake with First Solar (Nasdaq: FSLR) following the stock’s 18 percent rally Friday in the aftermath of an uncommonly strong earnings report. With today’s 4 percent follow-through, shares are up 67 percent since we recommended purchase on Aug. 28.
The headline numbers included a 50 percent year-over-year revenue jump accompanied by a near-doubling of net earnings to $1.94 per share, while the pro-forma $2.28 per share more than doubled Wall Street’s consensus. First Solar has consistently warned that its results will be lumpy, and this time the lumps proved sweet thanks to the disposal of some projects as well as the first infusion of recognized revenue from a big solar project under construction in California’s Riverside county.
One might further quibble that an annual review lowering the estimated costs of First Solar’s program for recycling obsolete panels from its projects boosted operating earnings by $49 million, or 24 percent.
But the numbers really worth paying attention to are those that prompted us to add the stock to the Growth Portfolio in the first place. These start with First Solar’s rapid marginal improvement in the conversion efficiency ratio of the cadmium-telluride film coating its panels, which gives the share of the available energy they are able to convert into usable power. The ratio reached 13.3 percent by the last quarter’s end, up from 13 percent three months earlier and 12.7 a year ago. But First Solar’s most advanced line now achieves 14.1 percent, which is on track to turn into a company-wide average in the coming months en route to much more ambitious goals in the high teens over the next few years.
This incremental progress on industry-leading technology continues to drive down the industry’s lowest per-watt generating costs. These fell by 8 cents to 59 cents per watt, thanks to the technical progress as well as cost savings. Management noted on the conference call that the 14 percent conversion efficiency it expects to achieve company-wide next year would lower the cost to the low 50s, and low 40s excluding freight warranty and recycling costs.
Reduced costs per watt of generating capacity are translating into ample cash flow. Cash from operations totaled $375 million in the most recent quarter and is on track for a conservatively forecast $800 million this fiscal year, versus $762 million in 2012. More attractively still, free cash flow — that is generated cash not reinvested — hit $284 million this quarter, and has totaled $725 million over the last year. It’s boosted First Solar’s cash net of debt to $1.3 billion, which when subtracted from the company’s still modest $6.2 billion market cap results in an enterprise value of $4.9 billion, or less than 7 times trailing free cash flow. This is dirt-cheap for a company with an industry-leading technology on the cusp of unsubsidized competitiveness with fossil fuels.
Despite the big lump of revenue recognized by First Solar’s its orders booked in the latest quarter doubled the reported sales, bringing the book-to-bill ratio for the year above 1. That suggests that the significant revenue drop Wall Street expects next year may not materialize, or if it does will prove only a short-term blip.
Analysts haven’t been able to forecast sales or earnings reliably and generally still dislike this stock, with the 2 Buys and 3 Outperform ratings offset by 13 Holds, 3 Underperforms and 1 Sell. The mean price target has been left in the dust at $45. There are a lot of upgrades and target raises coming should the company sustain recent momentum.
It might do just that. With the stock breaking out in volume to a two-year high, there’s not a lot of technical resistance based on former levels until the 80s.
It’s also likely that at some point profit-taking will set in, leading to a retest of Friday’s gap. If you bought on our advice at $37, there’s nothing wrong with taking some money off the table, as I did Friday in a couple of retirement accounts I manage for relatives.
But this is not a momentum play or a trading pick for us, but still the same value stock that was egregiously underpriced two months ago, now less underappreciated but still cheap for the upside that it promises. Those who didn’t buy in August, as well as those who did and have gained more confidence in this story, can and should buy it here. We’re raising our buy below target to $67.
— Igor Greenwald