Don’t Fall for the Siren Song of Renewables

As someone who frequently writes and speaks about energy, I often champion policies I believe to be in the long-term national interest.

But as an investor, it is important to never let the vision of what I would like to see cloud my judgment of the companies that benefit from what actually is. So while I — and I suspect a good number of readers — would like to see the world running on sustainably sourced energy, the reality is that our fuel choices are going to be made based on cost, convenience and, occasionally, government mandate if consumers balk at cost and inconvenience.

One reason I have historically steered people away from investing in various renewable energy companies is that they either fail the test of cost and convenience or merely exist as a result of a government mandate. Note that I am not opposed to governments providing some incentives for renewable energy, but simply cognizant of the fact that most companies in this space will ultimately fail. As a result, this area has particularly high risk for investors.

Why is it so hard for renewable fuels to compete with petroleum? Some people — especially those with a stake in renewable energy — will claim that it’s because of powerful entrenched interests or that oil is unfairly subsidized. But that’s not the real reason.

The real reason is that, in the case of all fossil fuels, nobody had to plant or harvest the biomass, nor did they have to apply heat and pressure to convert it into hydrocarbons. Mother Nature did all of that, and then let those energy-dense hydrocarbons accumulate into immense deposits.

Contrast that with the process of planting and harvesting biomass on an annual basis. This requires labor, pesticides, herbicides, fertilizers, and sometimes irrigation. All of these things add costs. The biomass — which has much lower energy density than fossil fuels — must then be transported to a conversion facility. After various inputs that can include heat, pressure and chemical catalysts, the biomass can be converted into the sort of hydrocarbons that Mother Nature created over great spans of time.

Over time, as fossil fuels are depleted, it costs more money and energy to extract and process them. As as result, some renewable fuels will become more competitive over time as oil prices rise (as long as they aren’t themselves heavily dependent on fossil fuels, which is the case with some “renewables.”)

It should be readily apparent that the price point at which most renewable fuels can compete on equal footing with fossil fuels is still above (and sometimes far above) the current price of oil. I wouldn’t invest in an oil company that requires oil to be $100 a barrel to be competitive, and by the same token I wouldn’t invest in a renewable energy company that requires $100/bbl oil.

There are some fuels that can compete with oil on price, but for the most part they are also based on fossil fuels. In my 2012 book Power Plays, I compiled a list of possible transportation fuels and compared their prices.

Fuel costs chart
Source: Power Plays

At the time I compiled this list, there were three fuels cheaper than gasoline: natural gas, ultra-low-sulfur-diesel (ULSD) and methanol. (The price of Brent crude was listed to show prices relative to oil.) From an energy policy standpoint, the price of all three fuels is attractive. But each has some relative weaknesses.

Natural gas prices have risen in the last year but are still at a significant discount to gasoline. However, cars that can burn natural gas are usually significantly more expensive than their gasoline counterparts. Further, natural gas infrastructure is still lacking. Nevertheless, the discount to oil is so large that I expect natural gas vehicles to continue to penetrate into the transportation fuel market — and some of the companies I recommend are based on that philosophy.

Another fuel coming in slightly cheaper than gasoline was methanol. Methanol is an alcohol like ethanol, except it has 1 carbon atom whereas ethanol has 2. It is typically produced from natural gas, but can also be produced from biomass. (Methanol was originally called “wood alcohol.”) Even with the heavy subsidies lavished on ethanol, you could purchase methanol unsubsidized for a lower cost per unit of energy.

Methanol has some disadvantages. First, it is more corrosive than ethanol, which is itself more corrosive than gasoline. Second, methanol is toxic. Then again, so is gasoline and denatured ethanol. Further, the windshield washer fluid that you can buy for a buck or two at the store contains a lot of methanol. You can also buy fuel additives like HEET that are almost pure methanol. So even though it is toxic, it already sold over the counter and biodegrades in the environment very quickly (because microbes love methanol).

But the biggest knock against methanol is that, because the energy density is half that of gasoline, motorists must fuel up twice as frequently. This inconvenience was a major factor in dooming the largest methanol experiment in the country.

In 1997 there were over 21,000 M85 (85 percent methanol and 15 percent gasoline) flex-fuel vehicles (FFVs) in the US, mostly in California. At that time, the state had over 100 methanol refueling stations providing fuel for light vehicles as well as hundreds of methanol-fueled transit and school buses.

But the limited fueling infrastructure proved frustrating for drivers. California’s program lasted 25 years and 200 million miles in aggregate, but the state finally pulled the plug in 2005. This was also the year Congress passed the Renewable Fuel Standard, shifting the advantage decisively to corn ethanol with a national mandate that methanol has never enjoyed in the US.

While methanol passes the price test as motor fuel, it fails the convenience test when compared with gasoline. So even though methanol will continue to attract attention because of its relatively low cost, energy sector investors should avoid methanol companies that are targeting the automobile transportation market. These companies would only start to become interesting if methanol begins to trade at an even wider discount to gasoline.

Diesel is also of interest from an energy policy standpoint. While it is often more expensive on a per-gallon basis than gasoline, diesel contains more energy per gallon. Further, diesel engines are significantly more fuel efficient than gasoline combustion engines, so the cost per mile driven can be quite a bit lower.

While diesel engines have long been popular in Europe as a result of tax incentives, the US has discouraged diesel-powered automobiles by taxing diesel at a higher rate than gasoline. Thus the premium price for a diesel engine isn’t nearly as compelling as in Europe. As a result, US refineries are geared toward gasoline and European refineries toward diesel. A shift to diesel in the US could lower our oil consumption, but would also require a significant investment by refineries.

So, while I support energy policy initiatives that diversify the fuel supply, from an investor’s standpoint gasoline will continue to be king for the foreseeable future. The time will eventually come when gasoline’s dominant position is threatened, but until then we won’t send investors chasing companies premised on wishful thinking.

Around the Portfolios

Occidental Petroleum (NYSE: OXY)
Normally, a corporate board at odds over the future of the company’s chief executive would be a red flag. But for a stock that has recently lagged its peers as badly as Growth Portfolio holding Occidental, dissension at the top as detailed Friday in The Wall Street Journal may represent progress of a sort.

After all, the board members allied with Chairman Ray Irani reportedly want to oust CEO Stephen Chazan out of frustration with the share price and company performance. Fair or not, this criticism is at least preferable to a unified and complacent front in defense of the status quo.

Occidental is trading at a discount, in part, because of a history of disproportionate enrichment by insiders, notably Irani himself, who pocketed $460 million in 2006 before getting pushed out of CEO’s job in favor of Chazan in another pay controversy four years later. Over the course of a decade, Irani netted $857 million according to The Wall Street Journal, though at least the stock was performing then in contrast to the action of the past two years.

Investors have also been put off by the fact that nearly 40 percent of the company’s production is abroad, predominantly in the Middle East, though much of that is in the rich Persian Gulf states where the odds of regime change are relatively low. In any case, Oxy has already been shifting is capital spending to the US and notably to its Permian Basin properties in west Texas, which make it the top producer in the leading US oil state. The company is also heavily involved in California and best positioned to exploit the crude-rich Monterey Shale should the state ever permit hydraulic fracturing.

Oxy’s Mideast business depends on the personal contacts of its chairman, a Lebanon native of Palestinian descent who may be looking for an exit strategy of his own. Irani, 78, reportedly organized the current plan to replace his former protege Chazan as the CEO. Chazan, however, has the support of some institutional investors who may try to oust Irani and his allies from the board, according to The Wall Street Journal.

With any luck, the infighting will attract activist investors, and ultimately a new CEO who will shake up the company and extract the value embedded in its underappreciated assets.

Schlumberger (NYSE: SLB)

The leading global oilfield services provider is no stranger to political risk, and has recently faced up to fears that it might have to pull out of Venezuela given the heavy payment arrears of the state-owned PDVSA oil giant. Last month, the company warned that PDVSA’s deteriorating payment rates could cause it to miss its target for double-digit earnings growth this year. But this weekend, Schlumberger announced a new payment agreement with PDVSA that will allow it to recognize all of its first-quarter Venezuelan revenue. Traders took the news in stride, and Schlumberger shares remain trapped in a two-year trading range. But the deal underscored the fact that even cash-strapped clients have few alternatives to Schlumberger if they wish to maintain their output.

— Igor Greenwald

Stock Talk

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