Friday, May 15, 2009 at 01:36AM
Byron King, Editor of Agora Financial's newsletter, Energy & Scarcity, addresses issues of "chronic underinvestment in productive assets" in this exclusive interview with The Energy Report who have kindly allowed us to carry it in full.
Source: The Energy Report 05/14/2009
A former Navy flyer and one-time field historian on the staff of the U.S. Chief of Naval Operations, Byron King has a gift for putting events into historical context. In this exclusive interview with The Energy Report, he addresses issues of “chronic underinvestment in productive assets.” How will more than six billion people—all wanting a higher standard of living—manage on a planet with dwindling resources? Byron also offers insight into alternative energy sources. They aren’t everything that some people think, but they offer opportunities for investors.
The Energy Report: You edit Agora Financial’s newsletter, Energy & Scarcity. How do you define scarcity?
Byron King: I look at scarcity in the classic sense of shortages, of not enough to go around. When you look at world development in the last century, growing from a population of one billion or so, for much of the time 90% of the people were on the outs and maybe 10% were on the in. The Western world—North America, Europe, Japan and parts of the rest of the world—had access to ample resources, whether it’s mineral resources; energy resources; water, fresh water; food, what-have-you. That’s where we get the modern theories of economics, and commodity cycles. That’s the history that we see. But you have to be careful where you get your history.
Now we’re living in a world with over 6½ billion people. One billion or so are at or approaching a middle-class standard of living. The other 5 billion or so? They understand what a better existence means for them. When, say, 4 billion more people are competing for that oil or the mineral resources—the copper, the nickel, the iron ore, the food that you can grow on the arable land, the fresh water, the fish in the sea—you deplete your resources a lot faster than in the good old days.
Historical commodity cycles are useful examples. But the commodity cycle that we’re living in now, and that’s evolving very rapidly, is going to be quite different. It’s outside that proverbial “box.” That’s where the scarcity concept originates. So when people say, “it’s different this time,” well, yes it’s a couple of billion people “different” this time.
TER: But is it really a scarcity of commodities? Or is it that we haven’t we been able to increase our production of commodities to accommodate the increased demand? Or are we just at the inflection point that production hasn’t increased enough to match demand that we project in the next five years?
BK: There has been chronic underinvestment in productive assets in most modern Western societies. It’s generational. It’s perverse. We brag about it. We call ourselves a “consumer society.” As opposed to what? A “producer” society? Yes, because we don’t produce near as much as we consume. How long can that last? Until the rest of the world catches on to the con, I suppose. Which is happening right now.
The West has been lucky since the end of the Second World War. We saw immense discoveries of oil, for example, in the Middle East in the ’40s, the ’50s and the ’60s that got developed in the ’70s, ’80s and the ’90s. We’ve had a couple of generations’ worth of cheap energy and, by extension, cheap credit.
But the world hasn’t replaced those early oil discoveries with new discoveries because where else are you going to look? Where’s the next North Sea? Where’s the next Alaska?
People say, “What about offshore Brazil?” Okay, let’s get 200 miles offshore in the South Atlantic in 8,000 feet of water. Drill 28,000-foot wells at $200 million a piece. It’s an order of magnitude different than anything we’ve ever done. So in that sense, how does a world of six billion people imitate the past in any future resource scenario?
I don’t think it can. Brazil will be good for Brazil. But Brazil won’t save the world. Not our world, the Western world, anyhow. So we in the West have to come up with different ideas for energy resources and how to exploit them.
Now add this. In the last year we’ve seen the breakdown of much of the world financial system. Or at least what our adversaries like to call the “Anglo-Saxon Model”—that’s NOT a compliment, by the way. Large swaths of the old investment paradigm have just gone away. In the olden days, when you had a mega-development, you could raise financing. Can you do that today? Maybe some of the really, really big guys can do a $4 billion development. But it’s much more difficult now than it ever was.
TER: Many people are looking to invest in oil because they think the price is still relatively low compared to where it will settle out. What’s your viewpoint about oil as a commodity or as an investment play?
BK: Oil right now is at a relative low point. Someday, we’ll look back and think these were the good old days. We had the immense run-up in oil last year. The high was $147 per barrel. The low was $33. Oil has been working its way back up, now into the mid-$50s.
There’s a lot going on with those swings. Part of it has to do with the world issues of the economy breaking down and demand just falling off a cliff. But at the same time, supply is falling. OPEC has been cutting back, and has shown good production discipline in the past six months. OPEC is working hard to stabilize prices.
TER: When will that decrease in production output hit the market pricing?
BK: It’s happening now. OPEC started cutbacks in December, January and February. It takes 60 to 90 days for that production cutback to hit the refineries. They turn the valves out in the field, and less goes into the pipeline. Then they load fewer tankers, and those tankers have that long route out of the Persian Gulf, across oceans to the unloading terminals. Depending on the route the tanker takes, you’re looking at 60 days, or even 90 days. So, really we are seeing the impact of the cutbacks now as we speak. We have less oil on the markets from the Middle Eastern oil patches.
At the same time, other players in the industry are loading up tankers with oil and literally just parking them offshore. They’re betting on higher oil prices in the summer and fall. I understand that over 100 million barrels of oil are in floating storage in leased tankers, either sailing slow circles in the ocean or anchored out someplace.
TER: Doesn’t that imply, though, that until that floating inventory is consumed, it won’t affect the price of oil?
BK: That will slow down price increases to some extent, for a while—maybe into next year. If you draw down 500,000 barrels per day from floating storage, it’ll take 200 days to get 100 million barrels down to zero. Of course it doesn’t work in quite such a linear fashion. But it illustrates the point.
The medium- and long-term issue for the price of oil is that a lot of oil investment projects worldwide have been deferred, delayed or cancelled. That’s going to come back and bite the world really hard two years, three years, five years out. I’d compare it to an investment earthquake in the energy sector. Now we’re in for the energy aftershock.
The worldwide rig count is, say, half of what it was a year ago. Entire elements of the drilling and oil service industries are experiencing cutbacks. Big companies like Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL) and Baker Hughes Inc. (NYSE:BHI) have laid people off, including skilled personnel. Smaller companies have laid even more people off. We’ll be sorry about that, eventually. You don’t just decide one day you need more rigs and take them out of storage. It will take many months—years, really—to get rigs back to where you need them when we come out on the other side of this recession.
TER: So at some point in time we’re going to eat through our ready inventory. We’ll need to produce more oil to accommodate the demand.
BK: Yes, we’ll need more wells. We won’t have the wells. And we won’t have the rigs, the drill pipe, the drill bits, the skilled workers to drill them and complete them.
We ought to be drilling more wells now; expanding oilfields; doing more exploration and development. But we’re not. So I think the world probably has seen about the highest output that it’s ever going to see. Within the last two or three years when the world hit daily output of 87 million barrels of oil, or oil equivalent when you throw in the natural gas liquid—I think that’s going to be the biggest number that we’ll ever see in human history. It’s all downhill.
TER: That brings us to the peak oil idea.
BK: Yes. There are geological limits as to how much hydrocarbon you can get fairly easily from a traditional oil well. There are a lot of hydrocarbon molecules out there, but they’re not in those nice, easy-to-drill oilfields where you can just poke a hole and pump them out. Mankind could do other things to get the hydrocarbons. We understand the technology. But it’ll take a lot of investment—and a lot more energy—to get those dispersed, harder-to-trap molecules.
The one sweet spot in the energy industry right now for drilling is in the deep-water. There just are not enough deep-water rigs for working in water that is more than 2,500 feet deep. After lowering equipment through the water column to the seafloor, they have to go through maybe 20,000 feet of rock, half of which might be a salt cap that you’ve got to drill through to get to that pre-salt layer.
Offshore Brazil is one of the key plays in the world for that, but you’re also seeing it in what they call the Lower Tertiary, or the Wilcox Trend, offshore in the Gulf of Mexico. You’re seeing a lot of deep-water development off the coast of West Africa. The Russians are eyeballing doing a lot of work up in the Arctic, so the deep-water rig and the drilling ship business is doing well in that regard.
My favorite sector right now is a niche within the energy industry—the subsurface equipment players. Companies like Cameron International (NYSE:CAM), FMC Technologies (NYSE:FTI), Dril-Quip Inc. (NYSE:DRQ) and VetcoGray, which is part of General Electric. These firms make the deep-water equipment—the Christmas trees and blowout preventers and pumps that go literally a mile or almost two, under the seawater. They put this equipment down on the ocean floor, and it might never again see the light of day. The subsea equipment has to work well, and work for decades in these oilfields. That’s one sweet spot in the energy industry that seems to be doing pretty well.
TER: If we’re going to be short on resources in oil and natural gas due to cutbacks in exploration or drilling; so, should we play those commodities? Or should we listen to what the world is talking about in terms of energy alternatives and play those instead?
BK: That gets into a loaded political question. Depending on how you want to invest in the energy business, you can pick up companies that have good reserve positions in fossil fuels, and good technical competence at a relative bargain. Looking ahead five, 10 or 20 years, is the world still going to want to burn hydrocarbons? Will we still be working in the current, anti-CO2 paradigm? Or will people start to worry about living through a few generations of low-energy poverty? Will they vote in new politicians?
When you go into alternatives—wind, solar, whatever—we’re starting from a really small base. If you thought of U.S. energy as a big pizza pie, alternative sources wouldn’t account for even a small slice. It’s like a sliver of one slice. At most, alternatives are 4% of the total energy mix in the United States. And a lot of that is because companies like Weyerhaeuser Company (NYSE:WY) burn sawdust to run their mills. When the government people make up statistics, they call that alternative energy.
Right now the United States gets 40% of its electricity from burning coal; it gets not quite 30% from natural gas, maybe 20% from nuclear. A tiny fraction of electricity comes from windmills on the prairies of North Dakota. They say we’re going to really have a huge build-out on this in the next couple of decades. Well, maybe we are, but I’m not sure how we’re ever going to accomplish that. I don’t know that we have the industrial capability.
There are, of course, some outstanding investments in alternative energy. Trinity Industries (NYSE:TRN), for example, is a railcar company but it also makes windmill towers. These aren’t backyard flagpoles; they’re big enough that you could put a Boeing 757 on top of one of them. That’s about the equivalent of the two megawatt wind turbines up there spinning away.
For my money, I think that the safest way to play the alternative energy industry is in the geothermal world. The one big pure play company I like is Ormat Technologies Inc. (NYSE:ORA), in Reno, Nevada. It’s an international company, and they do everything—engineering, design, building equipment. They actually operate on their own account, too. They have acreage and wells. They make steam; they spin turbines; they generate electricity and they sell it.
There are a few other pure play, small geothermal prospects. US Geothermal Inc. (NYSE.A:HTM) (TSX:GTH) has an operation at Raft River, Idaho. To my mind, they’re still figuring out how to make money, but at least they’re doing it. Eventually, it’ll work out. Some other smaller developers are Western GeoPower Corp. (TSX.V:WGP), Sierra Geothermal Power Corp. (TSX.V:SRA) and Nevada Geothermal Power Inc. (TSX:NGP) (OTCBB:NGLPF), and there’s a tiny company called Polaris Geothermal Inc. (TSX:GEO), which operates in Nicaragua. And if you want the largest geothermal producer in the country that’s publicly traded, that’s Chevron. They produce more geothermal watts than anybody else.
TER: These smaller producers like Western GeoPower, Nevada Geothermal, and U.S. Geothermal, is there a potential acquisition play for someone like a Chevron to come in and add more geothermal properties?
BK: The small geothermal guys don’t talk about being for sale. But there are political mandates for utility companies to come up with so-called “green power” or zero carbon power. State legislatures are enacting renewable portfolio standards—RPS. And Congress is going to set a national standard. Some of these small geothermal companies are probably being eyed by larger utility systems or power companies that feed into the utility system. The RPS mandates are coming. Things will be so tight from a regulatory standpoint, that if you don’t have green power moving down your transmission line, you’re out of business.
In the short term, the geothermal guys are development stories. They’re putting themselves into operation. In the medium to long-term, these are probably rollup or takeout kind of stories. If we talk about this five years from now, I think we’d be talking about how all these companies got taken out. It’s just a question of when and how and what’s going to be the mechanism that takes them out.
TER: Why do you see the geothermal sector as an opportunity for investors when the companies are not making money at it?
BK: Let’s back up. Geothermal has been around for 100 years, but from our investment standpoint right now it’s an early-stage industry. It’s starting from little more than scratch. There was a geothermal proto-boom in the 1970s, but it fell apart by the mid-1980s. In the 1980s and ‘90s, energy was cheap. So who needed geothermal, or anything else? Geothermal was a curiosity. There were only a small number of serious new projects in the U.S.
What has driven geothermal development in this decade has been what’s driven other alternative energy development—government subsidies. Whether it’s tax credits or the RPS mandates, public policy is driving it. There will come a point, a critical mass, maybe 2% market penetration or so, where there’s enough technical skill and people available. Also, the utility industry will have to get used to working with geothermal power to an extent that everybody finally gets it all figured out.
At the end of the day, geothermal power is about making electricity, and there’s hardly one electron in the U.S. grid that isn’t regulated by some public entity someplace—the 50 different state Public Utility Commissions, the Federal Energy Regulatory Commission. It is a highly regulated industry. Geothermal has to make that jump into the regulated energy space. It’s not there yet. Moving in the right direction, but not there.
I am not saying that geothermal is a bad investment right now. I have a lot of hope for the future for geothermal power. But as we speak, there’s a serious element of risk you won’t find in other established energy industry plays. The geothermal stocks can go up or down based just on what’s in the news yesterday or today versus tomorrow.
Very few of these geothermal projects are actually putting power into the grid and getting paid for it. Once we see more geothermal electrons moving down the grid and once the cash starts flowing from the utility rate payer, putting that check in the mail every month, paying the utility, and the utility pays the geothermal producer, we’re going to get a better handle on it.
Right now the geothermal industry has a lot of business plans and a lot of forecasts, and a lot of companies that (if they’re spinning a turbine at all), have been spinning it for just a short time. They haven’t got all the bugs and kinks out of their system. They give great presentations at the conferences. But my question to a lot of these guys is, “Where’s the money?” They’re burning more cash than they’re generating. So if you want to get into this early, it’s speculative. Understand that. But there could be a very handsome return downstream. And again, much of it is politically driven.
TER: Are these some of the things you’ll be talking about at Agora’s conference in Vancouver in July?
BK: I will be talking about these things—gold, trends for gold; energy and other issues related to that. I will be talking about oil and alternative resources. Vancouver is always a great conference. This is the 10th anniversary of that conference. We always get great comments from attendees, so anyone who is interested should really check in with Agora Financial for the details—that’s AgoraFinancial.com.
Byron King writes for Agora Financial’s Daily Reckoning and Whiskey and Gunpowder (a self-styled “independent investor’s daily guide to gold, commodities, profits and freedom”). Byron edits two newsletters, Energy and Scarcity Investor and Outstanding Investments, This July 21-24, Byron will speak at the Agora Financial Investment Symposium in Vancouver, BC.
Byron graduated cum laude from Harvard University with a degree in geology. Later, he received his Juris Doctor from the University Of Pittsburgh School Of Law, and an advanced degree from the U.S. Naval War College. Byron served for many years in both the active and reserve components of the U.S. Navy. Byron also worked as a geologist for Gulf Oil in the exploration and production division. And Byron practiced law, focusing on bankruptcy and other contentious matters involving people and money.
Byron has written extensively about Peak Oil and world energy developments. His expertise includes precious metals and alternative energy sources such as solar, wind and geothermal. Byron has provided advice on national energy policy to the U.S. Department of Defense.
To read more articles written by Byron King, click here or go to www.dailyreckoning.com.
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