How To Play Energy in the Intermediate Term ~ market folly

Tuesday, June 24, 2008

How To Play Energy in the Intermediate Term

Energy demand is quickly rising, while supply cannot keep pace. I read two interesting pieces yesterday: one in Forbes by Mark Mills and one in The Economist. Both have to do with alternative energy and the current energy situation. The thoughts in both pieces tie together a lot of my investments theses into a cohesive whole. I have been long natural gas, coal, and nuclear through various investment vehicles for a while now. They represent my energy plays for the intermediate term while the alternative energy wave gains momentum. While I'm in each energy name for a specific reason, there is an underlying macro trend that provides justification for investing in all those forms of energy: The rate at which we are consuming energy is far outpacing the supply. So, what does this mean? Higher prices across the board. And, I'm just talking about the U.S. here. (Throw China in the mix and you've got a big problem.). Then, on top of that entirely, I've been performing due diligence on possible investments in solar, wind, nuclear, and hydropower to 'spread my bets' and diversify within the alternative energy space for a longer term play, as these plays will undoubtedly require a longer time frame to come to scale. But for now, I really want to focus on the energy outlook in the intermediate term. To really frame things, I want to highlight a segment taken from the aforementioned Economist article which touches on some staggering statistics and estimations regarding energy:

"The market for energy is huge. At present, the world’s population consumes about 15 terawatts of power. (A terawatt is 1,000 gigawatts, and a gigawatt is the capacity of the largest sort of coal-fired power station.) That translates into a business worth $6 trillion a year—about a tenth of the world’s economic output—according to John Doerr, a venture capitalist who is heavily involved in the industry. And by 2050, power consumption is likely to have risen to 30 terawatts."

As you can see, the numbers are quite large and the trend is for power consumption to increase. In terms of using such power, the Forbes article states that "America uses just 15% more oil today than when the first modern energy crisis hit in October 1973. But electricity use is up 115% since then." The majority of electricity generated in the U.S. comes from coal, natural gas, and nuclear (all non-renewable sources). Now, recently we've seen a lot of hype around renewable sources such as wind, solar, and water. Don't get me wrong, I'm all for supporting these advancements. But, let's be real for a second. These energy solutions will take many years to be brought to scale. Five or Ten years down the road, they could have a very meaningful impact. But, in the mean time, what's the solution? Currently, wind is gaining ground in terms of stealing power generation 'market share' if you will. But, by supplying only a whopping 1% of power, it's not making a big dent by any means. The growth in energy demand will simply outpace what little supply that is coming to market. Longer term, the renewable sources should have some sort of an impact. But, in the near-term, this presents a real problem.

I realize the alternative energy space represents some great investment opportunities for the longer term and I will obviously be investing there too. But, let's focus on the here and now, where we can find some feasible investment theses poised to benefit in the next 1 year, 3 years & 5 years (ie: sooner rather than later). Consider the following paragraph from the Forbes article:

"Coal generates half of America's electricity. The U.S. is the world's second-largest producer. China is the largest, and used to be a net exporter. A year ago China became a net importer of coal. So U.S. coal exports are rising now, up 13% already this year. America has plenty of coal, but as exports grow its price will start tracking world coal prices. Those (world coal prices) have more than doubled in the past year to $100 per short ton, and Merrill Lynch forecasts another near doubling by year-end."

Then, add in the following quote from The Economist article:

"China is building coal-fired power stations at a blazing rate."

To those who doubt the reality of the coal story: get real. The main fact to take away here is that China used to export coal. But, now that they are growing so fast and consuming so much energy, they are now a net importer. As the second largest producer, the U.S. feeds China's hunger for energy. Add in the fact that the U.S. has to power half of its own electricity with coal, and you've got a big demand problem. Yet again we fall back on the fact that demand is rising faster than supply. Prices go up. This is all depicted by The Economist's chart that illustrates primary world energy consumption and primary electricity production:

As you can see, oil is obviously the top form of energy consumed. But, coal is a close second in terms of consumption. And, in terms of world electricity production, coal leads the pack. So, the commonality here is that not only does the world consume a lot of coal behind oil, but it is the leading source of electricity worldwide. In the intermediate term, coal is not going anywhere. Investing in it only makes sense. The world requires more energy. Therefore, the world requires more coal. Rising demand for coal equals rising coal prices. And, the same can be noted about natural gas (although on a slightly smaller scale).

On that note, let's turn to Natural Gas, the source from which both the U.S. and the world in general receive around 20% of their electricity. And, referring to the Forbes article, we see yet another problem:

"Demand is up, but supply is not. Natural gas is largely a domestic fuel (as oil was decades ago). But U.S. production is falling because of environmental restrictions on exploration and tapped-out existing gas fields."

Demand outpacing supply yet again. Prices go up. Add in the fact that natural gas can continue to ride oil's coat tails in terms of price appreciation and you've got a party.

Lastly, the article touches on nuclear power. This power source supplies 20% of American electricity as well. And, as you can see from this depiction from The Economist, nuclear power has been slowly but surely gaining energy 'market share' over the past 3 decades:

France has really led the pack in terms of fully committing to nuclear power and has thus set the standard for other nations to follow their lead, should others be willing. But, there are problems with this source of energy due to political/safety/you-name-it concerns. Add in the fact that getting these nuclear power plants approved and built takes forever and you've got some barriers. So, if it takes forever to build a plant, and existing plants could have problems keeping their licenses, how does nuclear help us address the energy demand in the near-term? The Forbes article asks the same question:

"So how will this scenario play out if more plants don't get built? The first thing is that utilities will burn more natural gas."

Oh ok, let's just burn more natural gas which we already don't have enough supply of. That's encouraging. /End sarcasm. So, as you can see, we have a problem here. No matter which way you really look at it, prices have to go higher. Demand is growing faster than new supply can be brought to market. The U.S. has to take care of its own coal situation since it accounts for a vast majority of power generation here. On top of that, you have China who is a net importer of coal now because they are even more energy hungry than we are. This equals higher prices. And, if the U.S. isn't willing to pay those higher prices for that coal, those coal producers will have an eager buyer waiting in China. Natural gas demand is surging, yet supply is not necessarily surging along with it. Yet again we see higher prices. Nuclear power could be a much longer term solution, but offers us nothing in the near-term due to the time it takes to even get a plant set up in the first place. Wind power, although gaining popularity, is still a ways away from making a significant impact in terms of servicing the rising demand. Wind power is indeed generating a percentage of power in America, but it's still nothing too meaningful... it's literally 1%. This, like nuclear, will take time to a) gain more popularity and b) actually be implemented in mass. Solar, probably the most 'hyped' of all possible solutions, only supplies 0.01% of power according to the article and is probably the furthest out from having a major impact. Lastly, the Forbes article mentions hydropower as another option that only generates 7% of power in America, but is losing 'market share' due to dams being dismantled. This option does not offer any near-term solutions either, because it still faces the challenge of adopt-a-bility and implementation. Not to mention, there is very limited hype/popularity around this option currently (although I'm sure that will change soon).

So, what we do know is that all of the renewable sources of energy will not be able to meaningfully service rising demand in the near or intermediate-term. So, for the next few years, it is clear that the reliance on coal and natural gas will continue. While I don't doubt that meaningful inroads will be made in the areas of solar, wind, nuclear, and hydropower, we're still a long ways away from any major increase of energy supply. So, we use what we have: coal and natural gas. And, due to rising demand, the prices of these energy sources will go up. Add in a short supply scenario to either or both of those, and you have a recipe for sky high coal and natgas prices. No matter the scenario, you need to be playing energy. Wind, nuclear, solar, and hydropower are worth a look with a longer investment time frame, while coal and natgas seem poised to benefit in the immediate future.

And, on that note, here are some plays best positioned to benefit from this intermediate scenario. For coal, I like Arch Coal (ACI), Massey (MEE), and Alpha Natural Resources (ANR). I like these names for both the energy thesis as well as the metallurgical coal/steel demand we are seeing. For natural gas I like Chesapeake (CHK) and Sandridge (SD) for their shale prospects, heavy insider buying, and management teams that have vast experience in the industry. I also like playing the United States Natural Gas Fund (UNG) that tracks the price of natural gas itself, which I anticipate will continue to appreciate. As I mentioned in the beginning of this piece, I'm in numerous energy names for varying secular theses. But, rising energy demand/dwindling supply is the underlying thesis that ties them all together.

Note: All these names are quite extended and due for a pullback, so enter here at your own risk. I know I'll be waiting for the next major pullback to re-load. I've been in these names for a while now and even though they have seen massive run-ups, I still believe the street is underestimating the underlying trend here. I'm long ACI and MEE and have been taking profits along the way. I'm also long CHK and UNG, but have smaller positions than normal due to recent profit taking. I'm waiting for a pullback on SD as it continues to blast towards the stratosphere. I will continue my strategy of taking profits on new highs and buying back on dips, assuming nothing has fundamentally changed at that time. Obviously, it is essential to monitor the ongoing situation to make sure the thesis hasn't become flawed. Because, if that were to occur, these names would come crashing back down.

Make sure to check out the Forbes article I referenced, as I think it brings up some interesting points. Also, check out The Economist article I cited, which also is a very thought provoking piece.


The Green Skeptic said...

Excellent post. I plan to reblog it on The Green Skeptic, because I think my readers would appreciate your thoughts (and I'm in Alaska with limited web access). Thanks for the analysis of The Economist and Forbes coverage -- and keep up the good work.

Jake de Grazia said...

Any technologies in the world of energy efficiency that you think we should be watching? Any companies you especially like?

J. (marketfolly) said...

green skeptic, thanks very much!

jake, that's a problem area i'm finding. its hard to really find pure plays. you have any on your radar? i certainly can't find any worth really monitoring

GreenMonster said...

Great post and great analysis. One threat to intermediate-term growth is the prospect of carbon tax or a cap-and-trade system that will likely come in the new administration. Of course, it all depends on timing and implementation details. But do you think your investment thesis still holds if a bill gets passed by mid-2009?

J. (marketfolly) said...

greenmonster thanks. you do bring up a good and concerning point. its tough to gauge simply because there's a lot of international growth for coal. so, even if such a bill is passed in america, we would see dampening in US business but still growth overseas. but then the other part of the intermediate thesis is natgas and that would benefit from taxes on coal in america. ultimately, i don't see it as a huge concern simply because i've seen numerous articles about coal growth in china, the middle east, and even europe. i'll do another post with some of those pieces i've found.

i think if that panned out, i would reduce exposure slightly to coal and boost natgas exposure. but, i'd still obviously want exposure to both. its all about coming up with the right allocation in each energy type.

Anonymous said...

J, really good piece, who would have thought that all those gains would be given back in the months to follow.

jegan said...

MF.. If you do not follow 'Zmans Energy Brain' you might want to have a look.... Very detailed and lots of commentary on oil, natgas and coal.

This is the link to his blog this week, which carries a conversation regarding natgas..