The Energy World is Flat. Lacalle Daniel
the “big demand growth” will come. These expectations are missing a key point: the change we are seeing is not cyclical, it's structural. The new economy, even in China, is less about large industries and massive construction.
Think “against the box”
One of the main traps for investors in the energy markets is to follow consensus.
The energy world is driven by extremely optimistic assumptions of demand growth, and downward revisions of estimates tend to be shrugged off as “noise” always looking at the elusive long-term perspective. This “growth mirage” that we will discuss later is best exemplified by the average adjustment in demand growth from the IEA and OPEC.
According to my analysis, every year demand growth estimates are revised down an average of 15–20 % from the January estimates. Since 1998, only one year, 2012, has seen meaningful upward revisions from initial estimates.
My experience in the past years as an analyst and a portfolio manager has taught me to use forward guidance from companies and agencies with extreme caution. This has helped me to avoid the constant stream of profit warnings and to keep a moderated view about the supply–demand picture, which has proven to be right. We have not seen a supply shock or a demand boost. This philosophy of not just thinking “outside the box” but also understanding that the compilation of data made to support forward guidance is tainted by diplomacy.
Governments are always optimistic about GDP, and always overestimate the correlation between GDP and energy demand. A correlation that has been broken since 1998, where strong economic growth does not necessarily imply industrial and energy demand rising. The best way to add value and make money is precisely to question and understand the intricacies of forward-looking guidance, put under scrutiny the details, and always know that it will be better to err on the side of caution, rather than let ourselves be guided by consensus. As an investor one must know that none of the companies' executives, analysts at agencies or brokers will suffer professionally from providing optimistic guidance. It will always be justifiable with “unexpected one-off” events. The same happens with doomsday predictions, as we have already seen with peak oil.
The assumption of ever-rising prices due to supposed depletion and alleged energy shocks has been what we call in the financial world “a widow maker” as an investment strategy.
During the early 2000s, the telecom industry continued to push the boundaries with the new 3G technology. But governments controlled the licenses, and were determined to maximize the amount of money they could raise from them. To keep the competitive pressure, they offered fewer licenses than the number of operators likely to bid. A similar auction had been applied in the United States and had to be re-run when the winners defaulted on their bids. Yet, and despite the potential harm to the telecoms future competitiveness, the European governments proceeded with the blind auction and sealed bids.
Telecoms were in a difficult position. If they lost the auction, they felt they would miss out on the next technological phase of the business. Many assigned a strategic premium and made high bids, often financed via debt. The result was staggering. The UK auctions raised £22.5 billion. The German auctions raised around £30 billion. To put this in perspective, this was 10 times more per megahertz than the television companies were charging at the time for national broadcasting.11
A similar dynamic where majors are investing “not to miss out” is also taking place across the energy markets.
Investments “to be there” throughout a possible game-changing environment are typical of the energy industry. It's called “position rent”. The economic decision to devote large amounts of money in energy investments comes not only from the possibility of generating solid returns on an equity investment, but also from the opportunity that technology gives to higher asset value and strategic position of the company in a country. Out of the hundreds of billions of capital investments made every year in energy around 5 % to 10 %, looking at the plans of the large integrated companies, will likely be in “strategic opportunities” or “security of supply” where returns are unclear, but companies feel the need to be involved. These figures are higher when we look at national companies of the calibre of Gazprom or PetroChina. A very significant amount that unwillingly helps the flattening process.
Certainly, these strategic decisions can play an important role in the future competitiveness and solvency of these companies. Whether in a real estate boom, or internet boom, or energy boom, paying too much to stay ahead may well be the kiss of death. The corporate graveyard is full of companies that paid too much at the top.
The “strategic premium” and “geopolitical risk positioning” are eroding peak demand pricing with incremental supply, both from new capacity and new technologies. The erosion of peak pricing has been instrumental in improving the economic outlook of countries, because it reduces the shocks and undesired effects of uncertain and volatile pricing.
Another important consideration is the “venture capital” approach, supporting new technologies via the deployment of “risk capital” through a diversified portfolio.
During the dotcom revolution, it was clear that many new technologies and start-ups would not make it. But the mindset was that “we just need one winner”. It was impossible to “guess” who the winner would be, so investors were diversifying and spreading their bets, reaching to a much larger number of projects.
In the transportation world, several technologies are looking to break the crude oil monopoly. In addition to the more widely known and accepted compressed natural gas (CNG), LNG (for trucks, trains, and ships), electric car vehicles (ECVs), and hybrid vehicles (HVs), during the 2013 Motor Show in Tokyo, Toyota shocked the transportation world wih the announcement of the commercial launch of a fuel cell vehicle (FCV).
Yet, there are powerful forces that can delay change.
In 2009, my analysis “against the box” indicated that the expectations from the EU and US governments for electric vehicle sales were totally unrealistic and simply impossible. Five years later, the electric vehicle has turned out to be a much smaller alternative than these governments had anticipated. But, ironically, the penetration of the electric car was not “killed” by the oil companies or energy lobbies, as many people think. The list of “murder suspects” for the delay in electric cars is quite long, and includes those governments who were seemingly trying to promote the electric car industry in the first place.
Start with the bailouts of the car companies. The industry was deemed “too big to fail” in the United States and Congress worked out a $25 billion loan and by December 2008 the US government became the majority shareholder of General Motors.
In this environment, it is not surprising that the subsidies from EU and US governments to buy a new “conventional combustion engine car” (and help reduce the brutal inventory of unsold vehicles) exceeded by six to one the amount devoted for the development of electric cars. Anecdotally, 2010 turned out to be the year of highest sales of SUVs since 2006,12 as the government subsidies strongly incentivized the absorption of inventory and accelerated the renewal of the fleet, reducing significantly the potential for electric cars for years.
There are other important factors that have slowed down the development of electric cars, which we will discuss in more detail in Chapter 14. One of them is pricing. An electric car, which seeks to replace a combustion engine vehicle, cannot succeed if it sells at an average of 50 % higher than the alternative. This concept of promoting expensive alternatives does not make for a realistic economy. Alternatives will only exist if they are more attractive, cheaper, and efficient. Another factor is taxation. The EU collects €250 billion a year in taxes from petrol and diesel (taxes on petrol range between 40 % and 65 %).13 So, if the electric vehicle took a significant percentage of market share, governments may be forced to “transfer” the gasoline/diesel tax to the power sector. In fact, subsidies to power, including renewables, but also coal and gas, have resulted in a higher average cost of electricity across the EU.
Following
Paul Klemperer (2002). How (not) to run auctions: the European 3G telecom auctions.
European Commission.