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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
A stronger, more informed approach to the energy markets
The Energy World Is Flat provides a forward-looking analysis of the energy markets and addresses the implications of their rapid transformation. Written by acknowledged expert Daniel Lacalle, who is actively engaged with energy portfolios in the financial space, this book is grounded in experience with the world of high-stakes finance, and relays a realist's perspective of the current and future state of the energy markets. Readers will be brought up to date on the latest developments in the area, and learn the strategies that allow investors to profit from these developments. An examination of the markets' history draws parallels between past and current shifts, and a discussion of technological advancements helps readers understand the issues driving these changes.
Energy has always been at the forefront of the economic agenda, being both the key to and a driver for development and growth. Its centrality to the world of finance makes it imperative for investors and analysts to understand the energy markets, irrespective of where on the wide range of energy spectrum observers they fall. The Energy World Is Flat is a guide to the past, present, and future of these crucial markets, and the strategies that make them profitable. These include:
- Understanding the state of the energy markets, including key developments and changes
- Discovering the ten pillars of a successful energy investment strategy
- Reviewing the history of the energy markets to put recent changes into perspective
- Learning which technologies are driving the changes, and how it will affect investors
The recent energy market changes were both unexpected and so fundamental in nature that they represent a true shift in the energy macro- and microeconomic landscape. Investors and analysts seeking a stronger approach to these markets need the expert guidance provided by The Energy World Is Flat.
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Veröffentlichungsjahr: 2015
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Table of Contents
Title Page
Copyright
Dedication
Disclaimer
Chapter One: The Mother of All Battles. The Flattening and Globalization of the Energy World
Nuclear politics
The sustained spike in natural gas prices
Fracking and the collapse in US natural gas prices
US tight oil
Geopolitics and high crude oil prices
Expensive oil, cheap natural gas
The market does not attack, it defends itself
Winners and losers
Notes
Chapter Two: Lessons from the Internet Revolution and the Dotcom Bubble
The bubble path
Think “against the box”
Lessons not to forget
Notes
Chapter Three: The 10 Forces that are Flattening the Energy World
Is the energy world flat?
Chapter Four: Flattener #1 – Geopolitics: The Two Sides of the Energy Security Coin
The oil weapon
The gas weapon
Notes
Chapter Five: Flattener #2 – The Energy Reserves and Resources Glut
What energy scarcity?
Reserves and resources
Crude oil concentration, but no shortage
OPEC almighty
Reserve protectionism
Marginal cost of production
The “unconventional” resources
Discoveries vs. additions: “can we rely on finding new oil fields?”
Sorry, no peak oil
No peak gas either
Notes
Chapter Six: Flattener #3 – Horizontal Drilling and Fracking
Never bet against an engineer
Technology increases volume
Technology reduces costs
Innovation vs. imitation
“Fracking” and horizontal drilling
Myths and realities of shale gas and tight oil
Notes
Chapter Seven: Flattener #4 – The Energy Broadband
Pipelines open new markets
LNG and the globalization of natural gas
Storage bottlenecks and commodity islands
Shipping, floating pipelines and storage
Notes
Chapter Eight: Flattener #5 – Overcapacity
Déjà-Vu
Diplomatic demand outlook
Saudi Arabia heavy sour crude oil
Location, location, location
Pro-cyclical behaviour
Notes
Chapter Nine: Flattener #6 – Globalization, Industrialization, and Urbanization
Testing the hypothesis of “Ever-Increasing” demand
The “Diplomatic” demand clause
Notes
Chapter Ten: Flattener #7 – Demand Destruction
More with less
The “Invisible Hand” of efficiency
The “Visible Hand” of efficiency
Note
Chapter Eleven: Flattener #8 – Demand Displacement
The battle for transportation demand
What the production engineers missed
The “Challengers”
The end of crude oil's monopoly in transportation
The new frontier: hydrogen fuel
“Who killed the electric car?”
The battle for electricity and industrial demand
The energy domino
Notes
Chapter Twelve: Flattener #9 – Regulation and Government Intervention
The role of the government
Regulation vs. free markets
The virtuous mix of regulation and free markets
The vicious mix of regulation and politics
Carrot and stick
Privatization and deregulation are not the same
Independence of the regulator
The political cycle is too short
The war on pollution and coal
The war on pollution
The war on coal
Renewable energy and the disinflation of power prices
The world of wind power is becoming flat
The world of solar power is far from flat
Biofuels and Food Inflation
Notes
Chapter Thirteen: Flattener #10 – Fiscal, Monetary, and Macroeconomic Flatteners
The “OPEC put”
Energy consumption in producing countries
Mortgaged future production
The paradox of plenty
The oil tax weapon
Monetary experiments and the credit risk time bomb
Monetary experiments
Financial flows. Let's blame the speculators
Notes
Chapter Fourteen: Implications and Opportunities in the Financial Markets
Concluding Remarks
Notes
For A Competitive European Energy Policy
The Oil Price War: Another Chapter in the Mother of All Battles
Index
End User License Agreement
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Guide
Cover
Table of Contents
Begin Reading
THE ENERGY WORLD IS FLAT
Opportunities from the End of Peak Oil
Daniel Lacalle
Diego Parrilla
This edition first published 2015
© 2015 Daniel Lacalle and Diego Parrilla
Registered office
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom
For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please visit our website at www.wiley.com.
The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmit-ted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.
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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. It is sold on the understanding that the publisher is not engaged in rendering professional services and neither the publisher nor the author shall be liable for damages arising herefrom. If professional advice or other expert assistance is required, the services of a competent professional should be sought.
Library of Congress Cataloging-in-Publication Data
Lacalle, Daniel.
The energy world is flat : opportunities from the end of peak oil / Daniel Lacalle, Diego Parrilla.
pages cm
Includes index.
ISBN 978-1-118-86800-3 (cloth)
1. Energy security. 2. Energy consumption. 3. Petroleum reserves. 4. Petroleum industry and trade. 5. Energy industries. I. Parrilla, Diego, 1973– II. Title.
HD9502.A2L3325 2015
333.79–dc23
2014044969
Cover image: ©shutterstock.com/Madlen
Cover design: Wiley
Dedication
From Daniel Lacalle
To all my colleagues in the energy sector and decades of hard work looking for a better world, and in particular to those who passed away during geopolitical conflicts and terror attacks. We will never forget you.
To Patricia, Jaime, Pablo and Daniel, my parents, my brother, and his family. To all my uncles, aunts, and cousins who give and share so much joy. To all of them, my never ending source of energy.
From Diego Parrilla
To my wife, Gema, and my children, Yago, Lucas, and Carmen. My life and purpose in life.
To my father, Paco, and my mother, Nieves, my role models.
To my brother Paco, the best brother I could have wished for. My inspiration.
To my sisters Nieves and Marta, the geniuses of the family.
And, of course, to our sister Belen, our Guardian Angel.
Disclaimer
The opinions expressed in this book by Daniel Lacalle and Diego Parrilla are strictly personal and do not in any way reflect the opinion, strategy or philosophy of the firms they work or have worked for, nor should be taken as buy or sell recommendations
Chapter OneThe Mother of All Battles. The Flattening and Globalization of the Energy World
There is nothing permanent, except change
.
Heraclitus
At 2.46 pm on the 11 March 2011, the largest earthquake in the history of Japan triggered a giant tsunami wave that would change the energy world forever.
I was on a conference call in my office when the prices of the Japanese yen started to swing wildly. Something had happened. Shortly after, the news was hitting the wires: “Massive 9.0 Earthquake Hits East Coast of Japan. Tsunami Warning Issued”. While Japan had a long history of earthquakes, such as the Unzen earthquake and tsunami in 1792 that left a death toll of over 15,000,1 a tremor of 9.0 on the Richter scale was at a whole new level, and would make this earthquake the largest in the history of Japan and the fifth largest globally since records began in 1900.
Within minutes, a series of giant tsunami waves reached Fukushima Daiichi power plant. More than twice as high as the protective seawalls, the waves flooded the power station and damaged the back-up generation and cooling systems. The situation was out of control, and radiation was eventually released, making Fukushima the worst nuclear accident since Chernobyl in 1986, both rated level 7 on the International Nuclear Event Scale.
Nuclear politics
I immediately recognized Fukushima as yet another “black swan”, an event that has a very large impact that no one had anticipated before the fact, but that everyone viewed as obvious after the fact. The scale of the earthquake and the unfortunate series of events were unique to Fukushima, but lessons would be learnt and new processes and security measures would be put in place, as has always been the case when accidents and natural disasters have occurred.
But within days, and despite decades of safe nuclear power, countries around the world were closing down nuclear plants and rethinking their plans of extending the life of existing plants and building new ones. Politicians had taken over and were reshaping the future of nuclear power.
But not all countries reacted the same way. Fukushima did not change the position of France, which produces over 75% of its own energy needs from nuclear power. And it did not change the position of China either, which maintained its plans to build up to 70 new nuclear plants by 2020.
The nuclear world was polarized, but I was optimistic that common sense would prevail and that short-term knee-jerk reactions would give way to long-term constructive solutions and even safer power generation across the world.
There is, however, no doubt in my mind that Fukushima was a critical milestone towards the end of OPEC's dominance. Let me tell you why.
The sustained spike in natural gas prices
The close down of all nuclear capacity in Japan left a large gap in power generation that had to be filled by coal, natural gas, and crude oil.
The seaborne coal market was able to absorb the increase in Japanese demand with relative ease, but the much smaller market of seaborne liquefied natural gas (LNG) suffered a severe shock that sent prices skyrocketing.
Prices of natural gas in Asia more than doubled reaching over $20/MMBtu, equivalent to over US$110 per barrel of oil equivalent (USD/boe).2
Fukushima impacted other large Asian consumers, such as Korea, Taiwan, and China, who also rely on natural gas for their current and future power generation mix, reinforcing the perception that Asia would buy “unlimited amounts of gas, at unlimited prices”.
The imbalances could not be resolved easily, and the price of LNG for delivery to Japan stayed at an extremely high level for several years in order to direct any available LNG towards North East Asia.
In March 2014, three years after the Fukushima accident, and after extensive political debate in Japan, Japanese Prime Minister Abe announced his pledge to gradually restart nuclear reactors towards the end of the year, which will most likely ease the demand and domestic tightness of natural gas in the region.
However, the sustained high prices and optimistic demand expectations have been a major incentive to the development of new production and liquefaction capacity around the world. The list of producing countries and investments is long.
Look at Australia, for example, investing over half a trillion dollars in new LNG infrastructure to unlock large stranded reserves.
Or Mozambique, where local engineers in the mid-1990s were telling me how desperate they were to prove the large potential of the country, but where the perception among politicians was that it was not worth exploring. Ten years later, with the incentives of high prices and cooperation with international investors and companies, the country made some of the most important gas discoveries and infrastructure development in the region.
Or, even Cyprus and Israel, where large discoveries are putting them on the energy map …as producers!
Fracking and the collapse in US natural gas prices
While Fukushima created a demand shock and sharply higher global LNG prices, a quiet revolution had been taking place in North America for over a decade that had transformed the supply and drastically reduced prices of domestic US natural gas.
For decades, engineers knew about the vast amounts of natural gas resources that were trapped inside shale formations, but had not found a way to extract them commercially on a large scale. But the supply revolution which had started quietly in the Barnett Shale, Texas, in the early 2000s changed that.
“Not sure I told you before”, a senior member of one the largest sovereign wealth funds in the world told me, “I have a degree in nuclear engineering. My first job during the 1970s was to research the application of nuclear technology to extract natural gas from shale formations. It has taken a few decades, and a different technology, but I guess my fellow engineers have finally won”.
Indeed, production engineers had found a solution to unlock the gas trapped inside shale rock formations thanks to the combination of horizontal drilling and hydraulic fracturing. And the potential was massive.
The United States, once thought to be in critical shortage of natural gas, was now enjoying an abundance with enough supply to cover over 100 years of demand.
I remember the first time I heard “US energy independence is real”. It was in 2006, and I was meeting large oil and gas producers in Houston. I had endless debates about decline rates, lack of commerciality, environmental risks, the impossibility to replicate the success of the Marcellus Shale elsewhere in the United States, and other considerations. At that time the view was that shale gas would not be economical below$8/MMBtu and that decline rates would make the “fad” disappear soon.
But the reality turned out to be quite different.
By April 2012, following the unusually warm winter in North America, the price of US natural gas had fallen to $2/MMBtu,3 levels not seen for over a decade. The words of a good friend resonate in my head: “never bet against human ingenuity”.
The divergence in prices between North America and Asia had indeed been extraordinary. Exactly the same molecules of natural gas were trading at a 1000% premium across the world. The implications are deep, and go beyond energy markets.
Access to abundant, cheap, and cleaner energy has been an important contributor to the recovery and enhanced competitiveness of the United States relative to the rest of the world. On the other hand, expensive energy has had a negative impact on the Japanese economy and competitiveness.
Looking forward, the combination of political and logistical constraints may keep these extraordinary differentials for several more years, but this will not last forever. The markets are sending strong signals, and the response is simply a matter of time.
US tight oil
The shale gas revolution is not just about natural gas. It is also about crude oil.
The engineering feats of horizontal drilling and fracking have been applied with great success in the extraction of crude oil from shale-like formations.
The impact of this “tight oil” is very significant, and has contributed to the growth towards record domestic production in North America.
I was in Moscow in 2006 when a senior executive of a large national oil multinational told me “shale oil is a bluff”. I started talking about the rapid development in technology and reduction in the cost curve, and how the trend would make tight oil economical within three years at above $70/bbl. I could see he was getting agitated. “I will not see shale oil reach a meaningful level of production, and neither will my children nor my grandchildren”. And four years later, during a debate in Spain with some peak oil defenders who had never seen an oil field in their lives, I was told again “shale oil is a bluff”. Yet, during that time, the production in North Dakota had increased threefold,4 twice as much as what doomsayers said would be “the peak”, contributing to the record US production, now as high as Saudi Arabia. Yet, still today I hear the occasional “shale oil is a bluff”.
Geopolitics and high crude oil prices
The oil embargo in 1973 had taken everyone by surprise, changed the energy world forever, and shaped international politics and economics.
Energy security became a top strategic priority for governments around the world, who were using any tool at their disposal to reduce their dependency on Middle East oil.
The high prices of the 1970s displaced crude oil from power generation and industrial uses in favour of coal, natural gas, nuclear, and other alternatives.
But crude oil managed to maintain its monopoly over the transportation sector. Gasoline, diesel, and jet fuel are all derived from crude oil and have so far faced limited competition from other fuels such as natural gas and electric cars.
Consumers have tried to find cheaper and more reliable alternatives, but until recently they have not been available on a large and commercial scale. But things are changing, and quickly.
In the meantime, geopolitics has remained a major source of volatility and uncertainty, giving consumers an incentive to find alternative solutions.
In 2011, around the same time as the Fukushima disaster was changing the nuclear and natural gas markets, North Africa was involved in a geopolitical tsunami that would become known as “the Arab Spring”.
The events that started in Tunisia quickly spread across the region – Egypt, Libya, Syria, Bahrain, Algeria – in what seemed like an unstoppable geopolitical domino that would eventually reach the core of the Middle East.
I was supposed to fly to Riyadh in Saudi Arabia around those dates. During my career in the oil industry I have travelled to many live conflict areas – Sierra Leone, Nigeria, Colombia, Venezuela, and Jordan – and from the airport to the hotel to the meeting to the hotel and back to the airport,I have always been accompanied by bodyguards and a convoy of armoured cars. Sometimes it felt a bit excessive, but time would prove them right. During those trips I had numerous scares. Perhaps the worst one happened at the Sheraton in Ikeja, Nigeria, when we were woken in the middle of the night by gunfire as a mob was trying to assault the premises. Luckily the situation was kept under control, yet, as scary as it was, we had our morning meetings at the hotel the day after as if nothing had happened. However, this time, for some reason, it felt different.
The developments in North Africa sent crude oil prices sky-rocketing in response to both actual and potential supply disruptions.
But the consumer world was better prepared this time and started to trigger its defence mechanisms. The US Energy Information Administration (EIA) coordinated the release of 60 million barrels from its global strategic petroleum reserves, helping to calm and stabilize the nervous markets.
Luckily the situation was contained, and the largest producers such as Saudi Arabia were not impacted, and despite the ongoing disruptions in North Africa, prices moved to what felt like an unstable equilibrium at high but moderate prices.
What is important to note is that events that perhaps create the perception that the energy world is not flat, such as geopolitics, supply concentration, and the dependence on oil, are actually strong flattening forces that destroy those imbalances.
How? Well, for every geopolitical event and every issue of security, consumers have always reacted by building buffers and making contingencies, from storage, to demand destruction, to new discoveries, to developing new technologies.
In 2014, despite the ongoing supply disruptions from Libya, oil sanctions in Iran, ongoing conflicts and disruptions from Sudan and Syria, and a drastic reduction in Iraq volumes, the price of crude oil had a very moderate response.
Yes, geopolitics can result in higher prices in the short term, but invariably result in lower prices in the longer term. The net result: a flatter energy world.
Expensive oil, cheap natural gas
In 2012, the price of crude oil in North America was almost 10 times more expensive than natural gas in energy equivalent terms. Never before had the ratio between crude oil and natural gas been so wide.
The reason for such extreme divergence is that there is no direct mechanism of short-term substitution between them. As discussed, crude oil is mostly used for transportation, and natural gas for power generation and residential and industrial uses.
But how about the longer term? Is there a mechanism for substitution? Why continue to rely on Middle East oil? Why continue to feed our cars with petrol? Or with corn-based ethanol? Why not use natural gas for transportation? Exactly!
In North America, the abundance of natural gas reserves, a surge in production, and a steep price discount are incentivizing consumers to develop and implement technologies that use less oil and more natural gas.
The substitution is starting to be evident and will have major implications for the crude oil market.
I am amused when I hear people say that crude oil is untouchable or that the shale revolution will only impact North America. The revolution is global and has deep implications across energy sectors with many winners and losers, OPEC among them.
The market does not attack, it defends itself
One of the first lessons I learnt when I got involved in the world of commodities is that prices are both signals and incentives.
Prices signal imbalances and incentivize economic behaviour, as the market “defends itself”. For example, Fukushima created a positive premium that incentivizes the transport of natural gas to Japan. On the other hand, shale gas has created a negative premium for US domestic producers, while incentivizing the demand via the substitution of coal for power generation, or attracting petrochemical businesses back to North America.
The large price differentials across crude oil and regional natural gas are incentivizing the development of new infrastructure capacity such as liquefaction plants, pipelines, and storage.
Energy infrastructure is very capital intensive, and can take many years to complete. A new LNG project can easily cost from $5 billion to $10 billion, and take 5 to 10 years to complete. But once the barriers to entry are removed and the investment decisions are triggered and completed, the capacity increases inexorably, perhaps slowly, but surely.
And the greater the barriers to entry, the greater the price signal and incentives needed, often creating “super-cycles” or multi-decade round trips from shortage to glut and back to shortage.
Winners and losers
We are currently living through an extraordinary phase in the energy world.
History books will look back at this period of transformation, which will ultimately transcend into a new world order.
Those who depend on commodity price inflation to survive or justify long-term returns are in trouble, but a flatter energy world is not a one-way “price inflation versus price deflation bet”. The dynamics are complex and reach beyond energy markets.
But before we dive into the energy revolution, the flattening of the energy world, and its winners and losers, I would like to review the recent history of the internet revolution and dotcom bubble and the important lessons and parallelisms it can show for the energy markets.
Notes
1
National Geophysical Data Center.
2
Conversion factor from 1 million British thermal units (MMBtu) to crude oil barrel (bbl) is 5.8 MMBtu/bbl.
3
Bloomberg and NARECO Advisors.
4
US Energy Information Administration.
Chapter TwoLessons from the Internet Revolution and the Dotcom Bubble
Of all the things I have lost, the one I miss the most is my memory
.
Mark Twain
He who knows how will always work for he who knows why
.
David Lee Roth
I finished reading The World is Flat1 shortly after it was published. Four years had passed since the internet bubble had burst, and the word “dotcom” still carried very negative connotations. Many investors were left with a bitter taste.
It was easy to lose perspective of the bigger picture of what the internet revolution had done. It was easy to get lost in bubbles and valuations. But Thomas Friedman was an eye opener for me. His “post-mortem” analysis brought a new dimension.
The dotcom bubble had accelerated the impact of the internet revolution, and with it, the flattening of the world.
The internet has revolutionized the way we do business. But in the energy sector, not many things have changed. I suffered a few episodes of kidnap scares and terror threats when I was in the oil industry. We had to travel with an army of bodyguards and various vehicles and still, at least on three occasions, we were attacked by professional kidnappers aiming at the funds of the energy industry. One day, after a violent episode in Caracas, a colleague said “in a few years all will be done by video call and there will be no need for this”. Twenty years later, the energy business is still about meeting face to face …But technology and efficiency are gradually eroding peak pricing power.
The bubble path
This flattening, or equalization, of the world happened in two phases.
First was the “boom phase”, which took place during the 1990s, as a technological revolution led by internet, mobile, and broadband, had a major impact on productivity and growth expectations. Valuations were going up exponentially, based on growth expectations, not on profits. Traditional valuation methods, such as PE ratios, were largely ignored. A venture capital mentality had developed, where the potential winners would more than offset the losers in the portfolio. The cash piling in was used to acquire smaller promising businesses, feeding into the frenzy. Everyone wanted to participate and large amounts of capital flowed into the new industry. Pretty much overnight, the world was “wired” with fibre optics. High return expectations had attracted capital from other industries. A gradual build-up that might have taken decades, happened instead in a few years. The bubble had accelerated a process.
Second, and equally importantly, was the “bust phase”. Valuations had gone too far, supply had increased beyond realistic expectations. Bad news for profits. Valuations collapsed and many companies went bankrupt. The “paper valuations” disappeared, but the assets, such as fibre-optic wires, stayed. And thanks to the write-offs, they were now available at very low prices, pretty much free. The investor party was over, but the consumer party had only started.
During the following decade, consumers were the main beneficiaries of the IT revolution. Outsourcing on a large scale became a reality. Our IT specialist was now able to support clients in Los Angeles, with lower cost and faster turnaround.
The world was becoming more equal. It was becoming flatter. For the first time in history, talent had become more important than geography. The brain drain from emerging markets was reduced, in fact, it reversed, as many experienced emigrants returned to their roots and developed successful businesses at home that took advantage of the new opportunities.
The dotcom bubble had played an important role after all.
Technological revolutions that increase supply. The “game changers”
The technological revolution of internet, mobile, broadband, and other technologies of the dotcom revolution has changed our lives. There was a “before” and “after”. No question about it.
Likewise, the energy revolution of fracking, horizontal drilling, and other aspects are “game changers” that produce a “quantum leap” in the supply of oil and gas reserves and production.
The energy revolution is already a reality in North America, but its reach is global.
The demise of peak oil theories and doomsday predictions are clear side effects of the energy revolution.
Not only has the United States become one of the largest producers in the world with 11 million barrels per day, but also global oil production today is more abundant and diversified than ever.
The “call on OPEC” (the barrels needed from OPEC to balance the market) has remained at 29 million barrels per day for years with spare capacity exceeding 2.5 million barrels per day.2
With shale oil and oil sands, the reliance on imported oil has shrunk to decade lows, the supply–demand balance is stronger, and the geopolitical risk premium attached to oil prices has been dramatically cut.
Think about 2013. Despite large disruptions in Libya, sanctions on Iran, Syrian unrest, and Iraqi cuts in supply, oil prices barely moved more than $10/bbl from bottom to peak, averaging $104/bbl3 despite global recovery in economic growth.
In the rest of the world, public opinion and governments are divided about the energy revolution exemplified by fracking. Some countries in the European Union started out by banning fracking, and many others are still ignoring the full implications and potential of the energy revolution, or perceive it as an irrelevant force.
Part of the scepticism comes from environmental concerns. But think about the early days of offshore drilling. In the early 1990s, ultra-deep-water drilling faced fierce critics from the media and environmentalists. The debate then was very similar to today's debate for shale. The oil industry learned from the accidents and offshore drilling is now a safe and major contributor to world oil and gas production. Likewise, fracking and horizontal drilling are and will continue to grow in a safe and environmentally friendly way.
High expectations attract large amounts of capital
During the dotcom revolution, equity valuations of many companies implied exponential growth. The word “dotcom” had a “Midas touch”. Capital was flowing in, and new ideas, technologies, and infrastructure were able to raise funding with extreme ease, as investors and “venture capital” looked for the next golden investment.
As the “tide was rising” everything looked good. The internet revolution was a game changer. Some of the more established firms like Microsoft were in a strong position, but there were many small start-ups, such as Google, Amazon, and eBay, that have become large multinationals and showcase the reality of the new economy. But some others became major “flops”, such as pets.com in North America or boo.com in Europe. With the benefit of 20/20 hindsight, it is easy to see why the winners won, and why the losers lost.
The “euphoria” of the markets was no excuse to get involved in the wrong company or business, but also no excuse to miss out on the good companies and businesses. The opportunities then, and today, are enormous.
In the energy space, the energy revolution is facing similar dynamics. On the one hand, it has the potential to be a game changer, but not everything that goes up with the tide will be winners in the long run. Today's current extreme price differentials across regions and across fuels offer very attractive returns on investment. And the capital is flowing in and supporting large investments in infrastructure of supply, from exploration through distribution. Annual capital expenditure exceeds $750 billion.4 Look at exploration, with major discoveries in Kazakhstan, Israel, Cyprus, Uganda, Ghana, Mozambique, Brazil and Colombia, to name a few. Or LNG with major investments in Australia, West Africa, and Yamal (North East Siberia). Or look at the pipelines, expanding all across Europe and Asia. Or storage and trading hubs, such as Shanghai and Singapore. The “invisible hand” is responding to the incentives.
In the energy revolution, just like the internet revolution, there will be large winners and losers. There are some “energy Googles” and “energy pet.coms” out there. We do not have the benefit of 20/20 hindsight, but we do have the tools to analyse and understand the forces and dynamics at play.
As a senior member from the Central Bank of Spain once told me, “Trading is not a science. It is an art. But it helps to know a lot of science!” Very true.
Excessive expectations for demand growth result in overcapacity
During the dotcom revolution, expected returns were largely driven by assumptions of exponential demand growth. From telephone landlines to mobile phones. From shops to e-commerce. From regional to global. The potential for growth seemed unlimited. Invariably, many sectors built significant overcapacity. Among them, fibre-optic broadband infrastructure was one of the most critical.
Similarly, in the energy world, investment decisions are predicated on a view of “world energy demand growth”. Demand forecasts are based on “diplomatic” assumptions about global growth (which tend to be revised down more often than not) and where important forces such as efficiency or substitution are often underestimated or ignored. We know from the past that overcapacity is often the result of overly optimistic assumptions about the future. As Jim Steinman wrote, “the future ain't what it used to be”. Well, today's demand expectations seem to imply that “Asia will buy unlimited amounts of gas at an unlimited price”. Is the writing on the wall?
Furthermore, think about the impact of shortages in energy and infrastructure: “black-outs”, “brown-outs”, or simply long queues at the petrol station. Not good news for the economy. Worse news for politicians. The overcapacity of energy supply is therefore a desired state for consumers, which explains why, in addition to “private” investors, there is a strong centralized, planned, and strategic process driven by governments and state-owned enterprises. Look at China …
Efficiency is also proving to be a game changer, acting as a source of “demand destruction”, and often ignored in demand growth estimates. Think of global industrial output for example, which has increased by 2% per annum with flat energy consumption growth since 2005.5 The world is producing more with less energy. In the US gasoline demand has fallen every year since 2007 thanks to efficiency, as the light duty vehicles went from 20 miles per gallon to 24. The IEA estimates that improving efficiency to 34 miles per gallon could reduce global oil demand by 4%.
According to the International Energy Agency (IEA), greater energy efficiency could cut the growth in global energy demand by half. The accrued resources or “savings” from efficiency gains could facilitate a gradual reorientation of the global economy to higher added value investments and a gross domestic product (GDP) that is led more by the consumer than industry.6
We will continue to hear and read optimistic assumptions about energy demand growth. It hasn't happened since 2005, yet many anticipate that 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.
The strategic premium results in overcapacity
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.7
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 2006,8 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%).9 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.
Overcapacity eventually reprices assets and the cost of services
Following an extremely volatile period, the dotcom bubble finally burst in 2001. Equity valuations had collapsed across the board. Many companies went bankrupt. Others were not worth much more than the cash they had raised from investors. There were many winners too, who took advantage of the situation and expanded through acquisitions. Among them was Apple, who in 2000 acquired SoundJam MP and its team of developers. Apple simplified the user interface, added the ability to burn CDs, removed its recording feature and skin support, and renamed it iTunes. In October 2001, Apple launched the first iPod as “one thousand songs in your pocket”.
But for internet and broadband, competition and overcapacity made them available at a fraction of what had been anticipated. Bad news for the telecoms industry. Good news for consumers.
The future of the energy world is highly uncertain, but it is not unthinkable (in fact it is our base case) that the large development of “parallel” infrastructure will lead to a similar situation.
Commodity assets and prices are driven by marginal economics. Large imbalances between supply and demand can result in sharp swings in valuations, as producers know well.
The current energy revolution is relevant. Previous oil crises were largely “just about oil”. This time it is not only oil supply and demand forces competing against each other. This time we have new dimensions as natural gas, renewables, and other fuels become real threats to crude oil's relevance. With more options available, the impact of price spikes and peak pricing is eroded, preventing economic shocks. As such, despite constant global conflicts, the “oil burden” (the amount of money devoted by OECD countries to pay for imported oil) has not surpassed the “tipping point” of 5.5% of GDP.10
New technologies displace older and more expensive ones
The internet revolution was a game changer. It opened a whole universe of new opportunities that (for most people) were unimaginable, even at the peak of the market in 2001.
The success of the internet, Apple, and Facebook has left a long list of direct and indirect casualties across industries. Look at Blackberry or Nokia for example, once upon a time leaders in their sector, today at risk of disappearing. Or look at music-buying patterns. CD shops are history. Or think about the impact on the advertising industry, increasingly dominated by companies like Google and Facebook. Many newspapers are struggling as their advertising revenues via digital are a fraction of the print. Who would have said that 10 years ago?
The needs of the consumers are being addressed but they are being served and consolidated with superior and new technologies. The old and expensive technologies are dead (even if they don't know it yet).
New technologies increase competition and create deflationary forces
Thanks to the development and overcapacity in broadband, wireless, and applications like FaceTime or Skype, I am now able to have a live high-definition videoconference (voice and image) with someone across the Atlantic pretty much “for free”. Yet, a telephone call (voice only) would cost me an arm and a leg. “This must go down in history as a major inconsistency”, I keep thinking to myself. “I can eat and smell a cake, cheaper than just smelling it. This is crazy. Something has to give”, and it does not take a genius to figure out who the losers in this battle will be.
