The BP oil disaster in the Gulf set a new world record in out­pouring of rage from the media, the people, and Washington. Many investors dumped the stock, and BP dropped from 60 to 30. What should a financial analyst do? It’s likely that BP will be a pretty good stock over the next few years from its current depressed level because negative PR can only abate at this point and BP still has a gigantic asset base and profitable operations, but make sure your boss thinks so too before you write a buy ticket.

Energy

The final plugging of the oil leak was done by drilling a “relief well” to intersect the messed up pipe. This sounds like just an­other routine project, but the technological capacity needed to drill this relief well is quite amazing. I used to follow the oil and gas industry as an analyst in the 1970’s. In those days drill pipe routinely veered off course as the hole was drilled. If the drill bit ended up within 200 meters of its desired location that was considered just fine. The BP relief wells are intended to intersect an existing pipe, that means that the accuracy can be measured in centimeters. This is an extraordinary improvement in tech­nology.

Most drilling activity in the United States is now shale forma­tions such as the Marcellus in Pennsylvania. Many of the wells in shale formations are drilled as horizontal wells. The original bore hole is drilled vertically into the formation, and then the drill bit is turned 90 degrees so that it drills a horizontal segment that may extend 2,500 meters sideways. The same vertical hole can be used to drill several horizontal segments in various directions so that one well can gather gas from a very large area.

Deep water drilling and horizontal wells create profit opportuni­ties as technology makes it possible to exploit these oil and gas de­posits. But obviously they do not increase the total available energy resources of the planet.

Peak Oil

For many years, there have been a sizable number of geologists and analysts who believe that the oil fields of the world are close to peak production, and future annual production will decline. In March 2010, a paper was written at the College of Engineer­ing Petroleum at Kuwait University. The model estimated that the world’s ultimate crude oil production would be 2,140 bil­lion barrels, with 1,161 billion barrels remaining at the end of 2005 to be produced. The forecast was that world oil production would peak in 2014 at around 79 billion barrels per day. 2014 is soon. Despite the imprecision of this kind of forecast, this is a big deal, because even if the peak is in 2020 instead of 2014, that does not make any important difference in the history of the world. Any such peak is going to look bumpy and flattish and it’s always hard to decide whether it’s happened or not, but in any case, we can expect a big increase in the price of oil.

Water

There is an old saying in Colorado that “whiskey is for drinking, but water is for fighting over.” The majority of the earth’s surface is covered by water, but we cannot drink it because the ultimate pollutant of water is salt. You can’t drink the ocean. In February 2009, Leah and I participated in a visit to the Middle East orga­nized by the Chicago Council on Global Affairs. One stop was in Riyadh, the capital and largest city of Saudi Arabia. Our sta­tus was “guests of the king” so we were treated, well, royally. We had an escort of soldiers in four Cadillac Escalades, one in front of our bus, one behind, and one on each side. They cheerfully blew their sirens and traffic scattered at our approach, treatment fit for an emperor. Riyadh is a city of five million in the desert. The nearest body of water is the Persian Gulf, 400 kilometers away. Luckily, energy is very cheap in Saudi Arabia. Sea water is processed in desalinization plants using modern reverse osmo­sis technology, and then pumped through pipelines to the city. The third desalinization facility has just been built and is begin­ning delivery. The consulting engineering firm on the new proj­ect is ILF, an Austro-German private company. The new line is expected to provide 950,000 cubic meters of potable water per day (that is 264 million gallons per day). The power required to pump the water is 270 megawatts.

Making sea water drinkable takes enormous capital investment and enormous amounts of energy. One can say that the water crisis and the energy crisis are interchangeable. One of the best ways to gen­erate electricity is to let water fall from the top of the hill to the bottom of the hill through a hydro-electric generator. Alternatively, clean wa­ter can be produced from polluted or salty water by using electricity to run a desalinization plant.

Sustainable Energy

Five thousand years ago most of the energy consumed by man­kind was for food production. Sunlight, the basic renewable en­ergy source, made farms work. Agriculture also required a lot of water. Early civilizations developed in river valleys such as the Yangtze, Indus, Euphrates, and Nile because that was where the water was. Irrigation systems required leadership, coopera­tion, and therefore government. Religions started in river val­leys too. Early forms of agriculture lasted a long time. In 1776, Thomas Jefferson could look out the window at Monticello and see slaves working in the fields using horses and oxen as draft animals. King Sargon of Assyria saw the same scene 3,000 years earlier. Thomas Jefferson could not travel faster than the speed of a sailing ship or a trotting horse. He didn’t even have Face­book. Neither you nor I can make a plausible claim to be smart­er than Thomas Jefferson yet you think nothing of flying 1,000 for a business conference and flying home in time for dinner. The difference of course, was the Industrial Revolution. It was essentially about replacing the muscular labor of man and ani­mals with water power and then coal. For the first time people consumed more energy than their great-grandfathers had. Ma­terial production took off first as people made money, science and education soon followed, so that libraries, museums, and concert halls multiplied as well.

The mining and burning of coal created pollution problems early on. The peak oil theory is an iteration of the peak coal theory. That was worked out by the English economist Jevons, in his book The Coal Question written in 1865. Jevons tried to calculate the amount of coal reserves in Great Britain and the growth rate of coal consump­tion. He concluded that coal production would top out in 50 years. As it happened, the maximum production from British colleries peaked in 1913, 48 years from the book’s publication. If you think you can make a better 50-year projection for any economic variable, be my guest. Jevons made one important error when he assumed that the petroleum industry would never be an important energy source, even though Pennsylvania was producing commercial quantities of oil at the time he wrote The Coal Question. Nobody’s perfect.

There are a limited number of candidates for the role of energy producer of the future. Coal is still the major source of electric power despite its emission of carbon dioxide. Sustainable energy people would like to live in a world where coal use goes down, not up.

It is likely that in ten years oil production will be no more than it is now and on the way down. Natural gas is an extremely important energy source for the next 50 years because there is plenty of gas that can be produced easily. Gas will be very important but in another cen­tury, gas too, may get scarce.

Nuclear power ought to do well over the next 50 years, because it is the one available technology with decent economics and no carbon dioxide emission. However there is still substantial political opposi­tion to expanding nuclear, so I do not think that nuclear can expand fast enough to gain share versus other energy technologies. There is research work being done on nuclear fusion that would produce power without using uranium. That sounds good because uranium is also a depleting resource. The future of fusion power has been quite stable. Forty years ago, fusion researchers said that they would have a commercial fusion system in 40 years and today fusion researchers still say that they will have a workable system in 40 years. It would be a very good thing if fusion reactors could be invented. It is not an investable idea at this time.

There are some non-conventional oil sources that can be mobi­lized including tar sands and oil shale. Tar sands are commercial now in Canada and production will expand. Tar sand plants take a lot of capital and actually burn a lot of natural gas to extract the oil. Envi­ronmental damage by the industry is considerable. My best guess is that tar sands will be an important energy source in the future but will not produce more than 16 million barrels a day, which is only 20% of current world oil production. Oil shale has even worse problems in terms of capital costs and environmental damage, although if we get desperate enough, oil shale is available.

Now we get to renewable energy systems. These are hot items and fashionable to invest in. Included are hydro power, solar panels, windmills, biomass, and geothermal. These systems tend to have long range potential but short range problems. Let’s go through them.

Hydro power, a well-known technology, is a reliable source of electricity and does not emit carbon dioxide. The problems with hy­dro power include a shortage of potential sites for new large hydro systems, high capital costs, and environmental negatives. As an ex­ample, the Mekong River in Southeast Asia was one of the relatively un-dammed major rivers. It passes through many countries: China, Burma, Laos, Thailand, Cambodia, and Viet Nam. Each of these countries would like to have more electric power, but there are major problems in getting these countries to cooperate on a rational devel­opment system. There will be damage. For instance, Cambodia has a very large freshwater lake, Tanle Sap, which is the best freshwater fishery in the world. Some of the plans in development threaten the survivability of this fishery.

 Solar panels generate electricity and are being made by nu­merous companies around the world. The trick here is to increase the efficiency of the panels at an economically competitive level. So far, coal fired electricity is much cheaper than solar, so much so, that large government subsidies are required to keep solar in the game. Germany is an interesting example. Germany is not a good place to use solar panels because from October through March sunshine is unusual. After lengthy travels in Germany, my wife and I made up a curse. If someone aggravated us, we cursed them with “May you become a bathing suit salesman in Berlin!” However Germany had installed more solar panels than anyplace else because the government paid enough of a subsidy to make it work. Now most governments around the world are in fiscal crisis and Germany is planning to dramatically reduce its solar subsidy. That would reduce orders for solar panels in Ger­many by 100%. Other countries also scratched their subsidies. That suggests that solar stocks should be traded from the short side.

Windmills have some of the same characteristics as solar. High capital costs, free energy costs, and unreliable output. Not everyone loves them. Ted Kennedy was renowned for the obsta­cles put in the way of a proposed wind farm offshore Cape Cod. And he was a fervent environmentalist until someone suggested putting up a wind farm that could be seen from his living room window in Hyannis. The same problem of disappearing govern­ment subsidies affects wind as well.

Geothermal falls under the comprehensive list of energy sources and seems to work well if you have an available site, but there are only a few good sites in the world. The best site in the United States is Yellowstone Park and I do not think the Ameri­can people are ready to turn Yellowstone Park into an industrial park.

Biomass has always been an important source of energy. Many underdeveloped societies burn wood or dung. The biggest application of biomass has been ethanol converted from corn. You can run a vehicle on ethanol or an ethanol-gasoline mix. The catch is that production of ethanol takes as much fossil fuel energy as the ethanol contains (fertilizer, diesel fuel, and distill­ing). And it is widely believed that the ethanol industry is not economically viable but it must be considered part of the farm subsidy program. You may remember that biomass stocks were very hot for a couple of years and then crashed.

Wiser

Sustainable energy issues are very important to me. I have con­tributed substantial time and funding to the Wanger Institute of Sustainable Energy Research (WISER), at Illinois Institute of Technology in Chicago. WISER will support sustainable energy research and train engineers to apply the solutions which have been developed. It would be wonderful if you think that the sustainable energy question is crucial and contribute time and money to an institution of your choice.

Ralph Wanger, CFA, Senior Advisor,
Wanger Investment Management, Inc.