The Energy Effect

Energy-Effect-Oil-In 1933, expectations were high when Standard Oil secured the first contract to drill for oil in Saudi Arabia. By October 1973, the situation was much different when the Organization of Petroleum Exporting Countries (OPEC) increased oil
prices by 130% to the United States in reaction to America’s support of Israel during the war with Syria and Egypt. This event eventually escalated to a total embargo of oil to the U.S. from OPEC that lasted over a year. While this is just a distant memory for most people, the embargo touched off a series of regulations, concerns, and reactions that impact the energy market to this day.

In reaction to the embargo by OPEC, congressional leaders made a series of steps to protect U.S. interests and reduce dependency on foreign energy sources. One of the pieces of legislation designed to rectify the problem was to prohibit exports of oil from America to foreign countries. This was supposed to keep the limited domestic oil supply within U.S. borders. An unintended consequence of the legislation was a dramatic private sector reduction in capital investment designed to modernize shipping ports that were equipped to handle energy exports. Infrastructure expenditures to transport energy related products, such as natural gas pipelines were also reduced. Congress believed that a scarce resource needed governmental protection, especially one tied to national security. People were scared. Future economic growth was threatened because expansion without energy was believed to be impossible.


Energy-Effect-PlateauMany of the pre-2010 projections were based on a concept called Hubert’s Peak. The general idea is that once 50% of oil reserves are extracted from an underground oil source, extraction rates begin to fall, driving up extraction costs and, eventually, lowering supply. In 1972, it was estimated that there existed 30 years of world oil supply before Hubert’s Peak was reached. America had already reached, and passed this condition. What was going to happen in 2003, 30 years down the road? Continued economic growth was in question. Inflation was feared so much that governmental price controls were implemented. Energy was quickly becoming the most important factor in the future development of the world’s economy.

Energy-Effect-ProductionOver the next four decades, efficiency and alternative energy efforts were launched, and re-launched, and many were abandoned. Energy efficiency initiatives were implemented, some through forced legislation. Criticisms were heaped upon foreign nations that were not using energy efficiently, or worse, polluting the environment. Many of the solutions focused on reducing the immediate supply fear and political objectives while ignoring the true long term conditions of energy consumption. In this article, I will be attempting to provide a long-term, rational, non-political view into the future of the energy market and how it will impact global economies, markets, and related investments.

Let’s touch on the first misconception that energy resources are going to exhaust themselves and, essentially, leave everyone in an economic freezer. The “Production” chart shows the dramatic decline of oil once Hubert’s Peak is reached. Originally, this was expected to occur shortly after the turn of the century. We will give the forecasters the benefit of the doubt, and recognize it is difficult to accurately predict the exact amount of oil within ground reserves. However, all of these forecasts were developed assuming no new beneficial technological developments in exploration or refining and little improvement in efficiency.

Anyone who has read a newspaper knows there is now an ample supply of energy raw material located throughout the U.S. through the recent efforts of “fracking” and horizontal drilling. Many times it is referred to as shale oil reserves. The “Plateau Concept” chart shows how these discoveries dramatically changed the reserve forecasts.

This is very different from the predictions of steadily declining resources that were to start dropping in just a few years from now. Using the advanced technologies of fracking and horizontal drilling are not just benefitting the United States. Shale based oil reserves are found around the world, including our neighbors to the south in Mexico and South America, as well as in Africa, Australia and China. China holds the largest reserve level at 36.1 trillion cubic meters, almost 48% more than the U.S. reserves.

Energy-Effect-Gloabal-Shale-Gas

It is fairly clear that the U.S. will not be oil energy constrained going forward, at least well into the late 2050’s. Taking into consideration the, abundance of newly discovered natural gas and a 300-years’ supply of coal, The U.S. will not lack a supply of energy for economic growth. Exploration has been so successful that in May of this year, crude production reached a 28-year high. The U.S. has not witnessed these levels of production since 1985. Output has risen to 8.4 million barrels per day. This has made a significant dent in the country’s ability to be the supplier of domestic demand such that 87% of all domestic energy requirements have been met by domestic supply.

Currently, there is an oversupply of energy resources in the country that is being complicated by legislation passed back in 1975 which effectively prevents the exportation of crude oil. This has created the current situation in which crude exploration has expanded faster than refining, causing inventory buildups.

Most people interact with the energy market at the gas pump for their car or truck and in the winter time when it is time to start paying for fuel oil, propane, or natural gas. Even firewood’s price is related to the price we pay for energy to heat our homes and power our vehicles. Most people expect the price of these items to have some relationship to supply and demand. We often see prices for gas increases when there is a disturbance in the supply of crude oil due to a port closing or political disturbance in some part of the world. When the Strait of Hormuz was under threat of being shut off for shipping, there was an overnight increase in gas prices. This appeared to make sense because nearly 17 million barrels of crude passes through this area.

If the Strait were to be cut off, it would be rational to think prices should increase because supply would be reduced. Surprisingly, the true, long-term cost of crude oil has little relationship with these events. While occurrences that potentially could disrupt supply or refining impact short term prices, the real-long term, influencing factor is the stock market. The stock market is a general mirror of the economy, and when the price of oil is placed alongside the price of the market index, there is a very high correlation.

Energy-Effect-Oil-FlowNotice the strong correlation between oil prices and the market that has taken place since 2009. During this period there have been numerous geopolitical surprises in oil supplying countries, expansion of reserves and production in America, an overall increase in supply available for refining, and an increase in the known oil reserves. However, at the end of the day, movement in the market, which is driven by the economy, has generally determined the reason for continued increases in the price for oil based energy.

When energy prices are discussed the conversation always moves to, are we paying too much? The overwhelming answer is always, yes. But, are we really paying more than we did historically? Are the oil companies exploiting us because they control the vital resource? We already know the price for crude has move nicely along with the economy. It would be hard to charge oil companies and their related suppliers with accusations of gouging when prices so highly correlated to economic growth. After all, economic growth does not take place without the energy to move it forward.

I am old enough to remember filling my gas tank with high test (premium) gas for 25 cents per gallon. I also remember making a vow that I was going to stop driving if gas reached $1.00 / gallon while waiting in line on an even day of the month to fill my tank. Or, was it the odd day? I usually had to check the license plate to make sure whether it was my day or not. I didn’t want to be the one who cause a ruckus at the service station. (Yes, there was actually service, not food, at the gas station back then.)

Are we paying too mEnergy-Effect-5uch for fuel? I can’t say whether we are paying too much, just the right amount or too little. What I have determined is that we are paying about the same today as in 1982 when adjusted for inflation. No one expects to pay 25 cents for a loaf of bread, or $5.00 to go to see a movie. We are only paying marginally higher for gasoline than the long term inflation adjusted average.

Oil appears to be reasonably priced, based on historical averages, and the continued increase in known reserves, extraction advances, and refining improvements will most likely keep us all well supplied in this vital energy resource. While we will experience disruptions in the supply throughout time on a short-term basis, it is doubtful supply and pricing will be damaging in the long term. Energy stocks such as Exxon, Conoco, BP and Shell will probably be around a long time, conducting business and paying out regular dividends.

Oil is not the only energy resource the world requires to keep motoring along. We have come a long way since cars moved along getting a whopping 15 to 16 mpg. Now, even new diesel engines are emitting virtually zero emissions when using DEF additives. Even with these improvements, oil remains a concern long-term from the accumulative side-effects of carbon emissions. Alternative energy sourced supply is a long way off before it can be considered a reliable and effective resource. Two of the most promising technologies are wind and solar power. At the current accelerated pace of implementation and development, solar and wind will not be able to significantly contribute to economic development until 2110; just short of 100 years. This estimate by the IEA takes into full consideration that

  • The U.S. is continuing to advance the widespread use of alternative energy sourcing and continues to move rapidly in using existing fossil fuel with greater efficiently.Energy-Effect-2
  • European countries such as Germany advance along the alternative energy resourcing curve where new power plants are solar based and the country is setting an example for the world in efficient energy usage. Germany now gets more than 50% of its power from wind and solar sources.
  • China, one of the largest users of fossil based fuel, is also THE world’s leader in moving forward with solar and wind power implementation. In fact, China is currently implementing wind and solar sources three times faster than any other country.
  • Saudi Arabia is investing over $100 billion (US$) into solar so that that the country will be nearly 100% solar by 2030.

Even with these advancements there are some concerns with the reliability of solar and wind alternatives for America. In areas such as Washington and Oregon, zero wind conditions can exist for 14 days without interruption, preventing any power generation. No one currently has the technology to build energy storage to cover a two-week period. Solar has a similar problem where in many parts of the world, non-generating periods (cloudy days) can cover hundreds of miles for seven to ten days. There is also a cost differential currently that makes widespread use of solar and wind difficult. Since we need the fossil fuel backup to solar and wind for when the climate does not cooperate, a fast build out of solar and wind facilities, using current and near-future technology, would end up costing double the current cost to provide electric service. The $100.00 / month electric bill would end up costing $200.00 / month, or more, and be the most constraining on the least able to afford the increase. Economically, it would be a disaster and you can’t just tell everyone to wait and hold onto their plans for 100 years.

One of the most misunderstood energy sources is coal. Currently, coal produces 40% of the world’s electricity, and the percentage is increasing. Why would what is supposed to be the most environmentally-damaging energy source be expanding? Why not just build more alternative energy facilities?

There are 7,000 coal fired power plants in the world today of which 600 are in the United States. The U.S. has gone from 49% coal to 39% since just 2007 with demand for coal generated energy dropping to the lowest level in 25 years. However, in other parts of the world, demand for coal is increasing at the rate of 2.3% annually, at least through 2018, the next four years. Coal is currently the fastest growing energy source in the world and the second largest energy source, just behind crude oil.

Seventy-five percent of China’s electricity comes from coal. At the same time the country is implementing wind and solar energy facilities three times faster than any other country. Half of all the world’s steel production and cement production originates in China. Steel is smelted in a blast furnace that requires coke, a solid fuel made from burning coal in a low-oxygen environment. It is an important part of the chemical process to make steel. You can’t make steel without coke.

China is not the only country that is both advancing alternative energy and increasing its use of coal. Germany opened more coal fired power plants in 2013 than in the past 20 years; it is not just these rapidly developing nations that are dependent upon coal. Poland generates 86% of electricity from coal. This is happening on a global basis with 1,200 new coal plants proposed for construction in 59 countries right now. Environmentalists are strongly opposed to expansion in the use of coal. Of all of the current energy sources, it is the most damaging to the environment, but why is it expanding so rapidly?

Alternative energy power generation cannot keep pace with the expansion in demand for energy. IEA estimates that China alone will need twice the energy supply it consumes today by 2040, even with efficiency improvements. China imported 360 million tons of coal in 2013 and is expected to increase to 550 million tons by 2054, even with the rapid deployment of alternative energy generation capabilities. Demand at these levels places a different picture than huge surpluses on energy supplies even with the new shale extraction processes in place. It is not a shortage, but a normal, real long-term increase in demand.

Without coal there exists the strong potential for economic damage created through escalating energy costs. The global economy could easily begin to suffer from escalating demand levels for items such as steel, cement and electric usage resulting in higher prices for these critical items. This could quickly lead to rapidly increasing raw material prices on a global basis. It would be the most damaging to the nations least able to afford the price increases. In some cases, economic expansion would stop in these areas due to infrastructure development projects becoming too expensive. Highways, bridges, airports, train stations and other vital infrastructure projects would be too expensive.

While the economic benefit of coal requires expanded usage, there exists an unquestionable economic damage to the environment. The answer to this problem potentially lies within using the resource in an environmentally friendly manner. If this could be done, it would provide more time to the development of alternative energy sources.

Currently, Peabody Energy (BTU) and Huaneng Group in China have developed GreenGen which is also known as CCS. This is a coal refining process that emits zero pollution into the atmosphere. The first CCS power plant started generating power in 2010. The process is advanced enough that coal raw material can be turned into a fuel source which can be used in automobiles.

Energy-Effect-2

Canada is starting construction on a CCS power plant now. IEA recommends launching 20 large-scale CCS demonstration facilities to encourage nations to adopt the new technology.

Many things are changing on the energy generation and demand landscape over the long-term. The forecasted demand for energy has not changed that much; there has always been steady growth on a global basis. However, we have moved from a concern over oil supply scarcity that started in the 70’s, to one of ample, almost surplus supply. Alternative energy sources are coming on-stream and expanding at a rapid rate. Evan coal, one of the oldest sources of energy has advanced to a level where by-products can be disposed of in an economically and environmentally friendly manner. These are conditions that were not even imagined possible in 1973. All of these advances are bring about a better environment, than previously, while allowing economic expansion without the restrictive economic penalty of resource scarcity. These advances will provide the potential for consistent and economical energy resource supply for a smoother economic path. Now, if we could just get the geo-political arena to move along the same smoother path?

By | 2014-08-22T13:14:16+00:00 August 22nd, 2014|Categories: UI Journal|Tags: , , , , , |0 Comments

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Articles attributed to "Guest Contributor" are written by former employees or invited guests. Contents are for your consideration only The opinions expressed herein are those of the authors and do not necessarily represent the views of Charter Trust Company. Nothing contained in this communication should be construed as investment advice.

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