When on Wall Street, we made predictions for a living. We tried to predict the implications of events (which we also had to predict) on stock and bond prices, act on these predictions, and the key to success was to be right more often than wrong. Predicting long term trends was the best career strategy because it took a long time before the recipient of the advice could tell how good it was. So, with an active war under way, a heat dome frying the South and West, the US Congress unable to pass a defense budget, and Saudi Arabia now focusing its attention on golf, we decided this is the time to look ahead. Not at the weeds but at the big picture. So here are a few summer basics for a portfolio (meaning physical assets as well as stocks and bonds) focused on energy and climate.
- Infrastructure— There is massive spending ahead. Not just to decarbonize energy production, but to protect existing infrastructure from climate change, and also to rebuild Ukraine, accommodate migration of population fleeing war and climatic incursions on their environment. This means rising demand for metals, iron ore, cement, not just the rare metals that currently get the attention. Except this time around, buyers may demand the low carbon versions of the product, not the cheaper one from China, which could push up demand for carbon capture and sequestration and for hydrogen, in order to lower the carbon input and output at steel mills and cement plants.
2. Product standardization— Product manufacturers and their suppliers cannot achieve economies of scale if they employ different standards and equipment in each market. It is like the dilemma facing auto manufacturers who can choose to manufacture separate models for the higher emissions standards set by California, or build one higher standard model figure and achieve economies of scale. Similarly, we expect more products to meet low carbon standards even if not required by local politicians. Products not in line with, let’s say European or California standards, probably will have a short shelf life.
3. New products, resources and processes— Researchers, financiers, developers and geologists are hard at work on an amazing array of research: small nuclear reactors, fusion, superconductors, gold hydrogen, geothermal energy, solar power satellites, new air conditioner technology, better solar cells and even better batteries. Picking the right technology will not be easy. However, watch out for the establishment spokespersons who tell you why something will not work commercially. The first unit of any highly researched and intensively manufactured product is always prohibitively expensive. Instead heed the advice of Watergate’s Deep Throat and “Follow the money.”
4. Fixed costs— Most new technologies have low variable and high fixed costs. That matters to both investors and competitors. Industries with high fixed costs have difficulty operating in a competitive environment because competitors can lower prices to just above variable cost and keep going, which means companies in the business keep producing but earn no profits. Smart investors are reluctant to put money in such a business unless the company has some sort of contract or regulatory protection to keep prices well above variable cost. So, we expect most of the new investment to be made on contract or under regulatory guarantees. If not, beware. Second, outside competitors, who have high variable costs, need to
understand that the new firm, if pressed, has the power to reduce prices drastically and still stay in operation, making it a formidable competitor. (If this discussion puzzles you, read a text on regulation, or better still, J.M. Clark’s classic and eminently readable , The Economics of Overhead Costs. But do not walk away ignorant. This is a vital point.)
5. Food— War and climate change are bound to affect food supplies. With some land put out of production, demand for fertilizer could grow. And here is the problem. Nitrate fertilizer requires ammonia. Ammonia looks as if it will become a feedstock for industrial processes and a fuel. And ammonia production requires hydrogen. Could this turn into an energy vs food dispute unless hydrogen and ammonia producers build capacity fast enough?
6. Consumption less than expected— Beware projections of demand for energy. Electric cars of the future will use less electricity. Ditto for air conditioners and other appliances like electric stoves. Solar cells will produce more power per unit of solar energy. The projections of usage will almost certainly be too high especially since low hanging fruit like demand side management remains to be fully utilized. Thus, pressure on energy producers should not be so great that they cannot handle the demand. As it is, projections are not beyond what has been the case in the past. If there is any investment message here, it might be that the energy companies might overbuild just as consumers relearn the virtues of conservation. This is not a possibility that we previously considered. But it may shift investment opportunities to firms that sell the more efficient product first.
On the whole, we see enormous opportunities. Not so much in the legacy firms that will sell the energy to ultimate customers, but in the developers and suppliers of the new products and of the infrastructure without which not much will work.
By Leonard and. Hyman and William I. Tilles
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