The published inflation data are surprisingly unsophisticated in so far as they compare current prices with a snapshot a year earlier.

Just over a year ago, oil was every hedge fund manager’s favorite speculation. In summer 2008 a barrel got to well over $140, before falling sharply back.

That summer’s high oil price had the effect of canceling out the deflation which was occurring elsewhere in the economy, as the first phase of the credit crunch started to bite. It helped keep inflation up.

But by summer 2009, after hitting a trough of $30, the price was back down around $65 representing an annual fall in the oil price of over 50%. Now it was keeping the inflation figures down. Oil would continue to be below the price of 12 month previous throughout the period from January ‘09 to September ‘09.

Now – in the fall of 2009 – prices are more or less where they were a year ago, but 12 months ago they were falling fast, while now they are rising. So for the first time in over a year the effect of oil prices in the inflation figures, in October/November 2009, will be up again. And by January, even if prices don’t continue to rise from here, the low prices of winter 2008/9 will form the base. Oil will again be at twice the price it was a year earlier. This will have a marked impact on inflation data.

It’s not only the energy markets that threaten the “low inflation” data currently encouraging bondholders to continue buying government debt paying little more than 3.0% per year. There are well over two billion Chinese and Indians who used to make the unwelcome but necessary market adjustments on the demand side when world grain prices rose:

Some 30% of the world’s population went hungry.

Until the current decade, that was an important part of how world demand came into line with dips in world food production, before big price rises would cause Westerners to feel the sharp pain of a world food shortage. But this has now changed, and permanently.

The wealth and dollar reserves of the Asian countries are now large, and their people are not going to go hungry in future (and quite right, too). Instead they will be competing on world markets, and the price of grains will start to show the very sharp spikes associated with unreliable supply and a newly inelastic demand in critical commodities.

You may remember the food riots of early 2008, and how they seem to have disappeared. Well, that occurred after a small dip in world grain production in 2007. Fortunately, by its end, 2008 had turned into a bumper year for the global food harvest and a serious crisis was averted. That bumper harvest brought global food prices down again – but for how long?

Rice gives us a hint of the nature of price movements we should learn to expect. From a stable base it spiked viciously upwards (by 300% and more) as it sucked in speculative money during the 2008 panic. But when it fell back as panic subsided, it still remained twice the original base level. It is from here that the next upwards spike seems to be starting.

In a similar pattern sugar has already started to cool off a bit, but pepper is in the earlier stages. At the end of August ‘09 it rose 17% in a week on news of a poor crop arising from adverse weather in South East Asia.

Unlike camcorders, food is not a discretionary purchase and under the harsh law of marginal utility – together with the new inelasticity of Asian demand – even modest food shortages will cause sharp price spikes, and maybe more riots, which indeed started to appear in Asia in September 2009, with tragic consequences.

When necessities are in short supply people behave in the opposite way to normal. Instead of reducing demand they tend to panic and stockpile food for safety, perversely increasing demand on those higher prices…

Regards,
Paul Tustain
BullionVault

October 13, 2009

The Price of Oil and the Inflation Time Bomb of Autumn was originally featured on Whiskey and Gunpowder

Drivers in the U.S. no longer determine the global price of oil. So oil prices can remain high despite a weak labor market — as we saw in the 1970s. If this winds up being the case, it’s bad news for owners of financial and consumer stocks and good news for owners of energy stocks.

Andy Xie, formerly of Morgan Stanley, is a great strategist who, while most other economists sought to justify the housing bubble, warned of the unsustainable U.S./China vendor finance trade model that grew so rapidly between 2001-2008. He recently wrote an article for Caijing magazine on the factors that might drive oil prices in the future. He writes:

Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.

Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange-traded funds individually or in baskets of commodities.

Oil is uniquely suited as an inflation-hedging device. Its supply response is very low. More than 80% of global oil reserves are held by sovereign governments that don’t respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.

Xie’s entire article is worth a read. You can find it at this link.

The Chinese government is sending strong signals to its banking system that it wants lending to slow down from its blistering pace. It remains to be seen whether this will actually result in a contraction in Chinese bank lending or whether lending may just shift from one sector to another. If I had to guess, I think oil prices will have a sharp correction this fall as Chinese stockpiling slows down and as oil and refined product inventories remain more than adequate to meet sluggish U.S. demand.

But this correction will offer trading and investing opportunities on the long side. As you see in the two charts below, the linkage between oil prices and U.S. inventories during the entire post-2002 bull market was not as close as you’d expect:

Here’s why I think a correction in oil prices will offer a buying opportunity: Inflation fears and stabilizing in global demand are not the only reasons the price of oil has doubled from its lows. Oil prices are up because the marginal cost of new supply — including from Canadian tar sands and from under thousands of feet below the ocean surface — is so high.

To Andy Xie’s important point about oil as an inflation hedge, I’d add that OPEC planners understand that they are trading a scarce, extremely energy-dense, nonrenewable, depleting asset for paper money. They also are beginning to grasp that indebted oil importers plan to ease their debt burdens by employing the heavy guns in the inflation arsenal: “quantitative easing.” So their portfolio preferences will shift away from government paper and toward retaining scarce oil in the ground for future revenues. In other words, “Why should we trade oil for dollars now if we receive higher prices five years down the road?”

This is just one of the many intricacies governing how the global oil market operates, and it helps explain why those who are perpetually bearish on oil prices waited for years and years for a rational, free-market supply response to higher prices that never arrived in force. That is, until last fall’s panic brought demand far enough below supply that prices crashed. Now, the conventional wisdom says that several million barrels per day of spare OPEC capacity will keep a lid on prices for years. We may discover by next year just how quickly this alleged spare capacity will come back online, and at what price.

The question then becomes why should national oil companies rush into the risks of making the enormous capital investments necessary to maintain production — let alone grow production. Nancy Pelosi and Ben Bernanke are not promoting policies to make energy cheaper; in fact, their playbooks virtually ensure the opposite. Privately owned exploration and production (E&P) companies that take smart risks will be the ones that deliver more supply at lower prices to help ease supply constraints.

Now, when you consider how the U.S. economy currently functions, you come to understand that rising energy prices induce enormous headaches for practically every consumer and business. Call rising energy prices a “deflationary force in the real economy” if you like. The point here is the irony of the situation: The Fed and Treasury are trying to reinflate a deleveraging private economy, and much policy could wind up accelerating the deleveraging process by adding pressure to the prices of nondiscretionary items like food and energy. After all, these are both global commodities, and capacity in these sectors is tighter than most market participants realize.

Bottom line: There is no easy, painless way out of a credit-financed asset bubble that artificially pumped up consumption. This artificial growth in consumption prompted entrepreneurs to misallocate resources into unproductive sectors that were temporarily pumped up by what looked like sustainable demand. Meanwhile, there are many sectors, including oil and gas, that have been underinvesting relative to the long-term global demand for mobile, modern lifestyles.

Sure, oil prices could correct sharply this fall as traders panic about a temporary glut in aboveground supply at storage terminals. But to use manufacturing terms, it’s the “raw material” and “work in process” inventory that really matters. That type of inventory, sitting higher up in the supply chain, is much tighter than the “finished goods” inventory sitting in storage terminals like Cushing, Okla. I expect we’ll see this tightness reflected in prices by 2010, even if demand remains stagnant.

Production capacity in oil and gas looks plentiful right now, but capacity naturally falls every year, and requires hundreds of billions in global capital expenditures just to keep supply steady. According to an exhaustive analysis published by Neil McMahon of Bernstein Research on Aug. 10, non-OPEC oil supply will keep declining in the coming years, despite healthy levels of investment. Outside of OPEC (where information regarding capacity and investment plans is murky at best) explorers are targeting smaller formations, as production from giant, decades-old fields declines. McMahon writes:

In the long term, we believe that oil prices will increase in line with the marginal cost of supply, which continues to rise as the complexity of new wells increases and production rates from established fields decline. Basically, not enough significant discoveries have been made in non-OPEC countries in recent years to help the supply situation before 2015. Additionally, flow rates from the few discoveries that have been made do not give rise to much optimism and, as in the past, the drop in absolute oil demand will be offset by rapidly declining mature field production with the recent fall in industry spending. So the continued decline in non-OPEC supply will provide an additional support for prices, as it feeds through to OPEC spare capacity. We believe that 2010 will see the next inflexion point in prices, as OPEC spare capacity begins to decline and demand shows positive growth for the first time in a number of years and we expect to see oil average $80 in 2010, $103 in 2011, $111 in 2012, and increasing to $140 in 2015.

You can imagine what this type of price trajectory will do to U.S. businesses that rely on cheap fuel, and have no ability to push through price increases. Considering how many more trillions of U.S. dollars will be floating around the global economy in 2015, and savers’ willingness hoard them declines, $140 per barrel might be conservative.

Global oil production capacity, rather than demand, will eventually drive prices. Bernstein projects 2020 oil production capacity will be about the same as it is now: 85 million barrels per day. We must consider net exports too; the global trade flows of this oil will certainly change. Over time, more tanker shipments will be diverted away from the U.S. and Europe and head to Asia. Also, in recent years, OPEC countries have been consuming more of their own product at home. Plus, the Chinese government has shown that it will beat any and all comers in the competition to secure supply under long-term contracts.

Regards,
Dan Amoss

August 28, 2009

Inflation and Oil Prices: Our Next Move was originally featured on Whiskey and Gunpowder

By August of last year, the price of oil was retreating, and it was a hard slog on the way down. By midwinter, in December 2008 and January 2009, oil prices were in the $30s per barrel – a drop of over 75% within six months. It was a wild ride.

Natural gas had a similar rise and fall last year. In July 2008, the NYMEX price for natural gas was around $13 per mcf (thousand cubic feet). By October 2008, that price was cut in half. In fact, natural gas prices trended down throughout the chilly winter of 2008-2009. The current economic pullback – our Great Recession – means that many industries, as well as the electric power sector, are using less natural gas. Think of the mills, plants, factories and other industrial and commercial sites that have scaled backor closed. They don’t need nearly as much natural gas or electric power.

Thus, energy demand has tumbled in North America. The price of natural gas has fallen, and hard. For a while this spring, gas prices couldn’t find a bottom. It’s only been in the past two months or so that the price of natural gas leveled off at around $4 per mcf.

Right now with natural gas prices under $4 we have an extraordinary opportunity! $4 natural gas is the equivalent of $30 oil – it just won’t last.  Better yet, I’ve got the perfect way to play this trend – a company that could hand you as much as 340%.

But before we get to the company I’m talking about, let’s take a look at what happened to natural gas drilling…

Drilling Activity Dropped Off a Cliff

Along with the price collapse for oil and natural gas, there was a dramatic worldwide drop in the count of drilling rigs. Drilling activity scaled back precipitously, in a tumble reminiscent of the previous hard times in the oil patch back in 1981 and 1982. Here’s a comparison between then and now.

If you want more exact details, here are the most recent rig count numbers from Baker Hughes, the world’s preeminent drill bit manufacturer.

Look at that change from last year! In North America – the U.S. and Canada combined – the rig count just plain fell through the floor to a recent level below 1,000. (It has crept up to 1,065 in the past couple of weeks.)

With low oil prices, there was less drilling in the U.S. and Canada, of course. But look at the international rig count. It’s interesting that the international count didn’t drop off all that much over the past year – only about 10% or so, as opposed to a drop of almost 60% in North America.

Why the difference between North America and internationally? The big pullback in North American activity was in rigs drilling for natural gas. That is, over half the drilling activity in North America is for gas. It’s different in the international arena, where most rigs are drilling for oil.

The bottom line is this…

The low prices for North American natural gas didn’t support drilling, hence the massive North American rig pullback. Also, much of the North American gas drill-out of recent years was financed with borrowed money. And the credit crunch froze almost all of the funds that were going into the North American gas-drilling sector.

So less demand led to lower natural gas prices. Lower prices could not support the financing model for the North American gas-drilling business. The easy money for gas wells dried up. And the rig count plummeted. Now what?

The Rig Count Has Found a Bottom

It looks like the worldwide rig count has found its bottom in recent weeks. In fact, the numbers are creeping up a bit, according to Baker Hughes. What’s going on?

Since February, the price of oil has steadily crept back to the $70 range per barrel. That’s up 100% from the midwinter low. The oil price increase clearly supports more drilling.

Why are oil prices up? Here are a few reasons. Cheap oil last winter led directly to lower fuel prices worldwide. Hence, overall world demand for oil stabilized, and in some areas, fuel demand has actually strengthened. Meanwhile, OPEC has cut oil output by about 5 million barrels per day. There’s less supply hitting the markets. Also, China has been filling its strategic petroleum reserve. And Chinese demand is up, year over year. The Chinese are not only buying new cars, they’re driving them.

As for North American natural gas, the price has stabilized at about $4 per mcf. That’s a low number. In fact, it’s barely enough to keep the industry alive in the short term. Some people call it a “gas glut.” It depends on our time frame. Long term? At $4 per mcf, natural gas is barely on life-support. This situation can’t last and it’s our opportunity to get into the KEY ENABLING TECHNOLOGY of the natural gas market, and do it with very limited risk!

Depletion Still Matters

At the same time, old Mr. Depletion is working his efforts. Hydrocarbons are, of course, depleting substances. Every barrel of oil lifted to the surface is one barrel less down in the hole. Every mcf of natural gas that blows out of the formation is one less mcf down there.

So each day of hydrocarbon production brings every well one day closer to the end of its useful life. And with most modern wells, the output curves are falling off pretty steeply in the first year or two. It’s counter to what a lot of people think, but it’s reality.

Wells don’t just produce large volumes of oil and gas year after year. Indeed, it’s a rare well (at least in North America, which has been drilled like a pincushion) that produces strongly after even one year. Most wells just plain slack off and output drops after the first few months or so. Sure, a well eventually will settle in at some level of output. And that level might last for many years. But in almost EVERY case, it’s a much lower level than in the first few months of the well’s existence.

We Need to Drill Wells

The only way around depletion is to drill more wells. In a broad sense, you have to look at well drilling as a long-term industrial process. The energy industry needs a pipeline (so to speak) of thousands of drilling prospects that get drilled on a regular basis. Break the process – with wild swings in the pricing mechanism, for example – and you’ve got trouble. We just plain need to drill wells.

But with the rig counts way down in the past year, a lot of those wells we need to drill have not been drilled. Thus, the energy process is derailed. The future is NOT now. In fact, the energy future is now moving out of our immediate control. The U.S. could be looking at serious depletion-induced natural gas shortages within a year to18 months. So the drilling cycle needs to kick back into gear.

Sooner or later – and I believe sooner – the rig count HAS to head back up. On the oil side, prices can support most drilling at this point.

Until we meet again,
Byron King

August 3, 2009

Prepare for the Rebound in Drilling was originally featured on Whiskey and Gunpowder

I described how geothermal power is the beneficiary of a lot of government benefits, from renewable-energy mandates to tax breaks. Thus, the geothermal companies (including five companies in the ESI portfolio) should be doing better in the stock market. But that’s not the case, even though the deck is stacked in favor of green power, especially geothermal. Where’s the return?

The Geothermal Business Model

Let’s ask a question of almost all of the current geothermal players. Is SOMETHING WRONG with much of the current geothermal business model?

Actually, WHAT IS THE BUSINESS MODEL for the typical geothermal energy pure-play company? Let me summarize in a general fashion.

• The typical geothermal pure-play starts with one or a very few visionary people, often engineers. These guys (almost always guys) have an idea. They do some prospecting and find a couple of sites with steam vents or mud volcanoes. Very often, the site is something that other players looked at or even drilled back in the 1970s. The sites are usually out in the middle of nowhere, like some gulch in Nevada or similar jurisdiction

• Then the players acquire relatively small acreage positions — a few thousand aces here and there — often from the Bureau of Land Management (BLM) or private parties. They try not to pay big money for big acreage. Indeed, many of the current geothermal guys have a $3 per acre mentality. For overseas projects, they usually obtain a concession from the government in a developing country. Not uncommonly in the developing country, the politicians studied Marxism in their university days

• Then the companies promote their geothermal site at conferences. They give their site a name like “Hell’s Hot Springs” to make it sound like the devil bathes there in the superheated steam. They show their slides, pound the podium and raise funds from private players. Eventually, they write a fire-and-brimstone prospectus and issue stock in the Canadian junior marketplace

• Then comes a years-long cycle of burning the cash. In the U.S. or Canada, they start a long process of obtaining federal, state and local government permits to do everything. They need permits to drive trucks over wilderness roads, to remove water, to blow exhaust into the air, to drill wells, to erect towers. Every geothermal site in the U.S. or Canada involves at least 700 permits and constant renewals. No wonder they need the tax credits on the back end

• Then they identify enough funds to drill a primary steam well, and a confirmation well or two. These wells are expensive — much more so than a comparable gas well, that’s for sure. In fact, there are only a handful of drilling rigs in the U.S. and Canada that routinely drill geothermal wells. Sometimes a rig breaks down or gets stuck at one site. That impacts the drilling schedule for other customers for many months onward. Often, the geothermal companies pay for drilling wells by issuing new stock and diluting the previous investors

• Then they hire a consultant. It’s almost always GeothermEx Inc., of Richmond, Calif. GeothermEx is not just small, it’s TINY! There are eight upper-middle-aged guys who do all the work. GeothermEx does good work despite having virtually NO competition. But it goes to show how small and clubby the geothermal world is

• Once in bed with its pals at GeothermEx (whoops, I mean “once it’s retained GeothermEx”), the geothermal company tests the wells for “the report.” Then the GeothermEx consultants write up “the GeothermEx report” on the heat and energy potential of the site. The key point of “the report” is how many megawatts (Mw) the project ought to yield over how many years

• Then the geothermal company shops the GeothermEx report around to the local or regional power companies to get a power purchase agreement (PPA). The PPA is a promise that IF the geothermal company ever produces electricity, the power utility will buy it at some price. (The utility companies like PPAs because they can impress the state utility regulators and get them off their back. “See? We’re working that green energy RPS mandate.”)

• Then the geothermal company uses the PPA to borrow money from a bank or other source of funds. If a utility company will pay for future power supplies, that’s bankable. “Energy bankers,” as they fancy themselves, have been trained to kowtow to PPAs based on GeothermEx reports. “GeothermEx reports are the gold standard in this business,” is the common expression

• Then the geothermal guys use the borrowed money to pay debts and bills and to drill more wells for steam production and water injection. At the same time, the small team of geothermal players — which could hold their corporate luncheon in the back of a McDonald’s restaurant — designs and builds a generating plant. This requires large upfront costs for construction and equipment

• Sometimes, the geothermal guys farm out the power plant as a turnkey project to a publicly traded company named Ormat. “Ormat is the go-to company in this business,” is the common expression

• Meanwhile, Ormat is tightly run by a family of bright, but very quirky, upper-middle-aged people. The company growth plan gets a C- and its succession plan gets a D, in my view. (Another story.)

• Then while the geothermal people are designing and building their generating plant, they have to worry about how to get the power from the plant to the main transmission wires. This often involves permitting and building out a new set of power lines from nowhere (out in Nevada or the like) to somewhere else (such as where the electric load is, in California or the like)

• Then, about four or five years down the road from the original lease sale, the geothermal company tests its steam wells and generating plant. If the dynamos spin true, the geothermal company now has electrons moving down the wires. That is, the geothermal company is in the power-generating biz

• Finally, with electrons in the wires, based on the PPA, the utility company starts sending a check every month to the geothermal company. It’s usually the first real cash flow that the geothermal company has seen in many years.

Let’s Think This Through

Most of the foregoing applies to most of the companies (public and private) in the geothermal space. This is how it works. This is the current geothermal business model, controlling things from prospect to power line. Of course, not everything applies to everybody. But you get the idea.

Let’s think this through. If you’re a small company with a handful of employees, how can you possibly accomplish and manage all of this… and make money for your investors? You’ve got a cadre of people who do it all. They prospect for acreage, lease it, obtain permits, raise funds, drill-drill-drill, test the wells and other systems, design and engineer a power plant, procure material and equipment, build out a generating system, erect power lines, spin electrons and deal with a regulated utility.

Does it sound like there’s a lot going on? There are lots of moving parts, with lots of things that can go wrong. And it’s all going on for a long time, on borrowed money or invested funds. So it takes a lot of time and cumulative risk to see any monetization. No wonder the geothermal stock prices are in the dumps.

There’s Got to Be a Better Way

Indeed, it seems like this business model was put together by Rube Goldberg. And remember that I’m only focusing on the “big picture” aspects of running this show.

When you look closer, there are more “little pictures” in this effort. How many? Well, more than hang in the National Gallery. That is, there are countless items that are much smaller, but which add up to time, money and managerial competency (or incompetency).

Sure, running a geothermal project takes talent. You’ve got to be a jack-of-all-trades. I guess that’s why the guys at the top get the big bucks, eh? But c’mon. There’s got to be a better way. Yet it seems like everybody does it this way — or they did in the late-departed era of easy credit. But we don’t live in that era any more. There’s no more easy, patient money.

In the past five years or so, the geothermal industry has raised and spent a couple billion dollars using this business model. Can it raise another few billion in the years ahead? On this business model?

News flash to the geothermal players: Aside from insiders and a few other people who’ve been able to trade in and out of the stocks (mostly lucky, not good), nobody has made any decent return from geothermal. It’s always “next year, next year, next year.” And the business model, based on shoestring budgeting and lack of monetary return for years at a time, helps to explain why.

Stay Tuned…

Don’t get me wrong.  I still like geothermal and I’ll continue to monitor our geothermal stock positions closely.  The geothermal business is small.  It’s not something that many investors know about.  If just one or two of the companies in the ESI portfolio can make it out of the woods, that’ll hand us enough profit to make up for any others that lag behind.

For now, I want to hold all of the geothermal companies in the portfolio.  I’ll keep a close eye on the business environment, and get more information for you. I’ll check in with several of the geothermal companies in the ESI portfolio. I’ll find out exactly where they are on their project timelines.

Along the way, I’m going to see another private geothermal project. I’ll talk with other people who are working in the geothermal space. There are other business ideas out there — how to monetize the projects at earlier stages — and we need to know what they are.

That’s all for now. Thanks for reading.

Until we meet again,
Byron King

July 24, 2009

Geothermal Frustration, Part II was originally featured on Whiskey and Gunpowder

I Love Geothermal, But…

Longtime readers of Energy & Scarcity Investor know that I love geothermal energy. It’s my inner geologist channeling its way out. And my inner technologist, too.

I seldom miss a chance to learn more about geothermal. Based on what I know, I often say and write good things about geothermal power and many of the publicly traded stocks that embody the geothermal space.

When Agora Financial launched ESI back in November 2007, among the first investment ideas that I recommended were five geothermal stocks.

Waiting for the Geothermal Godot

What’s not to love about clean, green systems that draw “free” — sort of — energy from the earth’s heat? Yes, indeed. I love geothermal. But with apologies to Samuel Beckett, I’m getting tired of waiting for that geothermal Godot who never seems to show up.

Here we are a year and a half on and the five geothermal stocks in the ESI portfolio are all down from our entry point. Sure, they’ve bounced up and down over time. Small-cap stocks do that, especially ones with roots as Canadian juniors. Somebody plugs them at some conference or in a newsletter, if not Barron’s magazine or The New York Times. Then the stocks go up. Pretty soon, they drift down. The back story doesn’t stick.

That’s not how it’s supposed to work. The original idea for the ESI-5 was that with more investment, drilling and development work, the geothermal companies would do better. They’d grow more valuable organically. The stock market would respect that. Over time, the stock prices would rise. That’s not what happened.

What’s going on? The companies SHOULD be getting more valuable, right? Time has passed and the five companies are spending money on acreage, drilling and development, right? (Yes.) They’ve got deals with utility companies to buy their electric power, sooner or later, right? (Yes.)

Plus, we’ve got the federal and state governments mandating low-carbon energy. It’s straight up the alley for geothermal. We’ve got “renewable portfolio standards” (RPS) too. These are legislative mandates for utility companies to buy green power — a built-in market for geothermal. There’s even an RPS bidding war going on. It’s like each state wants to outdo the others in raising its RPS numbers.

So if you’re a geothermal company, these ought to be your salad days. There’s nothing quite like selling a product that other people have to buy under penalty of law, right? Of course, this ought to offend your free market sentiments. But that’s another discussion.

There’s more… We’ve got tax breaks galore for renewable energy targeted point-blank at geothermal. Plus, at the other end of the tax code, where the funds get spent by the legislature, we’ve got $350 million of recent government grant money just for geothermal. $350 million? That’s probably more research money than there are smart people who can spend it wisely. Still, the money is there.

Where’s That Geothermal Boom?

So where’s that geothermal boom? What has happened to geothermal in the past year? Why are the stocks down? Let’s mention the usual reasons, just to get them into the sunlight.

Well, there was that stock market crash thing. Stocks tumbled, including the geothermal guys. There was a bit of a stock rebound this spring, but not much for geothermal. (Better to be a big bank, right?)

Then for the past nine months, we’ve had a continuing credit crunch, slowing things down for the geothermal players. We’re experiencing the Great Recession, which has reduced electricity demand and put a damper on overall energy investment and risk taking.

Then there’s the natural gas glut that has taken much of the cost-competitive edge off of geothermal power, as well as other alternative energy systems. Ask T. Boone Pickens about his windmills.

The bottom line is that the stock market is NOT giving much present value to future geothermal plays. Hence the stock prices are down. Why is that?

With all the inherent technical advantages of geothermal power (like “free” energy from the earth), plus the government policies and tax breaks, the companies in the business — including the ESI-5 listed above — should do better in the stock market. But that’s not the case, even though the deck is stacked in favor of green power, especially geothermal. Where in the heck is the return?

I’ll pick up this discussion in Part II, tomorrow.

Thanks for reading.

Until we meet again,
Byron King

July 23, 2009

Geothermal Frustrations, Part I was originally featured on Whiskey and Gunpowder

Linda Traynham, our Whiskey morning glory, had us poking into HR 2454 when she mentioned Texan Rep. John Carter’s amendments to it in her recent shot.

Ron Paul is right on the money in saying this bill will “sell pollution permits to the industry as the Catholic Church used to sell indulgences to sinners.”

But the intrepid Carter was no Martin Luther. Dem House leaders barred his amendments from floor debate on June 25. Carter was bested by the 309-page amendment from California Democrat — and bill sponsor — Henry Waxman. Of course, Waxman’s folly came to a floor vote before House Members had time to read it. HR 2454 squeaked by with seven more yeas than nays.

Harry Reid expects Senate results this fall. But in the meantime, let’s take stock and follow the money trail to the bill’s real supporters.

Behind That Green Machine, Pope Goldman Is Pushing

Project Cap and Tax began with the unholy Enron. That blind Cyclops of Energy pushed hard for cap-and-trade policy before its 2001 demise. But you’ll never believe who wanted in on it next.

Insurance titan AIG. The once-proud member of USCAP.

AIG knew creating exotic “insurance” wasn’t going to stay profitable much longer. But investing in currently worthless carbon credits and tanking alternative energy companies COULD mean big-time money — if Congress wanted it.

Back in 2007, then-CEO Martin Sullivan wanted to jump in feet first, saying that AIG:

“can help shape a broad-based cap-and-trade legislative proposal, bringing to this critical endeavor a unique business perspective on the business opportunities and risks that climate change poses for our industry.”

Note that Sen. Dodd has been AIG’s donation darling since 1990 — netting $284,000 from AIG’s employees, executives and PACs. And right now, Chris Dodd can help make the Senate’s version of the cap and trade. He’s so pro-cap and tax he wants to tack on a carbon tax — above and beyond cap and trade — that he hopes will generate $50 billion annually for renewable energy research..

But in February 2009, Joe Barton (R) led to charge to cut AIG out of USCAP. He cited AIG’s use of taxpayer money to finance lobbying activities. Point for cap-and-trade critic Joe Barton! We bet GM will drop from the USCAP roster if Barton has a hand in it.

But AIG’s single biggest counterparty will pick up the slack. Goldman Sachs spent $3.5 million on climate issues alone last year.

Then on Jan. 12, 2009, former Goldman CEO Hank Paulson offered think tank Resources for the Future (whose chairman of the board is also a Goldman alum) this interview: “How Markets Can Help Address Climate Change and Other Major Environmental Problems.”

We doubt this interest is merely because Hank Paulson is a lifelong bird-watcher.

Paulson confides that he “could see at Goldman” the value of carbon credits: “to come up with a system ultimately that has got credibility or is verifiable, that when someone pays to avoid it, you know, a ton of carbon emissions, they know they’re really getting a ton of carbon emissions avoided.”

When pressed, Paulson pooh-poohed the carbon tax. He said a tax wasn’t transparent, as the cap and trade was — amid crowd hoots and howls of laughter — as he emphasized the words “fair,” “credible,” “efficient” and “transparent.”

Is this the same man who guaranteed an efficient, transparent, and, um, highly credible, unregulated credit default swaps market? Is this the same purveyor of the clarity and transparency of the Moody’s and S&P ratings on bundles of mortgages?

But where Paulson may have stepped down, a new pro-CAP man steps up.

Treasury chief of staff Mark Patterson clocked lots of time across the street from Capitol grounds. From 2005 until April 11, 2008, he lobbied for Goldman as VP of government relations. While you’d think allowing a former lobbyist to work on an issue he has lobbied for within the past two years would besmirch Obaman ethics, we’ve been assured that he “steps out” of such matters at the Treasury, like a judge stepping down from a case. Yeah, sure he does.

Goldman likes cap and trade for one big reason: Its investments depend upon it.

Follow the Money Trail to Mr. Derivative

When you ask who’s the biggest winner if the bill goes through, you’ll find the Chicago Climate Exchange (CCX), co-founded by Hank Paulson and Al Gore. Members include Amtrak, DuPont, Ford, Oakland, Chicago, and the Iowa Farm Bureau.

The whole idea is the brainchild of Richard Sandor — aka “Mr. Derivative.” He’s the guy to thank for interest rate futures, as well as earthquake futures. In the early ’90s, he pioneered the collateralized mortgage obligation(CMO). And while you might not know exactly what a CMO is, you’ve probably heard the name Kidder, Peabody — where Mr. Derivative worked. By the mid-’90s, it held 28% of the total world CMO pie on its own balance sheet. Surprise, surprise, it all blew up in 1994, forcing the 130-year-old firm to the auction block — because of toxic instruments that look an awful lot like the mortgage securities that just blew up on us in 2007.

Do you feel confident?

Goldman sure does. It owns a 10% stake in it. It also owns a 19% share in CCX’s parent: Climate Exchange Plc. It nearly doubled its holdings in January 2009.

The icing on the cake is its stake in Blue Source, a Utah-based purveyor of carbon creds. In 2005, when Paulson drew up the bank’s environmental policy and started Goldman on a stream of energy partnerships, investments and subsidiarys, he offered this comment: “We’re not making those investments to lose money.”

In 2009, Goldman got caught up in a botched IPO of its investment Changing World Technologies, which turned Butterball turkey offal into diesel — at the cost of $80 a barrel — before filing for Chapter 11. You can bet Goldman will ensure this sort of misstep doesn’t happen again.

Government-Guaranteed Price Hikes

The government “cap” is what makes this market a true racket.

As Peak Oilers know, the less and less of a dwindling resource, the higher the price you can get from the people that need it.

Capped carbon follows the same logic. We start with a high cap of carbon pollution and that’s the national limit of how much CO2 can be emitted that year. Each year, that cap shrinks a little more, and the next year even more, until we reach the “no-harm” level — which some environmentalist absurdly place at zero.

Now here’s the catch. The government divvies up the shares of emissions among businesses that produce or consume energy. (This handout may be based on history of consumption.) Say hello to a new breed of lobbyist pimping a whole new tier of Beltway bureaucracy.

The “surplus” credits will trade on exchanges like Chicago Climate Exchange or Blue Source, allowing companies to outbid each other for the leisure of producing more than the government said they could.

Each year, the government will hand out fewer and fewer emissions indulgences. Meaning there will be fewer credits to trade. And we commodity buffs know that the less there is of something, the higher the price rockets.

And the Chicago Climate Exchange will score larger and larger sums from the corporate carbon largesse. Goldman and company have everything to gain from this.

And you’ve got to ask: What exotic new derivatives can come out of this? Will institutional investors bet on futures of how much the government will lower the cap in 2025…2030? Wait, there already is a Chicago Climate Futures Exchange. Of course, it’s the wholly owned subsidiary of the Chicago Climate Exchange.

Could the coal companies purchase carbon default swaps? After all, what happens when they discover the hydropower credits they bought in Brazil didn’t quash emissions as much as anticipated?

That brings us to a big flaw: Does it really work?

Capital Abandons Its Own Carbon Purchase Scheme

The best part of this swindle? It’s hard to tell if it’s a swindle. You see, the credits fund development projects in countries like India or Brazil, for installing things like hydropower plants or rice husk-fired generators. Watchdog group International Rivers concluded that three-quarters of these projects would probably have been funded anyway, since they were already completed at time of approval.

Consider tree planting. How do you measure the carbon offset? It all changes based on soil and climate conditions, not to mention growth rate. Only when a tree has lived 100 years does it become a net carbon absorber.

Mr. Sandor doesn’t care if it works or not. He finds the debate: “quite interesting, but that’s not my business…I’m running a for-profit company.”

So why does the House of Reps think cap and trade will work? Well, it shouldn’t — based on recent experience.

It’s “Green the Capitol” campaign began with compact fluorescents. Then it switched to natgas power to keep the lights on. But the Capitol still wasn’t carbon neutral, so the House bought 24,000 metric tons of carbon offsets on the Chicago Climate Exchange. (Yep, through the same outfit owned 10% by Goldman Sachs.) But in February, after not being able to confirm that it offset any of its carbon, the House dropped all plans to “go green” with offsets.

So we have a classic case of “do as we say, not as we do” from our honorable reps.

We got the above anecdote from Ted Gayer — who worked a single year as deputy assistant secretary of economic policy at the Treasury: 2007-2008. Wonder if the unpopularity of his opinions turned him toward Georgetown professordom?

Lest we leave out another odious option, let’s talk direct carbon tax. The carbon heavies would pay a penalty for the carbon content of their products. The idea is that companies would cut emissions for the sake of avoiding the tax. But they’d probably just tuck the added cost into what you and I will pay.

So that’s our choice: A private tax collection scheme that’s government backed or yet another Fed tax that business will probably loophole its way out of.

Either way, Shooters, we’ll end up with a case of cap and stick it…and you’re holding the bag, as usual. Estimates from various sources say you could pay $175-3,300 per household because of it.

The only way to trump this system? Hope the government will hand us a set of credits for owning — but not using — our clothes dryer…and then, as we hang our clothes to dry in the free sunshine, selling our credits to the highest bidder via the Blue Source Exchange.

Of course, if you feel the need to storm your senator’s home office during the summer recess, we wish you luck.

Regards,
Samantha Buker

July 8, 2009

Cap and Trade Shenanigans with the Chicago Climate Exchange was originally featured on Whiskey and Gunpowder

And speaking of colossally stupid government programs, you may have seen the news that the U.S. House of Representatives passed a climate change bill on Saturday by a narrow vote of 219-212. The cap-and-trade bill, otherwise known as Waxman-Markey (for the nominal writers of the bill), mandates that U.S. manufacturers and utilities reduce carbon emissions 17% from 2005 levels by 2020 and 83% by 2050.

Under the sausage making process that is the American Congress, the bill was filled with compromises. Congressmen from coal-producing states or states with lots of manufacturing jobs had to be bribed into supporting it through various means. It must now go the Senate, which must pass its own version of the bill.

If the Senate bill is different from the House bill (and it almost always is, given the different agendas in both bodies and the need for more bribes), the two bills go to “reconciliation.” That’s where a committee made of members from both houses settles on a final compromise version of the two bills and sends them back to their respective bodies to be voted on. Then it gets sent to the President to become the law of the land.

By the way you may have missed an amendment to the bill that’s stirred a bit of controversy. It was inserted the night before among the bill’s 1,200 pages, which you can be sure none of America’s elected officials actually read. The amendment placates Congressmen from Rust Belt states who worry about losing even more manufacturing jobs to the developing world (China). It requires the U.S. President to make a “border adjustment” on goods from countries that do not cap or reduce carbon emissions by 2020. It’s a tariff.

Already President Obama has backed off that particular amendment. He says, “At a time when the economy worldwide is still deep in recession and we’ve seen a significant drop in global trade, I think we have to be very careful about sending any protectionist signals out there.” Very careful, sure. But you already did send the signal didn’t you?

For what it’s worth, we think this was all an exercise in political window dressing to get some version of a bill passed. If the Senate and the House actually agree on a climate change bill that puts a high tax on carbon, then the apotheosis of Obama will be complete.

We will take The One at his word, though. Besides, as everyone knows, the real purpose of the bill is not to start a trade war (although it may do so). The purpose is to make conventional energy more expensive AND—in an era of declining government tax receipts and rising liabilities—to create a huge new source of government revenues by taxing carbon. It’s a revenue and power grab by an institution (the Nation state) that finds itself increasingly off-balance.

It’s also a massive project in socioeconomic engineering that ignores the reality (and physics) of energy generation in an industrial society. It’s true the world could benefit from cleaner and cheaper energy. But cleaner and more expensive energy is a recipe for economic suicide. It’s something Western nations seem particularly keen on committing, although we can’t really figure out why. It could be that the global Left simply finds modern life aesthetically ugly and consumerism (with all that pesky individual choice) a vulgarity that should be destroyed via legislation.

But speaking strictly in economic terms, unless a region or a country has ample hydroelectric or geothermal resources, it’s impossible to meet base load electricity needs reliably with renewable energy. Advocates envision a world full of ultra-long life batteries, windmills, and solar farms. But it’s just a fantasy. If the climate bills become law in Australia and America, it will accelerate the deindustrialising of Western economies and mean the transfer of even more manufacturing jobs to the developing world.

Of course maybe that’s just what the architects of these laws want. Who knows? We know they want to tax productive enterprise and make the bulk of the population dependent on government handouts. That makes people compliant and easily controllable. That is big government Utopia. Advancing the fears of climate change is the easiest way to get more control.

We’d expect to see the construction of a lot more natural gas fired power plants in the coming years in the West (although they are more expensive than coal-fired plants). All those re-chargeable plug-in hybrids have to get their electrons from somewhere. If it’s not going to be coal (which will be taxed out of existence), it’s probably going to be cleaner-burning natural gas power plants, powered by both conventional and unconventional gas.

Right now, global LNG capacity is rising and stockpiles are fairly high. But if you keep your eye on the big picture and we see a transition of the world’s power plant fleet from coal to natural gas, it obviously favours gas producers and explorers. Australia is moving ahead by leaps and bounds in this area with conventional offshore production in the North West Shelf and Timor Sea and more unconventional production (hopefully) from coal-seam-gas in Queensland.

Regards,
Dan Denning

July 1, 2009

Climate Change, Cap, Trade, and the End of the Industrial West was originally featured on Whiskey and Gunpowder

You see, on my recent trip to Kentucky’s Bourbon Trail, one thing stuck in my mind: TAXES. I was utterly shocked when I heard what the distillery tour guide was saying about a $13.50 per gallon tax on any distilled bourbon. That’s over $700 of taxes per barrel. And that’s before the bourbon even gets to the bottle. For me and you, fellow Whiskey Shooter, there’s another tax when we get to the counter—somewhere around 6%.

So what’s the total bourbon tax?

According to the Kentucky Distillers’ Association, around 53% of the cost of the average-priced bottle goes to local, state, and government taxes.

I guess that’s why the tour guide took the time to tell us about the taxes. That way we wouldn’t be bitter when we paid $30 for a bottle of “corn juice.”

So the tour went on and our group wandered through the rest of the distillery — tasting the freshly distilled 160 proof grain alcohol, feeling the corn mash and playing in the gift shop…

But wait. Isn’t this taxation that same kind that created rebellions?

My tour group, and Americans in general, have been lulled to sleep, as if Uncle Sam slipped us a Mickey. Last I checked, the U.S. isn’t an alcohol supplier. Nor is it a real estate agent. Nor is it a car lot. But it seems like the current administration wants to get its hands on everything.

And the way things are going, who knows what’s next…

The Latest Nickel-and-Dime “Tax”

You gotta give it to ’em: At least Washington came up with an appropriate nickname for its latest cash grenade. It’s called “cash for clunkers,” and last week the House approved the bill — with your money!

It simply amazes me that something this poorly thought up could pass so quickly through the largest legislative body in the U.S. Just think about it: 435 well-paid pairs of eyes took a look at this bill. And a majority OK’d it!

In case you haven’t heard of the latest clunker of a bill, let me give you the rundown…

It’s a $4 billion plan to subsidize sales of new cars with better mpg. Essentially, if you have a car that gets less than 18 miles per gallon and you “upgrade” to a new car that gets at least four more miles per gallon, you’re eligible for at least a $3,500 tax credit.

I love the well-accepted term “tax credit.” Does everyone on the Hill think we’re that easily swayed by bills that contain such positive-sounding phrasing?

Here at the Whiskey Bar, we aren’t that easily fooled. This “tax credit” is a simple euphemism for free money — money that you and I as U.S. taxpayers are providing. Simply put, it’s taking money from our pockets and giving it to new car buyers in an effort to jump-start new car sales.

I don’t know about you, but paying for my neighbor’s car wasn’t on my agenda today.

But let’s dig a little deeper, since we could be footing the bill…

The bill, as it stands, is less likely to be affecting normal car owners — so this is for our SUV/truck-driving neighbor. Because even if you bought a 1990 Chevy Cavalier or Ford Taurus, you’re still probably getting well above 18 mpg.

So obviously, this bill is almost strictly for those non-Peak Oil-thinking, overzealous SUV or truck buyers. These folks have roughly the same restraint and foresight as those who purchased houses that they couldn’t afford.

This bill is almost comical. But frankly, where does the spending stop on Capitol Hill? Combine this with the latest auto bailouts and it’s really starting to look like our nation has turned into a new and used car lot.

Things are getting scary ’round these parts.

Government Spends, You Save…

Those dollars in your pocket aren’t looking as great as they once did. And as I see it, with an overburdened and overspending government, the dollar could be in for a crude awakening.

That’s because one thing is for sure: Over the next few years, the world is going to spin, the U.S. government is going to spend, and all of this will be running on the same fuel: oil.

As I wrote a few months back, the price of gasoline is going to rise. And that mainly stems from the rising price of crude oil.

As you know, the world’s commodities (most notably oil) are priced in U.S. dollars. As the dollar weakens, and as the Earth still spins and demands more energy, the price of oil is going to rise.

In my opinion, over the next three months to five years, oil is going to rocket — even more so than the price of gold. We got a taste of what can happen when oil spiked last year to $147 per barrel. And from my standpoint, it’s inevitably going to be back to those levels, or higher.

My best advice for protecting your hard-earned dollars over the next five years is simply to invest in all facets of the oil industry: oil service companies, oil holding companies, oil technology companies, and the commodity itself (through ETFs or commodity options).

Sure, the Obama administration wants to improve mpg, but one thing is for sure: We’re still going to be burning oil for decades to come — more and more every year. And although we may hit some rough patches for demand, the overall trend line is going to be UP.

By investing in oil, you’ll protect your wealth and profit at the same time.

After all, we all want to be able to afford our next bottle of bourbon.

Stay ahead of the curve,
Matt Insley

June 17, 2009

Taxing to Better Mileage? was originally featured on Whiskey and Gunpowder

The article began with a description of California’s current rail service between the Bay Area and Los Angeles. A commission of nine-year-olds in a place like Germany could run a better system, of course. It’s never on schedule. The equipment breaks down incessantly. A substantial leg of the trip requires a transfer to a bus (along with everybody’s luggage) with no working toilet. You get the picture: Kazakhstan without the basic competence.

The proposed solution to this is the most expensive public works program in the history of the world, at a time when both the state of California and the US federal government are effectively bankrupt. By the way, I wouldn’t argue that California shouldn’t have high-speed rail. It might have been nice if, say, in the late 20th century, some far-seeing governor had noticed what was going on in France, Germany, and Spain but, alas…. It would have been nice, too, if the doltish George W. Bush, when addressing extreme airport congestion in 2003, had considered serious upgrades in normal train service between the many US cities 500 miles or so apart. The idea never entered his walnut brain.

The sad truth is it’s too late now. But the additional sad truth, at this point, is that Californians (and US public in general) would benefit tremendously from normal rail service on a par with the standards of 1927, when speeds of 100 miles-per-hour were common and the trains ran absolutely on time (and frequently, too) without computers (imagine that !). The tracks are still there, waiting to be fixed. In our current condition of psychotic techno-grandiosity, this is all too hopelessly quaint, not cutting edge enough, pathetically un-”hot.” The fact that it is not even considered by the editors of The New York Times, not to mention the governor of California, the President of the United States, and all the agency heads and departmental chiefs and think tank gurus and university engineering professors, is something that will have historians of the future rolling their eyes. But for the moment all it shows is that we are collectively too stupid to survive as an advanced society.

Ironically (if you go for gallows irony) a sidebar in the same issue of The NY Times Sunday Magazine featured the latest architect’s wet dream of an airport-of-the-future (p.35). Note to the editors and architects: commercial aviation is toast (we just don’t know it yet). We’re back in the $70-plus a barrel-of-oil aviation death-zone for airlines.

Also ironically proving that America is not alone in techno-triumphalist mental illness was another big article in the same magazine featuring French President Nicolas Sarkozy’s neo-Modernist fantasies for vast new construction projects in Paris. Note to Sarko: the developed world’s metroplexes are headed for shocking contraction, not further expansion. I know this is counter-intuitive, but a little applied prayerful research will bear it out. And, by the way, the last thing any city on earth needs is more skyscrapers — i.e. buildings that have no chance of ever being renovated when they reach the senility stage of their design-life. For really mind-blowing statements, this one from that article is a standout: “Paris’s current problems as a city can be traced to the very thing that makes it most delightful — its beauty.” Right. So, the solution will be to make it more like Houston.

Actually, I doubt the French people consider these schemes anymore plausible than ur-Modernist Le Corbusier’s 1924 proposal to bulldoze half of the Right Bank and replace it with dozens of identical skyscrapers. The French people laughed at Corbu, and put their vertical slums outside the city center, but notice that we Americans actually did it, replacing our old human-scaled center cities with priapic arrays of glass-and-steel tubes surrounded by parking lagoons. Anyway, nobody in the OECD world will have the energy to carry out anything like this again, not even France with its nuke plants.

Which brings me back to the New Urbanist annual meet-up last week in Denver. Given the gathering conditions of what I variously call The Long Emergency or the economic clusterf**k, they have had to shift their focus starkly. For years, their stock-in-trade was the greenfield New Town or Traditional Neighborhood Development (TND), a severe reform of conventional suburban development. That sort of reform work was only possible when 1.) the continued expansion of suburbia seemed utterly inevitable, requiring heroic mitigation and 2.) when they could team up with the production home-builders to get their TND projects built. To the group’s credit, they realize that these conditions are no more. Suburbia is now cratering, both as a repository of wealth in real estate and as a practical matter of everyday existence. They get that the energy crisis and all its implications are real and that our response to it had better be deft. They understand that the capital resources we thought we had for Big Projects are flying into a black hole at the speed of light. Mostly they see that he time for “cutting edge” fashionista techno-triumphalist grandiosity is over.

To put it bluntly, the Congress for the New Urbanism (CNU) is perhaps the only surviving collective intelligence left in the United States that is producing ideas consistent with the reality. They recognize that our survival depends on downscaling and re-localization. They recognize the crisis we will soon face in food production, and the desperate need to reactivate the relationship between the way we inhabit the landscape and the way we feed ourselves. They recognize that the solution to the liquid fuels crisis is not cars that can run by other means but walkable towns and cities connected by public transit.

This is exactly what you will not find in the pages of The New York Times or the political corridors of power. Oh, by the way, the Obama administration contacted one of the leading lights of the New Urbanism in the weeks after the inauguration. He never heard back from the White House. I guess they’re not interested.

Regards,
James Howard Kunstler

June 16, 2009

The High-Speed Rail Cart Before the Horse was originally featured on Whiskey and Gunpowder

Much of Brazil’s South Atlantic development will require drilling wells in waters up to two miles deep, through four-five miles of rock beneath the seabed. The prize at the end will be oil deposits with reserves estimated in the tens of billions of barrels. With access to this offshore bounty, Brazil expects to take its place among the first ranks of energy-producing nations in the world.

Brazil’s state-controlled national oil company (NOC), Petroleo Brasileiro SA (Petrobras) plans to spend over $175 billion in the next five years just on offshore development. The immense investment involves buying and building dozens of new drill ships and seagoing platforms, along with many dozens more support and servicing vessels. Petrobras will lay thousands of miles of pipelines on the seafloor, connecting massive complexes of subsea equipment that will sit atop hundreds of oil wells.

To finance much of this development, Brazil has turned to China. With the active support of the Chinese government, many Chinese banks are lining up to extend loans to Brazil’s energy sector. Right now, there is an agreement for a Chinese consortium to lend Petrobras $10 billion. In exchange, Petrobras will eventually ship 200,000 barrels of oil per day to Chinese refineries. There are more such long-term finance supply deals in the works.

The Chinese government has established strategic guidelines for its national firms. That is, the Chinese government has set goals for Chinese firms to supply China’s long-term needs for energy and other natural resources. The Chinese are looking well ahead into the rest of this century, and even into the 22nd century. They want to ensure their future access to a diverse global supply chain, as well as win entrée into resource-rich regions of the world for Chinese industries and support firms.

Why are the Chinese receiving such a warm welcome in Brazil? According to Sergio Gabrielli, CEO of Petrobras, “The U.S. has a problem. There isn’t someone in the U.S. government that we can sit down with and have the kinds of discussions we’re having with the Chinese.”

In other words, there is a new geopolitics of oil at work. In the olden days, it would have been large international oil companies (IOCs) like Exxon Mobil, Shell and BP walking into a room to meet with the Brazilians. The IOCs were the only game in town. They controlled the financing and the technology for large developments.

But today, the biggest deals begin with a political understanding at the top, hammered out between the highest levels of the respective governments. This top-down political deal making cuts out the IOCs, except where they have technical expertise that can be hired on a contract basis.

In essence, we are witnessing the end of the post-World War II economic construct of the world’s financial system. That construct always had a Western bias. But the 2008 crash of the Western business and financial model has changed everything. It has left a barren worldwide financial landscape for large development projects. Most traditional Western financing is simply not available for large projects. And as French author Francois Rabelais (1494-1553) once noted, “Nature abhors a vacuum.”

Thus has the Western financial crisis handed well-capitalized, government-backed Chinese banks and industrial firms an unmatched competitive advantage. With the traditional credit markets dry, Chinese banks have transformed into key lenders for the resource developments that will fuel the next generation of humanity. Indeed, for now, the Chinese are the world’s ONLY lenders for large resource development projects. See Brazil, Exhibit 1.

China’s Rare Earths Monopoly – All But Insurmountable

China’s support for Brazilian energy development is not the only angle that the Chinese government is pursuing for its future gain. China’s large reserves of foreign exchange, as well as its national strategic focus, has enabled incomparable – even insurmountable – progress for the Middle Kingdom to corner the world supply of substances called rare earths. Here’s the production chart for the past half century. Obviously, something is going on here.

Now that we’ve seen this chart, the questions arise: What are rare earths? And why are they important?

Rare earths are the 15 elements within the lanthanide series of the periodic table, plus the elements yttrium and scandium. The best known are lanthanum, cerium, neodymium, praseodymium, gadolinium, europium and samarium.

Here’s why rare earths are important. They’re used in a wide range of industrial and electronic applications. For many years, large amounts of lanthanum and cerium have been used in petroleum refining, with the result of increasing yields from each barrel of oil by about 10% while extending the life of other expensive catalysts like platinum. And rare earths find their way into myriad other applications, from aerospace super-alloys to rechargeable cell phone batteries.

More recently, large volumes of rare earths (especially neodymium) have gone into magnets. In fact, rare earths are a key component in strong, permanent magnets. It’s not those cute little refrigerator magnets; your computer contains a number of tiny magnets in its hard drive. If there are no permanent magnets, there are no computers. Or DVDs or DVRs or iPods, etc. Say farewell to your wired way of life.

And then there are the giant 1-ton magnets used in large windmill assemblies. Each windmill magnet is about the size of a car engine and uses 560 pounds of neodymium. The implication is that if the U.S. wants to erect windmills to generate electricity, the nation is making a long-term commitment to buy and use unprecedented amounts of neodymium. And there are NO substitutes. For just this one “clean energy” application, large amounts of rare earths – and the ores and mines to produce them – are essential.

There are many other clean-energy applications for rare earths as well, particularly in the now forming electric car industry. Neodymium magnets are key components in electric motors and regenerative braking systems used in hybrid vehicles. Without these magnets, no electric cars will ever roll off an assembly line, let alone whiz down an American highway.

Another significant demand for rare earths will come from large rechargeable batteries for electric cars. Nickel-metal hydride (NiMH) rechargeable batteries, for example, contain cerium and lanthanum in a form called “mischmetal.” And right now, NiMH batteries are the battery of choice for many hybrid vehicles. Overall, a typical hybrid electric vehicle can use about 50 pounds of rare earths – between the rechargeable battery pack, the permanent magnet motor and regenerative braking system. (Plus other tiny magnets for the sound system, power windows, power seats, windshield wipers, etc.)

So clearly, demand for rare earths is set to skyrocket. Just clean energy applications will drive unheralded demand for metals of which most investors – let alone consumers – have never heard.

It’s also important to keep in mind that almost none of the rare earths used in large power systems (like windmills) or electric vehicles (such as with NiMH batteries) are currently being recycled. The long lifetimes of the magnets and batteries, coupled with the lack of recycling technologies and dedicated facilities, means that any increase in supply can only come from new mining.

Another factor is that there appears to be an official Chinese policy to slow down export of rare earths. Chinese exports have decreased by 8% or so each of the past three years. Chinese suppliers have placed foreign customers on allocation, at reduced quantities from years past. The Chinese explain that they have closed mines for environmental reasons. Yet the Chinese also promise adequate supplies of rare earths if foreign users will move their industrial facilities into China.

According to Yoichi Sato, head of the Rare Earths Department of Japan’s Mitsui Industries, China is displaying its long-term strategy toward these critical elements. Mr. Sato believes that China is playing a complex game with the world’s rare earth consumers.

First, China is restricting rare earths exports, to provide its own high-tech industries with the chance to flourish and gain a competitive edge over rivals in Asia, Europe and the U.S. And second, it will force many foreign firms to move their high-tech factories and research centers to China to circumvent quotas. China, to be sure, has a small army of highly capable scientists and engineers who focus on rare earths applications – over 15,000 Ph.D.-level individuals, by one count.

Mitsui’s Mr. Sato believes that China will use its existing monopoly status in rare earths production to crush any competition that emerges. While about 42% of worldwide rare earths resources are outside China, there are NO non-Chinese sites with any significant processing or refining capacity. In the game of rare earths, China holds almost all of the cards.

Mr. Sato has stated, “Many people are looking at establishing alternative refineries and sources outside China, but the investment is not necessarily a sound one because of the threat of price revenge by China. If new projects emerge, as they have recently in Malaysia and Australia, China could just drop its prices and force rivals out of business.”

And as if on cue, in April 2009, Chinese firms used their financial muscle to buy large stakes in potential foreign rivals in Malaysia and Australia.

I hope that you now understand the importance of rare earths to the 21st-century economy of the West, particularly to the energy future of the U.S. I’m following this situation very closely. There ARE some potential investment opportunities in rare earths, but only in very small, thinly capitalized firms.

Until we meet again,
Byron King

June 12, 2009

Brazil’s National Commitment to Energy – Bankrolled by China was originally featured on Whiskey and Gunpowder