UBS on Energy Future

Dismantling the old energy network and building the new

As you know I believe that as energy becomes less and less efficient to extract and turn into useful work, the amount of land, labour, materials and capital required to compensate will soar. The need for greater land to access the less dense forms of energy is termed “energy sprawl” but it might just as well apply to the other resources including labour although immobility of labour may give a different impression.  

You will recall http://www.plosone.org/article/info:doi/10.1371/journal.pone.0006802 which highlights that based on existing legislation, the US will require an additional 206,000 square kilometres of land to meet its 2030 energy requirements. Similar reports have been written on Germany by its Renewable Energy Agency which says that 4m additional hectares of land – (the country measures 35.7m hectares) - will need to be diverted to ethanol, solar parks and wind farms to facilitate existing plans to reduce the power industry’s dependence on fossil fuel to 50% use by 2020 - (presently 62% compared with 72% in the States and 84% in China). As you know, my own estimates are that the energy network globally will rise from around 5% GDP today to nearer 17% over the next 10 years as the global EROIE falls from 20 to 5, but I want to understand what exactly that means.

There are two aspects that need to be considered. The first is whether this happens in an environment of growing energy production as it has in the past, or whether it happens whilst energy production is stagnating. The second aspect is the location of where it will happen.

If we turn to some recent history and look at the last 20 years as the EROIE fell from 40 -(for every 1 unit of energy put into the ground in terms of oil rigs etc, an additional 40 were recovered) - to 20, the ratio between the cost and value of energy rose from 2.4% to 4.76%. Whilst that is a relatively small change, and certainly not of the scale I anticipate for the next 10 years, it has nevertheless been the real economic story over the last 20 years although very few people realise it.

The growth in global energy production from 1990 has not been associated with the North Sea or Alaska. It has not even been driven by the Middle East or the former Soviet Union. Instead it has come primarily from China where coal production of around 3bn tons per annum is equivalent to almost 38m bpd of oil, nearly 46% of world coal production or about 14% of total world primary energy consumption, ie oil, gas, coal, nuclear hydro, and alternatives. It was this growth that fuelled the Green Revolution, lifting agricultural productivity and freeing the rural Chinese up from the land. It was accessing this fuel that drove the growth in Chinese rail, ports and roads. And of course the benefits from the productivity that came from burning the fuels drove the growth in construction, textiles and manufacturing etc that we associate with China’s growth, all of which generated greater domestic wealth and therefore increased the demand for more energy, driving a virtuous circle of more investment and more energy; part of the so-called Jevons Paradox.

The Chinese miracle economy, or the growing energy network that I describe, happened in an environment of growth in global energy production. Not only did the energy network shift to China, but rightly so, it kept an increasing proportion of the value added within the country as well, hence the jump in domestic living standards relative to those in the West. It sucked jobs away from the West, keeping some at home and reallocating others to countries like Brazil and Australia where it needed their iron ore, copper and soy production etc. This has driven an incredible rotation of capital, but it happened whilst global energy production was rising. Imagine that rotation happening in a world of static, or worse still, falling energy production.

Assuming my numbers are correct, as the EROIE falls over the next 10 years from 20 to 5, the energy network would rise from 4.76% of the world economy to 16.7%. That is a huge shift, ripping capital from one industry to give to another. It would be a miracle if productivity didn’t fall substantially in the wider economy, but ignoring that and assuming linear moves, if the global energy output was able to grow 3% pa then the growth in the energy network would be 16.7% per annum whilst the rest of the economy – (what I call the energy subsidy) – would grow by 1.6% per annum. This is a transfer of relative but not absolute wealth and so is comparable to what we have seen over the last 20 years. To achieve even flat energy output over that period however seems very unrealistic to me, but nevertheless assuming that were to happen, the growth in the energy network would be 12.3% per annum whilst the energy subsidy would shrink by 1.6% per annum. In other words there would be not only a relative fall in wealth for those not participating in the energy network but also an absolute fall. In the environment of an actual decline in world energy production, the global economy as a whole shrinks at the same stage that there is a massive reallocation of wealth; a double whammy for the losers.

As you know I believe nuclear fusion is the only way out of this. The scale and kind of energy (extremely high density) it would release would drive economic growth on a scale never seen before, just as the growth released from the industrial revolution was bigger than previous energy revolutions. This morning I was reading about simulated fusion being achieved by accelerating a diamond methane bullet into a target at 1000km per second, and achieving energy breakeven, highlighting that there is continuous progress and new technologies being developed, however whichever way you look at it, viable fusion is still several years off, so in the meantime we have to expect the economy to radically change shape.

China has already turned a net importer of coal, oil and gas and various government bodies have made very clear statements suggesting that domestic production will rapidly deteriorate beyond about 2015, although it should be said that other government agencies have said otherwise. The latest stimulus package announced earlier in the week is clearly aimed at developing the oil and gas reserves in Xinjiang and Inner Mongolia, but as we know Xinjiang is 3000km from Beijing and the Gobi desert makes infrastructure investment in Inner Mongolia incredibly expensive, which is why the resources haven’t been developed until now. The stimulus plan also involves Tibet for its copper and water, and as we saw in the daily today other investment is also starting to pour into Mongolia itself but that obviously suffers from similar problems. We also know of massive rail and port construction projects in various parts of Australia, Indonesia, South Africa, Mozambique and Russia to access coal. I was even hearing of plans for the US to build a rail system to transfer Powder River Basin coal (Wyoming and Montana) to the West coast to then ship it to China, but this seems highly unrealistic given that the US EIA has said that because of the declining energy content of US coal reserves, it would have to increase domestic production by 80% by 2030 to meet domestic needs.

The oil network will increasingly bring Brazil into play. It is already increasing its steel production as its needs will soar. Because Brazil wants to keep a greater proportion of the value added form its energy (ie the value rather than just the cost) it has stated that it will not export crude oil, only manufactured or refined product. Domestic steel production is an obvious example, and of course as more of the value is kept domestically, so more steel is needed, so the growth in the industry is not just being driven by the oil infrastructure but also by the fact that the domestic car market is expected to become the 4^th largest in the world this year. Similar logic can be applied to the Middle East where domestic oil consumption growth is already on a par with China which has resulted in flat oil exports over the last 5 years. Even Australia’s mineral tax hike can be viewed in the same light, ie keeping more of the value added domestically.

The other area that offers significant potential is Central Asia and Russia, which as I described yesterday seems to be moving closer together again; Russia, Belarus and Kazakhstan have formed a customs union that is planned to evolve into a more ambitious common market. Relations between Poland and Russia have seen an extraordinary warming in recent months. The Ukraine has moved sharply towards Moscow, partly in the hope of receiving financial relief and Azerbaijan has turned to Russia to act as mediator in an internal conflict. Even Georgia says that if the US/Russian “reset” leads to a more modernised Russia, that’s good for us all. Brzezinski’s book The Grand Chessboard  says that it is increasingly recognised that Russia’s active participation in the region’s development is essential to the area’s stability, and it would bring significant economic benefits. Greater stability and increased wealth within the region would contribute directly to Russia’s well being and give real meaning to the “commonwealth” promised by the acronym CIS. Stability would attract far more capital into the region, and as a group it would act as a counterweight to China, which I think is how US is starting to view it. It is worth remembering that the former Soviet Union achieved growth rates of around 8% – 10% in the 1950’s and 60’s, so its not impossible to imagine. There is often talk that Russia is re-considering an old Soviet plan to build a 200 metre wide 2500km canal to transfer 27 cubic kilometres of water a year from the Ob and Irtysh rivers in Siberia to central Asia to try and counter the hydrological disaster around the Aral Sea and meet their water needs, which I can imagine would certainly be on the cards if the region does start to work more cooperatively. Russia’s trade with Western Europe is already EUR250bn a year, and in 2007 & 2008 we used to hear of convoys of trucks in massive traffic jams transporting European luxury goods to Russia. To me this seems like one of the bigger more positive bets that we can make that is not in the least bit discounted by the market. If Medevev can make a more stable political and legal environment, then I think capital will come in.

The energy network will encompass alternative energy even though it is incredibly expensive, and a lot of it will be eliminated because of negative EROIE’s when the full costs are taken into account. There will also be huge needs for land, capital and materials as I said at the outset, so commodities such as copper will be in huge demand as it is essential in building the network to turn these lower concentrates of energy into useful work. With copper ore grades declining rapidly, the energy intensity of extraction is also adding to greater energy needs. It is highly unlikely that the necessary resources will be in the same location, so far from the environmentalists idea of international trade falling; it is likely to increase although going to different destinations than today. What you have to remember is that as the efficiency of getting energy out of the ground and turning it into useful work deteriorates, so the energy intensity of the economy increases.

I think it is relatively easy to imagine which areas might be the beneficiaries of this. I think when you look at  the data it is also relatively easy to see where the big losers will be. I do not think it is the States. They have coal, shale gas and the outer continental shelf. They also have the land necessary to compensate for the declining energy efficiency, which allows them to buy Middle Eastern oil etc. Europe is already way ahead of anywhere else in terms of adopting alternatives, with Western Europe getting 49% of its direct power (ie not embedded in imports) from non fossil fuels, way ahead of anywhere else. The energy required for other countries to get to a similar position would be astounding, particularly given they will be making the investment with much lower EROIE energy inputs than when Europe made the switch. Of the large economies China is in by far the worst position. Its present reliance on fossil fuels – (83.5%) - is by far and away the largest percentage of the major economies, so the necessary investment (energy, capital and labour etc) is far bigger than elsewhere. To then add salt into the wounds, because China is still relatively poor at a per capita level – (China’s energy network is already a much larger percentage of its economy than in the richer West) – the cost of this switch will be completely prohibitive.

My bet would therefore be that we should be looking for a major rotation out of China into the “next China”, ie the next supplier of 38m bpd of oil equivalent. That is not going to be one country, but my guess it is going to centre around Russia, the Central Asian states, the Middle East and North Africa, with Canada, Brazil and Australia also key parts. As long as government’s allow efficient allocation of capital then Europe and the States will remain relative winners of the industrial economies. Because of Europe’s location next to the central pool of energy, and its huge trade with the region, and its head start in non-fossil fuels, I would think it could actually increase its relative power. Europe also runs a balanced trade position overall so it does not  need the scale of restructuring as a whole that is necessary in the States, although as we know, within Europe, southern Europe does need to lift productivity.  

In terms of assets to be shorting, I think you have to look at long duration assets in the “rest of the economy” or “energy subsidy” side of the economy. A lot of industry will disappear, or at least downsize. Office space going up that is unrelated to the energy network side will be obsolete although as I say I would think that can best be captured by selling Chinese property to perhaps buy Russian. Banking is the obvious loser as, by definition, its present portfolio will have a far greater exposure to the much larger “rest of the economy” – (presently 95.24% of the economy) - than the energy network side. Again however, the big loser should be Chinese banks rather than western banks although I do still anticipate significant further restructuring in Western banks.

The way I have presented this switch suggests a smooth process. It will be nothing of the sort. I have described the energy network rising relative to the rest of the economy, as returns on energy assets rise and returns on other assets fall. This would be bad enough if it was to happen equally around the world, but it won’t. A lot of the assets that will suffer will be financed by debt, and as that collapses it will force other selling until the central bank steps in and resets capital. I would suggest that a very small percentage of the investing community or corporate world has any idea about this story, and so capital is clearly being allocated on the immediacy of today’s fashions rather than this structural change that is happening beneath the surface which means that the scale of capital destruction will be extremely aggressive which means the willingness of people to take risk and invest in projects will be lower than we are used to.