The prospect of wind energy replacing fossil fuels in the near or intermediate term, however, is virtually impossible to imagine. The problem is largely structural and logistical. First, for wind energy to replace natural gas- and coal-based electrical plants, an entirely new wind-based electrical transmission infrastructure must be constructed, along with some 500,000 new wind turbines—just in the U.S. alone. Best case, this would require decades to accomplish, and no such massive construction is underway.
But even if this were accomplished, wind shares with solar the limitations of electricity itself. How do you power a farm combine on electricity? An airplane or container ship? For that matter, a two-ton pickup? No one knows the answer, but if there is one, we are surely decades away from finding and implementing it.
Hydrogen
The possibilities inherent in hydrogen power hit the mainstream in 2003 when General Motors drove their experimental hydrogen-powered vans to Washington, D.C. That year, President Bush proposed significant federal funding for hydrogen cell research.
Why the excitement? Because hydrogen is an element already in use to fuel the world. It's the hydro in hydrocarbon. Remember we said earlier that with hydrocarbon fuels, we burn the hydrogen and waste the carbon. We don't separate the two; we burn the whole thing, and use the one for energy and send the other out the tailpipe.
On the other hand, if your hydrogen source is water (the H in H 2 0), then your only waste product is oxygen. Hydrogen has already been proven to be a potent energy source, and water is surely very plentiful nearly everywhere around the world. Plenty of energy, with no pollutants, no shortages. No wonder everyone's excited.
So what's the problem? Simply this: in the natural world hydrogen is never found alone—it is always bonded to some other element, like carbon or oxygen. How do you split off hydrogen from the other element, create a net energy surplus and store that energy for practical use? That is the question.
Remember those hydrogen-powered GM vans we mentioned earlier? That hydrogen was derived from natural gas, one of the hydrocarbon fuels we're starting to run short of. That's obviously no solution at all. It is only when we are able to efficiently spilt hydrogen from oxygen in water that we can enjoy the worldwide hydrogen revolution many hope for.
The rub here is that quite a lot of energy is required to break the chemical bond between hydrogen and oxygen. That energy has to come from somewhere, be it sunlight or fossil fuels. Fossil fuels are the energy source we're trying to replace, so we're left with the challenge of using sunlight to efficiently break hydrogen off from oxygen in water. And no one is close to knowing how to do that, because sunlight's power is only a fraction of what current technology needs it to be to perform the hard work of separating hydrogen from oxygen.
That leaves the hydrogen fuel cell, a somewhat different animal. A fuel cell is more like a battery than an engine. Through a chemical process it produces electricity from hydrogen without burning it. This is where most of the research is going, especially in the arena of hydrogen-powered automobiles.
However, even the most optimistic estimates of the build-out of a full-blown hydrogen-powered economy range between 30 and 50 years. Hydrogen may well prove to be the energy source of the future—the distant future.
After briefly reviewing the promises and challenges inherent in alternative energy sources, we can only come to the conclusion that an alternative to oil as a primary energy source is, at best, decades away. As investors, that is our main concern. The issue is not whether technological progress will eventually create a replacement for fossil fuels as the world's primary source of energy. That's probably inevitable; at least we hope it is.
The question before us as investors is, what happens between now and then? The answer: almost certainly higher oil prices for the foreseeable future. Which brings us to our final, and most important topic—how investors aware of Peak Oil can profit from the higher oil prices which seem to be a near certainty in the years ahead.
What Every Investor Must Now Consider
To capitalize on the oil boom now underway, investors obviously need to carefully weigh the potential benefits of the various oil-based investments. There are several, and we should carefully consider each.
Oil stocks
Generally, we are speaking here of shares of multinational oil companies (like ChevronTexaco and ExxonMobil) which are traded on major exchanges through stockbrokers.
Historically, these stocks have profited from bull markets in the price of oil. Because these companies' cost of exploration is more or less fixed, they earn more when they receive more for the oil they've drilled. For investors, that's good news.
However, what happens to the price of, say, your BP shares when news hits that a major, very expensive drilling project in the Gulf of Mexico they had hoped would yield millions barrels turns out to be a bust? This is not an unheard-of development. Your shares in BP will suffer. Even though management may have had some advance warning, retail investors like yourself will certainly be the last to know about it.
A recent development with Royal Dutch Shell further illustrates the uncertainties inherent in oil stocks. The Anglo-Dutch company stunned shareholders in January 2004 when it downgraded its estimate of proven reserves 3.9 billion barrels, a 20 percent reduction. Its stock plunged nearly 15% after the news broke. Then, three more downgrades followed, for a total reduction in estimated reserves of 23 percent from previously reported levels, depressing its stock price for months.
Shell later dismissed several top executives and delayed release of its annual report for two months, creating more uncertainty for investors. When Shell's annual report finally came out, “rebuilding credibility” and “regaining trust” were said to be the company's new key priorities.
Let's consider another, unfortunately all-too-realistic scenario. Imagine a major terrorist attack is launched against the overseas natural gas plants of a few major oil companies.
This attack will shrink their bottom lines for months, perhaps years to come. Aside from the loss of physical plant, loss of production capacity and loss of the gas itself, management will now be completely preoccupied in a Herculean effort to get their companies back on their feet again; psychologically, financially, and logistically. They will have to break the bank to implement new security measures and build new physical plant, which will require resources that management had hoped to put to more profitable uses.
Their shares, of course, plunge immediately upon release of the news. Other oil company stocks also take a major hit, for fear they might be next to suffer the terrorists' wrath.
At the very same moment, however, the price of oil and gas is skyrocketing with the news, since new energy shortages, and new dangers of overseas energy exploration, have now emerged. Are investors in oil company stocks profiting? Quite the opposite; they are losing their shirts. Why? Because they haven't invested in oil, they've invested in companies who hope to find and market oil, which is not the same thing.
For these reasons and many more, with oil company stocks you are buying the shares of large, diversified, multinational corporations— you are not buying oil . The price of oil may or may not result in a concomitant rise in the shares of any given company, as their prospectuses will tell you.
Natural-resource mutual funds
Natural resource mutual funds eliminate one of the larger disadvantages of buying individual oil-related stocks. Like all mutual funds, natural resource funds broadly diversify their holdings among many stocks, so that a crisis in one company does not wipe out your entire investment.
However, while diversification brings a degree of safety, it also inevitably reduces returns. Among any group of companies, within a given window of time some will always underperform others, and those lower earnings will be reflected in the price of their stock.
Almost by design, then, a mutual fund will usually offer somewhat mediocre performance compared to other alternatives, simply because diversification itself almost requires the holding of underperformers. This is the price you pay for the benefit of diversification.
This shortcoming of diversification is magnified with natural-resource funds, because they usually include forestry, mining and other non-oil-related companies in their holdings. Because of the historic volatility of oil shares, most fund managers are uncomfortable weighting their holdings too heavily in oil-related stocks. Thus these funds are not a pure oil play and do not deliver the results of a pure oil play.
Those relatively few funds whose charters do allow them to invest exclusively in oil company stocks are still bedeviled with the same core issue that all investors in oil company stocks face: even though the price of oil is going up, some major players may not, for any number of company-specific reasons, be able to capitalize on it.
Oil futures and options
If you want a thrill ride even greater than high-stakes Vegas gambling, you've found it in the NYMEX pits in New York, where energy futures contracts and options on those contracts are frantically traded.
With futures and options on futures, you receive the benefit of profiting from the rise in the price of oil. When the price rises, the value of the futures contract or “call” option you purchased will go up with it. Since they are both inherently leveraged instruments, your percentage return on capital is excellent. That's the good part.
The downside is, well, the downside. In any market, even a major bull market, there are periods of consolidation, periods of decline. This is actually healthy for markets, because as profits are taken, it tends to cool off speculative fever. Bull markets are not always—or even usually—a straight-to-the moon affair. They usually consist of a long series of higher highs and higher lows.
So what happens if, in the week you decided to jump in and buy a highly leveraged oil futures contract, the market decided to take a well-deserved breather? If the breather is deep enough and long enough, you can not only lose the money you deposited with your commodities broker, you can lose more than you put up. You will get a call from a margin clerk demanding more money. There is almost no limit to how much money you can lose in futures if you place your bets at the wrong time.
For this reason, some have fled to the “safety” of options on futures, which also bring excellent returns when you are right and if your timing is perfect. The benefit with options, however, is that, unlike futures, you cannot lose more than you originally invested. But if your timing is off, even by just a few weeks in some cases, you can still lose every penny you invested, because options “expire” at a set date. Indeed, options professionals know that 80% of all options expire worthless. You know the futures pits are another world of speculation when an 80% probability of losing everything you invested is supposed to be a comforting thought.
Oil & gas partnerships (Part 1)
The last category of oil investment is exactly that—investing in oil, through an oil & gas partnership. U.S. partnerships explore for oil & gas in proven areas of the country, with the anticipation of discovering “black gold” and returning a long-term flow of income to its partners. Oil & gas partnerships are the only means most investors have to personally own and sell oil. None of the other oil investment alternatives we've discussed invest directly in the commodity itself. And it is oil, as we've seen, whose price promises to continue to increase over the long term.
As limited partners in a drilling partnership, investors own a percentage of all the oil and natural gas extracted from the wells they helped pay for. If drilling is successful, the rising price of oil and gas go directly to their bottom line returns, since the price received for their oil will move more-or-less in lock-step with oil's worldwide price
There is, of course, no guarantee that oil and/or gas will be struck by the partnership. That is the risk the partners take. To help compensate for that risk, the IRS offers oil & gas partners generous tax deductions which can result in a significant reduction in federal taxes. (We discuss this in detail in Part Two of this discussion.)
No other energy-related investment we've discussed is subsidized by the federal government this way. Today, more than ever, the U.S. has an interest in encouraging the domestic production of energy and reducing our dependence upon foreign oil. That's why U.S. taxpayers receive almost unmatched tax incentives to encourage them to join together to discover oil and gas. Most importantly, though, the potential exists to earn a significant long-term flow of income from any successful drilling project.
In Part Two of this topic, we demonstrate in detail the uniquely advantageous economics of oil and gas partnerships , and why more and more investors are joining together to claim their piece of America's ever-more-valuable energy resources.
We hope you have profited from this discussion of Peak Oil and its implications for investors, as much as we have enjoyed sharing it with you. We invite you to contact us at the number below any business day with questions you may have about Peak Oil, oil investments, or the world oil situation generally.
And, as always, we at Mammoth Resource Partners wish you every success as you navigate your own portfolio through these challenging, yet potentially profitable, years ahead. |
