Investing in Energy: An Exercise Not for the Faint-hearted

Investing in Energy: An Exercise Not for the Faint-hearted
Managed Funds Association Forum 2001
New York City
July 11,2001
By: Matthew R. Simmons
President
SIMMONS & COMPANY INTERNATIONAL

“Investing In Energy: An Exercise Not for the Faint-hearted”

It is an honor to address your group today about what is happening in the
energy industry and the investment opportunities and pitfalls that energy,
an incredibly important and woefully misunderstood aspect of our economy,
represents. I probably often get accused of exaggerating the importance of
energy to our economy and our lifestyles. This could easily be the case as I
have been involved in energy-related investment banking and analysis for
over 30 years and for 27 of these years energy has been my main focus. I
suspect someone concentrating that exclusively in breakfast cereals or
tinker toys might also end up exaggerating the importance of their own areas
of expertise. But, I am a passionate believer in the importance of energy.
Moreover, I am totally convinced that there is nothing in our economy that
comes even remotely close to the importance of having reliable and
affordable energy supplies. Without energy, not a thing we cherish works. It
is the economic equivalent of oxygen to the human body. And I am just as
convinced that we now face a genuine and severe Energy Crisis that will
frame our economic outlook, and the investment opportunities and pitfalls,
for most of the next decade.
If the Energy Crisis is properly addressed and solved, it will propel not
just the U.S. economy but also the rest of the world’s economies into a new
sphere of prosperity. If we fail to get the job done, it will be the one
reason, absent a serious war, that could destroy our future economic
prosperity. So, the stakes could not be any higher.

From an investment standpoint, these ever-volatile energy markets will have
an increasingly important impact, sometimes positive, sometimes negative, on
many aspects of the economy. And there is no reason to assume that the
recent high levels of volatility in both energy prices and energy stocks
will soon moderate. If anything, the volatility might simply rise. Whether
such volatility is healthy for energy or more of an insidious cancer is an
entirely different topic - and one worthy of an intense debate!

As I assess the seriousness of this Energy Crisis, I will spell out, as
carefully and specifically as I can, why I think it is so real and so
serious. What amazes me the most is how few energy observers share my energy
concerns. Too many energy experts assume that all the recent price
volatility are simply spikes and that the past couple of years of turmoil in
the oil, natural gas and electricity markets were an aberration. Also, many
well-intentioned people like former President Jimmy Carter and noted
economist, Paul Krugman, have gone to great lengths to publish that we have
no energy problems. According to them, President Bush is simply concocting
these false charges in order to hand out to all his oil buddies. These
charges about fabricating an energy crisis are wrong. They are naive and
they threaten the well-being of our economy.

Unfortunately, we are entering a period of very high risk that a slowing
economy creates the illusion that we have somehow solved all of our energy
problems. There is no question that economic slowdowns will impact energy
demand. But if anyone thinks this solves the lack of added energy capacity,
they are also implicitly assuming that economic growth has permanently
ended.

Why do I believe we face such a serious Energy Crisis? Because I am
convinced that almost all pockets of spare energy capacity are now gone.
When spare energy capacity is gone, it will take years to add even one or
two percent of new energy capacity. Adding energy capacity does not happen
in small chunks. Each discrete chunk costs hundreds of millions or billions
of dollars to create and takes years to effect. If energy demand also grew
in such limited chunks, running out of spare energy capacity would be a
trivial issue. Sadly, this is not the case.

Like it or not, changes in energy demand are far more fickle. They can
easily grow by between one to three percent from one season to another. This
seasonal fluctuation can be satisfied by drawing on inventories, but once
these cushions are reduced to minimum levels, shortages begin to appear. The
irrefutable fact remains that over the intermediate to long-term, energy
demand cannot exceed energy supply.
In the 1970’s we suffered through three separate energy shocks. Two of these
energy shocks involved oil. The third involved natural gas. In all three
cases, the problem was quickly solved. In the 1973 and 1979 oil shocks,
consumer hoarding triggered both events. The worst offenders were motorists
who constantly topped up their gas tanks and accidentally created a “run on
our energy bank.” We solved both oil shocks by getting our consumers to calm
down.

The natural gas crisis in the winter of 1977/1978 was created by extremely
cold weather that sent demand for gas throughout the Mid-West beyond the
natural gas industry’s physical capacity to increase natural gas supplies.
Because this event triggered the closure of factories and schools, we passed
laws making the use of natural gas illegal for many utility and industrial
users and soon, this crisis also subsided.

This time, our energy crisis is not a temporary event caused by abnormal
consumer hoarding. Thanks to an extended period of economic growth in the
U.S. and the world’s economies, energy demand has grown beyond any published
forecast over the past decade. This almost unprecedented growth used up
virtually all spare energy capacity. And this time around,  it is not just
oil or just natural gas. We are out of excess capacity of any meaningful
amount in all three forms of energy: oil, natural gas and electricity. That
this all happened simultaneously was an accident, but the convergence of all
three has created a “Perfect Energy Storm.”

In the U.S., we measure total energy demand in quadrillion Btu units. For
those of you unfamiliar with the term Btu, it is the energy equivalent of a
match head of energy. In 1990, U.S. energy consumption totaled 86
quadrillion BTUs or 86 (or 86 quads.) By 2000, our energy consumption had
grown to almost 100 quads. In just ten years, the U.S. on its own, used the
added energy equivalent of almost 8 million barrels of oil per day. This is
the equivalent to the total oil consumption of Japan and South Korea today.
This added energy use is also more than all the oil and natural gas liquids
produced in the USA.
On a global scale, total energy growth was far higher. Asia’s energy demand
growth was twice the volume of the USA, despite its bout with the Asian ‘Flu
and almost no energy growth from Japan over the past few years. Global
energy numbers are surprisingly hard to get in any finite detail as
conversion rates differ from one model to another. But, total global energy
demand, excluding the one-time collapse in energy use from the Former Soviet
Union, grew by over 28 million barrels a day in just 10-years. This growth
is essentially what OPEC, in total, now produces in daily oil supply. And
all the growth occurred in less than 10 years. This growth almost rivaled
the unprecedented energy growth of the 1960’s and early 1970’s. But the
growth came “unannounced” and according to almost all energy economists, was
not supposed to even happen.

All this growth would have been fine had our capacity to produce energy
grown at a similar rate. But here is where the problem lies. For numerous
unfortunate reasons, the world added surprisingly little new energy capacity
as we went through this unbelievable demand surge.
In our oil markets, only one major new field was developed in the Middle
East in the past twenty years.

In 1990, OPEC still had close to 10 million barrels a day of spare capacity
shut in behind wellhead valves. Today, only one OPEC producer (the Kingdom
of Saudi Arabia) has any significant “behind a wellhead valve” shut-in
supply. And even this amount is probably far smaller than most people think.

Outside of OPEC, while over 100,000 new wells were drilled around the
non-OPEC world, total non-OPEC supply only changed by less than two million
barrels a day in a decade of rapid technological changes that unlocked many
sources of new supply that were beyond reach as the 1990’s began. All this
new technology was about to glut the world with too much oil, but after all
the hype and perpetual oversupply concerns, non-OPEC supply grew by only
4.6% in ten years.

Outside of Asia, almost no new refinery capacity was added. On a global
scale, outside the Former Soviet Union, total refinery capacity grew by only
9110th of 1% per annum. This was despite oil demand, excluding the FSU
collapse, growing twice as fast. The world’s tanker fleet actually declined
in size as this remarkable decade of energy growth came and went. With the
exception of the one major oil pipeline now almost complete to transport
some oil from the land-locked Central Asia, no major new petroleum pipelines
were built. A decade ago, throughout the complicated infrastructure to
deliver and process oil to where it can be consumed, we had lots of spare
capacity. Today, thanks to the growth we had in energy demand, this excess
is essentially gone.

In the natural gas side of the energy business, supplies grew rapidly over
the past decade. But steadily rising decline curves in too many important
parts of the world are now forcing exponential growth in drilling new gas
wells to merely keep daily gas supplies flat.
In Canada, for instance, gas well completions grew by 41% in 2000 over 1999
but Canada’s daily gas supply grew by a mere 2%. In the USA, rigs drilling
for gas have escalated three-fold over the past five years, but this has
merely kept the current production base flat.
The reason so much drilling occurred to keep daily natural gas supplies
essentially flat was because new finds were ever smaller while technology
increased the rate of decline to levels never experienced before.

Europe still gets 28% of its gas needs from the giant gas fields of Siberia.
But, these fields finally began experiencing sizable declines in 2000,
putting Europe’s gas supply in a far more precarious state than most energy
planners in Europe now appreciate. If the Siberian decline rates for natural
gas bear any resemblance to the decline rates Siberia suffered in its oil
production, Europe could be in for the gas shock of all time.

The world has vast amounts of what the industry calls “stranded gas”
reserves. But the reason they are described as “stranded” is that no
infrastructure exists to get the gas out of the earth and delivered through
a “not yet built” system of either pipelines or the even more expensive
natural gas liquefaction systems. This stranded gas can be used. It simply
takes lots of money and a long time to convert stranded gas into consumable
gas.

The infrastructure to drill and develop more oil and gas is now old and
frayed. For almost twenty years, very few new assets were added while the
old asset base was kept in tact by massive cannibalizing of the existing
asset base. Less than 50 new offshore rigs were added to the worldwide fleet
in the past decade and fewer than 100 new land rigs were added around the
globe. Numbers on other components of the intricate oil service sector are
hard to get but there is no evidence that any aspect of this system added
any more new capacity. Most of the industry’s drilling related assets were
added over 20 years ago. And remember, rigs do not operate in user-friendly
regions. The manpower issues and limitations throughout the people-intensive
oil service sector are just as significant as the fragility and age of the
asset base.

When you switch to the world’s electricity grid, the numbers are even more
sobering. In America, prior to 1990, we religiously added about 10% to our
electricity grid every five years in the form of power plants. But as the
1990’s began, this important building program ground to a halt. In the first
five years of the 1990’s, America added 4% more power generation and then
added only another 2% in the last five years of the 20th Century. But, few
new power plants were the least of our electricity mistakes. We added
virtually no new transmission lines on a percentage basis.

This would have been no problem if electricity demand had flattened out. But
electricity’s growth held at a steady 2.5 to 3% through the last decade
before it recently began to accelerate. Electricity data is unreliable so
the numbers are still being debated. But kilowatts generated in 2000 grew by
at least 4% over 1999 and the numbers through the first six months of 2001
show net generation for the past 52 weeks still running 4% above last year’s
52 week total.

If you track the U.S. peak weekly electricity use, it grew by almost 20%
from record 1994 levels to peak weekly use in 2000. Since electricity cannot
be stored, you need generating capacity for the peak hour on a
region-by-region basis. Otherwise, the regional power regulators need to
impose rolling brownouts and if this does not work, then rolling blackouts
are the only fix to keep “wire meltdowns” from occurring. But like the other
aspects of the energy system, these electricity mistakes were not limited
only to the USA. Most other parts of the OECD added as little new
electricity capacity as the USA did. And outside the OECD, few countries
have any form of real electricity cushion (otherwise known as reserve
margin.)

Mexico’s electricity numbers highlight why most developing countries have
blackouts with such regularity that they never even make the news until they
get so dangerous that draconian demand restrictions have to be imposed, like
Brazil is now doing. The USA has a shortage in spare power capacity because
we only have 830,000 megawatts of power plants for our 280 million people.
Mexico has fewer than 40,000 megawatts of power plants, less than 5% of the
USA, for its 100 million people. No wonder blackouts are so common.
The world made two fatal energy mistakes over the past decade. First, too
many energy experts boldly predicted that energy demand growth was waning.
From the numbers I have shown you, this was clearly a classic mistake.
Second, the energy business began to embrace a “Free Market/Deregulation”
spirit or philosophy. This would have been fine had it been done in a
careful and prudent manner. But someone forgot to include in this
“just-in-time” market efficiency energy model the urgent need to allow for a
safe cushion of spare energy capacity. To the contrary, these energy
insurance reserves were too often deemed “energy inefficiencies” that could
be used up in lieu of adding new energy capacity.

We rapidly switched from running most of the energy industry on long term
contractual agreements to a pure spot market, just-in-time energy supply. To
make matters worse, the industry then embraced a new way to set energy
prices. One after another form of energy prices was set based upon what
speculators on commodity exchanges decided, largely based on gossip and two
minute charts rather than any sound long-term energy fundamentals or
economic returns set to insure the world had a safe and reliable energy
system in tact. As a result, we used up the world’s invaluable energy
cushion that underpinned the world’s ability to rely on ample, safe,
affordable and dependable energy supplies. This would have been bad enough,
but ever-lower “spot market” energy prices created abysmal financial
returns, thus insuring no extra energy capacity would be added.

In a giddiness reminiscent of the roaring twenties, we used up every aspect
of our energy cushion and chalked the entire exercise up to “a new era of
energy efficiency”. So the world will now have to pay for this mistake in a
very costly and possibly painful manner, as there is only one truism in the
energy world.

Energy demand cannot exceed energy supply.

A bigger question is whether the world can experience much real economic
growth without the ability to grow energy demand. For a decade, too many
energy observers pretended that the economy and energy were de-linking or
had de-linked. But this was simply wishful thinking or sloppy analysis or
both.

Our financial markets, in the form of falling stock prices, are telling us
that the economy is slowing down to an extent that these energy problems are
quickly fading away. This thinking is as dangerous to the well-being of our
economy as being a pacifist was when World War II was about to begin. A
temporary slowdown in demand is only a brief respite from the issues. Unless
the world begins a rapid expansion of our capacity to increase energy
supply, the days of economic growth will be over until someone invents an
economy that can grow without any increases in energy.

There are many powerful proponents of energy conservation and better energy
efficiency who argue that we do not have to expand our energy supplies. We
can simply embrace better energy usage.

In the current edition of Foreign Affairs, Amory Lovins, the father of
energy conservation, has an article called Fools Gold in Alaska. He tells us
that “available and proved technologies that use energy more productively
would exceed the expected production from the Arctic National Wildlife
Refuge by more than 50 times.”

 This is a bold statement as it implies that we can save almost 15 million
barrels of oil equivalent energy each day by simply embracing more energy
efficient measures. These are tempting solutions to our serious energy
problems but let me give you a few simple energy facts that cast some doubt
on the credibility of these outlandish claims.

In our transportation markets, the most radical energy saving device now on
the drawing boards is an 80-mile per gallon car that the automobile industry
promises to have prototypes available by 2004. If you could produce one
million of these cars and have them on our roads tomorrow to replace the
average vehicle now driven, it would save just over 40,000 barrels of oil
each day. This is a far cry from the energy equivalent potential of ANWR. It
is barely what ten Gulf of Mexico wells can produce for every million 80-mpg
cars.
Mr. Lovins and his energy efficiency colleagues also boast that simply
changing the CAFE standards of our SUV’s and light trucks will quickly save
nearly one million barrels of oil each day. These numbers are almost
accurate but some timing issues need to be considered. The current car
turnover rate averages about 13 years and the light truck turnover rate is
25 years.

So unless some federal mandate to ban the use of our current vehicle fleet
is effected, it would take 15 to 25 years to fully realize these savings.
Like the 80-mpg car, these “energy savings” are largely figments of someone’
s imagination - particularly in the near term.
They are important advances that need to be made and they are wonderful
concepts for people who hate the thought of ever adding any new energy
capacity to preach. It is tragic that the massive savings we hear about so
often simply turn out to be numbers that do not work.
In the average U.S. household, the refrigerator is the single largest energy
user. If someone could suddenly create a 50% more energy-efficient
refrigerator, and we instantly replaced the 110 million refrigerators
currently in use, we would save 2/10ths of 1% of America’s total energy use.

Energy conservation is an important long-term ingredient to a balanced and
diversified energy strategy as is the development of wind and solar energy.
But none of these solutions are more than slivers of real energy supply or
energy substitution.
A deep recession can save us some real energy use. Blackouts create instant
energy savings. In Houston, we recently had an extremely serious flood. In a
24 hour period, the flood destroyed the energy complex of our 53-story
office building and our energy use dropped from a growth of 21% between 1998
and 2000 to zero until a new power system could be built. These are the only
real energy savers that work but they work in a very agonizing fashion.

There is no easy alternative to adding more energy capacity if we want any
of the aspects of our lives we all cherish so much to continue. So the job
must get done.

The question then has to be: How much added energy capacity do we need? As
opposed to whether any added capacity is needed at all. One guideline to the
amount needed is to simply use the International Energy Agency’s most recent
World Energy Outlook 2000. While their numbers might not be perfect, they
were seriously undertaken and hint at the magnitude of needed growth.
The IEA numbers estimate that worldwide oil and gas demand will grow to 154
million barrels of oil equivalent by 2010, an increase of about 36 million
barrels of oil equivalent per day over current use, or a growth of 30% in
total volume of supplies needed to meet such demand. They also forecast
electricity generation to increase by almost 40% by 2010. These numbers
suggest that our energy capacity needs to grow by at least 30 to 40% by 2010
merely to meet growing demand.

Even if we were already in the midst of a massive energy capacity expansion
program, it would still be a gigantic challenge to add so much so fast. But
even if this could be accomplished, it misses two other important steps.
First, if we only add enough energy capacity to merely meet demand, we fail
to re-create a new energy cushion of spare supply. So in addition to the
minimum demand needs, I believe that a reserve of at least 10% needs to also
be added.

But a far more important task is to also refurbish or rebuild the entire
energy complex that allows the world to use close to 200 million barrels of
oil equivalent energy each day. Too much of this complex infrastructure is
extremely old. If a refurbishment/replacement program is ignored, then we
risk adding all the badly needed new capacity but barely expanding the base
as too much of the existing system rots away.

How much will such a program cost? No one has a clue as no blueprints have
even been thought out. I have taken a pencil to some of the more obvious
aspects of this expansion and I can quickly get to a number in excess of $5
trillion dollars over the next decade. And this number ignores many parts of
the needed supply and uses current cost estimates. Once a real building boom
begins, capacity constraints throughout the infrastructure to build this new
capacity will likely drive prices much higher.

How does the world pay for this costly program? There are only two ways. We
can assume the governments of the world fund the cost, or we need to have
energy prices rise to a level that creates safe and reliable financial
returns so the private sector gets the job done There is no other miracle
fix

Do higher energy prices doom the economy as too many people argue has
already happened? I would argue just the opposite. Without higher energy
prices, the world will never even begin to add the necessary energy capacity
to eliminate our current capacity squeeze. And without new capacity, our
economies cannot grow.

It seems almost impossible that the world could spend over $5 trillion in
new energy investments and sink into a deepening recession. The only way we
might avoid such a recession is to bite the bullet and get the energy
expansion underway. But this is a tricky exercise if the “free market”
assumes energy demand is stopping and energy prices then collapse. Perhaps
the biggest danger to not properly solving our Energy Crisis is the false
perception that lessening demand growth through an economic downturn is the
solution to our energy problems.
What does all this mean from an investment standpoint? Is the run in energy
stocks almost over as many now think? Are we about to plunge into a new
round of low energy prices? Or, will the world get its act together and
resolve to end the Energy Crisis that is so real and so dangerous? If the
latter is the answer, then investing in energy might be the only safe haven
in the market over the next complicated years of feverishly rebuilding our
energy complex.

Investing in energy will not be a simple, risk-free exercise, even if we
spend the necessary trillions of dollars to solve our Energy Crisis.
Choosing the right energy areas and the right time to get in and get out
will be a tough investment task.

Fighting off energy misconceptions that end up having little to do with real
energy fundamentals but might have everything to do with getting crushed on
investment performance remains a big risk in energy investing. Wrong
perceptions came close to crushing the energy markets three times during the
decade of the 1990’s.

Getting in too early or too late is a tricky investment decision in any
market sector. The risk is even greater in energy investing. Nuclear energy
will clearly have its day in the sun, but the “day” could be five or even
ten years away. New energy devices like hybrid cars, fuel cells and ways to
store electricity in real bulk might end up creating a new generation of
John D. Rockefellers but many of these start-up technologies might also
become the next generation of failed dot coms, too.

If energy prices need to rise to pay for this massive investment, owning
assets in the ground as the best way to own energy has a safe ring to it.
But if these assets suffer decline curves of 20 to 40% per year, they might
be gone long before energy prices rise to where they logically need to be

So, picking the right place and the right time in energy investing will
remain a complicated process and one not without a fair degree of risk.

And be cautious as you read or hear the energy views from many seasoned
energy experts. There is a deep-seated bearish bias in the minds of too many
seasoned analysts that comes not from thousands of hours of detailed
analysis but from deep scar tissue as a result of living through all the
painful energy collapses which plagued the industry for the past twenty
years.

Getting a fix on the fundamentals of energy is not a terribly complicated
task. However, it is hard to get good and totally reliable energy numbers.
The whole energy data reporting system is badly in need of an overhaul. My
biggest complaint of so many energy analysts, though, is not their lack of
analyzing the real numbers, as bad as the data might be. Too often, too many
energy analysts simply develop a thesis and then assume is it right as long
as several of their peers share the same notion.

So getting energy investing right will remain a tough task and not an
exercise for the faint-hearted. But the Energy Crisis must be solved and
billions or even trillions of dollars of wealth will likely be created as
this vital job gets done. And if the job is not done, the world will be a
darker place as the 21st Century gets underway than anyone would have
imagined as the New Millennium began.

Thank you for your attention to this serious issue. Its importance goes far
beyond how to successfully invest in energy.

Energy genuinely is “Economic Oxygen.” This oxygen system is at risk and
must be fixed.