BTU - State Of The (Energy) Union

2023-09-13 09:46:34 ET

Summary

• Energy is a complex topic, but one way to look at it is energy return on energy invested. I also look at energy density, where uranium is a clear winner.
• Wind and solar energy cannot support the energy demands of modern life and so-called renewable energy sources have many flaws that make them a terrible option for base load power.
• There has been underinvestment in coal, uranium, and offshore oil, and I'm expecting a bull market for these sectors due to the capital cycle and their cheap valuations.
• I mention several stocks that I'm invested in that should be able to benefit from these factors and produce outsized returns moving forward.

Over the last couple weeks, I have had several discussions on investments, energy, and broader financial markets with friends. I enjoy these discussions, but I also have a tendency to ramble from one topic to the next. Part of this is just simply due to how interconnected and complicated the energy world is, and part of it is me getting distracted bouncing from topic to topic. When I write about it, I'm able to be more concise and to the point. Today I want to talk in more detail about energy return on energy invested, energy density, and why I'm so bullish on offshore oil, coal, and other commodity sectors.

I think it takes one look at the chart above to realize that we are never going to have an electric grid that can support our energy demand if that grid relies on wind and solar. Our whole way of life is built on cheap and convenient access to abundant energy. Food in the grocery store and being able to drive to work are two examples of things that we take for granted in the modern world that are a result of cheap energy. For example, I wouldn't be able to get organic bananas from Mexico for $1.00 per pound this afternoon without cheap energy. Each form of energy is suited to different things, and each has strengths and weaknesses, but without oil, gas, coal, and nuclear energy, the world would look a lot different. In human history, we have never gone from a more efficient source of energy to a less efficient energy source, which is why I don't see a bright future for wind and solar.

Wind & Solar

Even if you want to ignore the unusual number of whales washing up onshore on the East Coast, or the thousands of eagles and other birds that are killed every year by wind turbines, all it takes is a little bit of research into wind turbines and solar panels to realize just how ineffective it is for power generation. If you want a couple headlines that show some of the flaws in "renewables", here are a couple worth reading. The first covers the renewable projects that are already looking for rate increases despite subsidies. The second is a headline on Britain's offshore wind market going no-bid for the first time. Could the technology improve dramatically in the future? Maybe. I'm skeptical, but the current calculations could change. For now, solar and wind are not viable to produce reliable base load power in my view.

One of the other things people ignore is what it takes to create wind and solar panels. Now we get to take a short detour into the coal industry, which is responsible for more than two thirds of global steel production. Not only do solar and wind have much less bang for the buck as far as energy produced, but it takes a lot of steel, and by extension, coal to produce.

Each megawatt of solar power requires up to 45,000 kg (99,000 pounds, or 49.5 tons) of steel, which requires 31,500 kg (69,300 pounds, or nearly 35 tons) of steelmaking coal…. The average wind turbine requires up to 260,000 kg (572,000 pounds, or 286 tons) of steel, which requires 170,000 kg (374,000 pounds, or 187 tons) of steelmaking coal.

Over the last couple years of obsessively following financial markets, I have learned a lot about the energy sector. The whole energy sector is more cyclical than your average business, but that means there is potential for outsized returns if you catch the wave right. I think that we have a bull market in front of us for most commodities due to the lack of investment over the last decade.

Capital Cycles

In the past I have talked about the cyclical nature of the world and financial markets. I talked about different assets near the peak, financial market themes like ESG also being near the peak, while commodities and other assets that are out of favor are closer to the trough of the cycle. One of the books I read last year was Capital Returns by Edward Chancellor, which talks about the capital cycle and investment returns.

For me, the lack of investment is most obvious in several sectors, primarily coal, uranium, and offshore oil rigs. It's most commodities, but I think the bull case for these three sectors in particular is relatively simple to understand.

Coal

If you look at the capital cycle picture above like a clock, I think we are still around 8:00. We still aren't seeing new investment in the sector, the valuations are still extremely cheap, and companies are buying back stock like crazy at these low valuations. My assumption is that we will also see coal prices head higher in the next couple years, but that will just be gravy in my opinion. Coal demand is still growing and some of the best coal assets have 20 to 30 year lives. I'm curious to see what happens to signal the end of this coal cycle, but I don't think we are anywhere close to the top of the cycle for the sector.

I'm wishing I had bought some Alpha Metallurgical Resources (AMR) instead of just sticking with Peabody Energy (BTU), but it's only a matter of time until we see something closer to fair value with stocks across the coal sector. AMR has reduced shares outstanding by more than 25% since the start of their buyback program a year and a half ago, and Peabody just bought back more than 8% of their stock in one quarter. You can argue that most of the coal sector would still be cheap if share prices doubled from here as they would still have single digit P/E ratios at current coal prices. AMR and Peabody aren't the only companies in the sector with huge capital return programs, but are just two examples that I think will be trading much higher in the next couple years.

Offshore Oil

While I don't think we are near the peak of the coal cycle, I think we are only in the third or fourth inning of the offshore cycle. The offshore oil investment cycle is very long compared to conventional or shale oil and I think we will be smack dab in the middle of a huge bull market for offshore oil companies in a couple years. The super bull case for offshore is $1,000,000 day rates for high spec rigs, which I believe means we could potentially see at least a double on stocks like Transocean (RIG), Valaris (VAL), and Noble Corporation (NE). Tidewater (TDW) will be along for the ride as OSV day rates follow along.

The capital cycle for offshore looks like we are running into a situation with a huge mismatch on supply and demand for rigs, and I think we will go way past the last cycle peak with day rates above $600,000. I'm hoping that it runs to $1,000,000 per day or higher, but we will have to wait and see on that. I have written about the offshore sector in the past, going into more detail about what will lead to new builds, how long it will take, but I'm still very bullish on the sector even after a huge run to start the year.

The offshore cycle is long and slow compared to shale, which can ramp production quickly. Many projects are 5-10 year investments and require huge upfront spending. While that was disastrous for offshore companies in the last downturn, we are at the beginning of the bull cycle for the sector in my opinion, and I think we see higher day rates than the last cycle peak. I don't know if it takes three years or five years, but I think companies like Transocean, Valaris, Noble, and Tidewater will all provide attractive returns for investors, despite the fact that they have been massive outperformers coming off the bottom a couple years ago. On the producer side, I am bullish on most of the oil sector, but I chose to own the South American producers like Petrobras (PBR) (PBR.A) and Ecopetrol (EC) for their dirt cheap valuations and huge dividends.

Uranium

Like offshore oil, the cycle for uranium is a very long cycle. The last peak was in 2007, and like offshore day rates, I think we will eventually exceed the last cycle peak, which was over $130 per pound. The price to produce uranium has been higher than the price of the commodity for years, and I think we are going to overshoot on the other direction at some point in the next couple years. I have seen predictions that we are on our way to $100 per pound. I think we will probably go higher than that a couple years from now, but we will just have to wait and see.

Moving back to the energy density side shows that nuclear is the only real solution that makes sense for baseload power. To generate one gigawatt of electricity shows the difference between nuclear (which also has no carbon emissions) and solar and wind. You can fit a nuclear reactor on one square mile of land, while you would need 431 wind turbines or 3.1 million solar panels to produce the same amount of power. The technology for nuclear power has also been improving, and I keep hearing about molten salt thorium reactors, which sounds like the next logical step.

You might be asking, well, what about the nuclear waste ? You would be better off asking about what happens to solar panels and wind turbines and their waste that ends up in landfills. The nuclear waste issue is actually not a problem when you look at it objectively.

How much is there? If all the nuclear waste from U.S. power plants were put on a football field, it would stack up just 50 feet high. In comparison to the waste produced by every other kind of electricity production, that quantity is close to zero.

Stop Letting Your Ridiculous Fears Of Nuclear Waste Kill The Planet , by Michael Shellenberger

Conclusion

Our push for wind, solar, and electric vehicles is going to have consequences. It's only a matter of time. I wasn't able to cover EVs today, but that push is just as misguided as solar and wind in my mind. I'm fine with readers that disagree, but just take some time to look at a lithium mine, cobalt mine, or nickel mine. All of these are powered by diesel excavators and the commodity bottlenecks are going to cause problems if we continue to go down this path. I think we are going to be driving internal combustion engines for decades to come and we simply don't have the commodity production to put enough batteries in cars.

As a society, we should be focused on building nuclear plants for base load power, pipelines to transport natural gas to places like California and the Northeast, and investing in oil production because all of these things will lead to cheaper energy and higher standards of living. The energy density and energy return on energy invested should be the main considerations for future investments in energy. One of the things that has become obvious to me over the last couple years is that there is no such thing as a low energy rich country. We take our standard of living for granted, but maybe we shouldn't. If our leaders continue to make (and incentivize) poor investments in energy, I believe it will eventually come back to bite us.

As an investor, I'm focused on learning as much as I can about the way the world works. I like to say that if you want to find out the way the world really works, follow the money. If you want to make money as investor, you should try to figure out where big money is going over the next 1-3 years. In the last couple years, that approach has led me to the commodity sector. I think we are in the early stages of a broad commodity bull market, and I'm even more bullish on the coal sector, offshore oil, and uranium. I think the capital cycle shows that we still have a long way to go with all three, and I think the moves for each sector could be explosive.

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