R-Squared Energy Blog

Pure Energy

CNN on The Long Recession

One of the themes I have been hitting during my recent presentations concerns the oil price risk hanging over our heads. My hypothesis goes something like this. The days of huge supply excesses in the oil production world are over. Those 5 million barrel per day supply cushions of 10 years ago kept oil prices low, and fairly stable. As the excesses shrank we began to see increasing volatility and prices steadily climbing. Higher oil prices have historically caused recessions. We are currently in a recession, albeit one in which high oil prices weren’t the primary cause. (More on that at the end).

But, oil supplies were already tight prior to the recession. The recession has lowered demand, and at the moment we find that we again have a fair excess of oil production capacity. As global economies strengthen, that increases the demand for oil. One of the things I have been pointing out in my presentations is that U.S. oil demand dropped by 1.2 million bpd over the past four years, but demand in India and China increased by 1.9 million bpd over that time period.

Therefore, it won’t take long for the capacity cushion to shrink and for oil prices to spike up again, putting us back at risk for recession. This was the basis for my essay The Long Recession – and I think it helps explain why oil is back up to $80. This is going to make for a long recession, and one in which the attempts to recover will trigger the higher oil prices that tend to bring on recession in the first place. It is a merry-go-round that we need to get off of, but it won’t be easy.

CNN has a story out today that covers this theme:

Forget $100 oil. $80 oil is a problem

NEW YORK (Fortune) — Are cash-strapped American consumers on for another date with energy price misery?

The U.S. economy remains weak and one in six Americans can’t find enough work. Yet oil prices have risen steadily this year. A barrel of crude costs $79 and change, more than double its price at the end of 2008.

That could complicate recovery in an economy that, despite the tumult of the past two years, remains as consumer-driven as ever.

I think “complicate recovery” is putting it mildly. We have to recognize the economic danger posed by being so dependent upon something that has the potential to swiftly bring the economy to its knees – and that is also in high demand by countries like India and China.

The story also points to the role oil prices played in bringing on the recession:

And though it’s futile to single out any one trigger for the recession that started at the end of 2007, the downturn didn’t start in earnest until consumers’ energy budgets breached the 6% mark in November that year.

As energy prices soared and incomes came under pressure, Americans first stopped buying pickup trucks and then deserted the local car dealer altogether. Car sales plunged in the spring of 2008 before falling off a cliff with the collapse of Lehman Brothers that September.

“The price of oil played a bigger factor in the recession than people seem to be remembering,” Hamilton said.

I would argue that the U.S. would have been pushed into recession eventually even without the subprime mortgage crisis. There are also a number of people who would argue that high oil prices led directly to the recession; that it was oil prices stretching family budgets which led to people not being able to pay their mortgages. Regardless of which theory is true, it is a historical fact that spiking oil prices have caused economic slowdowns, and over the past year oil prices have doubled. It is tough to see an easy way out.

In closing, I am still traveling for a couple more days (writing this from a small library in Oklahoma), and as I mentioned in the previous post I am about to miss my wife’s birthday for the 4th year in a row. So I want to wish her a Happy Birthday tomorrow, and at least this year I will be home only one day late. Plus, I will be arriving in Hawaii with our two Miniature Schnauzers that we had to leave behind when we moved to Hawaii. She doesn’t feel too bad about me missing her birthday, because the reason is that I had to take a detour to Texas to pick up the dogs. So, she is going to be reunited with “the pups” after three months apart (this is a result of Hawaii’s tight restrictions on importing pets) – and I think she feels that’s a great birthday present. At least I hope she does, because I didn’t get her anything else. Now that I think about it, I should go shopping…

November 18, 2009 Posted by | economics, oil prices, recession | 79 Comments

Rate Crimes: Impeding the Solar Tipping Point

The following guest essay was written by Paul Symanski. Paul is an electrical engineer with expertise in solar energy, and shares his views on why solar power often faces unnecessary headwinds.

—————-

To anyone who has ever spent a day in Arizona’s Valley of the Sun, it is obvious. The sunniest state in the nation is blessed, cursed, with a fierce sun. Yet, as one explores the landscape, artifacts of the capture of solar energy are conspicuously absent. This dearth is true for solar electric, domestic hot water, passive solar design, and even for urban design. It is as if the metropolis stands in obstinate defiance against the surrounding desert and its greatest gift.

Yet, the incessant sun is a constant agitator. Even visitors happily distracted by the Valley’s many amenities will remark while lounging by the pool, drinking in the clubhouse, or enjoying a repast on a misted patio, “Why doesn’t Arizona use more solar energy?”

Solar Tipping Point

One answer to this persistent question can be found once one comprehends that Arizona is where it first occurred: where solar energy first became economical.

Around the turn of the millennium, four decades after its destiny was foretold, an investment in electricity generated by an on-site photovoltaic system became a better investment than traditional investment vehicles. Finally, solar energy had become economically transcendent. Because of its abundant solar resource, solar energy’s transcendence occurred in the center of the desert Southwest, in sunny Arizona. It may not be mere chance that this tipping point coincided with the world’s peak production of petroleum.

The concept of “grid parity” has been promulgated by an energy regime that sees the world through grid-centric eyes. A more accurate and revealing comparison is investment parity. This approach more completely – and perhaps more directly – accounts for the myriad hidden costs embedded in the economics of the world’s energy system. Both the recent economic troubles and the fact that the solar tipping point occurred during an historical low for electricity prices in Arizona reinforce the validity of economic ascendancy of solar energy.

Implicit in the concept of grid parity is an ultimate arrival where both sides rest in balance upon the fulcrum. This subtle point of terminology further invalidates the utility of the concept of “grid parity”. The balance will likely be a brief moment of hushed breath . . . before the tipping continues in favor of solar energy.

The concept of grid parity also establishes a false dichotomy that reveals the term to be an indirection. Solar energy should be one of a multitude of energy sources to be impartially and intelligently incorporated into a flexible network of energy sharing. The concept of grid parity is a creation of a hierarchical system of centralized generation and distribution. Like the system that created it, the term ‘grid parity’ should be recognized for what it is.

The concept of a tipping point is a more appropriate metaphor. It is this tipping point that those favored by the status quo vigorously resist.

Delay Tactics

It is crucial that energy costs be accurately accounted in order to establish valid policies. Yet, in any forum where energy is discussed (present company excepted), retail energy costs are typically presented as an average, or as a range of values. Even in conversations amongst economists, engineers, scientists, business leaders, policy makers, and others who help guide our energy future, superficial valuations proliferate. Blunt statements of cost nearly always exclude associated economic, competing, and externalized costs. More dangerously, such simplification disguises a complex and telling reality.

The key observation – and the linchpin of the Rate Crimes exposé – is that the avoided cost value of solar electricity and other energy management strategies has long been dramatically lower than the retail cost of electricity under particular rate plans.

The graph below plots the avoided cost value of on-site solar electricity against retail energy costs under the Arizona Public Service E-32 commercial rate schedule for the summer season. The ranges of kilowatt demand and kilowatt-hour consumption reflect those of small businesses.

The avoided cost value of solar electricity is half that of the retail cost of electricity for a great portion primarily because of the uncontrollable billing demand, and a precipitous declining block rate structure compounded by the uncontrollable billing demand being used as a multiplier for the extents of the expensive initial block.

Of the hundred largest electric utilities (by customers served), fourteen are located in the sunny Southwest (excluding the unregulated utilities in Texas).

Of these fourteen, three have commercial rate plans with structures that most defeat the value of solar energy and energy conservation measures. These utilities are: Arizona Public Service, Salt River Project, and Tucson Electric Power. All are Arizona utilities.

Conclusion

The Arizona rate schedules provide an enormous subsidy and encourage prodigal consumption by discounting energy to the largest energy consumers. This was historically a common situation in other places as well. However, Arizona is special due to its extraordinary solar resources.

The pricing system redirects costs from any apparent savings in the residential and industrial sectors into the small commercial sector. Small commercial ratepayers have less capital, have fewer person-hours to commit to unusual projects, have less-diverse expertise, and are often constrained from making modifications to their premises. The redirection of costs into this captive market creates a hidden tax through the higher costs of goods and services, and through the subsequently higher sales tax charges.

Furthermore, while more fortunate homeowners can avoid energy costs by investing in subsidized solar energy, renters remain a captive market.

As you may surmise, nearly the entire Arizona economic and political system is complicit. Beyond Arizona’s borders, the state’s electricity generation from coal and nuclear sources remains the West’s dirty little secret. Environmentally conscientious Californians can nod appreciatively at their Tehachapi and San Gorgonio Pass wind farms; while behind the turbines, on the eastern horizon, the cooling towers and smokestacks of Arizona keep bright their nights.

All Arizonans need to be able to gain full value for investments in energy conservation and in solar energy. Until Arizona’s repressive rate schedules are reformed, energy efficiency measures and solar energy in the nation’s sunniest state will have diminished value. This diminishment of the value of solar energy affects all of us by delaying a cleaner energy future.

—————-

Paul Symanski is an electrical engineer, designer, human factors specialist, marketer, machinist, graphic artist, musician, LEED AP, and economist born of necessity. He is experienced with renewable energy, including expertise in solar energy both in practical application and in the laboratory. He is also a competitive masters-level bicyclist. ratecrimes [at] gmail [dot] com

http://ratecrimes.blogspot.com/

August 6, 2009 Posted by | analysis, Arizona, avoided cost, distributed energy, economics, guest post, investment, rate schedule, reader submission, smart grid, solar power | 53 Comments

The Long Recession

Sometimes people ask me what I think will happen as a result of peak oil. Well, it depends. We could see alternatives – natural gas, ethanol, GTL, CTL, etc. – fill the gap of falling oil supplies for a while. It just depends on how quickly production falls. But if the alternatives are not up to the task, then I think what we will see – borrowing terminology from The Long Emergency– is The Long Recession. Here’s how it would work.

As economies heat up, demand for oil increases. This puts upward pressure on oil prices, which can ultimately cause a recession such as the one we are in now. Historically, spiking oil prices tend to consume disposable income and lead to recessions. Jeff Rubin, whose new book I recently reviewed, has claimed that four of the past five recessions were caused by spiking oil prices.

In normal cycles, oil companies build up capacity when oil prices are high. A recession caused by high oil prices, combined with overcapacity built up during the price rise, can keep oil prices at bay for a long time. But what if oil capacity can’t be overbuilt, because oil production has peaked? In this situation, oil prices will start to recover just as soon as the economy starts to come out of recession. This may in turn “restall” the economy, leading to a long recession that just repeats the cycle every time the economy begins to recover.

It is hard to say that we are at that point. However, oil prices have recovered quite a bit of lost ground, and have now crossed $70/bbl:

$70 oil menaces budding recovery

At the end of May CNNMoney.com ran a story asking if $60 oil will kill any economic recovery. ‘No,” most analysts said – consumers could shoulder $60 crude, and analysts didn’t see prices going much higher.

Now oil is touching $70 a barrel. Goldman Sachs recently said it sees crude at $85 by the year’s end. With the economy still on life support, oil is drifting dangerously close to being the wet blanket at the recovery’s party.

Hmm. Sounds like what could be waiting on the other side of this recession is…a recession.

There are alternatives that start to become economical with oil at $70 or more. Oil sands, for one. Natural gas vehicles also start to look pretty good at those oil prices. Even GTL, CTL, and BTL stand a chance of being economical if oil prices hang around at lofty levels. But companies – especially oil companies – are pretty risk averse when it comes to predicting oil prices. I doubt any U.S. oil companies are basing future economics on the expectation of > $70 oil. If they were, you would see far greater investments into unconventional energy sources.

June 9, 2009 Posted by | btl, CTL, economics, gtl, oil prices, recession | 20 Comments

Let’s Talk About Personal Finance

This is a digression from my normal posts on energy and the environment. As I have said before, this is not a blog on investing or personal finance. Despite that, finance and energy often intersect, so it is a topic that comes up frequently. It is a topic that I am frequently asked about via e-mail, especially in today’s economic climate. Maybe my experience can help someone else avoid some of the mistakes I made. This is not advice directed at the advanced investor. They would have learned these lessons long ago. This is addressed to the average family who may have a negative savings rate, and is struggling to make ends meet.

The idea was spawned by a recent story in The Guardian:

Subprime crisis: US foreclosures bring homelessness to the middle class

Homeless people living in cars and mobile homes across the US are being joined by a new breed: the middle-class. As mortgage foreclosures continue rising month on month, growing numbers of middle-class professionals are losing their homes and downsizing from four bedrooms to four wheels.

Guy Trevor lost his job as an interior designer when the market contracted, thanks to the mortgage foreclosure crisis. “I see myself as a casualty of a perfect storm,” he said. “The people sleeping at the parking lot are very friendly. They’re just like me – they come from normal, everyday homes. I think a lot of people in this country don’t realise that they, too, are a couple of pay-cheques away from destitution.”

I am going to sharply disagree that Guy Trevor lost his job due to the mortgage foreclosure crisis. My guess is that he lost it due to poor financial planning. And while there are exceptions, generally this should not happen to anyone. So I want to give some advice on managing personal finances. What are my qualifications to do this? Let me give you a personal history.

My Personal Finance History

When I was growing up, I was always working and trying to save money. I bought my first pickup with money I saved from working a paper route for 2 years. I mowed lawns, picked up aluminum cans, and have worked pretty consistently since I was an 11-year old on my paper route. I was a born saver, and not a spender. I dreamed of one day becoming a millionaire. I did not want to rely on Social Security for my retirement income, as was the case with all four of my grandparents.

Putting aside the judgment of whether this was a noble goal for a child, in my 9th grade algebra class I finally saw that it could be realized. My 9th grade algebra teacher, Mr. Moore, taught us about compound interest. This was one of the most amazing discoveries of my life up to that point, and a definite life-changing event. If I only saved $2 a day, and averaged a paltry 5% of interest, I could accumulate $130,000 by the time I turned 60.

Not a fortune, but then again I am only saving $2 a day and only getting 5%. If somehow I could manage a 10% return, then my $2 a day ended up being $600,000 by the time I turned 60. And if I could manage some real savings – say $100 a month, or $3.33 a day (at the time I was making about $200 a month) – then I would have a million dollars when I turned 60. For the first time in my life, I could see a path to my goal that didn’t involve winning the lottery, or otherwise striking it lucky on some long shot.

The power of compound interest has been at the core of my financial planning since that school day in 1981. I knew the ingredients to wealth: 1). Live below your means, so you can save some money. 2). Save the money in a “do not touch” account; 3). Maximize your long-term returns.

Since that time, things have gone mostly according to plan. However, I have made some mistakes. As a 20-year old I was working full-time for Campbell Soup Company in Paris, Texas, but I was also going to college full-time and putting myself through school. (I worked the night shift – 10:30 to 7 a.m. – and then got up and drove an hour to college). I had accumulated about $30,000 from saving and investing my earnings (I had “discovered” mutual funds), and this was almost twice my annual earnings at Campbell Soup. I was well ahead of schedule for my goal of a million dollars by the time I turned 60.

But then I made one of the biggest financial errors I have ever made. I bought a brand new Toyota 4×4. Of course the payments were only $330 a month, but over the course of the payments this would consume half of my savings to that point of my life. And if you do the math since then, that new truck and subsequent higher insurance payments has cost me close to $100,000 (what I could have earned had I invested the money). On the other hand, this time period also saw me make a wise (or perhaps lucky) move. Due to the volatility leading up to Black Monday, I sold all of my mutual funds on the previous Thursday, October 15, 1987. (I made a similar defensive move earlier this year that has saved me a lot of money).

During my 20’s, I graduated from college and decided to go to graduate school. Those were some lean times, but even then I managed to save money. My graduate stipend – for teaching and doing research – was $12,000 a year – a pretty big pay cut from my Campbell Soup days. I was married, and rent was going to cost us five to six hundred dollars a month. So, with the money we had saved up as a down payment, we bought a condo. Instead of $600 rent payments, we had a $200 mortgage – and I eventually sold it for a profit.

While in graduate school, I researched the cheapest foods I could get without starving my wife and me, and we watched every penny. I ate grits on a number of occasions, and I would go to the $2.99 Pizza Hut buffet and eat enough for lunch and dinner. My wife and I once got into a fight because she bought a trash can for the kitchen. We had been using paper sacks. She took the trash can back. This was the reality of a situation in which I was determined to live below our means.

By the time I was 30, I had graduated, had two children, and was working as a chemical engineer. My wife – based upon a mutual decision – would stay home and raise the kids, and that has been the case for the past 15 years. Our savings at the time amounted to more than a year’s salary, and I was generally on target to reach my million dollar goal. Then I made major strategic error #2.

Technology stocks were booming, and I was seeing some pretty clueless people get rich. AOL, JDS Uniphase, Cisco, Amazon.com, PMC-Sierra, Ciena were among the hot stocks of the day. I read story after story of why these companies could only go up: It’s technology, for crying out loud!

So, about that time two things happened. I took my first expatriate assignment to Germany, and as a result I had to sell some of my mutual funds. Unlike some of the mutual fund companies, ETrade had no qualms about me having an online account from Germany. So I started trading tech stocks. (In fact, I started out with chemical companies, made some fast money, got overconfident, and jumped into tech stocks with both feet).

Initially, I made some fast money, and decided this was pretty easy. I started investing on margin. But then things turned down. If JDSU was a buy at $200 a share, it was an absolute steal at $150. Down to $100? I wished I had more money to put into it so I could average my cost down. Do you know what JDSU trades for today? About $12, and that still carries of forward PE of over 30.

This incident was the second defining moment of my financial life. I returned to the U.S. at the end of my expat assignment, and I pondered the future. My fast-track to a million dollars had been derailed. I almost felt like I was starting from scratch. So I made some decisions. First, I knew that engineers in the oil industry earned more money than engineers in the chemical industry. Further, I felt like oil production was going to peak in the not too distant future, and the oil industry was probably going to be printing money as prices skyrocketed. So, I left the chemical industry and joined the oil industry.

Second, I decided that I would never again invest in things that I didn’t understand. I still can’t tell you exactly what JDS Uniphase does. Something with the Internet. But I don’t understand the field well enough to distinguish the pretenders from the contenders.

Third, I vowed that I would always understand the risks. I shun investments that I deem as high-risk, even though I may be giving up substantial rewards. Moderate returns for moderate risk have been better for me than high returns that go along with extreme volatility and an occasional disastrous year.

Finally, I decided to invest only for the long-term. No more market-timing for me. I would evaluate a company based on the fundamentals and my expectations of where trends were heading (e.g., the health care sector looks good as the Baby Boomers age) and invest accordingly.
Those principles have guided my financial planning since then. I have not had a down year since 2000. In hindsight, as a result of my strategic error with the tech stocks, I developed a sound financial plan that has been very good to me. I am probably better off now than had I not taken such big losses in 1999-2000 because of the way it caused me to change the way I invested.

Financial Rules That I Live By

Here are some of the rules I live by:

1. Live within my means. That means that I don’t typically make purchases on credit that would take time to pay off. If that means I drive a crappy car – and I have driven crappy cars before – then that’s what I do.

2. No credit card debt. While in some cases it may make sense to carry credit card debt (e.g., you got 0% interest for six months), you have to be disciplined. You never want to carry a balance with a > 10% interest rate. You will have a tough time keeping your head above water.

3. Save a minimum of 10% of my income. Over the years, that has probably been closer to 30% for me. I have always maxed out my 401K every year that I worked. I maxed out IRAs, Health Savings Accounts, and Education Savings accounts. Saving that money pre-tax has the added advantage that money that would have gone toward taxes is now accumulating returns.

4. Do my own taxes. Doing your own taxes can give you a lot of insight into how to manage your finances in a way to minimize the take of the tax man. Study all of those deductions, and make sure you are taking the ones you are entitled to take. For most people, doing your own taxes should not be that difficult. Take last year’s tax return and start from there. If you get stuck, the IRS has various hotlines to help you out. Even if you can’t complete it by yourself, you will learn something by going through the process.

5. Invest in things I understand. For me, that’s primarily energy-related, but I also invest in sectors (like health care) that I think are well-positioned for the future.

If you are already buried in debt, and now struggling under higher food and energy costs – then it will be difficult to put your financial house in order. My advice would be a cut in your standard of living, followed by elimination of any high interest debt as quickly as possible. Don’t try to invest money in anything if you are carrying a credit card balance at 17% interest. Get that paid off first. Then start saving a little each week before you think about bumping your standard of living back up.

Remember, the sacrifices you make now are intended to lessen the need to make sacrifices later. Eat, drink, and be merry may be a lot of fun, but even better is to eat and drink in moderation, save some money as a result, and prosper in the long run.

July 8, 2008 Posted by | economics, investing, personal finance | 20 Comments

Let’s Talk About Personal Finance

This is a digression from my normal posts on energy and the environment. As I have said before, this is not a blog on investing or personal finance. Despite that, finance and energy often intersect, so it is a topic that comes up frequently. It is a topic that I am frequently asked about via e-mail, especially in today’s economic climate. Maybe my experience can help someone else avoid some of the mistakes I made. This is not advice directed at the advanced investor. They would have learned these lessons long ago. This is addressed to the average family who may have a negative savings rate, and is struggling to make ends meet.

The idea was spawned by a recent story in The Guardian:

Subprime crisis: US foreclosures bring homelessness to the middle class

Homeless people living in cars and mobile homes across the US are being joined by a new breed: the middle-class. As mortgage foreclosures continue rising month on month, growing numbers of middle-class professionals are losing their homes and downsizing from four bedrooms to four wheels.

Guy Trevor lost his job as an interior designer when the market contracted, thanks to the mortgage foreclosure crisis. “I see myself as a casualty of a perfect storm,” he said. “The people sleeping at the parking lot are very friendly. They’re just like me – they come from normal, everyday homes. I think a lot of people in this country don’t realise that they, too, are a couple of pay-cheques away from destitution.”

I am going to sharply disagree that Guy Trevor lost his job due to the mortgage foreclosure crisis. My guess is that he lost it due to poor financial planning. And while there are exceptions, generally this should not happen to anyone. So I want to give some advice on managing personal finances. What are my qualifications to do this? Let me give you a personal history.

My Personal Finance History

When I was growing up, I was always working and trying to save money. I bought my first pickup with money I saved from working a paper route for 2 years. I mowed lawns, picked up aluminum cans, and have worked pretty consistently since I was an 11-year old on my paper route. I was a born saver, and not a spender. I dreamed of one day becoming a millionaire. I did not want to rely on Social Security for my retirement income, as was the case with all four of my grandparents.

Putting aside the judgment of whether this was a noble goal for a child, in my 9th grade algebra class I finally saw that it could be realized. My 9th grade algebra teacher, Mr. Moore, taught us about compound interest. This was one of the most amazing discoveries of my life up to that point, and a definite life-changing event. If I only saved $2 a day, and averaged a paltry 5% of interest, I could accumulate $130,000 by the time I turned 60.

Not a fortune, but then again I am only saving $2 a day and only getting 5%. If somehow I could manage a 10% return, then my $2 a day ended up being $600,000 by the time I turned 60. And if I could manage some real savings – say $100 a month, or $3.33 a day (at the time I was making about $200 a month) – then I would have a million dollars when I turned 60. For the first time in my life, I could see a path to my goal that didn’t involve winning the lottery, or otherwise striking it lucky on some long shot.

The power of compound interest has been at the core of my financial planning since that school day in 1981. I knew the ingredients to wealth: 1). Live below your means, so you can save some money. 2). Save the money in a “do not touch” account; 3). Maximize your long-term returns.

Since that time, things have gone mostly according to plan. However, I have made some mistakes. As a 20-year old I was working full-time for Campbell Soup Company in Paris, Texas, but I was also going to college full-time and putting myself through school. (I worked the night shift – 10:30 to 7 a.m. – and then got up and drove an hour to college). I had accumulated about $30,000 from saving and investing my earnings (I had “discovered” mutual funds), and this was almost twice my annual earnings at Campbell Soup. I was well ahead of schedule for my goal of a million dollars by the time I turned 60.

But then I made one of the biggest financial errors I have ever made. I bought a brand new Toyota 4×4. Of course the payments were only $330 a month, but over the course of the payments this would consume half of my savings to that point of my life. And if you do the math since then, that new truck and subsequent higher insurance payments has cost me close to $100,000 (what I could have earned had I invested the money). On the other hand, this time period also saw me make a wise (or perhaps lucky) move. Due to the volatility leading up to Black Monday, I sold all of my mutual funds on the previous Thursday, October 15, 1987. (I made a similar defensive move earlier this year that has saved me a lot of money).

During my 20’s, I graduated from college and decided to go to graduate school. Those were some lean times, but even then I managed to save money. My graduate stipend – for teaching and doing research – was $12,000 a year – a pretty big pay cut from my Campbell Soup days. I was married, and rent was going to cost us five to six hundred dollars a month. So, with the money we had saved up as a down payment, we bought a condo. Instead of $600 rent payments, we had a $200 mortgage – and I eventually sold it for a profit.

While in graduate school, I researched the cheapest foods I could get without starving my wife and me, and we watched every penny. I ate grits on a number of occasions, and I would go to the $2.99 Pizza Hut buffet and eat enough for lunch and dinner. My wife and I once got into a fight because she bought a trash can for the kitchen. We had been using paper sacks. She took the trash can back. This was the reality of a situation in which I was determined to live below our means.

By the time I was 30, I had graduated, had two children, and was working as a chemical engineer. My wife – based upon a mutual decision – would stay home and raise the kids, and that has been the case for the past 15 years. Our savings at the time amounted to more than a year’s salary, and I was generally on target to reach my million dollar goal. Then I made major strategic error #2.

Technology stocks were booming, and I was seeing some pretty clueless people get rich. AOL, JDS Uniphase, Cisco, Amazon.com, PMC-Sierra, Ciena were among the hot stocks of the day. I read story after story of why these companies could only go up: It’s technology, for crying out loud!

So, about that time two things happened. I took my first expatriate assignment to Germany, and as a result I had to sell some of my mutual funds. Unlike some of the mutual fund companies, ETrade had no qualms about me having an online account from Germany. So I started trading tech stocks. (In fact, I started out with chemical companies, made some fast money, got overconfident, and jumped into tech stocks with both feet).

Initially, I made some fast money, and decided this was pretty easy. I started investing on margin. But then things turned down. If JDSU was a buy at $200 a share, it was an absolute steal at $150. Down to $100? I wished I had more money to put into it so I could average my cost down. Do you know what JDSU trades for today? About $12, and that still carries of forward PE of over 30.

This incident was the second defining moment of my financial life. I returned to the U.S. at the end of my expat assignment, and I pondered the future. My fast-track to a million dollars had been derailed. I almost felt like I was starting from scratch. So I made some decisions. First, I knew that engineers in the oil industry earned more money than engineers in the chemical industry. Further, I felt like oil production was going to peak in the not too distant future, and the oil industry was probably going to be printing money as prices skyrocketed. So, I left the chemical industry and joined the oil industry.

Second, I decided that I would never again invest in things that I didn’t understand. I still can’t tell you exactly what JDS Uniphase does. Something with the Internet. But I don’t understand the field well enough to distinguish the pretenders from the contenders.

Third, I vowed that I would always understand the risks. I shun investments that I deem as high-risk, even though I may be giving up substantial rewards. Moderate returns for moderate risk have been better for me than high returns that go along with extreme volatility and an occasional disastrous year.

Finally, I decided to invest only for the long-term. No more market-timing for me. I would evaluate a company based on the fundamentals and my expectations of where trends were heading (e.g., the health care sector looks good as the Baby Boomers age) and invest accordingly.
Those principles have guided my financial planning since then. I have not had a down year since 2000. In hindsight, as a result of my strategic error with the tech stocks, I developed a sound financial plan that has been very good to me. I am probably better off now than had I not taken such big losses in 1999-2000 because of the way it caused me to change the way I invested.

Financial Rules That I Live By

Here are some of the rules I live by:

1. Live within my means. That means that I don’t typically make purchases on credit that would take time to pay off. If that means I drive a crappy car – and I have driven crappy cars before – then that’s what I do.

2. No credit card debt. While in some cases it may make sense to carry credit card debt (e.g., you got 0% interest for six months), you have to be disciplined. You never want to carry a balance with a > 10% interest rate. You will have a tough time keeping your head above water.

3. Save a minimum of 10% of my income. Over the years, that has probably been closer to 30% for me. I have always maxed out my 401K every year that I worked. I maxed out IRAs, Health Savings Accounts, and Education Savings accounts. Saving that money pre-tax has the added advantage that money that would have gone toward taxes is now accumulating returns.

4. Do my own taxes. Doing your own taxes can give you a lot of insight into how to manage your finances in a way to minimize the take of the tax man. Study all of those deductions, and make sure you are taking the ones you are entitled to take. For most people, doing your own taxes should not be that difficult. Take last year’s tax return and start from there. If you get stuck, the IRS has various hotlines to help you out. Even if you can’t complete it by yourself, you will learn something by going through the process.

5. Invest in things I understand. For me, that’s primarily energy-related, but I also invest in sectors (like health care) that I think are well-positioned for the future.

If you are already buried in debt, and now struggling under higher food and energy costs – then it will be difficult to put your financial house in order. My advice would be a cut in your standard of living, followed by elimination of any high interest debt as quickly as possible. Don’t try to invest money in anything if you are carrying a credit card balance at 17% interest. Get that paid off first. Then start saving a little each week before you think about bumping your standard of living back up.

Remember, the sacrifices you make now are intended to lessen the need to make sacrifices later. Eat, drink, and be merry may be a lot of fun, but even better is to eat and drink in moderation, save some money as a result, and prosper in the long run.

July 8, 2008 Posted by | economics, investing, personal finance | Comments Off on Let’s Talk About Personal Finance

Updated Corn Ethanol Economics

Executive Summary: The current cost to produce a gallon of ethanol is approximately $3/gal. The current price of ethanol is $2.86/gal, which explains why ethanol producers are shutting down. If corn and natural gas prices remain high, I think ethanol has to rise to something like $3.40-$3.60/gal to make it worthwhile to ethanol producers. So, if I was a commmodities investor, I would probably go long ethanol right now. The only risk factors I can see – given that there is a mandated (and rising) demand for ethanol – is if corn or natural gas prices collapse.

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This is an update to a post I originally made back in February 2008: Corn Ethanol Economics. While this is approximate, I think I captured most of the major economic considerations. In fact, one of the comments I received following the first essay was: “I work in an ethanol plant. Those numbers are pretty accurate, but the price we get for ethanol has been going up lately. Our margins have been poor lately, but are improving. But you did capture the important economic factors that have hurt us lately.”

Since then, natural gas, corn, and ethanol prices have all risen. So what do the economics look like today? The following is my previous analysis, with updated numbers.

I found multiple references for all of the numbers I am going to use, but I will only reference a single source. According to Ethanol Reshapes the Corn Market, one 56-pound bushel of corn will yield up to 2.7 gallons of ethanol and 17.4 pounds of distiller’s dried grains with solubles (DDGS).

The price of corn for July delivery as of this writing is $7.24/bushel, so each gallon of ethanol contains $7.24/2.7, or $2.68 of corn per gallon of ethanol. However, the DDGS can be sold, so a credit is applied for that. The current price of DDGS as of this writing is $175/ton, which is $0.0875/lb. Given that a bushel of corn yields 17.4 pounds of DDGS, there is then a $1.52 credit, which spread over 2.7 gallons is equal to $0.56 gallon. This reduces our cost per gallon to $2.68 minus $0.56, or $2.12 for just the corn input. (Note that there is sometimes a credit for carbon dioxide sales, but it is very small relative to the other costs and credits).

I still have to consider utilities (natural gas is a major cost), labor, enzyme and yeast costs, and depreciation. I have a spreadsheet from an actual ethanol plant, but there isn’t much in the public domain that I could find on this. The closest thing to a source on these is the spreadsheet in the presentation Fossil Fuels and Ethanol Plant Economics (for a standard dry mill process). If you look at Page 16 of the presentation, you can see that all of the miscellaneous costs together total approximately as much as the corn inputs. If you take the spreadsheet on Page 24 and change the natural gas price to the current price of $13.20/MMBTU, you get an overall energy cost of $0.51/gal of ethanol. (You can play around with the original spreadsheet that is in the PDF here). The sum of enzymes, yeast, and other chemicals comes out to be $0.14/gal, and labor, maintenance, and various miscellaneous expenses add another $0.23/gal.

On depreciation, I have several sources for capital costs that are pretty consistent. In the EIA’s Energy Outlook 2006, capital costs per daily barrel of corn ethanol ranged from $20,000 to $30,000, depending on the size of the plant. This breaks down to between $1.30 and $1.95 per gallon of installed capacity. This is also consistent with A Guide for Evaluating the Requirements of Ethanol Plants, which states “Current capital cost per annual gallon of installed capacity for an ethanol plant ranges from $1.25 to $2.00.” So let’s be conservative and say that we want to build a big plant, so the capital costs are on the low end at $1.30/gallon. Depreciate that over 15 years and this portion amounts to about $0.08 per gallon (but is captured above already).

However, for biomass to liquids facilities – which would include the biomass gasification to ethanol that some are calling cellulosic ethanol – the capital costs in the EIA’s Energy Outlook 2006 are listed at around 5 times that of a conventional corn ethanol plant. Thus, the capital depreciation portion is going to be around $0.40 per gallon of ethanol. (On the other hand, the feed costs should be much lower).

Summary

Times are tough for ethanol producers. This is what the economics roughly look like at $7.24 per bushel of corn and $13.20/MMBTU of natural gas. To produce 1 gallon of ethanol requires:

  • $2.68 of corn
  • $0.51 of energy
  • $0.14 of enzymes, yeast, etc.
  • $0.23 of labor, maintenance, and various miscellaneous expenses

There is a DDGS credit per gallon of ethanol of $0.56. Thus, the total cost to produce a gallon of ethanol today is $2.68 + $0.51 + $0.14 + $0.23 – $0.56, or exactly $3/gallon of ethanol. For reference, the July contract for ethanol in the Midwest closed yesterday at $2.86. And $3/gallon is merely cost of production. It doesn’t take into account any return on investment.

Also note that due to the lower energy content, this production cost is equivalent to a $4.48 per gallon production cost for gasoline ($3/0.67) – and that this production cost is a moving target: As long as the ethanol mandates are driving up the price of corn and increasing the demand for and cost of natural gas, corn ethanol producers must chase their tails in a vicious circle.

Producers are going to be hard-pressed to ever match the 2006 windfall that was given to them when the MTBE phaseout drove ethanol prices sky-high. But my conclusion is – since ethanol is mandated – some marginal producers will shut down and prices will rise. If everything else remained constant, I think ethanol would have to rise to something like $3.40-$3.60/gal to make it worthwhile to ethanol producers. So, if I was a commmodities investor, I would probably go long ethanol right now.

June 24, 2008 Posted by | corn prices, economics, ethanol, ethanol prices, investing, natural gas | 9 Comments

Neste Moves Forward with Green Diesel

I have written periodically on ‘green diesel’, which should not be confused with biodiesel. Neste, Petrobras, and ConocoPhillips (in a venture with Tyson foods), have all entered the green diesel arena. (See a bit on the projects from these companies here; explore the green diesel stories I have written here).

Green diesel is produced either from hydrotreating or hydrocracking plant oils or animal fats (Neste, Petrobras, COP) or via the BTL reaction (Choren). Green diesel is chemically different from biodiesel. Green diesel has chemical properties identical to petroleum diesel, while biodiesel is not a pure hydrocarbon (it contain oxygen atoms, hence the somewhat different physical properties).

Today, Bob Rohantensky sent me the following story indicating that Neste just announced that they will build a facility in the Netherlands:

Neste Oil to build a NExBTL renewable diesel plant in Rotterdam

Neste Oil is to build an 800,000 t/a plant to produce NExBTL renewable diesel in Rotterdam in the Netherlands. Construction will start immediately and the facility is scheduled to be completed in 2011. Total cost of the investment is projected to be €670 million. Neste Oil announced its decision to go ahead with a similar-sized plant in Singapore in November 2007. Both plants are linked to Neste Oil’s goal of becoming the world’s leading producer of renewable diesel fuel.

NExBTL renewable diesel is based on Neste Oil’s proprietary technology, which can use a wide range of raw materials. In its plant in Finland, the company currently uses a mix of palm oil, rapeseed oil, and animal fat to produce renewable diesel. Offering excellent product quality – even better than fossil diesel – NExBTL can be used in all diesel engines.

Neste Oil has a major R&D program under way to develop new renewable raw materials for fuel production, and is working towards a target of completely non-food raw material use by 2020. Neste Oil is cooperating with over 20 universities and research institutions globally as part of this program, which is divided into six areas, including non-food vegetable oil, wood-based materials, and algae.

Regarding the NExBTL diesel, Neste says:

NExBTL renewable diesel is an advanced fuel based on renewable raw materials that performs more efficiently and has a lower level of environmental impact than fossil diesel or FAME-type biodiesel. Neste Oil requires its raw material suppliers to observe a responsible approach to sustainability. Feedstock of this type ensures that NExBTL renewable diesel has a 40-60% lower level of greenhouse gas emissions over its entire lifecycle compared to fossil diesel. NExBTL renewable diesel can be blended with conventional diesel fuel or used as such, and is suitable for all diesel engines.

Neste Oil is the leader in renewable diesel production. The company’s first NExBTL facility was commissioned in Finland at Neste Oil’s Porvoo refinery in summer 2007. Second facility is due to come on stream there in 2009. They both have a capacity of 170 000 t/a. In addition Neste Oil is building 800 000 t/a plants in Singapore and Rotterdam. Singapore facility is due to be completed by the end of 2010 and Rotterdam facility in 2011.

While this is an improvement, in my opinion, over biodiesel, they are still going to rely on oil crops such as palm oil. Destruction of rain forests in Malaysia and Indonesia to plant palm oil plantations poses a serious environmental threat. The future of green diesel needs to be based on non-food crops – especially those like jatropha that can be grown on marginal land – and waste materials such as biomass that is currently destined for landfills.

I am also curious about the costs per barrel. Let’s work that out. A barrel of oil weighs 0.137 metric tons (and has density similar to pure diesel). Then 800,000 t/yr is equal to 5.8 million bbl/year (16,000 bbl/day). For perspective, a mid-sized oil refinery will be around 250,000 bbl/day, but the Neste facility is certainly of a respectable size. The cost is projected to be €670 million. If I convert that to dollars, I can compare the cost to various other fuel technologies. A Euro is currently worth $1.53, so the project is going to cost US $1.025 billion. That works out to $64,000 per daily barrel. Again, for perspective the recently announced 400,000 bbl/day Jubail Refinery Project that Total is building with Saudi Aramco is currently estimated at $10 billion ($25,000/daily barrel).

Capital Costs of Fuel Facilities
Source: EIA Annual Energy Outlook 2006

To be honest, if Neste pulls the project off for that, it will come in at a competitive cost relative to other fuel technologies. See the above EIA figure for estimated costs of various fuel facilities. And that was from a couple of years ago, when stainless steel prices were significantly lower. So, on the one hand I hope Neste pulls this off, and on the other I hope they can source a different feedstock than palm oil for the plant.

June 13, 2008 Posted by | economics, green diesel, Neste | 9 Comments

Neste Moves Forward with Green Diesel

I have written periodically on ‘green diesel’, which should not be confused with biodiesel. Neste, Petrobras, and ConocoPhillips (in a venture with Tyson foods), have all entered the green diesel arena. (See a bit on the projects from these companies here; explore the green diesel stories I have written here).

Green diesel is produced either from hydrotreating or hydrocracking plant oils or animal fats (Neste, Petrobras, COP) or via the BTL reaction (Choren). Green diesel is chemically different from biodiesel. Green diesel has chemical properties identical to petroleum diesel, while biodiesel is not a pure hydrocarbon (it contain oxygen atoms, hence the somewhat different physical properties).

Today, Bob Rohantensky sent me the following story indicating that Neste just announced that they will build a facility in the Netherlands:

Neste Oil to build a NExBTL renewable diesel plant in Rotterdam

Neste Oil is to build an 800,000 t/a plant to produce NExBTL renewable diesel in Rotterdam in the Netherlands. Construction will start immediately and the facility is scheduled to be completed in 2011. Total cost of the investment is projected to be €670 million. Neste Oil announced its decision to go ahead with a similar-sized plant in Singapore in November 2007. Both plants are linked to Neste Oil’s goal of becoming the world’s leading producer of renewable diesel fuel.

NExBTL renewable diesel is based on Neste Oil’s proprietary technology, which can use a wide range of raw materials. In its plant in Finland, the company currently uses a mix of palm oil, rapeseed oil, and animal fat to produce renewable diesel. Offering excellent product quality – even better than fossil diesel – NExBTL can be used in all diesel engines.

Neste Oil has a major R&D program under way to develop new renewable raw materials for fuel production, and is working towards a target of completely non-food raw material use by 2020. Neste Oil is cooperating with over 20 universities and research institutions globally as part of this program, which is divided into six areas, including non-food vegetable oil, wood-based materials, and algae.

Regarding the NExBTL diesel, Neste says:

NExBTL renewable diesel is an advanced fuel based on renewable raw materials that performs more efficiently and has a lower level of environmental impact than fossil diesel or FAME-type biodiesel. Neste Oil requires its raw material suppliers to observe a responsible approach to sustainability. Feedstock of this type ensures that NExBTL renewable diesel has a 40-60% lower level of greenhouse gas emissions over its entire lifecycle compared to fossil diesel. NExBTL renewable diesel can be blended with conventional diesel fuel or used as such, and is suitable for all diesel engines.

Neste Oil is the leader in renewable diesel production. The company’s first NExBTL facility was commissioned in Finland at Neste Oil’s Porvoo refinery in summer 2007. Second facility is due to come on stream there in 2009. They both have a capacity of 170 000 t/a. In addition Neste Oil is building 800 000 t/a plants in Singapore and Rotterdam. Singapore facility is due to be completed by the end of 2010 and Rotterdam facility in 2011.

While this is an improvement, in my opinion, over biodiesel, they are still going to rely on oil crops such as palm oil. Destruction of rain forests in Malaysia and Indonesia to plant palm oil plantations poses a serious environmental threat. The future of green diesel needs to be based on non-food crops – especially those like jatropha that can be grown on marginal land – and waste materials such as biomass that is currently destined for landfills.

I am also curious about the costs per barrel. Let’s work that out. A barrel of oil weighs 0.137 metric tons (and has density similar to pure diesel). Then 800,000 t/yr is equal to 5.8 million bbl/year (16,000 bbl/day). For perspective, a mid-sized oil refinery will be around 250,000 bbl/day, but the Neste facility is certainly of a respectable size. The cost is projected to be €670 million. If I convert that to dollars, I can compare the cost to various other fuel technologies. A Euro is currently worth $1.53, so the project is going to cost US $1.025 billion. That works out to $64,000 per daily barrel. Again, for perspective the recently announced 400,000 bbl/day Jubail Refinery Project that Total is building with Saudi Aramco is currently estimated at $10 billion ($25,000/daily barrel).

Capital Costs of Fuel Facilities
Source: EIA Annual Energy Outlook 2006

To be honest, if Neste pulls the project off for that, it will come in at a competitive cost relative to other fuel technologies. See the above EIA figure for estimated costs of various fuel facilities. And that was from a couple of years ago, when stainless steel prices were significantly lower. So, on the one hand I hope Neste pulls this off, and on the other I hope they can source a different feedstock than palm oil for the plant.

June 13, 2008 Posted by | economics, green diesel, Neste | 8 Comments

The Ripple Effect

This is why I think we have some tough economic sledding ahead as the full impact of the current oil price starts to ripple out:

Beyond gasoline: Prices surge for oil-based goods

New York – Besides gasoline, the Department of Energy calculates, there are 57 major uses of petroleum – everything from cosmetics to ballpoint pens, nylons, and even the waxes in chewing gum.

That is why the effect of high oil prices is now spreading well beyond the pump, where gasoline hit another record price of $3.98 a gallon on Wednesday. Now, consumers will have to brace themselves for other higher costs, since businesses such as Kimberly-Clark, Procter & Gamble, and Colgate-Palmolive are raising prices on their products to recoup energy costs.

In brief, this means less money in consumers’ pockets in the months ahead. But it also goes beyond consumers. For example, the price of asphalt is up 65 percent so far this year – and municipalities’ and states’ road departments are cutting back. This may mean bumpier roads ahead.

Most people don’t realize how many products around them are oil-derived. Oil prices have increased so rapidly that there hasn’t been time for the price of oil-based products to catch up.

We have already seen the airlines get hit hard, but we still haven’t seen the worst of that. Just today:

Continental Airlines to cut 3,000 jobs and 67 planes

Airlines, trucking, and auto sales are the early casualties of high oil prices, but you should brace yourself for higher prices on almost everything. I think the only thing that will prevent that would be an immediate collapse in oil prices back to the $50 range, but I don’t see that happening.

Note: I am flying to the U.S. tomorrow, and will be out of contact for a couple of days.

June 5, 2008 Posted by | airline industry, economics, oil prices | 17 Comments

Corn Ethanol Economics

Someone e-mailed a few days ago and asked some questions about the present economics of corn ethanol. I did a few calculations, which I think are interesting enough to share. (Note that because this is a snapshot, the numbers will change over time. But you should be able to use the methodology here to roughly calculate the economics at any point in time.)

I found multiple references for all of the numbers I am going to use, but I will only reference a single source. According to Ethanol Reshapes the Corn Market, one 56-pound bushel of corn will yield up to 2.7 gallons of ethanol and 17.4 pounds of distiller’s dried grains with solubles (DDGS).

The current spot price of corn as of this writing is about $5/bushel, so each gallon of ethanol contains $5/2.7, or $1.85 of corn per gallon of ethanol. However, the DDGS can be sold, so a credit is applied for that. The current price of DDGS as of this writing is $170/ton, which is $0.085/lb. Given that a bushel of corn yields 17.4 pounds of DDGS, there is then a $1.48 credit, which spread over 2.7 gallons is equal to $0.55 gallon. This reduces our cost per gallon to $1.85 minus $0.55, or $1.30 for just the corn input. (Note that there is sometimes a credit for carbon dioxide sales, but it is very small relative to the other costs and credits).

I still have to consider utilities (natural gas is a major cost), labor, enzyme and yeast costs, and depreciation. I have a spreadsheet from an actual ethanol plant, but there isn’t much in the public domain that I could find on this. The closest thing to a source on these is the spreadsheet in the presentation Fossil Fuels and Ethanol Plant Economics (for a standard dry mill process). If you look at Page 16 of the presentation, you can see that all of the miscellaneous costs together total approximately as much as the corn inputs. If you take the spreadsheet on Page 24 and change the natural gas price to the current price of $8/MMBTU, you get an overall energy cost of $0.33/gal of ethanol. The sum of enzymes, yeast, and other chemicals comes out to be $0.14/gal, and labor, maintenance, and various miscellaneous expenses add another $0.23/gal.

On depreciation, I have several sources for capital costs that are pretty consistent. In the EIA’s Energy Outlook 2006, capital costs per daily barrel of corn ethanol ranged from $20,000 to $30,000, depending on the size of the plant. This breaks down to between $1.30 and $1.95 per gallon of installed capacity. This is also consistent with A Guide for Evaluating the Requirements of Ethanol Plants, which states “Current capital cost per annual gallon of installed capacity for an ethanol plant ranges from $1.25 to $2.00.” So let’s be conservative and say that we want to build a big plant, so the capital costs are on the low end at $1.30/gallon. Depreciate that over 15 years and this portion amounts to about $0.08 per gallon (but is captured above already).

However, for biomass to liquids facilities – which would include the biomass gasification to ethanol that some are calling cellulosic ethanol – the capital costs in the EIA’s Energy Outlook 2006 are listed at around 5 times that of a conventional corn ethanol plant. Thus, the capital depreciation portion is going to be around $0.40 per gallon of ethanol. (On the other hand, the feed costs should be much lower).

Summary

Times are tough for ethanol producers. This is what the economics roughly look like at $5 per bushel of corn and $8/MMBTU of natural gas. To produce 1 gallon of ethanol requires:

  • $1.85 of corn
  • $0.33 of energy
  • $0.14 of enzymes, yeast, etc.
  • $0.23 of labor, maintenance, and various miscellaneous expenses

There is a DDGS credit per gallon of ethanol of $0.55. Thus, the total cost to produce a gallon of ethanol today is $1.85 + $0.33 + $0.14 + $0.23 – $0.55, or exactly $2/gallon of ethanol. For reference, the February contract for ethanol in the Midwest as of this writing is $2.15. And $2/gallon is merely cost of production. It doesn’t take into account any return on investment.

Also note that due to the lower energy content, this production cost is equivalent to a $3 per gallon production cost for gasoline – and that this production cost is a moving target: As long as the ethanol mandates are driving up the price of corn and increasing the demand for and cost of natural gas, corn ethanol producers must chase their tails in a vicious cycle. Producers are going to be hard-pressed to ever match the 2006 windfall that was given to them when the MTBE phaseout drove ethanol prices sky-high.

Anyway, this was a useful exercise for me to understand the magnitude of the various inputs (and the DDGS offset) in corn ethanol production. I hope you found it of some value. If you see errors or have suggestions, please let me know.

February 2, 2008 Posted by | corn prices, economics, ethanol, ethanol prices, natural gas | 291 Comments