Agora Financial’s Rude Awakening

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Dubai, UAE

·      The “paralyzed” U.S. power industry and what you can expect to pay for it,
·      The trouble with keeping the lights on in the Middle East,
·      Deciding when it’s safe to go back in the market waters and much more…

Joel Bowman, reporting from Dubai in the Persian Gulf…

One may assume that, with the relatively immense, though finite, oil and gas reserves here in the Middle East, keeping the lights on would be the least of the region’s concerns. Not so.

Although the Gulf Cooperation Council boasts the world’s largest exporter of crude (Saudi Arabia) and of natural gas (Qatar), the problem of delivering that energy to the rapidly expanding economies here is one of pressing concern.

According to a report by the Middle East Economic Digest, there exists a serious supply and demand imbalance caused, in part, by a lack of infrastructure investment earlier in the decade. Angus Hindley, research director of MEED, said recently that the “GCC utilities are facing the most challenging time in their history.”

In order to meet the growing demands of the region’s swelling population, MEED reckons an additional 60,000 megawatts of new power capacity - around 80% of currently installed capacity - will be required across the Gulf by 2015. The massive undertaking, which also includes the need to develop the GCC’s desalination infrastructure, is estimated to cost anywhere between $70 billion and $120 billion.

That’s real cash, even for the Middle East.

Dubai is perhaps the most at risk of an impending supply shortage, with both power and desalination demand forecast to triple in size to 16,000 mw and 800 million gallons per day respectively by 2015.

Hindly argues the magnitude of required investment and development in such a short time “raises the specter of power shortages across the region, and in particular in Dubai, Kuwait and parts of Saudi Arabia - despite the fact that the region has substantial oil and gas reserves.”

These kinds of stories probably don’t come as a surprise to many investors. The Middle East, for all its impressive developments and tall buildings, is, after all, still rightly considered an emerging market. The stock indexes here reflect the kind of sensitivity to “hiccups” in the developed world that you would expect of developing economies. The Dubai Financial Market’s measure, for instance, has been cut in half since its lofty highs back in January of this year. The results are similar, and in some cases much worse, across the GCC.

Still, member states of the six-nation council boom along at a GDP of approximately 6.2%. (Merrill Lynch expects that to drop by 1.7% over the next year, but hey, what developed economy would not delight in a 4.5% GDP figure, regardless of how unsustainable it may be?)

From Moscow to Muscat to Mumbai, the developing world is rife with stories of failing or inadequate infrastructure. It’s to be expected of both rapidly expanding countries in their economic infancy and of aging powers where neglect and ill-managed public works programs have left a legacy of disrepair. In the former category, you’ll find stories like the one we’ve just briefly mentioned. In the latter, you’ll find, perhaps to the surprise of some, the U.S. of A.

Ever the inquisitive gentleman, Byron King of the Energy & Scarcity Investor attended a privately sponsored presentation on U.S. energy policy earlier in the week where he uncovered some rather disturbing facts much closer to home. He kindly shares with us the inside scoop in today’s column. Details below…

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A “Jaws” Market
By Byron King

Do you remember the line from that 1975 classic movie Jaws? “Just when you thought it was safe to go back in the water…”  (Play some eerie, lugubrious music — in dark, minor key, please.) But of course, it wasn’t safe to go back in the water. Overly anxious buyers of stocks might want to keep this movie’s story line in mind.

In Jaws, a great white shark was swimming along the beaches of the New England town of Amity, munching on unsuspecting members of the bathing public. A small flotilla of shark-hunter wannabes went out to catch the beast. At first, it seemed like they nailed old sharky. But then the offending fish popped back out of the sea again for another snack. Finally the town police chief (Roy Scheider) and a crusty old sailor (Robert Shaw) went out on the hunt. The movie, of course, came to a terrifying, but satisfying conclusion.

But do you remember the subplot of Jaws? The shark scare was bad for business. So the Amity town authorities spread the word that the shark was gone. They wanted people back at the beach, getting sand in their toes and spending lots of money. The government elders kept up appearances, dismissing the severity of the problem. Again and again, they encouraged people to believe that things were getting back to — ahem — “normal.”

Ah, yes, “normal.” Let’s all get back to normal. It’s only normal if you enjoy 800-1,000-point swings in the stock market in a matter of one or two days. Really, this is not a bear market. It’s a great white shark market. Rallies are nothing more than churning chum in the water. It’s as if you were to dip your toe in and get your foot bitten off. Swim at your own risk.

So let’s remember the beaches of Amity. Is there any reason to stay in the water when a mean, hungry shark is out there? In the same vein, is there any reason to stay in the market right now? Would you be better off just selling out and converting it all to cash? Why turn yourself into shark bait, right? But still, if you sell out now, it will be for a low price. Lower than in the past, that’s for sure.

Oh, man. What I would not give for a copy of The New York Times Sunday business section from about next March. And I sure wish that the government people and big bankers of the world were half as good at their jobs as the likes of Roy Scheider and Robert Shaw were at killing monsters of the deep. Only in the movies, I guess.

OK, so I don’t have a copy of the Sunday business section from next March. But I think I know what at least one major issue will be within the next 24 months. The headlines will scream, “Power Failures, Price Spikes Plague Northeast U.S.” And the same thing will also hit the Western U.S. And the Southeastern U.S. And parts of the Midwest.

They sure did not talk about power failures in the presidential debates, did they? I don’t know why not. All the insiders know about it. Indeed, power failures and price spikes are baked into the national economic cake. People who follow these things are quite sure of it. It’s just a question of when, exactly, the lights will start to flicker.

We already had one experience with a regional blackout. Do you remember the power failure of Aug. 14, 2003? Almost the entire Northeast U.S. went dark, except it occurred in the middle of the day. The effects were immediate on over 50 million people in the U.S. and Canada.

Skyscrapers just stopped working — no elevators, no lights, no water, no nothing.
Hospital operating rooms went dark. Traffic signals stopped functioning and people were in the midst of instant gridlock. If you ran out of gas, there was no power for the pumps at the gas station. Refrigerators stopped humming and large amounts of food spoiled. Rail systems stopped running — from streetcars in Toronto to subways in New York and Amtrak and freight trains in the middle of nowhere. FAA flight controllers had to communicate with airborne pilots via battery-powered walkie-talkies. Sewage systems shut down, and a lot of you-know-what backed up in many low-lying areas.

The 2003 power failure was bad news, although short in duration. And then it was back to business for America. Things became (if you will excuse the expression) “normal” again. Just like in Amity.

Looking back, the utility companies got the power back up and running, right? And the experts investigated the origins of the problem, right? The people who know all about power grids fixed the problem, right? It could not happen again, right? The U.S. power grid has ample electricity-generating capacity, right? And there’s plenty of transmission to move power from one region to another, right?
Well, no.

Earlier this week, I attended a privately sponsored presentation on U.S. energy policy. The main speaker was a senior faculty member from Carnegie Mellon University. This guy has been “doing electricity” for about 40 years or so. He has written reports for the National Academy of Sciences. When the people at the U.S. Department of Energy have a question about electricity, they call this CMU professor.

The news is not good. In 2007, there were about 144 new coal-fired power plants on the drawing boards of the U.S. energy utilities. But, said the professor, “We will probably build none of them.” Indeed, “The electric industry in the U.S. is in terrible shape,” said the CMU man. So we should expect local and regional brownouts and blackouts to become common occurrences “within five years.” But the first isolated instances of brownout and blackout will hit us much sooner than that.

Why is there such a gloomy forecast? Because essentially, the deregulation of the 1990s was botched. According to the CMU electricity expert, botched deregulation “slowed investment, raised prices and led to more and more uncertainty.” So now few utilities or their executives want to take political, regulatory, technical or financial risks. Hence, the entire long-range planning cycle has broken down.

It’s almost impossible to decide what to build, and at what scale. Costs are exploding, particularly for new construction. It’s safe to say that most power plant construction cost projections have doubled within the past 18 months. The prospect of fast-changing environmental regulations also adds to the uncertainty. No one wants to build a power plant and learn in five or 10 years or so that environmental regulations are going to shut it down.

Even the alternative energy industry — with wind, solar and geothermal as the poster children — has formidable challenges. The biggest issue is cost competitiveness. That’s because alternative systems provide power at costs that range from slightly higher to much higher than traditional power from, say, coal plants. Then there are issues of reliability, due to the intermittent nature of wind and solar, and the still-novel nature of geothermal power. And other issues include the lack of transmission from the usually remote sites of wind and solar facilities.

Overall, U.S. power producers face the prospect of many different forms of investment uncertainty. What will be the availability of different fuel mixes? Will coal still be useable? Or will natural gas be available at a cost they can afford? Can power producers invest in nuclear systems when there is still no definite program for disposing of the waste stream over the next 50 years? Or should the utility companies go all out for alternative systems?

But the next question is how much can consumers afford to pay? And what rates will the regulators allow? If utilities invest in alternative power systems (like wind or solar) that produce electricity at, say, 20-30 cents per kilowatt hour (kwh), will the regulators set those relatively high costs as the level of reimbursement? And for how long? What if the regulators permit the higher costs for only a few years and then penalize the utilities because some “better” technology comes along? At the end of the day, the base line cost of electricity is set against the cost to produce comparable coal or natural gas-based electricity. And this cost setting occurs even though there is a growing bias against burning carbon in the U.S. political and regulatory culture. One attendee at the discussion commented, “When you’re in a ‘no-win’ situation, guess what? You can’t win.”

The CMU professor has looked at historical trends for power in the U.S. His best estimate is that over the next decade or so, the price for electricity will about double on average throughout the nation. “This would put the cost of electricity about on par, as a percentage, with where it was back in the 1950s.” But that is only if people keep making investments in new power systems and the nation adopts conservation and efficiency measures on a large scale. Absent that? It’s lights out.

So you might not see it in your daily life — not yet, anyhow — but the power industry is currently paralyzed by the uncertainty of lopsided risks. And as old power plants age and go off stream, there will be less and less reserve power. Costs are going to rise. And reliability will fall. It’s inevitable.

So one investment sector that ought to do well over the next five years is power and backup power systems. And particularly, the companies that should do well are involved in power systems that are off the drawing boards and in some phase of construction, or near completion. It’s inevitable.

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[Rude Endnote: Look out for a rough ride at the open today. Asian and European stocks were crushed (again) overnight. The Japanese Nikkei finished the session down almost 7% while China’s Hang Seng and London’s FTSE ended down over 5% and 3% respectively.

S&P 500 Index futures expiring in December are down around 3% as we write, while futures on the Dow are down some 2.5%.

It looks like another case of the “here we go agains.”

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com