Archive for August, 2006

Global warming picture pairs, coastal erosion.

Take a look at this global warming pictorial from the BBC.  Not just pictures of disappearing glaciers, but some interesting coastal erosion pictures as well.  Coastal erosion is aggravated by increasingly frequent severe storms and the slight rise (so far) in sea levels.

Just as we cannot attribute any particular storm to global warming (and there is still some argument about the trend), it is also impossible to attribute any instance of coastal erosion, such as the one above, to global warming. 

Coastal erosion has been going on throughout history, as have intense storms, droughts, and heatwaves.  The trends of all these things, along with atmospheric CO2 levels well above any that have ever been seen, together form a preponderance of evidence in support of climate change.

As an investment manager, I make my living by acting when the evidence is sufficient, not by waiting until all the evidence is in.  That doesn’t mean new evidence won’t make me change my mind later, but the whole point is to take action before other investors decide to act.  In the case of global warming, I feel we (as a planet) have already waited longer than we should before taking meaningful, large-scale action. 

As a mathematician who studied chaos theory, I know that a small difference in initial conditions, such as an 8 inch rise in sea levels, can cause a completely different outcome (a coast being unharmed, or completely washed away.)

I’ve greatly modified this post in response to a conversation with Lars Smith, see the comments below, and his post in his Conservation Finance Blog.

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Over the limit on ethanol?

What are the limits on ethanol production? 

According to NREL’s John Sheehan, at this months Energy Analysis Brown Bag, ethanol production from corn is set to reach 4 billion gallons this year, and 7.4 billion gallons per year by 2011, based on current and planned production capacity.  (As an aside, on August 10, the Douglas County News-Press published a very pointed editorial from him on the travesty of IREA funding disinformation about global warming.)   Given that a bushel of corn will produce 2.8 gallons of ethanol, that will make ethanol demand for corn in the
US 1.4 billion bushels in 2006, and 2.6 billion bushels in 2011.  Since the annual corn production in the
US is around
11 billion bushels, ethanol production is already having a significant impact on the price of corn for food.

As Lester Brown, President of the Earth Policy Institute pointed out in the Aug 21 issue of Fortune(the particular article I’m referring to does not seem to be available online), the market is already setting the price of agricultural commodities at their oil equivalent value.

Unlike Lester Brown and John Sheehan, I think this will be a good thing for the world’s poor.  Yes, food prices will go up, but the poor are not only consumers of food; they are also producers and potential producers.  In the
US, the percentage of poor rural residents has been
consistently higher than the percentage of poor urban residents throughout the last 50 years.   In
Africa, the world’s poorest continent, farmers can often not make a living because they
cannot compete with subsidized first-world farmers.

If world food prices rise because of demand for biofuels, this may at last reverse a great injustice, where subsidies for first world farmers have prevented third world development.  Allowing myself to get wildly optimistic for a moment, if fuel demand permanently boosts agricultural commodity prices (which seems very likely), that might even open the way to removing subsidies for European and North American farmers.  The Doha round of world trade talks failed in large part because of rich world unwillingness to cut agricultural subsidies, which is a great shame, because cutting subsidies would be a great boon to first world taxpayers, as well as third world farmers.

I think the best way to play the biofuels boom as an investor is by betting on the trend of rising agricultural prices.  While large agricultural companies like ADM have already seen the benefits of this trend, the currencies of third world agricultural based economies should benefit, as well as the price of agricultural land in the US.  Much US farmland may benefit twice from renewable energy, since land in windy areas also has the opportunity to gain income from wind leases.  This was a large part of the theme of the Intermontain Harvesting Energy Summit I attended this spring.

On the downside, stimulating agricultural production can lead to deforestation.  Greenpeace can push for all the moratoriums it wants on soy from deforested areas, but that won’t keep soy oil or ethanol from deforested areas going into our tree-hugging gas tanks.  Global commodities, such as soy, corn, soy oil, and ethanol will just go to countries and companies who don’t participate in the boycott, removing their demand from the world market, and lowering the world price for everyone else.  This is the same principle we use in our favor when we buy Green Power: the actual electrons running my laptop are probably from a coal fired plant, no matter if I pay for green power or not.  What I’m actually purchasing with green power (in theory… may green power markets still have kinks that need to be worked out) is the fact that I’m stimulating green power production as much as I would if all my power actually did come from green sources.

Another worry about the rapidly rising biofuels capacity is distribution.  John Sheehan’s estimate of 7.4 billion gallons of ethanol in 2011, and 700 million gallons per year of biodiesel would amount to a around 5% of gasoline consumption and less than 2% of diesel consumption.  Since the current fleet of engines can run with no problem on 10% ethanol (in
Brazil “gas” typically contains
25% ethanol.), we would not need to use any E85 to use all the planned ethanol production.  Similarly, B20 can be used in all but the coldest parts of the country year round, so converting just 2% of diesel consumption to biodiesel could also be accomplished through existing distribution.

I find it likely that the constraints on biofuel production will come in the form of the price of the feedstock, which will be driven by oil prices.

While ethanol and biodiesel will be necessary parts of weaning us off our dependence on oil, current technologies cannot go very far to getting us there without a much greater push towards more efficient automobiles.  Raising average fuel economy by just 10% would reduce fuel use and greenhouse gas emissions over twice the amount the flat-out biofuels production we’re seeing will. 

We can easily double the fuel efficiency of our current fleet with a combination of plug in hybrids (powered by cheap wind) and more efficient engines.  Only when we’ve done that can we hope that cellulostic ethanol and biodiesel can start to supply our remaining fuel needs. 

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Wave power squatters

According to Verdant Power, Oceana Energy Co is blocking wave power development at as many as 12 prime sites in US waters.   An article in Cape Cod Online also makes this accusation.

 This is an example of teething problems in regulation for an new industry.  The Federal Energy Regulatory Commission’s (FERC) procedures allow anyone to apply for a preliminary permit, which effectively ties up a site for 3 years while the applicant studies the feasibility of using the site.  If this process is being used, like late-90s Cyber Squatting to effectively hold prime sites for ransom with no real intention of ever developing them, the regulatory system needs fixing.

 The good news is that now is the time to be fixing the regulatory system for ocean power, where the technology is still in its infancy.  Imagine if all the prime sites were taken up not by squatters, but by real ocean power farm using poor technology.  If the best sites have to wait 5 years to be developed, and the regulatory system gets fixed in the meantime, that will probably end up being a good thing: all the best sites will then be available for much better, more resilient, higher power producing technology.

According to a lawyer and family friend who did legal work for early wind farms, there are still wind turbines in Tehachapi Pass from the early 80’s which are no longer functional, never produced much electricity, but can’t be taken down, because the original investors would be hit with gigantic back taxes if they were decommissioned.  Maybe a little wave squatting will keep much of that from happening for wave power.

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B5 Grand Cherokee

I just saw a news report on biodiesel.org that Jeep will be fueling their new Grand Cherokee CRD with B5 at the factory.  Has Dr. Z been reading my “Why I Bought a Jeep”  article?

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John Turner’s Renewable Energy Future; renewable technologies compared.

When you want an informed, but unbiased opinion, it’s usually best to ask someone John A Turnerwhose livelihood does not depend on coming back with the “right” answer.  When it comes to comparing different renewable energy technologies, one of the best experts I’ve heard from is John Turner.   Dr. Turner is a principal scientist for the Center for Electric & Hydrogen Technologies & Systems at the National Renewable Energy Laboratory (NREL), in Golden, Colorado.

The Hydrogen economy is that long hoped for world in which one day our cars will fill up at the corner hydrogen station, and combine that fuel with oxygen in the air, a process which will create electricity for the car’s motor, and with the only emissions being water.  It all sounds wonderful, but to reach that nirvana of zero emissions, the hydrogen itself needs to be produced with non-emitting technology.  That is because, contrary to oversimplified hype from politicians, hydrogen is not an energy source, but rather an energy carrier.  Like a battery, it has to be produced (charged) before it can be used.

Dr. Turner’s goal is to guide us to the hydrogen economy with as few missteps as possible, with missteps in his mind being the used of unsustainable technologies to get there.  Since he wrote his visionary 1999 article in Science, outlining a path to a “Renewable Energy Future” in which hydrogen serves as portable energy storage for an economy fueled solely by renewable sources of power.  The weak link in this chain is fuel cell technology.  Fuel cells are used to efficiently convert hydrogen and oxygen to electricity and water.  They have been around for well over a century, but are still too expensive for use in cars, although they are practical in some military and larger scale civilian operations.  A similar problem exists for hydrogen storage.

In contrast, hydrogen as a storage medium for electricity from intermittent power sources such as wind is a technology whose time has come. Norsk Hydro is currently doing a trial run of a wind/hydrogen combination system on a small Norwegian island, powering 10 homes.

What is most interesting to me about his presentation, is his unbiased comparison of different renewable technologies, along with nuclear, and Internal Gasification Coal Combustion (IGCC) with carbon sequestration.

He compares these technologies for robustness: the ability to meet our future energy needs; for expense, and for Energy Payback.  Energy payback and the related measure EREOI (Energy Return on Energy Invested) give us an idea of how much of our energy will have to be devoted to making more energy.

Here’s the run-down (with some additions of my own):

Technology

Energy Payback/ EROEI Robust? Price per kWh (approximate 2003 prices) Long term?
Wind

3-4 months; 20-30x

Yes

5-8 cents

Yes

Solar PV

3-4 years; 8x

Very

21-24 cents

Yes

Concentrating Solar

5 months; 40x

Very

8 cents

Yes

Biomass

varies

No

7 cents

Yes

Geothermal

varies by source

No

4-7 cents

Yes

Nuclear

1 year, not counting waste disposal. <20x

Yes

13-18 cents

?

Coal (w/ carbon sequestration)

16% of energy required for sequestration.

For now

5-6 cents

70 yrs, at current growth rates.

Energy efficiency

months; 50x +

Can never get all energy from efficiency

1-2 cents

Yes

(Items with links are from linked sources)

We’ll need all these energy sources, but Wind and concentrating Solar (CSP) stand out as near-term, robust, economical solutions, while Energy Efficiency and Geothermal will give us the most bang for our buck as we try to get started down the road.

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The Wisdom of Crowds and Selecting an Investment Manager

The Wisdom of CrowdsI just read James Surowiecki’s The Wisdom of Crowds.   The provocative title refers to the idea that, given the right circumstances, a group of people will consistently reach decisions which are better than the decisions that the smartest people in the group would be able to reach on their own. 

As someone who considers himself an investing expert, it might be surprising that I like this book.  After all, he frequently cites examples from investing as to how bad the “experts” are.  For instance, a vast majority of mutual fund managers under-perform their benchmarks in any given year, as well as over longer periods. 

Surowiecki’s conclusion is that the crowd (in this case, the market as a whole) is smarter than most mutual fund managers, and even if there are managers who are smarter than the market (The namesake of my cat, Warren Buffett, being a prime example), the amount of effort necessary to distinguish a superior manager (if it is possible to do at all, since past performance is not a guarantee of future results) is far in excess of the possible reward.

Why are most money mangers so bad at the job they are paid to do?  Because it is more risky for them to take non-consensus positions, than it is for them to buy the same stocks everyone else is buying, even if they know those stocks to be overvalued.

Surowiecki concludes that, while there may be superior investment managers who can consistently outperform the market, the effort necessary to identify those managers is likely to be prohibitive.  After all, past performance is no guarantee of future results, and we are as likely to be fooled by randomness into choosing a manager who is lucky as we are to choose a manager who is killed.

I disagree.  I feel it is possible to identify superior managers, and Surowiecki has laid out the tools to do so, even if he does not realize he has done so.  He shows quite convincingly that stock markets can be very efficient when the participants are diverse, and reach decisions independently.   As he also shows, most money managers fail on all counts.

Markets are efficient at finding the best prices for stocks when the participants are diverse and independent.  Since that is often not the case in the stock market, there will be opportunities for individuals to outperform the market.When looking for such an individual, what are the clues?

  • Any manager whose holdings mimic the entire market (i.e. are extremely diversified) can be ruled out.  His returns will also mimic market returns, and will likely even under perform, due to fees and commissions.
  • His choices should not be random; they should be based on private information or research that is not available to (or is being ignored by) the entire market.
  • There should be some reason to believe that this private information or research gives him some true insight into the value of his investments: a portfolio of five companies chosen at random will not perform the same as the market as a whole, but there is no reason to believe it will outperform, either.

If you believe, as James Surowiecki does, that the necessary effort is prohibitive to find a manager like this, the best investment strategy would be to index, that is try to mimic the entire market’s return for the lowest possible fees. 

To me, the possible gains from above-average performance seem well worth the effort necessary to find the few superior managers. Over a period of 20 years, the difference between a 7% annual compounded return and an 8% annual compounded return is about 25%.  In other words, you would get the same effect by starting with $100,000 and earning 8% for 20 years, as you would by starting with $80,000 and earning 7% over the same period.

 The trick is not to give too much weight to past performance, but instead concentrate on the factors which might allow a manager to acheive superior performance in the future.  As an example, here is how I would go about selecting a mutual fund based on the above criteria.  The same approach would apply to a hedge fund or private account manager, except for the fact that in this case, the search for such a manager might truly be outside the ability of most individuals, since the relevant data is not readily available in a searchable form.

  1. Have a small number of positions (since these are less likely to mimic the market,) or changing emphasis on particular industries or sectors which vary significantly from market weighting.
  2. Have low turnover (private information is hard to come by, and given the effort involved, it is not likely to lead to rapidly changing strategies.)
  3. Have a methodology that emphasizes independent research, and is easy to explain.  Black box approaches based on computer models can work for a time, but the market has a tendency to make them go rapidly obsolete.  This is a large part of the reason past performance is such a bad predictor of future results.  “Fundamental” investment strategies tend to pass this test, so long as they are based on deeper research than plucking various ratios from a company’s financial statements.
  4. Look for funds that don’t fit well into any one “Style” or capitalization category.  Independent and diverse thinkers will be hard to categorize.
  5. Funds with less than $1 billion under management.  When assets under management get too high, it becomes difficult to act on what private information you have without greatly moving the market.
  6. Look for low “Beta” compared to the fund’s category. Beta is a measure of correlation with the market as a whole, and can be a proxy for diversity.
  7. Make sure that the fees you are paying are justified by the excess returns (in comparison with the risk involved) the strategy is likely to yield.

Using the Yahoo! Mutual fund screener, with the following criteria: manager tenure > 5 years; no load; expense ratio < 1%, assets < $1 billion, turnover < 30%, is a good place to start.  This yields a reasonable number of funds to sort through, and the choices can be further narrowed by ignoring the index funds, and by checking Beta under “Risk.”

Happy Hunting!

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