JOYG Joy Global Inc. (MM)

Not all the important news is centered on Greece and Italy. The International Energy Agency, or IEA, this week released its World Energy Outlook. The IEA is not some wild-eyed "peak oil/global warming" fringe group. They are about as mainstream and staid a group as you are going to find.

The bullet points below come from the fact sheet associated with the report (see here). I comment on the implications, particularly the investment implications after each bullet point.

• Major events of the last year have had an impact on short- and medium-term energy trends, but have done little to quench the world’s increasing thirst for energy in the long term. The level and pattern of energy use worldwide varies markedly across the three scenarios in this year’s World Energy Outlook (WEO-2011), which differ according to assumptions about government policies on energy and climate change. The New Policies Scenario is the central scenario of WEO-2011. It assumes that recent government policy commitments are implemented in a cautious manner.

Perhaps the only silver lining of the worldwide economic weakness has been that it has slowed the growth of world energy demand, particularly in the developed world. However, growth has continued at a pretty rapid rate in the developing world, especially the BRICs. China has slowed to only 9.0% growth or so, and is likely to continue growing at that sort of rate, but off of a bigger base. India, Brazil and countries like Indonesia are all in very high incremental energy demand phases of their economic development.

China is likely to be the world’s largest auto market again this year. The difference between new auto sales in a place like China is that each new car represents incremental growth in the auto fleet. In the U.S. the auto market is largely a replacement market. Since new cars are more fuel efficient than old cars, that means higher new car sales here actually lowers world oil demand, but higher new car sales in China means higher world oil demand.

• In the New Policies Scenario, world primary demand for energy increases by one-third between 2010 and 2035 and energy-related CO2 emissions increase by 20%, following a trajectory consistent with a long-term rise in the average global temperature in excess of 3.5°C. A lower rate of global economic growth in the short term would make only a marginal difference to longer-term energy and climate trends.

The good news is that the IEA sees substantial progress on increasing energy efficiency and the development of non-fossil fuel energy sources over the next quarter century, the spread between the growth in energy consumption and CO2 emissions is significant.

Coming up with an increase of one third in world energy supplies is going to be a huge challenge. A 3.5 degree Centigrade rise in world average temperature is HUGE. It is about half the difference between the current temperature and what it was at the end of the last Ice Age. Since the end of the last ice age, apx. 10,000 years ago, sea levels have risen by about 300 feet. Even a 30 foot rise in global sea levels would put many of the largest cities in the world under water.

Shorter term, that will mean more adverse weather developments, and thus many more catastrophic losses, for the Insurance Industry. If they are able to raise their premiums enough to compensate, then that will act as a major tax on growth. If they are unable to...well, let's just say you don’t want to be invested in the industry, especially the re-insurance firms that will bear the brunt of the early claims. Berkshire Hathaway (BRK.B) would be vulnerable, as would many of the smaller players such as ACE (ACE) and XL (XL).

• The dynamics of energy markets are determined more and more by the emerging economies. Over the next 25 years, 90% of the projected growth in global energy demand comes from non-OECD economies; China alone accounts for more than 30%, consolidating its position as the world’s largest energy consumer. In 2035, China consumes nearly 70% more energy than the United States, the second-largest consumer, even though, by then, per-capita energy consumption in China is still less than half the level in the United States. The rates of growth in energy consumption in India, Indonesia, Brazil and the Middle East are even faster than in China. Emerging economies also dominate the expansion of supply: the world will rely increasingly on OPEC oil production as it grows to reach more than half of the global total in 2035. Non-OECD countries account for more than 70% of global gas production in 2035, focused in the largest existing gas producers, including Russia, the Caspian and Qatar.

The growth of energy demand in the Middle East is significant. One has to assume that any government, democratic or despotic, will favor domestic consumption over exports, leading to lower available exports. This will lead to a biding war between China and the rest of the world for the available exports.

If we start to move towards using natural gas as a transportation fuel, then the U.S. might surprise to the upside as a source of natural gas production given our huge shale gas resources. On the other hand, they seem very comfortable about the ability of countries in the Middle East to be able to increase their production.

I am not nearly as confident about that. Half of all of Saudi Arabia’s production currently comes from a single oil field, and that field has been in production since the 1950’s. There is no comparable oil field left to be put into production.

• World demand grows for all energy sources. The share of fossil fuels in global primary energy consumption falls slightly from 81% in 2010 to 75% in 2035. Natural gas is the only fossil fuel to increase its share in the global mix over the period to 2035. Absolute growth in natural gas demand is similar to that of oil and coal combined. Oil demand increases by 15% and is driven by transport demand. Coal demand, dictated largely by emerging economies, increases for around the next ten years but then stabilizes, ending around 17% higher than 2010.

This should be very good news for the oil service industry. The easy oil has been tapped already, and the new fields are in more remote areas and much deeper in the earth. That means that the oil service intensity of each well is likely to rise. In other words, firms like Schlumberger (SLB), Halliburton (HAL) and Baker Hughes (BHI) are secular growth companies. The increasing cost of new incremental wells will put a floor under the price of existing oil supplies. Any oil firm with existing (and lower cost) reserves is likely to benefit enormously. However, reserves are likely to be replaced at a much higher cost than the reserves they replace.

The future also looks very bright for the mining equipment companies such as Joy Global (JOYG) and Caterpillar (CAT) due to the rise in demand for coal over the next decade. As most of the rise in coal demand will happen in the emerging markets, U.S. railroads are likely to benefit as we export more coal and the rails ship it to the ports. This would be a big offset to the possible problems on the insurance side for Berkshire.

• In the power sector, nuclear generation grows by about 70%, led by China, Korea and India. Renewable energy technologies, led by hydropower and wind, account for half of the new capacity installed to meet growing demand. Overall, modern renewables grow faster than any other energy form in relative terms, but in absolute terms total supply is still not close to the level of any single fossil fuel in 2035.

One has to question that sort of rise in worldwide nuclear energy over the next quarter century in the wake of the Japanese disaster. The tide in Europe, for example, seems to have decisively turned against the use of nukes. Germany is on a path to eliminate all of its nuke generation over that period. Renewable sources (especially excluding hydropower) make up a tiny fraction of world energy output now, so it is a rapid growth off a small base situation. At this point it looks like the U.S. and Europe have lost the race to China to be the primary supplier of renewable power.

• Large-scale investment in future energy supply is needed. In the New Policies Scenario, $38 trillion in global investment in energy-supply infrastructure is required from 2011 to 2035, an average of $1.5 trillion per year. Two-thirds of this is required in non-OECD countries. The power sector claims nearly $17 trillion of the total investment. Oil and gas combined require nearly $20 trillion, increasing to reflect higher costs and a need for more upstream investment in the medium and long term. Coal and biofuels account for the remaining investment.

That is a lot of money, about 10% of U.S. GDP each year. Again, firms like Halliburton look like great secular growth stories. The big engineering and construction firms such as Fluor (FLR) are also poised to benefit from the construction of those power projects.

• The energy world becomes more inter-connected and more focused on Asia. More than half of world oil consumption is traded across regions in 2035, increasing by around 30% in absolute terms compared with today. Trade in natural gas nearly doubles, with gas from Russia and the Caspian region going increasingly to Asia. India becomes the largest coal importer by around 2020, but China remains the determining factor in global coal markets.

There are some very big pipelines that will have to be built for Russia to supply China with that amount of gas.

• Policy action to curb demand for energy-security and climate reasons, and the ability to develop new supplies, will be critical to the long-term outlook for international oil and gas markets. Global oil demand in the New Policies Scenario increases slowly to 2035, reaching 99 mb/d – up from 87 mb/d in 2010. Oil’s share of global primary energy use nonetheless drops from 33% today to 27% in 2035. Growth in demand comes mostly from non-OECD Asia, whilst OECD demand falls. The crude oil price rises to $120/barrel (in year-2010 dollars) in 2035.

Given the rise in demand forecasted, this increase in the price of oil looks very optimistic to me -- almost flat in real terms with Brent crude trading at about $110 (and Brent, not WTI, is the world price). Despite sustained very high energy prices, between 2005 and 2010 world oil production has only increased by 0.7%. That is a total figure, not per year.

The annual growth in production to meet that demand is 0.52% per year. That is a major acceleration. Just where do they think that production is likely to come from. Remember, that we have to find substantial new fields each year just to keep up with the depletion of existing fields.

On the other hand, there is a limit to the price of oil that the world -- especially the developed world -- economies can stand before they start to turn down. As the U.S. has to import the vast bulk of its oil, that is not good news for the trade deficit. If we were to aggressively move towards the use of natural gas as a transportation fuel we would be in much better shape.

 
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