The Bottomless Well

John Mauldin | Thoughts from the Frontline
March 24, 2006

Today we begin what will be an intermittent series on oil and energy. Each and every year there is a need for more and more energy of all kinds. The one thing we can say with confidence is that energy demand and usage in the next 20 years is going to increase dramatically as more than half the world aspires to middle class (and more!) life styles, which will put huge demands on our energy resources. Will oil production slow down and then peak in the future? Quick answer: yes. Will we run out of energy? Quick answer: no. But that implies a shift in how we currently produce and use energy.

But first, I am really excited to be able to announce that I have a new relationship with EFG Capital, an affiliate of EFG Bank, which is the third largest bank in Switzerland (based in Zurich). EFG will be working with me in helping clients in Latin America, Switzerland, the Middle East and Asia. They join a growing family of partners with whom I work: Altegris Investments in the US, Absolute Return Partners in Europe and Pro-Hedge Investments in Canada. Our mission is to help accredited investors find alternative investments like hedge funds and commodity funds, as well as other investments, that make sense in today's investment climate. Rather than traditional long only stock portfolios, we look for managers who have discovered a niche where "alpha" is lurking and who have developed a system for attempting to mine that alpha. One of the nice things about having an international group of partners is that each firm does a lot of research in trying to discover managers and funds, and by sharing that work, it multiplies the "reach" of the entire network. The sum is indeed greater than the individual parts. EFG is going to be a real important part of the family and I am really happy to have them as a new partner. (Past performance is not indicative of future results, and there is no guarantee that any investment program will result in positive gains.)

If you are an accredited investor (Basically $1,000,000 or more net worth) and would like to know more about how we can serve you, I invite you to go to www.accreditedinvestor.ws and fill out the form and one of my partners will be in contact.

(In this regard, I am president of and a registered representative of Millennium Wave Securities, LLC, member NASD. Please read the risk disclosures at the website and at the end of this letter.) Now, let's look at energy.

The Bottomless Well

I have been doing a lot of research for my next book on how the next 20 years will unfold. A lot of it is very exciting, but it is not always good news, as there are issues we are going to have to confront as a world society. Biotech, nanotech, demographics, globalization, the next wave of communications technologies, robotics, healthcare will all cause major changes in the world of the future. And none of the above is more controversial than energy. The variety of opinions on how the future will play out in terms of energy is amazingly wide.

There are those like James Howard Kunstler, author of The Long Emergency," who predict the end of civilization as we know it. It is not just that we will run out of oil, but that the wars and climate change will undermine the very foundations of human society. He literally suggests you would be better off teaching your children to learn to hitch up a wagon than sending them to school to become a public relations executive. Remove sharp objects from the room if you read his book.

In later letters we will deal with the concept of peak oil. And we will come to that end, as the amount of oil we can produce in any one given year will one day hit the wall. Slowly the amount of oil we pump will be less each year, forcing large changes in where we capture and how we distribute energy. But it will not be a catastrophic event, just as the change from wood to coal or from whale oil to Kerosene was not the end of the world. It simply changed how we captured energy.

I want to call your attention to a remarkable book by Peter Huber and Mark P. Mills called "The Bottomless Well." It is provocatively sub-titled "The Twilight of Fuel, the Virtue of Waste, and Why We Will Never Run Out of Energy." Huber and Mills take a very hard look at the way we normally think about energy and turn conventional thinking on its head. I highly recommend it. (www.amazon.com)

In the book they propose what they call seven great energy heresies. Let me list them and then comment on them at leisure.

The cost of energy as we use it has less and less to do with the cost of fuel. Increasingly, it depends instead on the cost of the hardware we use to refine and process the fuel. Thus, we are now witnessing the twilight of fuel.

"Waste" is virtuous. We use up most of our energy refining energy itself, and dumping waste energy in the process. The more such wasteful refining we do, the better things get all around. All this waste lets us do more life-affirming things better, more cleanly, and more safely.

The more efficient our technology, the more energy we consume. More efficient technology lets more people do more, and do it faster - and more/more/faster invariably swamps all the efficiency gains. New uses for more efficient technologies multiply faster than the old ones get improved. To curb energy consumption, you have to lower efficiency, not raise it.

The competitive advantage in manufacturing is now swinging decisively back toward the United States. Steam engines launched the first industrial revolution in 1774; internal combustion engines and electric generators kicked off the second in 1876 and 1882. The third, set in motion by two American inventors in 1982, is now propelling the productivity of American labor far out ahead of the competition in Europe and Asia.

Human demand for energy is insatiable. We will never stop craving more, nor should we ever wish to. Life is energy in unceasing pursuit of order, and in tireless battle against the forces of dispersion and decay.

The raw fuels are not running out. The faster we extract and burn them, the faster we find still more. Whatever it is that we so restlessly seek - and it isn't in fact "energy" - we will never run out. Energy supplies are infinite.

America's relentless pursuit of high-grade energy does not add chaos to the global environment. If energy policies similar to ours can be implemented worldwide, our grandchildren will inhabit a planet with less pollution, a more stable biosphere, and better-balanced carbon books than at any time since the rise of agriculture some five thousand years ago.

A Quad Here, A Quad There

They use a measure of energy they call a Quad or 100 quadrillion British Thermal Units. In the US we use about 100 Quads of energy a year: 40 to produce electricity, 30 to fuel our cars and another 30 to generate heat in one form or another. That is up from 7 Quads in 1910 and 35 Quads in 1950, and it is rising every year as we bring on more and more energy demanding products.

In fact, much of our new technology is inherently energy greedy. Our computers are on day and night. A simple desktop unit "consumes 10 to 100 watts even when it's idle - and considerably more when it's working and connected to a large monitor, printers..." Your broadband connection runs 15 watts, you PDA cradle runs from 2 watts when it's empty to 12 watts when charging. Your TV consumes even larger amounts to be ready to go to "instant on." I mean, who wants to wait a half a minute for a TV to warm up? That was so 1960s!

This demand for energy will send fuel costs rising. We have seen how the price of coal, oil and uranium has risen in just the past few years. But it is not as big an issue (in the grand scheme of things) as the doom and gloom crowd think it is.

"Oil is largely out of the electricity side of the picture, because it generates about 5 percent of U.S. electric power. Electricity prices aren't strongly tied to the price of coal or uranium either, which together generated 75 percent, because most of the cost of power lies in the power plant and the distribution system - in capital and logic, not in combustible chemicals or fissile atoms. All in all, raw fuel accounts for over half of the delivered cost of electricity generated in gas-fired turbines, about one-third of coal fired power, a tenth of nuclear electricity, and none of the cost of hydroelectric and solar power."

Further, taxes can be as much as 80% of the cost of electricity, depending upon which state you live in, and certainly impact the price of gasoline. In many parts of the world, taxes are more than half the cost of gasoline, and yet German Greens want to increase them even more, to where the average German family would only take a driving vacation every five years.

Of course, it takes a lot of energy to get this fuel to a usable form. But that is already the case. "Energy consumes itself at every stage of its own production and conversion. Only about 2% of the energy that starts out in an oil pool two miles under the Gulf of Mexico ends up propelling two hundred pounds of mom-and-the-kids two miles to a soccer field."

Most of the raw power of the fuel we burn is given off as waste heat. We purposely waste energy so we can get what is left over into a form where it can be used. Much of the energy in a car engine is given off as heat. How much do we "waste" heating and cooling our houses?

As we will see in a few paragraphs, we are not going to run out of coal or uranium or other sources of energy. But what about oil? How, Kunstler asks, will we run our cars without oil? And current logic and technology suggests he may have a point. Can we really afford to pay $10 per gallon for gas as supplies dwindle and the demand for oil increases world-wide? But it is not current technology that will solve the problems. It is technology that is still on the drawing boards.

But even with cool new technologies, oil prices will go up. But $100 per barrel of oil is not the energy problem. It is the solution. When oil gets priced sufficiently high it will enable alternative sources to emerge and become widely used. Is that point at $100 a barrel or $150? No one can say for certain, other than that transformation will happen. Humanity will not go back to horse and buggy as Kunstler predicts.

As an example, the Human Genome Project was started in 1989. It was slated to cost hundreds of millions. Critics called it a huge waste of money, as it would take over a thousand years to map the human genome. And at the speed of then current technology, they were right! But by the mid-90's, technology had improved and almost 5% of the genome had been deciphered. Good progress, but nowhere near a finish line.

But in 1998 or so, Craig Ventner and Celera started an independent project using different and faster technologies. By the end of 1999, they had done about a third of the genome. By 2003, the project had been finished by both the public consortium and private company.

Today, the parts of a DNA synthesizer can be purchased for $10,000. Rob Carlson speculates that by 2010 a single person will be able to sequence or synthesize tens of millions of sequence bases a day. Within a decade a single person could sequence or synthesize all the DNA describing all the people on the planet many times over in an 8 hour day, or sequence his own DNA in seconds. Technology clearly improved the speed and cost of the process.

And we will see just as radical a transformation of our energy use. We will see the car become an electric car. Not because we are running out of oil, but because it makes sense to do so. And by becoming more efficient, the paradox is that we will use more energy, not less! The car "engine" will become an electric generator. Initially it will probably be some form of internal combustion or diesel engine, but over time that will change. Let's look at a few paragraphs from The Bottomless Well:

"Electricity is also taking over the power train in transportation - not the engine itself, but the system that moves power throughout the car. Diesel-electric locomotives and many of the monster trucks used in mining have already made the leap to electric drive trains; the oil fired combustion engine is still there, but now it's just an on-board electric generator that propels nothing but electrons. The transition to the hybrid electric car will be completed over the next two decades as well. During this same period, electric power trains will supersede steel shafts, belts, pulleys, and hydraulic systems in factories....

"Silicon-controlled electric actuators are now set to displace the steel camshaft on every valved engine. Put each valve under precise, direct, digital-electric control, actuated independently by its own compact electric motor - open and close each valve as dictated by current engine temperature, terrain, load, and countless other variables - and in effect, you continuously retune the engine for peak performance. Belts, shafts, and chains melt away. Everything shrinks, everything gets lighter, and every aspect of performance improves - dramatically.

"The last step in this evolution will be the largest: silicon and electric power will knock out the entire gear box, drive shaft, differential, and related hardware - all of which disappear when direct electric drives end up turning the wheels. .... power chips now make it possible to build high-power motors the size of a coffee can, and prices are dropping fast.

"When such motors finally begin driving the wheels, the entire output of the engine - anywhere from 20 kW to 100kW as measured now in standard electrical units of power - will have to be converted immediately into electricity before it is distributed, used, or stored throughout the car. It will take heavy-duty wiring and substantial silicon drives and electric motors to propel a hybrid-electric SUV down a highway at 70 mph - but they'll be far smaller than steel structures in today's power train. Cars will shed many hundreds of pounds, and every key aspect of performance will improve considerably.

"A far-fetched scenario? General Electric's 6,000 horsepower diesel-electric AC6000CW locomotive is powered by an enormous diesel-fueled engine-driven generator; everything beyond is electric. Komatsu's 930E- a monster mining truck with 300 ton capacity - is propelled by a megawatt (MW) Detroit diesel-electric generator. Everything else, right down to the 12 foot-wheels, is driven electrically. All-electric drives already control fighter jets and submarines. The surface ships now on the Navy's drawing boards are all-electric, from the propeller to the guns."

Electric motors are getting smaller and more powerful with each passing year. This will happen sooner than most realize. When you car is powered by a fully electric power train, the car will look like one big moving electrical appliance. Huber and Mills wrote:

"Given where battery technology is today, this appliance won't be able to run any great distances on batteries alone, but it will nevertheless have to have a substantial battery pack on board to provide surges of current when needed. This creates, from the get-go, the possibility of at least some opportunistic 'refueling' of the car from the [electric power] grid..." We plug our car in at nights and at work, using cheaper grid power.

But current battery technology is not what will be in place in 10 or 20 years. The ever elusive fuel cell is becoming more and more of a reality. Other new technologies are still in the labs.

While I cannot talk in detail, two weeks ago I was in a major university research center with a well known venture capital fund manager, who politely invited me to sit in with him as this university's researchers described some of their latest gee-whiz discoveries.

The one which really caught my eye was a totally new substance to store energy. They could make one gram of this substance store as much energy as we now store in well over 400 grams of battery. Of course, this was in a lab, with no real production. There will be lots of problems and issues to overcome. But it is now a chemical engineering problem and not a theoretical problem. Engineering is something we're good at. Some company (or companies) will figure out how to exploit this and bring it to the marketplace. Or maybe improve the concept!

Whether it is this technology or any of dozens being worked on in labs all over the world, battery technology and the application of power for transportation is going to be different in 2027 (not to mention 2017!) than it is today.

The Paradox of Efficiency

So, the car gets more efficient. Power plants get more efficient. But that does not mean we use less energy!

"Two centuries ago, no engine could surpass 10 percent efficiency. By raising boiler temperatures and pressures, engineers pushed performance to about 20 percent efficiency by the turn of the twentieth century. By mid-century, they were up to about 40 percent. Today, the best thermal plants routinely hit 50 percent efficiency.

"Efficiency gains this large ought to have had a dramatic impact on supply and demand - and they did. The price of transportation and electricity fell steadily. And the total amount of fuel consumed in those sectors rose apace. Efficiency may curtail demand in the short term, for the specific task at hand. But its long-term impact is just the opposite. When steam-powered plants, jet-turbines, car engines, light bulbs, electric motors, air conditioners, and computers were much less efficient than today, they also consumed much less energy. The more efficient they grew, the more of them we built, and the more we used them - and the more energy they consumed overall. Per unit of energy used, the United States produces more than twice as much GDP today as it did in 1950 - and total energy consumption in the Unites States has also risen three-fold."

But how can we continue to consume even more energy? What if China and India and the rests of Asia start to consume as much energy per capita as the US? How can the world survive? Where do we get the fuel?

Huber and Mills offer this great quote in a footnote. In 1886, J.P. Lesley, the state geologist of Pennsylvania, declared: "I take this opportunity to express my opinion in the strongest terms, that the amazing exhibition of oil which has characterized the last twenty, and will probably characterize the next ten or twenty years, is nevertheless, not only geologically but historically, a temporary and vanishing phenomenon - one which young men will live to see come to its natural end." Quoted in P. Giddens, Oil Pioneer of the Middle West (Standard Oil Company, 1955)

There is plenty of energy; it is just the price and the means of transport that are the issue:

"Today... humanity consumes 345 Quads per year of fossil fuel - which is widely supposed to be a huge amount of energy. Thus, the inevitable exhaustion of fossil fuels has been vehemently predicted since the 1970's, and somewhat less vehemently since at least the 1880's - just as the inevitable exhaustion of food has been predicted since the 1790's, the time of Malthus. But all such predictions center on what today's technology, driven by today's forms of power, makes reasonably accessible.

"No one seriously disputes that with better technology, and better power, we could retrieve far more. We already know where to find centuries' worth of coal - global deposits hold 200,000 Quads. Oil shale deposits hold 10 million Quad; heavy oils are already being extracted by brute thermal force from the Canadian Athabasca deposits, and bio-engineered bacteria could make the Earth's vast deposits of these oils economically accessible everywhere within a decade or less. Even more abundant is the energy locked up within uranium and other radioactive elements. The world's oceans contain over 10 trillion Quads' worth of deuterium, a fuel that we will in due course learn to unlock through nuclear fusion."

Fusion? Deuterium? Sounds Sci-fi, right? But an international consortium of various groups just committed $10 billion to a fusion research project in France, with the goal of a working reactor in ten years. Let me make a side bet: some private group or lab will figure this one out before they do, just like the human genome project. But no matter who does it, we will get plenty of cheap power.

And we may find even new and better ways to produce fuel. Right now, ethanol and hydrogen are expensive to make. But what if there were a better way? Remember Craig Ventner, who started Celera and blew past the government consortium on the human genome project?

He has taken his fortune made in Celera and is going to create an artificial life form. We have been able to splice genes into a cell or bacteria for three decades. Venter intends to start from scratch, creating his own entirely new life form. He expects to succeed in a few years.

When he (or the many who are in competition with him) succeeds, we will have a building block to start adding new functionalities. Venter imagines a bacteria that would chew up cellulose and turn it into ethanol. Another could turn sunlight into hydrogen. The list is endless.

Will he succeed? Who knows? The world is not dependent upon whether he does or not, but I wish him God's speed. Someone, or some group, in the hundreds of thousands of labs and garages all over the world will find new and exciting ways to harness energy. When I was last in London, I met with a very astute gentleman who was the "angel" investor for a new technology in Sweden that is a process to regulate valves and fuel in a regular internal combustion engine. The claim is that this simple device (computer driven! More electricity needed!) improves fuel efficiency by 20% or so and reduces pollution. Saab engineers evidently think it is the real thing. Developed by a team of powerful trained mechanical engineers? No, just a one man band literally working in his garage.

Will it ever get on your car? Who knows? The point is that there a hundreds of thousands of people and labs all over the world working on solutions to problems. It is a race, but history suggests inventors will win.

Of course, on the way to this new world, the price of oil will rise. We will need more of it before we need less. As we will see in later letters, there is an investable trend here. Commodity and energy plays are going to be with us for some time. But let's not bet on the end of the world just yet.

Venture Capital and Writers

As part of my research, I would like to talk with some venture capital fund managers, angel investors and private equity groups. I want to get a sense of what you see in your backyards and will reciprocate with some insights as well.

Who knew? Your history (or English or ...) degree is now in demand, assuming you learned to really write. I have two good friends who have asked me to help them find people who can write. Knowledge of financial markets is somewhat useful, but far more important is the ability to be able to really communicate in the written word. Send me a resume and I will send it on. These are real gigs for the young aspiring wordsmith.

This week has been very hectic. I did get to have dinner last Tuesday with Neil Howe, who along with William Strauss wrote Generations, The Fourth Turning and the recent Millennials Rising. All are highly recommended. www.amazon.com. Neil is a gentleman and a very interesting dinner partner. His insight into the national character is quite keen. I look forward to sharing some of his insights in the future.

It is time to hit the send button. My shadow has started complaining about having to keep up with me, so I guess I need to slow down. I hope to be able to hit the gym a few times this weekend, as well as relax with a few good books that are on my desk and spend some time with whichever kids are around. I need a slow weekend, as the weeks are getting faster.

Your ready for spring and the NBA play-offs analyst,

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