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Shales vs. solar: An investment perspective

There are many strident voices in the debate over energy. On the one hand, proponents of shale gas claim the extraction of natural gas from low porosity shale formations to be the energy panacea for which we have all been waiting. They have buzz words and sound bites such as “game changer” and “shale revolution”.

On the other hand, proponents of renewable energy post photographs of people gambolling in fields of daisies, the sun shining overhead with the caption, “a solar spill is just another beautiful day”.

Actually, one could now argue that a solar spill is becoming just another beautiful wealth creation vehicle.

It is a fact that hydrocarbon extraction has become more expensive over the past decade. Production from conventional fields peaked in 2005. The industry is now forced to explore and produce from unconventional sources, like shales and tar sands, and deep water. All of these are considerably more expensive sources of energy for the simple reason that they are considerably more difficult to extract, complete and produce. Break even costs for shale gas plays are averaging about $6-7/mcf while tight oil in the Bakken is now estimated at about $91/bbl. Not cheap by anyone’s standards.

Interestingly, however, from an investment perspective shales are not the most compelling story.

What if I told you that investors are locking in long term rates of return (20 years) of as much as 15%/annum. What if I told you that there is an industry which has enjoyed global installations growth of over 50% per year since 2006. And what if I told you that the cost of a module in this same industry fell by over 30% a year between 2008-2013. And I’m not finished. What if I told that in the US, cumulative installations skyrocketed from 1.7 gigawatt capacity in 2009 to 11 gigawatt capacity a mere four years later. In this same industry costs were $7 per watt in 2008 and by YE 2013 were roughly $4 per watt. And those plummeting costs are expected to continue. McKinsey estimates:

“…the overall costs to consumers are poised to fall to $2.30 by 2015 and to $1.60 by 2020.”

And, yes, these figures all pertain to solar.

So what does this mean? McKinsey explains it this way:

“These cost reductions will put solar within striking distance, in economic terms, of new construction for traditional power-generation technologies, such as coal, natural gas, and nuclear energy. That’s true not just for residential and commercial segments, where it is already cost competitive in many (though not all) geographies, but also, eventually, for industrial and wholesale markets.”

In other words, there is an energy paradigm shift occurring.

There are several dynamics at play here. Firstly, solar typically locks in long term contracts of usually 20 years. This is important as utilities have found that their customer base is fickle. Accounts will literally move for 1/10th of one penny in cost reduction. Further, solar provides utilities and individuals insulation from fuel price fluctuations. All businesses including utilities and individuals prefer stability in fuel costs because it makes it so much easier to plan and budget ahead. Hydrocarbon pricing is, unfortunately, anything but stable. Further, the one aspect that has proven absolutely consistent is that prices for energy have been steadily on the increase moving up 450% in just the last twelve years.

In spite of industry’s incessant claims that shales are the new energy panacea, the fact is that they are expensive to produce averaging in some cases literally multiples of the costs of conventional projects. In addition, they are short lived without continuous and prolific drilling programs. And lastly, they are not as ubiquitous as once believed. Yes, shales exist in many places and are broadly spaced but pulling economically viable quantities out of the low porosity rock has proved elusive. For instance, there are approximately 36 shale plays in the US and only about 6 of them actually produce in meaningful quantity.

In the case of tight oil, both the Bakken in North Dakota and the Eagle Ford in Texas have been prolific in their early stages, as are all shale plays due to the nature of how the hydrocarbon is released. Unfortunately this makes it appear that the play is truly successful when in fact industry has not been able to hold production stable for any meaningful period of time in any play to date. According to recent monthly drilling reports issued by EIA, the forecasting arm of DOE, in both the Bakken and Eagle Ford approximately 80% of all new production coming online is merely offsetting production declines from older wells. And both of these plays are only about 4-5 years old.

But perhaps the real proof of a new energy paradigm shift lies in the fact that financing for solar is becoming in some cases more attractive than financing for oil and gas projects. And that is of paramount importance because at the end of the day, it is always about money. McKinsey states:

“The cost of capital also is falling. Institutional investors, insurance companies, and major banks are becoming more comfortable with the risks (such as weather uncertainty and the reliability of components) associated with long-term ownership of solar assets. Accordingly, investors are more and more willing to underwrite long-term debt positions for solar, often at costs of capital lower than those of traditional project finance.”

If solar is indeed displacing traditional projects with better pricing this should continue to provide momentum. McKinsey concludes by stating:

“The heat-rate efficiency of the average coal-fired power plant has not significantly improved in more than 50 years…Underutilization and chronic inefficiency cannot be solved by financial engineering or offshoring labor. Something more fundamental is required. We see such challenges as emblematic of an unprecedented opportunity to produce and use resources far more imaginatively and efficiently, revolutionizing business and management in the process. Indeed, rather than facing a crisis of resource scarcity, the world economy will be revitalized by an array of business opportunities that will create trillions of dollars in profits.”

That is not only an energy paradigm shift. That is potentially the biggest wealth creation opportunity of the past one hundred and fifty years.

 

Photo credit: Wikipedia/Z Thomas

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