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MoneyScience Blog Header 2015 2


Daniel Lacalle Discusses the Flattening of the Energy World

Mon, 14 Mar 2016 07:47:00 GMT

The Energy World is Flat cover imageDaniel Lacalle is the author with Diego Parrilla of The Energy World is Flat: Opportunities from the End of Peak Oil out now published by Wiley. To receive 30% off your copy enter our promo code MON30 at the checkout when ordering direct from www.wiley.com

Jacob Bettany: Could you tell us a little bit about your background and how you came to write this book?

Daniel Lacalle: I started my professional experience in the oil sector after university in an integrated oil company. I worked in the energy sector in different areas from money markets to energy trading, in West Africa and the Middle East for many years. I then moved to the utility sector where I was in contact with all the companies who were developing the very first stages of wind and solar. I also have experience in the financial services industries, starting in an investment bank and then moving to being a Fund Manager in different funds from Citadel to Ecofin to PIMCO and now here at Tressis.

What drove me to write the book was the misunderstandings, myths and historical inaccuracies that I had seen in publications about the energy sector. I saw that both efficiency and technology were making a big change in the energy world and wanted to debunk the myth of peak oil that was very popular. The second factor was that there were many books about maybe oil on its own but very few about energy as in integrated concept including coal, gas, renewables etc. and that’s what we wanted to write about especially because when we wrote it the general consensus was that oil prices were going to be higher for longer and our view was the opposite!

Jacob Bettany: And you were proved to be correct of course! So with those aims in mind who is the book’s intended readership?

Daniel Lacalle: The book is targeted at anyone who is interested in the energy world from a very open perspective, someone that could be an expert but also someone who approaches the energy sector without knowing the basics. People will learn about the history of the energy sector, our view of what the future could be and about the forces that are driving such a change.

Jacob Bettany: The book does serve as an excellent introduction to the subject. In it, you argue that Fukushima was a critical milestone towards the end of OPEC dominance. Could you unpack that view a little bit?

Daniel Lacalle: The Fukushima accident happened at a time at which nuclear energy was quite popular and the media was talking about a nuclear renaissance. There were about 66 nuclear reactor projects due to be launched all over the world, mostly in China, the life of a nuclear reactor was being extended from 40 to 60-65 years, and there was a general positive view of nuclear that was abruptly changed. It also proved that when nuclear energy disappeared from the energy mix as happened in Japan, immediately the cost of energy and productivity and competitiveness of the industry’s structure suffered and consumers suffered because it would have to be immediately substituted with coal and gas. Because of the Fukushima accident and the closure of the reactors in Japan, energy in Asia rocketed to about the double the price. Japan went on to be the second largest importer of coal in the world and all this had a dramatic impact on the diversification of the energy supply globally. So with a drastic change of the political view particularly in Europe about nuclear energy that immediately launched widespread support for subsidised technologies like solar and wind, and also the realisation that the moment that nuclear generation disappeared the impact on the economy was very evident because the cost of energy would rocket and imports would also soar. So I think all that made a big leap forward for the consumer countries to develop quickly and drastically a policy that was more geared towards security of supply and diversification out of fossil fuel because of that milestone in the energy world.

Jacob Bettany: Do you feel that change in the attitude towards nuclear was unfair? On balance has the impact on the energy world actually been positive?

"Dramatic change is happening globally to technologies, also changes to efficiency, changes to diversification of supply even in fossil fuels – the fracking revolution has been very important – all these drivers flatten what was perceived as a very volatile market in the energy world in which the risk of running out of energy drove prices higher."

Daniel Lacalle: Of course Fukushima was a terrible accident and one wishes that no further accidents like that are needed to drive any change. In Europe, I do think it was quite unfair. The energy sector in Europe was part of the reason why energy prices had been stable, through consumerism and the behaviour of small to medium enterprises throughout the introduction of the Euro. It was very safe with safe standards. It was surprising in Germany, for example, a country with no seismic activity and definitely not an island surrounded by constant risk of large earthquakes. Also very close to the border they had advanced 58 reactors safely so I think that it perhaps took the political position a bit too far.

In the book I explain that it has made a big impact on energy prices for

consumers because of the too early and too generous subsidisation of solar and wind particularly in Germany and in Spain. It is unquestionably true that the fact that suddenly the political mind-set changed from the nuclear renaissance to diversification of supply and green energy was a positive move in an environment of volatility in fossil fuels. The competitiveness of solar and wind improved dramatically after the financial crisis. This huge support for renewables created large overcapacity in production which lowered the cost of solar panels etc. Another very good thing was the realisation that the change in mind-set to diversification of supply helped improve measures towards efficiency and that had a direct impact on fossil fuels and their consumption.

Jacob Bettany: What do you mean when you say 'the energy world is flat’? Would you mind briefly outlining the various 'flatteners' - as you describe them in the book?

Daniel Lacalle: The title of the book comes as a homage to The World is Flat by Thomas L. Friedman, that as we know was a very popular book a few years ago. Dramatic change is happening globally to technologies, also changes to efficiency, changes to diversification of supply even in fossil fuels – the fracking revolution has been very important – all these drivers flatten what was perceived as a very volatile market in the energy world in which the risk of running out of energy drove prices higher. Like in the technology revolution, the dotcom bubble, the enormous amount of investments that have happened to accommodate the growth in energy demand have created a surplus of capacity that on one hand makes the risk of running out or of disruption of supply minimal and on the other means that it continues the expansion of sources of energy that reduce the dependence on OPEC or on fossil fuels. So demand is growing but not in a way in which it could risk the supply demand balance and at the same time technology is massively eroding the risk premiums and the pricing of different sources of energy, flattening the energy world.

We structured the book around the ten flatteners which divide themselves into the flatteners affecting supply and those affecting demand. The first one affecting supply is that geopolitics is playing less of a factor in energy prices now because we don’t depend on just one country for a particular fuel anymore. The second is the reserves and resources. For many years we have had a misperception of diminishing and limited resources. The technology revolution has proven that the amount of reserves and resources available to deliver the energy required to cover demand are much higher than we expected. The third is what fracking has done to the perception about peak oil. Fracking is a very flexible technology in terms of production and is more spread out across the world than originally expected and so not only gives a level of flexibility that is not typical in fossil fuels but also massively cuts the geopolitical premium. The fourth flattener we discuss is the energy broadband. Like the dotcom bubble. All those investments carried out to attend to the market in China which didn’t turn out as expected but the investments have already been done and become sunken costs so people decide to run them because they already spent the money. The fifth flattener is overcapacity. The huge amount of investment in infrastructure we have seen in the environment of zero interest rates and also monetary policy have created overcapacity in many industrial sectors in different countries. That is flattening the demand growth curve.



Flattener number six which we explore is globalisation, important as economies become more industrial. As consumption overtakes industry as the growth driver the requirement of energy for GDP growth is much lower. Seventh we then talk about demand destruction. Demand destruction is very important because it is not only just the amount of energy required to generate a unit of GDP, but the policies that destroy additional demand growth e.g. increase in taxation, increase in measures taken by governments to reduce energy consumption either from a pricing or taxation perspective. For flattener number eight we consider demand displacement which is how different forms of energy are utilised. Oil is primarily used for transport. Gas fundamentally used for power generation. As new sources and technologies come to the fore the sources of energy are being used for different purposes.

Flattener number nine is government regulation. Policy responds to demand or supply shocks. As consuming countries decide to take measures to avoid dependence on producing countries they facilitate and sometimes incur overcapacity. That in itself flattens the energy world because the positions to make investments are not necessarily economical but strategic. The last flattener we identify is monetary policy, the most surprising for many. It has been perceived historically as extremely inflationary which would generate higher prices for dollar based commodities. Now it is the opposite. Monetary policy by being extremely expansionary reduces the potential growth of demand but at the same time with the constant drive toward devaluation and a constant lowering of interest rates instead of weakening dollar based commodities, the dollar becomes the safe currency when everybody else is trying to devalue.

Jacob Bettany: In the book you outline a robust argument against the concept of Peak Oil. Could you briefly go through that for our readers?

Daniel Lacalle: The concept of peak oil is extremely popular because as most conspiracy theories it is based on half truth and half lie. There are elements that are unquestionably correct, that if you have a source and you consume it reserves go down. But it incorrectly assumes that substitution doesn’t happen, efficiency doesn’t come to the fore and exploration and development don’t generate better and more reliable sources supply of oil. I remember when Matt Simmons wrote the book Twilight in the Desert about the most likely shock coming to oil prices, because of production in Saudi Arabia prices were going to fall abruptly. If you look at it today Saudi Arabia is producing 2 million barrels a day more than at the peak level that book was assuming more than ten years ago and its reserve base has improved because of discoveries and additions. So I think that what tends to happen with the peak oil theory is that it takes things in a negative context and comes to a very aggressive and incorrect conclusion that we’re going to run out of oil and not have any options. It completely disregards the improvements in efficiency and improvements in diversification. Peak oil relied on the fact that hydraulic factoring, deep water drilling, improved oil prices because it looks at it from the perspective of the barrel that is sustainable from an energy return on energy invested perspective. Energy return on energy invested is basically how much you spend in terms of energy to produce one unit of energy. What people forget is that technology doesn’t stop so the energy efficiency will change five years down the line. We are proving it right now. If you tell any peak oil theorist that OPEC would be producing 32 million barrels a day when they said they would never achieve 28, and they are doing it at $30 a barrel not at $150, it shows that the maths were completely incorrect. In fact if you looked at their estimates, they always say we expect this to happen this year but it doesn’t happen – the problem does not change they are just moving it forward instead of admitting they got it wrong and there is no problem with supply and demand.

"The concept of peak oil is extremely popular because as most conspiracy theories it is based on half truth and half lie."

Jacob Bettany: I take what you are saying at a global level – but we have seen instances where a single operation has become uneconomic to run, is that what you would expect?

Daniel Lacalle: You’re talking about operations which tend to be based not on geology or cost but on their balance sheet and their dividend policy. It’s a very big difference. It is not the same that I

decide not to invest in a field because it is basically not attractive at any level than to decide not to invest because I need to keep the dividend. It’s a capital allocation decision which is perfectly acceptable for the companies. In fact if you were to forget the balance sheet and dividend requirements on these companies it is actually right now arguably where they would be investing more because it’s cheaper, service companies have massively lowered their costs, and because the smaller companies have had financial difficulties. If I was not thinking about my dividend and just my rating, and I was thinking about the future I would be investing a lot more today now that I can go to my service providers for a rig and instead of paying $650,000 a day as I did in 2013 I’d pay $150,000 a day – that is a moment in which I would think of investing. What you’re saying, as we say in the book, is that the oil industry in general has been selling admirably to the world the view that they are countercyclical and they are not, they are cyclical. So it’s interesting to see that instead of investing in the low part of the cycle the industry tends to dramatically increase investments in the high part of the cycle. That perpetuates overcapacity as it has in the past because this allocation of capital at the peak level is so abrupt that they spend a lot more than they should in the high price times and then they don’t take advantage in the low price times. I’m not saying that you should invest in the arctic in particular, because I’ve always had a doubt about the economic returns when you can spend a fraction of that in North Dakota and produce a lot more oil quicker. But these are positions that are not based on the cycle, but on the mistakes of dividend and capital policies of the past. Obviously these are very large companies who do many things right, but if you think about this in periods of low oil prices it has always been the national companies therefore the ones that don’t have to address their shareholders about dividends being the ones that have taken advantage of low costs and low service charges.

Jacob Bettany: How do you think the energy market is performing and what do you see will happen over the next year?

Daniel Lacalle: We have seen the first wave of the flattening of the energy world that is mostly a supply shock. Now we will see the next phase which is China growing as a developed country and growing its energy imports by 1-2%. We are being extremely optimistic about the transition of China to a consumer economy. The demand growth estimates will continue to go down. From a price perspective $20 a barrel oil was a price that was not good for consumers or producers. Consumers in Europe have not seen a dramatic improvement in gasoline prices, yet it has a negative impact in terms of growth of economies of producing countries. We will settle at a price that is $33-40, not much higher than that because then all those companies the US that have been suffering will come back with a vengeance. It has happened in the gas market in the past. For oil we’re in for low prices for longer, around the $30-40 level. There may be moments it goes lower or higher, but that low volatility will persist. If you think about gold, supply demand balance is extremely tight there is no oversupply yet prices have collapsed. There is also an effect of the massive amount of ETFs, of futures that were linked to the oil price for financial reasons. As the market becomes more adapted to the view that it won’t stay lower for longer also a lot of those financial instruments disappear and that also impacts the volatility.

Jacob Bettany: Many of our readers are financial market practitioners and academics and I especially enjoyed chapter 14 on the implications and opportunities in the financial markets. You write that natural gas will be a winner in volume but not necessarily in price and also that the US natural gas ETF is a lot more complex than it looks and historically been a 'financial weapon of wealth destruction'. Can you explain this in a little bit more detail?

Daniel Lacalle: Natural gas is going to be a winner on volume not on price mostly because of diversification. It will become a winner on volume because of the decarbonisation of the more environmentally conscious world and the use of natural gas vehicles etc. will strengthen the use globally. This will not come with an increase in price because natural gas is a very regional market. It’s not transported as easily and as cheaply as oil. You have pockets of oversupply that constantly bring down the price, then it goes up a little bit. In Europe you have a problem of overcapacity. Russia has been reducing volumes coming into Europe year after year because demand simply is not growing as much as supply could attend. In India there are two factors, one that Japan is still in a low growth deflationary spiral which is an important driver of less growth demand. The other important drive of less growth in demand is China in which the industrialisation is losing ground while at the same time they have been very successful at developing their own resources of gas. That added to the glut of energy terminals in Australia adds to an environment in which there’s going to be a bust future for natural gas but it’s not going to be one in which price rockets.

"Decarbonisation of the economy is an unquestionable and unstoppable force because the disruptive technologies have not been and will not be erased in their growth because of low gas or oil prices."

Jacob Bettany: Although you make a distinction between clean energy and dirty energy, you don't focus on climate change in the book, is there any particular reason for this? What is your view on the impact of the Paris agreement on the markets you describe? When and to what extent should climate-related operational risks play a role in any analysis?

Daniel Lacalle: We consciously avoided taking a view on climate change in the book because we are not climate scientists and also

didn’t want to represent a political position. We do take it into account, as we talk about government regulation and the strive to address climate change. Decarbonisation of the economy is an unquestionable and unstoppable force because the disruptive technologies have not been and will not be erased in their growth because of low gas or oil prices. We mention that OPEC is wrong to think solar and wind are going to be reduced in their growth because of low oil prices – no. It’s a completely different position.

The Paris agreement was a huge disappointment for anyone who has climate change as the cornerstone of their concern. I am sceptical about the Paris agreements because if we wanted to really reduce emissions it would be extremely simple. China stops subsiding its coal companies, the European Union stops subsiding the automotive and steel industry and stops giving tax relief to state owned coal companies. That would immediately address the issue of C02 emissions and they’re not doing it. I’m more of a believer that it doesn’t even matter because technology and market forces will take care of it. I think it’s a disgrace that you go to Shanghai and can’t see the sun – that’s unacceptable. That should be addressed through policy but it’s not because they are state owned companies who employ a lot of people. I won’t go into the perverse incentives of keeping an industrial model that is obsolete.

The relentless slow driving force of technology will continue to surprise us all. Seeing it from a positive perspective, policy might help, but the last nail in the coffin of a carbon based economy is technology. Think of 3D printers. What they are going to do to the shipping industry we have not even started to think about.

Policy makers have only one thing on their mind, to sustain GDP for fiscal reasons. The way we calculate GDP is obsolete. Technology is going to take care of it and we will have to start addressing the beneficial cumulative impact of that technology.

Jacob Bettany: I am interested in your views on the UK nuclear industry.

Daniel Lacalle: I think that the government policies give a much higher price of carbon to the nuclear plants. I think in the UK there’s been a mistake in the decision to promote the nuclear terminals through the subsidisation of state owned companies in the UK. The consumer doesn’t benefit and the company investing is already a state owned company receiving vast amounts of subsidies. If the government thought nuclear was an option it should have been more market driven and definitely it should compete with the development of solar and wind and offshore wind. A conservative government could have taken a more market driven approach. The way it is addressed right now can be expensive for consumers and at the same time not particularly beneficial to industry in the UK.

Jacob Bettany: The energy world is a very fast moving sector – do you think you will feel compelled to write a second edition?

Daniel Lacalle: I’m really looking forward to writing a second piece about the demand picture and I think it would be a great way to address it from energy in the decarbonised new economy. How smart cities, efficiencies, disruptive technologies and the policies of becoming more conscious about the environment and climate change will affect demand. I think our view has become more consensual in terms of supply. Talking about peak demand in a decarbonised world is something that could be very interesting. The other day I was I was watching the film Avatar with my son, he said it makes no sense that this future is so technological yet they are looking for a source of energy. It was funny and I said you’re actually right, future is not going to be about extracting a mineral out of the ground, the future is going to be about the different ways that we recycle and I’m very interested in that premise. I look forward to writing about the future of energy demand in a decarbonised world.

The Energy World is Flat: Opportunities from the End of Peak Oil is out now published by Wiley. To receive 30% off your copy enter our promo code MON30 at the checkout when ordering direct from www.wiley.com

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