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MR. MICHAEL CEMBALEST:  Good morning, this is Michael Cembalest with the Eye on the Market podcast. And today I'm going to be discussing our tenth annual energy paper. I know we're all still focused on the virus; as things stand now there's been a spike in infections. The U.S. is now running one of the highest infection rates in the world, including compared to all sorts of developed and emerging economies.

The only silver lining here is that the spike in infections is not translating yet into a spike in deaths and hospitalizations, which continue to decline, even in some of the hotspot states like Arizona, Texas, Florida, et cetera. So we'll see if that stays in place. There's arguments for and against the status quo continuing, which we'll continue to monitor, along with all the developments in terms of antivirals, monoclonal antibodies, vaccines, et cetera on our coronavirus web portal.

     In any case we released our tenth annual energy paper this week. And I just wanted to highlight some of what's in there. It's a long piece; it's our tenth annual one. When I started writing about energy ten years ago I knew that we needed a technical advisor to shepherd me through some of the complexities of the energy ecosystem, and Vaclav Smil has been our technical advisor during this entire time, and it's been a pleasure and incredibly insightful and rewarding to have worked with him. And he worked with us again on this year's paper.

     So the interesting thing about COVID is that it knocked CO₂ emissions all the way back to where they were in 2006, but this is obviously a very temporary reduction. Already we're seeing the Chinese coal and oil demand is back to pre-pandemic levels and air traffic in China is recovering. The EIA expects a full recovery in global liquid fuels consumption to pre-COVID levels by, you know, no later than June of next year. So all of what's happening right now, with respect to the emissions declines are temporary.

     And what I wanted to focus on this year, as much as we could, is what kind of renewable energy transitions could deliver a more durable decline in emissions. Obviously it's not sustainable to have the world in an economic lockdown; what kind of renewable energy transmissions could translate into similar declines in global emissions?

     And so there's a bunch of different topics that we cover in here. One of the overarching themes to remember is that historical data is relevant; the history of energy transitions is that it takes as long as 30 to 40 years for a new energy type to reach 15 or 20 percent of global primary energy consumption. When you look at the transition from wood to coal and from coal to oil and from oil to natural gas, those transitions took many decades just for those new fuels to reach 15 to 20 percent.

     Now that we're finally at roughly four percent contribution of renewables to world primary energy consumption some of the forecasts we see are unfortunately way too hockey stick-y optimistic in terms of where we go from here. And one of the things to remember is, while the energy efficiency of the world is getting much better in terms of CO₂ intensity per unit of growth, absolute levels of emissions keep rising, and they're rising for a reason, which is that the developed world has outsourced the energy-intensive manufacturing to the emerging countries really over the last 25 years. So it's all well and good that the United States and Europe, and to a lesser extent, Japan, figure out ways of decarbonizing their electricity grids, but now that we've outsourced manufacturing, ammonia, steel and cement production to the emerging world, that's where a lot of the emissions are taking place, and that's where a lot of the new technologies would have to be applied to make a difference.

     So one of the things that we go through here is where primary energy comes from, where electricity comes from. Some of the important takeaways is that globally only about 20 percent of all energy consumed actually comes from electricity; the rest of it is direct energy consumption in transportation and by industry, and to a lesser extent, homes and buildings.

Even if you electrified the entire electricity grid, which is of course impossible--I'm sorry, even if you decarbonized the entire electricity grid with renewable energy--you would only really be decarbonizing 20 percent of global energy consumption. So understanding the limitations of decarbonizing the grid with wind and solar on this whole question of emissions is an important thing to understand, and highlights the importance of some kind of decarbonization progress in direct industrial use and in transportation, both of which are moving along really slowly.

     I have a lot of energy discussions with clients, with friends and with family, and some of them are interesting; almost all of them are interesting. Some of them are difficult. People have a lot of preconceived notions of things. And one of the sections this year in the paper is called The Ten Energy Commandments, because it's the ten most important things to try and understand about the world of energy and climate as you dive into this, if you're interested in getting into the details.

So I'm not going to go through all of the specifics now, but I'm going to tick through the topics that we discussed, one of which is why are the rapid, rapid declines in wind and solar levelized costs not translating into a faster pace of decarbonization on a global basis. And there's all sorts of issues there in terms of transmission costs and politics and intermittency and seasonality and things like that.

One of the things we discuss is how important it is not to conflate the speed of wind and solar costs declines with the speed of decarbonization. One of the other topics we get into in some detail is is it possible to electrify a lot of industrial processes that right now rely on coal and natural gas, so that if the grid were eventually decarbonized with renewables you could essentially have green energy production in industry.

It's not so simple; there are certain industrial processes that can be electrified; others can't. And even when you can, the cost per unit of energy for electricity is three to six times more expensive than natural gas. Now you can solve that with a carbon tax but let's see whether or not any countries have the appetite to set that carbon tax at a level that will equilibrate those two costs in terms of renewable electricity versus natural gas. So far we haven't seen anybody do that. It's simple to say, "let's decarbonize the industrial sector"; it's a lot harder when you get at the specifics of actually doing it.

We talk about energy storage. Some of the proposals for energy storage involve overbuilding massive amounts of wind and solar and then drawing down on stored energy in winter months so that you can turn off the natural gas peaker plants. The utility scale battery storage industry is in its infancy, and understanding the challenges there are important in understanding the feasibility of some of these more aggressive assumptions on using wind and solar to decarbonize the entire grid.

And then we've got a section on politics. In New Hampshire people effectively shut down a project that was going to solve a lot of the energy problems in the Northeast by importing hydropower from Canada, and they objected to it because they didn't want the high-voltage, direct current line bringing the power down. And so the New Hampshire siting council rejected it, and the federal government did not use any of its powers to overrule them. So sometimes there are some clean solutions that fall to the wayside because of politics. And instead, the Northeast is going to have to import natural gas from West Virginia and Ohio and other places and combust it in natural gas combined cycle plants instead of using Canadian hydropower because of politics.

We get into the question of the false narratives on carbon capture and storage and carbon mineralization, and some of these things that sounds great on paper but which tend to fall apart once you get into the engineering challenges. And we talk about the importance of reforestation, but not overestimating both the impact of replanting trees on actual CO2 sequestration, and the challenge involved with replanting millions of acres when the U.S. Forest Service tends to replant about 100,000 acres a year.

So we talk about the hydrogen economy, we talk about voluntary carbon offsets that airlines are looking at, and then we get into questions about ride hailing, and finally U.S. consumption in terms of cars, housing and food, and how those consumption patterns, if they change, could make a material impact on U.S. emissions a lot more than something like carbon capture.

Then separately from this whole question of the renewable transition we get into the question--two questions, on the oil and gas markets, which is are we now at the point of peak U.S. energy independence, and secondly what's the real reason for this dreadful performance of oil and gas stocks which were at their lowest valuations relative to the market in 90 years. Is it a stranded asset risk, or is it a supply shock?

And so, again, no time on a podcast to get into all the details, but on the question of U.S. energy dependence the U.S. has finally reached a level of U.S. energy independence that Nixon and every president since him talked about since the 1970s; we are now a net exporter, if you look in energy terms, across oil and natural gas and coal. But there are some challenges here, first of which is about 40 percent of all U.S. energy consumption is based on U.S. production that comes from hydraulic fracturing.

So there are two big issues, one of which is the water usage and water disposal demands of hydraulic fracturing and how that evolves with potentially-changing politics. And the second is even before COVID the investing in the U.S. shale revolution was something of a train wreck. If you look at the industry for a decade in aggregate it had negative free cashflow. I mean I've never seen anything like this. I've seen a few years where airlines and casinos and cable and things like that in the '80s and '90s had a few years of capital investment and it took them a while to recoup that. But I've never seen anything like a full decade where in aggregate the entire industry had negative free cashflow. And I think of 29 shale companies only a few ever posted a couple of years where they were free cashflow positive. So this was an industry that was built on growth and revenues, rather than profitability, and that started to crumble even before COVID.

So to me, given the rapid decline rates in shale wells, both in gas and oil, we're facing some challenges in terms of U.S. energy independence because the combination of the financial pressures on the industry, plus the political and environmental pressures on the industry, could bring this era of U.S. independence to an end, and we take a close look at that in section two of the paper.

And then the topic that was also interesting to us is there's a lot of people that believe the underperformance of oil and gas stocks are because of stranded asset risk. In other words the market is not valuing any of the reserve finds because within some period of decades the world's not going to need those reserves, so you're wasting money on E&P to try and find them.

And there are certainly some academic studies and some policy people that believe that, and so it's something to take a look at. I continued to believe that a big part of the explanation for the underperformance of oil and gas is a supply shock, rather than this question of stranded asset risks. If you look at the U.S. shale boom the vast majority of it reduced imports, rather than being exported. So you had this domestic supply shock, you had this explosion of production, a collapse in profitability, and again the S&P 1500 oil and gas sector had 13 consecutive years of negative free cash flow.

And so the lack of capital discipline, both by the investors in these companies, and the companies themselves I think is a better explanation, particularly considering when you look on a long-term basis there's a lot of different scenarios out there. Some scenarios--the IEA, the International Energy Agency, has one--some scenarios project that the world is going to leave millions of tons of oil equivalents, of oil and gas and coal, in the ground, because they won't be needed over the next few decades.

You should take a look at what the underlying assumptions are for that sustainable development scenario in terms of a dramatic increase in wind and solar, and 50 percent electric vehicles, up from maybe one or two percent right now, a collapse in the energy utilization of buildings, a decline in actual energy demand in countries like the United States, back to 1988 levels, despite a huge growth in population. So this sustainable development scenario is possible. And if that actually happened you'd have a lot of stranded asset risks.

But when I look at it the world certainly is not on the trajectory of the IEA sustainable development scenario right now, and I'm tempted to think that because of that what's really going on in the markets with respect to oil and gas stocks is related to their current profitability, rather than the stranded asset risk associated with the deployment or not of future reserve.

Anyway, that's enough for this week's podcast. Take a look at the paper. We're also doing a webcast at some point over the next few days, which you can sign up for, where Anton Pil and I will be talking about this. And obviously we will continue to stay focused on developments with respect to the virus and any second waves that occur. So thank you very much for listening and I will talk to you soon. Good bye.

RECORDED ANNOUNCER:  Michael Cembalest's Eye on the Market offers a unique perspective on the economy, current events, markets and investment portfolios, and is a production of JPMorgan Asset and Wealth Management. Michael Cembalest is the chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.

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