Eye on the Market

11th Annual Energy Paper

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MR. MICHAEL CEMBALEST:  Good morning, and welcome to the Eye on the Market energy podcast.  For the last 11 years, we’ve written a paper that takes a deep dive into the energy and climate issues that we think are most important to understand.

This year the paper is called Future Shock, and the reason is because without some kind of decarbonization shock treatment, we’re all going to be wedded to petroleum and other fossil fuels for longer than we’d all like.  The wind and solar power capacity additions around the world are accelerating.  They still represent just five percent of global primary energy consumption.

So in this year’s paper, we review why decarbonization is taking as long as it is, and we--and we take a very close look at four issues: the obstacles with respect to transmission, industrial energy use which is primarily fossil fuels difficult to electrify, the gargantuan requirements in terms of both mineralization and pipeline demands of sequestration, and the slow-motion revolution in electric vehicles.

Other topics include our oil and gas views, President Biden’s energy agenda, and then specifically how much natural gas will the U.S. need in the future in light of President Biden’s goal to decarbonize the electricity grid by 2035. 

We take a look at--a close look at Chinese energy use, some last words on the Texas power outage, and then we also answer some client questions on things like electrified shipping, sustainable aviation fuels, low-energy nuclear power, the hydrogen economy, and then some new carbon accounting approaches from MSCI.

It’s a pretty in-depth piece.  One of the reasons why we get into some detail is that a lot of our clients have a lot of expertise and knowledge about the sectors they work in.  But I find that there is a lack of understanding in a lot of places about just how the energy ecosystem works.

And so here’s a few--let me just point out a few of the charts that I think would be most helpful to look at.  One of them in the executive summary looks at the shift in energy intensive manufacturing over the last 25 years.

For all intents and purposes, the West has de-industrialized ammonia, steel, cement, plastics, and some of the most energy-intensive pillars of modern society.  So we’re going to talk in the paper a lot about the decarbonization that’s taking place in Europe and Japan and the United States.

But we should really be clear that after the de-industrialization that’s taken place in the West, um, the--it’s really the developing world’s adoption of wind, solar storage and nuclear power that are going to end up being the primary determinants of future global emissions outcomes.    

Think about this.  Africa as a continent still uses energy on a per capita basis that was last seen in Europe in the 19th century.  That’s expected to change.  And I know that our clients that have read our energy papers before understand this, but I just want to reiterate this because it’s so important.

There’s a lot of work going on around the world to decarbonize the electricity grid and that’s great news.  And we have a lot of charts in here tracking on how that’s going, and the collapse in the power purchase agreement prices for wind and solar both in the U.S. and on a global basis since 2012 have been remarkable, you know, in 70 to 80, 90 percent declines.

That said, electricity only represents 15 to 20 percent of global primary energy consumption.  In other words, the vast majority of energy use globally is still direct energy consumption in the transportation sector, by industry, and for residential and commercial heating.

That represents around 80 percent of all energy use and until you start to decarbonize that, the--the decarbonization in the grid itself is only kind of--is a small and partial solution.

There are three pages in the executive summary which get into detail for the U.S., for China, and for Europe on energy use by sector and fuel type.  In other words, industrial transport, residential and commercial end users, and what kind of fuel they’re using, what’s the split between direct energy use and electricity within electricity, how does that break down or cross fossil fuels, renewables and nuclear, et cetera.

And you can really see how the three regions are different and what their commonalities are.  And so we do get--I think it helps--it’s extremely helpful to kind of understand the global energy ecosystem by looking at it in this way.

We also do talk about our market views.  We were bullish on oil and gas last June.  We didn’t feel like it had much more to fall, and since then traditional oil and gas stocks have rebounded.

So have renewables.  Renewables have done extremely well but they’re doing some strange things.  I mean if you really think about it, there’s no reason that I can see that the--the transition to electric vehicles will increase the market capitalization of the total auto industry, right?  I mean it’s a high volume, competitive, low-margin industry.

And yet the industry’s total market cap gained 70 percent in the last three years ending January.  So there’s some strange things going on there.  I mean I think you can make some people--you can make some arguments about how Tesla should do versus the other companies. 

I don’t see why the total industry would rise by 70 percent because nobody is suggesting that automobile consumption per capita is going to be going up.  If anything, a lot of the investments that are taking place in the world are designed to make those numbers go down. 

So in Section 1 we take a look at electric vehicles and--and why the revolution has been so slow so far.  Outside of a couple of countries, I’ve never seen Norway talked about more than over the last year with respect to its electric vehicle share of 60 percent.

There’s a lot of things to understand about Norway that are very different than most other countries in terms of its population, its population density, where its electricity comes from, how cheap its electricity prices are compared to Europe and the U.S., and then within Norway specifically what they’ve done to engineer this EV revolution.

I think once you understand all that, you’ll probably agree with us that we should dispense with Norway as a paradigm for the world’s high density, car-loving countries.  And then we take a look at how the EV revolution is going elsewhere.

And then there are--there are four key components in the analysis.  Number one is the good news which is if you look at the United States and Europe as an example, no matter where you live, transitioning from an internal combustion engine car to any of the top selling cars and trucks would entail climate gains.

And so in other words you would need, for example, if you lived in Virginia or the Carolinas, you would need to be driving a traditional car that gets close to 90 miles a gallon in order to generate--have the same EV footprint, uh, as, um--a GHT footprint as in an electric vehicle.

So that’s the good news.  The GHG benefits from switching look good.  When people do switch, the challenge is a couple things.  The life cycle of today’s life vehicles are much longer than they were 20 years ago.  My college roommate had a 1983 Ford Mustang.  It was a terrible car.  It was in the shop all the time.

And at the time, the average life cycle of a car was only maybe seven years or so.  Whereas today, the average age of life vehicles in operation is 12, and in some parts of the country longer.  So that’s great news for proactivity household wealth, but it delays the penetration of new technologies like EVs.

And I think a misunderstanding of that life cycle is why so many of the projections from BNEF and Price Waterhouse and all these other places a few years ago for what EV shares would be in 2020 were so wrong.  Most of those forecasts ranged from 5 to 15 percent.  Last year they were just two percent.

The other thing to keep in mind is a lot of the analyses we see will compare, let’s say, the price gap between a Chevy Bolt and a Toyota Camry.  Well, that’s great for countries and states where most people are buying Toyota Camrys and can switch to the Chevy Bolt.  And, you know, the price gap there is, you know, maybe 15 or 20 percent.

The facts are in the United States around 80 percent of the U.S. light vehicle sales are SUVs and other light trucks.  So the Chevy Volt, or the Chevy Bolt I should say, is not a product substitute for people who buy Ford F-150s or the Chevy Silverado. 

When you actually look at those EV comparisons, the electric versions of those things which are coming out over the next year, couple years, the price gaps are much larger and so are the range differentials in terms of how far you can drive on them.  And, you know, that’s impacting the EV adoption cycle as well.

And then the last issue on EVs is there’s some evidence from European countries that--where a lot of EVs are being purchased that there were--they’re not necessarily replacing your internal combustion engine car, they’re supplementing them.  Because in most countries the EV purchasers are wealthier families, they buy an EV but it’s not, you know, replacing the EV for median income families and that obviously has a lot of climate implications as well.

The longest section in the entire paper this year has to do with electricity transmission.  A lot of deep decarbonization plans from Princeton and MIT and other places are finally acknowledging you can’t project 10 to 15--uh, a multiple of 10 to 15 times the amount of solar and wind generation capacity and have that translate into actual electricity on the grid unless you build a lot more transmission.

And so we first look on a theoretical basis what MIT and Princeton are saying about the benefits of building additional transmission.  These are the most hockey stickiest charts of all the hockey stick charts I’ve ever seen when you see one of the charts on the history of how--of the pace of transmission built in the United States compared to where these guys think it’s going to go.

The problem is where they’re saying it has to be built - California, New Jersey, New York, Massachusetts, Maine - these are some of the most NIMBY-est places in the country.  And I’m not sure what they’re thinking, uh, you know, about how this stuff is going to actually get built. 

Because when you actually look on the ground at what happens to transmission projects, at least in the United States and in parts of Europe, it’s a hornet’s nests of siting challenges, legal challenges, and projects are taking 10, 15, sometimes as long as 17 years to get built after being planned.

 So all these deep decarbonization plans are going to have to deal with that reality.  We talk through what I consider to be both a sad and farcical situation where there are massive gains to be had by Massachusetts importing cheap hydropower from Quebec, and then, um, a combination of the New Hampshire siting committee and some of its power generators killed the project, and so Massachusetts is going to have to combust more natural gas instead.  

We talk about the history of some of the clean line projects in the United States that were supposed to connect Oklahoma wind with Tennessee, or to connect Kansas wind with the east coast, and how a lot of the state and local objections have essentially killed, torpedoed, or crippled a lot of those projects.

So these are some of the realities that you have to understand when you’re looking on paper at these wonderful projections of deep decarbonization plans.  They don’t get at some of these practical day-to-day issues.

Even when some of these projects are approved, one of our clients is working on a project to bring wind power from Wyoming to California.  They started working on it in 2007.  And it was also at one point fast tracked by the Obama administration, and the project is only 15 percent reliant on private lands; 85 percent is on federal lands.  And yet still here we are, um, you know, 14 years later and the project is still kind of, quote unquote, in development.

So anyway the bottom line is the United States doesn’t have broad legislation that supports federal eminent domain for electricity the way it did for the interstate highway system in the ‘50s and natural gas pipelines in the ‘30s, and that’s a pretty big issue.

Okay.  So on carbon sequestration I will simply say this.  The highest ratio in the history of all of science is the ratio of the number of papers written on carbon sequestration divided by the actual implementation of carbon sequestration.

You know, the--it’s a much more complicated process than people acknowledge.  Again, there’s a lot of cocktail napkin analysis that’s being done and has always been done, but the fact is to even sequester a small amount of, uh--of U.S. carbon emissions would--would require the creation of an infrastructure system whose throughput volume in the U.S. would be higher than the volume of all the oil that flows through the U.S. distribution refining pipelines.

So that is a--is a pretty remarkable number.  And then we also talk through some of the issues about carbon mineralization as well as direct air carbon capture.  And we walk through all the math here. 

I’m simply going to tell you the conclusion from a paper in Nature Communications this year which talks about direct air carbon capture being an--and unfortunately an energetically and financially costly distraction in effective mitigation of climate challenges.

But we’ll show you the math.  Take a look at how much electricity and how much primary energy it would take to create the materials, essentially caustic soda, that would be required to react with CO₂ so that direct air capture can work. 

And then I think one of the most interesting parts of the paper this year deals with the industrial sector.  On a global basis and particularly in places like China, the industrial sector is the largest user of energy. 

And so I--the rational question people have been asking is ‘Well, why don’t we just electrify some of these industrial processes and then over time as we add more green electrons to the grid through wind and solar and hydro-expansion, we will essentially be decarbonizing the industrial sector.’

Now, there are certain processes, industrial processes, that can be electrified - some primary metals, secondary steel which is made in electric arc furnaces, machinery wood products, plastics and rubber - most of these things use fossil fuels for process heat which you could replace with electric heat.

It turns out it gets more complicated after that, like chemicals, pulp, paper, food, oil refining, uh, glass, bricks, cement.  They all have their own challenges that make them much harder to electrify in some cases.  You know, it’s as simple as saying “It’s hard to electrify production of things that don’t conduct electricity” which is what you’ve got with glass, brick, and cement.

And, you know, on every single one of these hard-to-electrify sectors you’ll find papers someplace that talk about pilot projects and demonstration projects.  The approach we generally use is when--when somebody approaches some kind of commercialization, then we’ll take a closer look and we’ll see how much it costs.

As things stand now, what we consider to be the harder-to-electrify industrial sectors use two and a half to three times the amount of energy as the ones that are easier to electrify.  And then even if all of those hurdles are overcome, you still have the issue that electricity per unit of energy is three to six times more expensive than natural gas.

Which kind of makes sense if you think about it because if you have an option to use natural gas combustion directly to provide heat, that’s going to be using a device that has maybe 60 to 70 percent efficiency.  If you then take natural gas and other fossil fuels and you start to combust them as well to make electricity it’s obviously much less efficient.

So in any case, the stickiness of industrial energy use in terms of its low contribution from electricity at just 12 to 15 percent has more or less been unchanged since the early 1980s.  So every time you see someone trumpeting massive electrification in the industrial sector, you should probably ask some pretty tough questions.

We have a section in the piece on our oil and gas call from last year.  The bottom line is that investing in the shale revolution was typically a train wreck.  If you look from 2010 to 2019, the aggregate free cash flow in the industry was negative every single year.

We felt this performance was more based on a collapse in capital discipline by management and the supply shock from fracking rather than a sign that there was an inflection point that we were at where demand for fossil fuels, domestically and internationally, was at a permanent decline.  So far it looks like we were right about that.

We’ve got a section in here that goes into a little more detail and you can take a look there.  And one of the real interesting sections in this paper looks at how much natural gas the U.S. might need in the future.

 And we make a bunch of assumptions.  I think most nuclear plants will be 50 years old or more by 2035, so we assume that two-thirds of them are decommissioned.  No more coal plants.  You have some modest growth in hydro-power.    Some electricity demand growth for accommodating, let’s say, 30 percent EV penetration by 2035, et cetera, et cetera.

And if you make all these assumptions and you assume capacity factors of 25 percent for solar and 35 percent for wind, it makes a meaningful dent in--of about a third in natural gas demand, but only around a third. 

And then again the bigger issue is that natural gas is used for electricity generation but also directly for heating and for industrial energy use.  And as we’ve discussed, if those two things don’t change very much, even if the pace of solar and wind capacity additions for the next 15 to 20 years matched the peak additions of the late ‘90s when there was a natural gas boom, the natural gas industry’s total production would only have to decline by maybe 10 to 15 percent versus today’s levels.

And it’s really an interesting analysis because what it shows you is even if you get very aggressive about future wind and solar growth, and the transmission generation--the transmission capacity required to accommodate that generation, under some kind of reasonable assumptions natural gas is still a pretty critical contribution to the overall energy ecosystem in the United States.

And so I think policy makers should be pretty careful before doing anything that assumes that that’s not going to be the case just based on some plans they’re seeing on paper today.

And the--you know, the conclusion that we made, um, that the--that my final sentence in the paper this year was that the overarching message of this paper is not climate nihilism or anything like that.  It’s that the behavioral, political, and structural changes required for the decarbonization are still grossly underestimated.

And if that’s the case, the companies that we all rely on for dispatchable thermal power and energy are going to need to survive and prosper until we get to that deep decarbonization ending place.

So that’s, uh--that’s it for the podcast.  There’s some other interesting topics in here.  And if you want to read something fun, you can read what I did in terms of analyzing the statements made--incorrect statements made about the causes of the Texas power outage.  We had some fun with that.

But anyway, that is our energy paper this year.  Take a look and we look forward to talking to you again soon.

AUTOMATED VOICE:  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 JP Morgan Asset management and is one of our most renowned and provocative speakers.

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