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FEMALE VOICE: This podcast has been prepared exclusively for institutional, wholesale professional clients and qualified investors only, as defined by local laws and regulations. Please read other important information which can be found on the link at the end of the podcast episode.

MR. MICHAEL CEMBALEST: Greetings everybody, this is Michael Cembalest from J.P. Morgan Asset Management. This is the 2022 Eye on the Market Energy Paper Podcast. We’ll actually be doing a series of podcasts with each week’s installment dealing with different topics from this year’s paper.

The events taking place in Europe underscore some of the unifying principles of this annual energy paper effort since its inception 12 years ago. And those three principles are number one, energy transitions differ a lot from transitions in technology, healthcare, biotech, and other sectors. We have a chart in here showing this, how the speed of disruption is very different in energy than it is from other things like broadband and smartphones and rideshare and things like that.

The second concept is that decarbonization of electricity is well underway, but decarbonization of industrial production, transportation, and heating lag much further behind. That’s a really important concept in understanding where we are on this whole renewable energy transition.

And the third principle that I was kind of writing about for a while in the wilderness is that countries that reduce their own production of fossil fuels under the assumption that renewables can quickly replace them face substantial economic and geopolitical risks. That now seems obvious given what’s happened in Europe, but it wasn’t obvious at all over the last decade.

So as I mentioned, we’re going to do a few podcasts on this topic, and this podcast is going to be dealing with the executive summary of the paper, which is a discussion of some of the most important issues in the global world of energy issues. This is really meant to accompany the paper. It’s hard to do this without charts, so I’m not going to discuss everything, but I hit the main points here. You should dial into the webcast or read the paper itself if you really want to see this come to life.

Anyway, what are some of the most important things I’m going to discuss on this particular podcast? Well, let’s start with three things. Why is the world still so reliant on fossil fuels, which still account for somewhere between 80 and 85% of energy consumption globally? Even in Europe, which has really been a leader in terms of renewable energy, they are 70% reliant on fossil fuels.

So three things. Number one, you probably read about this concept called levelized costs. I wouldn’t say ignore them, but they’re not great barometers of the pace of change. The levelized cost that compares wind and solar on the margin to fossil fuels I consider a misleading measure, because these cost estimates rarely reflect the actual cost that you need to have a grid with a lot of renewable energy on it, which is a lot of cost associated with extra transmission, ‘cause you have to create large renewable coverage areas, for example, getting wind power from Texas to St. Louis or Tallahassee. You also have to include the cost of backup thermal power required for times when renewable generation is low. And if you’re not going to do that, you’ve got to include the cost of utility-scaled battery storage. So I remain amazed at how much time people spend on levelized costs when they’re not really fully loaded for a real actual live economy.

Second, as I mentioned, the benefits of grid decarbonization are great, but they’re limited by the fact that we haven’t really electrified at all industrial energy use, transportation and have only electrified heating a little bit. And that’s one of the reasons why it still looks like the world may be 60 to 70% reliant on fossil fuels all the way out to 2050.

And then one of the third issues to pay attention to is the energy divide between the developed and the developing world. If you look out over the next ten years, it looks like Europe, Japan, and the United States are all going to use a lot less energy over the next three decades than even they did over the prior one decade. That’s great. But over the last 25 years, the developed world has shifted a lot of its carbon-intensive manufacturing of steel and cement and plastics to the developing world. So for all the congratulatory backslapping taking place in the developed world for lowering its energy consumption, a lot of that simply is a byproduct of having outsourced a lot of carbon and energy-intensive manufacturing.

Two countries that are, when you look at them, actually highly reliant, in places like China, India, Vietnam, and Indonesia, highly reliant on coal as a share of their energy. So those are the three big topics from my perspective that explain why the world is still so reliant on fossil fuels: the misleading barometers of levelized costs, the low level of decarbonization outside the grid, and then this shift in the developed and the developing world.

So where do we go from there? Well, there’s a Mark Twain quote of, that goes like this: reports of my death are greatly exaggerated. And I use that this year on a chart that shows the recovery of fossil fuel stocks and how they’ve massively outperformed renewable energy stocks since really the middle of 2020. Some of the craziest, weirdest things I heard about, ever heard about energy, were said during the spike in 2019 and 2020 in those renewable energy stocks, and the short version went something like this: fossil fuels are dead money since the renewable transition is irreversible, gathering steam, and rapidly displacing them.

I would agree that the renewable transition is irreversible, but the rest of it, not so much. In our energy papers over the last two years, we argued that the stars were aligning for a substantial rebound in oil and gas profitability, and the primary reason being that the poor oil and gas stock price performance was primarily the result of management decisions to focus on market share and revenue and not on profits. And global gas and coal consumption in 2021 are already higher than pre-COVID levels, and oil consumptions should surpass pre-COVID levels sometime this year.

And even more importantly, looking further out, these aren’t my forecasts, a lot of the forecasts that you see from Wood Mackenzie, the Energy Information Agency, the International Energy Agency, and BP show oil demand, global oil demand in 2030, in 2040, they’re not that different from levels of oil demand today. We also estimate that the US might need roughly the same amount of natural gas in 2035 as it consumes today. So that’s a very different picture than the one that, than the market narrative that you were hearing 18 to 24 months ago.

Of course, the big issue in energy right now is what’s taking place in Europe, which is paying a really steep price for its reliance on Russian energy. Essentially, Europe miscalculated. It reduced its own production of fossil fuels a lot faster than it reduced its own consumption of fossil fuels, and they are now caught in the vice of Russian energy reliance. The ramifications I think are just beginning to dawn on me and other people, which is a likely recession in Europe, energy consumption is going to displace non-energy goods and services in Europe, a lower rate of growth in Europe, less competitiveness of their exported goods, they may even require curtailment of industrial production in steel, fertilizer, and cement if they really go cold turkey from Russian energy, higher food prices, and political tensions domestically as some of the anti-establishment candidates take advantage of the household distress. Of course, the latest news is that Russia cut off Poland and Bulgaria from natural gas shipments ‘cause they refuse to pay in rubles.

We have some charts here that show the history of Europe’s reliance on Russian energy, going all the way back to 1980, and comparing Europe, China, US, and Russia in terms of energy dependence and independence. These are some pretty paramount issues right now, and you’ve got to see the electricity and natural gas price gaps between the US and Europe, because you have to see them to believe them. At one point a couple months ago over the winter, natural gas in Europe was $30 compared to 5 to $6 of BTU in the US, and the electricity gaps were similar.

I will remind everybody that in 2012 during the presidential campaign in the US, Mitt Romney tried to warn everybody about what Russia was really all about, and he was first mocked on the left for doing so, and then you all know what happened later on the right and their quasi-embrace of Russia that took place during the 2016 presidential campaign.

So can Europe quickly change course? It’s real difficult. The plan that’s been announced includes a very rapid uptake in wind and solar, where in real life, deployment is constrained by transmission delays and interconnection cues and things like that, electrification of home heating that so far is mostly a Scandinavian phenomenon. Building out more LNG import capacity, it’s called regasification capacity, that takes years and billions of dollars to do. And the most ironic one that came from the IEA was recommending greater use of nuclear power at a time when Europe is basically, outside France, abandoning it.

So Europe is not the only region really at risk here. And one of the charts you probably have seen before is that on a global basis, capital spending on oil and gas production is declining, but oil and gas consumption is not. It’s basically back to where it was before COVID.

So countries are faced with three broad choices. You either ramp up your own domestic production of fossil fuels, if you have them, to avoid a geopolitical and economic trap. You rely on countries like Russia, Iran, Qatar, and the Saudis and Venezuela for imported energy. Or you confront the obstacles to a faster renewable transition head on.

And the last option is what a lot of people want, what a lot of us all want, but it’s not something you’re going to accomplish by feel-good policies like cutting off sources of fossil fuel financing or university divestment or stuff like that. If you really want to make this happen, policymakers have to step in and curtail the ability of local communities to delay or cancel decarbonization and the transmission projects that are associated with them. It’s happening all across the United States, and it’s happening in spades in the most progressive states in the country, which is a topic we’ll talk about in the next podcast.

Policymakers would also have to build consensus for an economy-wide price on carbon. And without those two things, without confronting those states’ rights issues and the price for carbon, we’ll all remain stuck in the slow lane where we are now, despite the ESG policies and corporate carbon disclosure requirements and stuff like that. A revival of the Build Back Better bill in the US could help a little bit, but there’s no news to report just yet.

So over the next two or three podcasts, we’ll be getting into the details on this year’s topics. Before we get started though, we had a page in here to just remind you of two topics from last year that we summarized, because they’re critical to understanding the decarbonization challenge.

The first one is the challenges of electrifying industrial energy use. The global industry uses more energy than any other sector, meaning homes, businesses, transportation, et cetera. And electricity is a very, very small part of industrial energy use. In the US it’s been hovering between 10 and 15% since 1980 and hasn’t really changed. And that’s a testament to how hard it is to electrify industrial energy use. And of course, electrifying it would then allow you to decarbonize it. But if it’s hard to electrify, it’s hard to decarbonize.

And the big issues are industrial production often relies on ways to heat energy, which is lost during electrification, which makes it a lot more expensive to electrify it. And a lot of industrial products like plastics and cement and ammonia aren’t metallic to begin with, which makes electrification harder. So there’s a summary of that.

And then I know people hate to read this, but one of the highest, one of other topics we summarized is the highest ratio in the world of science, which is the number of academic papers written on carbon sequestration divided by the actual amount of carbon sequestration, which at last count was 0.1% of global emissions. The infrastructure required to do this is enormous. And I’m sorry, but the energy and materials requirements for things like direct air carbon capture are basically unworkable. If you think, capturing 20% of global CO2 through direct air carbon capture would require 40% or more of all of the electricity in the world. This is clearly an absurd proposition, and I’m not going to waste a lot of time on it.

So this year’s paper is called the Elephants in the Room. And it’s a phrase that refers to glaring, glaring issues that need to be resolved. So what are we going to be talking about? Well, there’s three topics on electrification, the transmission grid, clogged interconnection cues, things like that. Then we’re going to be talking about electric vehicle adoption and what policies might be needed to get US gasoline super-users, the one, that that small cohort of people consuming a third of the gasoline, how can we get them to switch to electric vehicles more quickly?

We’re also going to take a look at how rising metals prices affect battery cost. And then we’re going to conclude the electrification section with a look at home heating and specifically these new bans on onsite combustion of natural gas, propane, and fuel oil in new buildings. So far, mostly this is a Scandinavian phenomenon, but it’s coming to a city or country near you.

And then after that, the next podcast is going to take a very deep dive into the hydrogen economy, which is a concept that really is still in its infancy, and we’re going to take a close look at the use cases that we think are a lot narrower than advertised once you look at costs around your proficiency, materials handling, competition from electrification, things like that. So that’s enough for this week. Thank you very much for listening, and we’ll see you next time.

I do want to make one quick, brief comment before I go. One of the topics that I’m not writing about this year is the climate benefits of the switch from coal to natural gas. That’s still very much a work in progress. I don’t think there’s any disagreement that on a pure CO2 basis, gas has a lower emissions rate than coal. I mean that’s just kind of empirically true from a chemical perspective. The issue is these methane leakage rates. The EPA claims that they have fallen to just 1% of total production, but most of the climate science people I talk to don’t have a lot of confidence in those EPA numbers. And when they conduct their own measurements, they find that they’re understated by 50 to 100%, maybe more. So that methane, because if its concentration component as a GHG, that would offset a lot the assumed benefits associated with coal to gas switching. So that is still unsettled science, from what I can tell. Anyway, thanks for listening, and I will speak to you all next time. Thank you, bye.

FEMALE VOICE: Mike Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers. For more information, please subscribe to the eye on the market by contacting your J.P. Morgan representative. If you’d like to hear more, please explore episodes on iTunes or on our website.

This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information which can be found at www.JPMorgan.com/disclaimer-EOTM.

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