Monthly Update - September 2011

By: Stephen Johnston | Mon, Sep 12, 2011
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Some Thoughts Macro, Value & Austrian

Haven't heard of EROEI? You can be forgiven if its not a topic that is on the tip of your tongue with issues of sovereign insolvency, QE3 and the like dominating the airwaves.

I feel confident that EROEI is an acronym that will receive much wider recognition over the next decade. What is EROEI you ask? It requires energy to produce energy and that relationship is expressed as "Energy Return On Energy Invested" or EROEI for short. Why is EROEI important? Because we are in the process of transitioning from high EROEI sources of hydrocarbon energy to low EROEI sources - think Saudi Arabia versus the Alberta oil sands.

Even if you don't believe that peak oil is an issue, I would argue that EROEI decay is most certainly one. Discoveries of conventional oil total around 2 trillion barrels, of which around 1 trillion barrels have been extracted, leaving approximately 1 trillion barrels remaining. However the first trillion barrels was found on shore or nearby, shallow and concentrated in large reservoirs and generally in politically stable regions - the "easy" oil. The remaining oil is far offshore or deep underground, in smaller, harder-to-find reservoirs and mostly in politically unstable locations - the "difficult" oil.

I believe an increasing dependence on "difficult" oil has some serious consequences for the global economy.

Current production is around 86 million barrels of oil per day ("BOPD"). However an 86 million BOPD oil production profile of high EROEI sources is very different from 86 million BOPD of low EROEI sources. Effectively the net energy left over to drive economic growth is significantly lower in the latter scenario. Here are some highly approximate EROEI ratios for various energy sources:

To engage in a simplistic piece of analysis, assuming 86 million BOPD composed of 1970s oil & gas reserves - there is around 83 million BOPD net to fuel growth. Assuming 100% biofuels then this drops to 43 million BOPD. The farther down the list we must go to maintain supply the worse the net energy situation becomes.

Why do we care about this?

Economic growth is in large part a surplus energy function as well summarized by Chris Martenson in his book "Crash Course". A reduction in surplus energy will increase energy prices at the same time it is putting pressure on growth. If the real cost of hydrocarbon energy is going to increase then the real cost of other commodities will also increase as most have significant energy inputs. On balance, I believe the net result will be a transfer of wealth from commodity consumers to commodity producers.

In less vague terms, the prospect of deteriorating EROEI will certainly increase food prices, as modern agriculture depends heavily on the use of fossil fuels - for machinery, irrigation, fertilizers, herbicides, storage and transportation. Here are just a few examples:

A rhetorical question - if declining EROEI drives up the real cost of agricultural commodities will it confer a competitive advantage on land with lower energy intensity - e.g. no need for irrigation and low fertilizer use - such as Canadian prairie farmland?

I believe the twentieth century trend of low real commodities prices is in large part a reflection of the abundant, high EROEI supplies of energy that were available during that period. Without new sources of high EROEI energy I would argue that this favorable trend will reverse.

If this is the case then significant amounts of wealth will be transferred from commodity consumers to commodity producers - particularly to producers of commodities with the most inelastic demand curves. Declining EROEI is in part why I believe in 1) direct investments in western Canadian commodity production assets and 2) in investments that serve as proxies for the increasing real cost of commodities - e.g. businesses linked to commodity production.

Kind Regards



Stephen Johnston

Author: Stephen Johnston

Stephen Johnston - CIO
Petrocapita Income Trust & Agcapita Farmland Investment Partnership

Stephen graduated from London Business School and is the founder of one of Canada's largest farmland investment funds, Agcapita, and Petrocapita Income Trust an energy investment fund. Petrocapita and Agcapita are built around the core premise that the world is in a bull market in commodities driven by inflation and a step-change increase in demand and, accordingly, that investments with direct or indirect exposure to commodities in a politically stable environment such as Canada will provide above average returns. Agcapita holds a diversified portfolio of farmland and Petrocapita holds a diversified portfolio of low risk, producing energy assets.

Stephen has over 15 years experience as a fund manger - working for organizations such as the European Bank for Reconstruction and Development, Societe Generale and Baring Brothers. Stephen has appeared on Business News Network and CBC News and been quoted in such media outlets as Fortune, the Financial Times and The Globe and Mail.

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