A Folly in US Energy Financing

Ever wonder why gas prices at the pump have held steady around the $4 per gallon mark for the past two years, despite the global economic slowdown? The last time prices reached $4 was just after Katrina. Consumers then underwent sticker shock. Lately prices have pulled back a bit but come 2013, consumers may see $5 to $6 per gallon gas as the US economy rebounds. What is keeping fuel prices so high? Aside from the traditional market forces, there are many other factors that affect fuel prices too.

Certainly the conflicts in the Middle East (i.e. Syria, Egypt, Palestine) and the nuclear threats from Iran play a part. With the slightest inkling of a possible supply interruption, fuel buyers and speculators will jump into a buying or selling frenzy. Wars, threats of war, OPEC news or lack thereof are all likely triggers to set fuel buyers on edge creating havoc for companies and consumers alike. These erratic fuel price swings do more damage to an economy by spawning uncertainty and instability.

An important stabilizer for these lopsided market forces has been improved fuel efficient engine designs that presently deliver up to 40 miles per gallon (mpg). Already some designs are boasting 100mpg with their pilot models! – (ecomotors.com).  But, even if 100mpg cars were introduced to the US market today, fuel prices would most likely continue to rise because in addition to geo-political uncertainties, there are domestic ones as well.

MIT Energy Finance Forum
At a recent energy finance forum last month organized by MIT’s student run energy club (mitenergyclub.org), CEOs, thought-leaders, and entrepreneurs representing various facets of the energy industry discussed the many opportunities and challenges created by higher energy prices. Everyone agreed that moderate price increases backed by sound government policies could help boost a stagnant economy. They go hand in hand such that one could not exist without the other. Higher fuel prices stimulate new research for alternative fuel sources, encourage design engineers to do what they do best, and create public awareness on the importance of conserving energy. On the other hand, comprehensive government policies help companies and investors align their business strategies with US national interests as well as with each other. Having both in synch attracts new investors.

So when I heard panel members at the forum blame the high cost of energy on the Obama Administration’s lack of a national energy policy, I wondered if the Secretary of Energy, Dr. Steven Chu, had lost his way.  In 2012 Chu’s Department of Energy (DOE) invested in over 180 projects with ARPA-E, a new R&D agency for basic renewable energy projects. Chu’s ‘hit or miss’ approach to unveil the ultimate breakthrough without announcing a definitive national energy strategy has overshadowed the rest of the industry. Energy-sector CEOs have had to navigate rudderless relying on politically motivated investment tax credits and subsidy schemes (i.e. Renewable Energy Certificate or RECs) to make ends meet. The following are a few examples of how some have coped with the current situation.

PSEG
According to Ralph Izzo, the Chairman and CEO of PSEG, a New Jersey based utility company, DOE’s meddling with energy infrastructure projects  and the Obama administration’s lack of producing a national energy strategy have created such a high level of anxiety and uncertainty among investors, that no investor in their right mind would agree to finance the expansion or conversion of an energy plant today without insisting on a list of unfeasible assurances. In fact government subsidies and their tax credit schemes are never included in the financial proformas used to evaluate deals, since investors never know if the laws will survive the next political elections. Elections occur every four years and energy plant deals normally require a 20 year investment horizon. Izzo shared an insightful example of how the price of building a similar nuclear plant had jumped from $450m in 1989 to $10billion today. In his opinion the 20x price escalation was primarily due to the unwillingness of Congress to commit to a national energy strategy.

The uncertainties caused by the US Government’s indecisiveness is affecting not just fuel buyers but their capital investors too. Since renewable investments are so new and have yet to be securitized (packaged into tradable securities), cash-rich pension fund managers who invest for the long term have been barred from participating in non-traditional energy investments. Without more historic data from a broad range of similar investments and the availability of affordable financial tools to hedge against risks of loss, securitization of renewable energy projects has been challenging. Unfortunately, large cash reserves that would otherwise be used to finance infrastructure energy projects currently remain on the sidelines with dim chances of being deployed any time soon.

Siemens
Ironically, the more the DOE offers incentives to entice private investors to invest in large energy projects, the less likely private funds will participate in a deal. This very issue became part of a fascinating panel discussion with representatives from Siemens, Bechtel, CEIFA, Zanbato, and the DOE itself. The panel suggested the presence of a greater problem where investor expectations needed to be updated in favor of equity investments over debt. They highlighted that the risk profile of an energy-related project is significantly less from that of a bridge and hence should be structured differently. To them, bridges can ‘lead to no where’, while energy sources will always be in demand somewhere on the planet.

While it awaits for more favorable winds from Congress, the energy sector growth in the US has had to rely on internal financing along with many clever and unconventional energy financing partnerships.

Public-Private Partnerships in Energy
One way long term projects such as city metros and highways are financed is through the formation of a Public-Private Partnership or PPPs. How successful have PPP’s been with large energy projects? The truth is that not all PPPs are the same. In fact the lack of a reliable template that is easily transferable from one project to another was deemed ‘very difficult’.  Each deal had to be tailor-made from scratch to satisfy a long list of specific requirements. When compared to each other, PPP’s were no more than a name plate suggesting some form of a collaborative involvement among large players including the government.

A ‘public green bank’ operated in Connecticut under CEIFA (Clean Energy, Investment and Finance Authority) uses public funds to attract private investors into jump-starting small renewable energy projects. Directors of this new bank hope to show small success stories where their combined investments will eventually be pooled into a bond product and securitized for sale to larger players, possibly even to pension funds. Citing the Solyndra debacle, the CEIFA representative recommended that the US Government avoid large projects and instead focus on smaller ones that can be aggregated into securitized debt instruments.

A panel member from Siemens offered another PPP example involving three partners, an equipment manufacture, which in this case was Siemens, a methane gas buyer, which was Kimberly-Clark, and a client who produces methane gas (3-Rivers Solid Waste). To close the deal, Siemens had to front the equipment to the methane gas producer and agree to absorb 100% of the project risk. In turn Kimberly-Clark agreed to a floor price in the event the market of natural gas were to collapse. 3-Rivers Solid Waste leveraged tax exempt financing rates and loaded back end debt payments to Siemens during periods of maximum production. As you can see, each partner had to give up a little to make this deal work. (Additional details are listed at http://1.usa.gov/12FKdaS.)

Siemens impressed the audience further with another example of unconventional energy financing for a proposal to build 100 train coaches for Amtrak. In this deal Siemens agreed to underwrite the entire amount, if Amtrak, a US government owned entity, would agree to partially by-pass the open-bidding requirements and automatically award Siemens with one-quarter of the order. Government officials cited a possible violation to the fair bidding process, which according to the VP of Government Affairs, David McIntosh, has kept the deal tabled for now. Clearly Siemens is not happy with these and other similarly unconventional and risky arrangements, but noted that there are no better alternatives in the energy financing environment today. The Company hopes that its aggressive sales approach and patience will eventually pay off in the ‘very’ long run, while, it waits with the rest of the industry for the DOE to reassess its myopic R&D focus and introduce a comprehensive national energy strategy.

Aviation Biofuels, Leading the Way to a New Global Economy

If you are wondering what our future holds with an economy subjected to political gridlock, an overview of an emerging industry called aviation biofuels could offer some interesting insights. 

Airlines today operate on razor thin profit margins with an industry average of less than one half of one percent, largely due to soaring fuel prices that gobble up about 30% of ticket revenues. Many factors are to blame and ultimately the traveling consumer is unwilling or unable to pay the higher ticket prices airlines need to offset their mounting losses. Merger mania among top airlines has played itself out leaving fewer options on the table.  Aside from shaving off more capacity than they have already, airlines are looking elsewhere to stay in business. One area that remains unexplored is the diversification from a one fuel source model to multiple fuel sources, which would include biofuels.

At a recent Aviation Biofuels Development Conference in Washington DC organized by FC Business Intelligence based out of London, thought-leaders, investors, government officials, and private sector industry leaders spent two days evaluating the growing prospects of aviation biofuels. So nascent is this industry that not even the US Government had a handle on its realistic potential and implications. However much they differed in their respective opinions, conference participants did agree on the pressing need to stabilized jet fuel prices through the production of alternative jet fuels. Their target production for 2015 was 600 million gallons per year, which amounts to a mere fraction of the 36 billion gallons per year mandated by Congress for ground transportation fuel blending. What impressed me most between the many animated discussions was the underlying dynamics among so many capable players that for whatever their reasons had been thrust together into the uncharted territory of aviation biofuels.

By the second day, the conference reminded me of the knocking sounds of an engine running with the wrong type of fuel. Was it the engine design or the fuel mismatch that was at fault? …and then it occurred to me. It was neither.  The aviation business model, which in my example would represent the engine, was being forced to change its fuel sourcing strategy from a single fuel pathway (from ground to gas pump) to multiple fuel pathways. Both the engine in my example and the fuel type were up for a complete redesign and eventual realignment, hence the ‘knocking’ sounds.

To appreciate the tectonic impact from a transition to multiple fuel pathways, imagine for a moment what life would be like if every home in the US had its own oil well and processing plant in its ‘backyard’ that could easily produce optimal grade fuel at a price well below today’s market price. “That scenario is absolutely ridiculous!”, you might say under your breath.  …and yet, the emerging aviation biofuels industry speaks directly to this end.

Instead of purchasing fuel from traditional fuel brokers, airports are planning to produce their own fuel at a lower and more stable price using feedstocks and a processing facility located adjacent to the airport’s existing storage tanks. Under this arrangement, airlines would no longer be subjected to volatile energy prices caused, for example, by a political event in the Middle East. Also, by positioning biofuels production facilities in their ‘backyard’, airports can eliminate shipping and port handling costs. Once more, if airports succeed in producing their own fuel source, what would prevent industrial parks around the world to do the same?

The resounding significance from producing fuel at the point of consumption will give both companies as well as groups of companies a far greater and sustainable edge over their competitors.  Just how an energy-decentralized economy will play out in the end will be anyone’s guess.  One thing is for sure. The base of wealth and power both politically and economically will shift significantly.

Considering this new perspective, one can better understand the industry’s current frustrations. On the one hand the US Government is hesitating with its renewable energy strategies not knowing if an untested policy might eliminate entire industries (i.e. fuel transportation), reduce existing business tax revenue streams, and increase unemployment. In the meantime, the DOE (Department of Energy) continues to invest in biofuels R&D and to develop incentives for private investors willing to scale biofuel productions.

The progress in the aviation biofuels industry can be measured by the rapidly growing number of fuel-production pathways.  In fact there may be too many pathways and efforts are underway to standardize a comprehensive evaluation process. Also in play are efforts to improve efficiencies within each pathway such as increasing the energy yield per acre of feedstock. But despite all of these efforts, the price of biofuels per gallon remains well above that of most conventional fuels.

With Republicans unwilling to pay more for energy than the lowest cost fuels available, the future of biofuels remains potentially entangled in a political gridlock. However, as the real threat to the airline industry continues to grow, aviation biofuels may force opposing members of Congress to reconsider their positions.  If and when they do, the production of aviation biofuels may unintentionally trigger the decoupling of crude oil prices globally. When that day arrives, businesses will learn to compete not only on price, but also on their respective ready access to ‘backyard’ biofuels energy.

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Appendix – Conference Overview
The conference organizers did an excellent job of presenting an interactive forum that offered new pathways from the traditional one-pathway strategy discussed in the article.  This section was written for readers with an advanced background in the industry.  New interconnected pathways discussed included:

Investment Strategies, presented by Baker & McKenzie (bakermckenzie.com), focused on parsing project risk into tradable financial instruments to attract diverse groups of investors. For example, project assets would be pledged to a lender using a Special Purpose Vehicle or SPV. The DOE (Department of Energy – energy.gov) spoke of Master Limited Partnerships (MLP’s) where project assets can be assigned to an LLC, tax free, and later IPO’ed to raise cash to finance newer projects.  They are also working on redefining the definition of REIT’s to include biofuels investments.  These changes will qualify more investment funds including foundations and make it easier for private sector participation.

Fuel Processing, presented by GEVO (gevo.com), compared the differences between processing techniques using biology (i.e. enzymes) or chemicals (i.e. catalyst). Their catalyst category included a clever building block platform of iso-butanol a C-4 carbon molecule that like lego pieces can combined to produce not only ethanol but also other lucrative chemicals (i.e. C-8 for gas and C-16 for diesel). As demand shifts for each chemical, the plants daily production can be calibrated to optimize profits. Another company, Byogy Renewables (byogy.com), also a chemical processing company has developed technology to extract 80% of oxygen content in biomass to produce a 100% replacement to jet fuel (no blending required). They are currently partnered with Qatar Airlines.

Feedstock, presented by Paradigm Energies (paradigmbioaviation.com), reminded us that feedstocks or the raw materials used to process biofuels represents 80% of the cost of the biofuel produced. However, in the case of corn ethanol, for example, one of its byproducts can be sold for animal feed at a price close to the corn itself, hence, creating an offset revenue.

Paradigm Energies is in the waste-to-energy business. They source municipal landfills, ‘garbage’, for feedstock and supply a clean jet fuel called syngas that can be liquefied for blending or used to produce electricity. Cities are willingly pay a ‘tipping fee’ to have their waste removed, since landfills are unsightly and expensive to manage. The overall benefits to a city from a social and economic point of view are noteworthy, while the ‘tipping fees’ offer an offset revenue similar to corn. Potentially perceived as a ‘dirty business’, operators of similar waste-to-fuel schemes are mindful of potential negative public opinion for eliminating trash removal jobs, rezoning landfill areas, and other eventualities such as a plane accident that involves the use of a blended biofuel produced from ‘garbage’.

Another company, Solena Fuels (solenafuels.com) is building waste-to-garbage plants adjacent to city refineries in the UK. Cities with a population greater than 1.5 and 2 million can produce the 700,000 tons of garbage needed to operate one of their processing plants. One of its partners, British Airways, has recently placed an order for 5 plants to meet 2% of its annual fuel consumption.

Patents presented by Boeing (boeing.com) has become big business for this conglomerate. In the interest of helping its customers buy more airplanes, Boeing is actively redesigning its engines in an effort to move away from a one fuel model. They see their role as a catalyst to accelerate commercialization of biofuels and are aggressively taking a stake in new IP’s produced. The company uses its brand and influence to advocate policies and other related matters.