Friday, June 26, 2009

Free Energy

What does the graph of S&P500/WTI Oil price tell us (see previous post for the graph and early thoughts).

I think that it is showing us how much free energy is available for distribution in the world.

I am thinking this out as I seek to understand both the graph and its possible implications for us, so please excuse any ignorant or stupid mistakes which I make - but also please comment or email me a correction or suggestion for further reading when you find one, or even if you just plain disagree with my assumptions, observations, arguments or conclusions.

The corporation

A corporation has assets and uses those assets to convert inputs to outputs.
Assets represent energy captured and embedded semi-permanently within the business.
Inputs are items required in addition to the assets in order to produce outputs.
Outputs are the finished products of the business and can be exchanged for money.

Both assets and inputs cost money.

Money can be obtained in three core ways.
1. By issuing interest bearing debt, also known as corporate bonds.
2. By issuing shares which dilute the ownership of the business.
3. By selling outputs.

Money can also be obtained reasonably directly from certain classes of assets, such as owning shares or bonds, but this is not really the business of a productive corporation although many businesses (if not most) engage in this to some degree - no total extra value can be generated from a given amount of energy in this way.

Assets are capital items. Capital items are either tangible or intangible and are purchased using money.
A tangible capital item is something physical such as a building or a machine.
An intangible capital item may be less obvious such as a trained employee, customer goodwill or the systems and procedures for operating the business.

Both tangible and intangible capital items will degrade if they are not maintained.
Some capital items are fully paid up, for example a building may be owned free of all mortgages, but will still incur maintenance costs such as business rates and mending broken roof tiles or mending a hinge on a door.
Some capital items have large maintenance costs, for example a trained employee must be paid a salary regardless of whether any work can be usefully performed by them - or they may leave and the training capital investment will be lost. An employee may also degrade over time if not maintained in other ways such as using their skills regularly.
Some capital items have very difficult to define maintenance costs such as brand value or customer goodwill. It may be obvious that replacing a broken delivery van engine improves the chances of completing a piece of work, it will almost certainly not be so obvious that changing the company jingle used on the voicemail system has a positive effect on the bottom line (just try holding all other possible factors constant for six months while you make the measurements...)

So the assets of a business require funding when they are first acquired and they will then make a continuous demand for maintenance funds until they are no longer in use. There may also be disposal costs.

Raising money with bonds

Corporate bonds are issued to raise money NOW, and make a fixed claim on future free cash flows within the organisation. Some proportion of that future money will have to be set aside to make the interest payments on all the bonds outstanding. In addition the capital value of the bonds must be repaid when they reach the end of their life.

As such the price of a corporate bond represents :
a. The net present value (NPV) of the future income stream from that bond, as compared with the income stream available from a comparable risk free bond (i.e. a Government bond)
b. A tradeable speculative 'ticket' with a fixed lifetime (the duration of the bond). The price of bonds can go up and down depending on the perceived relative risk and it is possible to trade bonds to try to achieve a profit rather than simply relying on the interest payments income stream.
c. A robust claim on the assets of the company in the event of a liquidation (basically the destruction of the company and selling of the assets on behalf of the creditors) or bankruptcy (bondholders may end up becoming shareholders).

Raising money with shares
Issuing shares also raises money NOW, but make no direct claim on future free cash flows. Investors may well expect dividend payments but cannot demand them in the same way as bond owners. Shares may be sold, but they are a speculative investment to a much larger degree than bonds.

The price of a share represents:
a. The NPV of future free cashflows after all bonds are paid, but according to the degree to which company management decides to allocate the free cash to the shareholders as a dividend.
b. A tradeable speculative ticket with a chance of appreciation with an infinite lifetime.
c. A right to vote in the company management - unless a large proportion is owned (typically more than 5%) then no control is actually obtained.
d. A very weak claim on the assets of the company in the event of liquidation or bankruptcy. Shareholders are typically wiped out immediately in either event, shares losing all their supposed value.

All Corporations - the S&P 500

The S&P500 'price' represents an aggregate of the share prices of 500 of the largest U.S. corporations. As such it is a proxy for the share price of the industrial economy of the world.

The WTI Oil Price

The WTI Oil price is the cost of a barrel (42 U.S. gallons) of oil delivered at the start of the following month to Cushing, Oklahoma.

The Oil price represents:
a. The value of owning that barrel of oil at the date of delivery for use in some industrial process
b. A tradeable short term speculative ticket which expires on the delivery date.
c. A longer term speculative ticket which, provided the oil can be stored and the owner does not need to cash it in, represents the NPV of a barrel of Oil at any point in the future. There will of course be a maintenance cost to this storage.

Peak Oil aside

If you believe in the General (it must happen at some point) or especially the Special (it has happened/will happen very soon) theory of Peak Oil then you may well calculate that the accumulated maintenance cost of storing oil will never exceed the accumulated increase in price due to increasing rarity. In which case you should acquire all the oil you can and plan to store it pretty much forever - this may cause problems !

Of course you may be a major oil producer, in which case leaving it in the ground may be a good strategy.

Oil, Shares and Bonds

Unlike bonds which always generate an income stream, and shares which may do so, oil will never generate an income stream.

In fact there is a maintenance cost for the storage of oil as mentioned above, so in reality physical possession will consume corporate resources. Apart from the peak oil special case it would not normally be sensible to store more oil than is required for production process buffering.

Energy in the business

Energy is embedded in all assets and inputs either directly or indirectly. Although the purchase price of a piece of machinery will not necessarily represent the oil price (proxy of energy price) today, it surely was tied to the price of energy at some point in the past.

Businesses consume energy directly as part of the production process. Energy is embedded in raw materials through discovery, extraction, refining and transportation of those materials, and also in processed inputs such as sub-components or services purchased.

A business is an energy transformation machine made from energy purchased in the past and embedded in: The assets; Energy inputs which must be continually purchased as a maintenance stream; and specific energy directly and indirectly purchased as inputs in order to produce outputs for sale or storage as inventory.

The share price in energy terms is therefore a measure of the ability of the business to operate at all as a energetically favourable process in the future. By this I mean that the value embedded into the outputs must generate sufficient cash to service the energy purchase requirements of asset maintenance and input transformation and also meet the desires of the shareholders.

In a world which expects energy to become increasingly available (supported by measurements and observations) it will be possible to sustain an increasing share price to oil price ratio. The energy available in the future will be more than that available now, and so the business will be able to operate through to a distant date, generating surpluses sufficient for all maintenance costs - including debt service through bonds, and also providing dividends for shareholders.

At some point (general theory of peak oil) there will come a time when energy is actually less available. At some point in time PRIOR to this, i.e. PRIOR TO PEAK OIL, there will come a time when a business will start to find it impossible to pay dividends and reward shareholders, they will however have to continue to service bondholders.

Shares, Bonds and commodities

When that point is reached, and shareholders begin to see a decrease in dividend payouts and perhaps increasing rights issues (diluting shareholdings), we would expect the intelligent investor to choose to purchase bonds instead of shares. After all they are short-term relatively reliable instruments and less liable to fail to pay out.

This will create a self-reinforcing expectation that bonds are preferable to shares. An expected reduction in demand for shares into the distant future because energy is on the critical path of affordability for the business - however slight the effect to start with - will start a process to reduce share prices. This will affect demand for future shares and therefore also negatively affect the medium and long term speculative reasons for purchasing shares (not the short-term providing volatility is high enough).

Of course the absolute share prices can continue to increase forever... but the relative price of shares to oil will fall - and that is what matters. Money is not a substitute for energy and no form of energy provides as much free energy or is as convenient as cheap oil. To reiterate, the actual price of oil is not particularly relevant, your Government might start printing money for example and drive up share prices and oil prices... but once we are on the energy downslope then energy (oil) will tend to increase in price more and decrease less than the wobbling share price.

Corporations less able to raise money (purchase energy) through share issues will turn increasingly to bond issues and handicap their futures more and more by increasing the free energy which MUST be paid out through bond coupons. This in turn will reduce the availability to service shareholders and again make shares less (relatively) attractive.

Of course, commodities are a fantastic place to invest money which might otherwise go into shares, energy commodities especially so. Unfortunately this reduces still further the free energy available in corporates, who will further reduce shareholder payouts and in so doing encourage yet more bias towards bonds.

This vicious circle can of course be easily escaped if expectations of reducing energy supply can be proved false. This is unlikely because almost everyone now believes in and is aware of the general theory of peak oil, and very many market speculators have been discussing it for a long time.

Although there are many, many possible alternatives to oil as a source of energy none are as convenient, energy dense, or perhaps most importantly embedded throughout our entire economy, to the extent that oil is. Consequently business (and people) will need to survive on a smaller ration of free energy.

A great deal of our economies can be made more efficient, but not by the existing companies which have the cost structures of corporate dinosaurs. The businesses of the future, even the near future, will need to function with reducing energy waste each and every year.

The household and the local community can also be modelled as energy processing systems, more on this in a future rant!

In Summary

The S&P500/WTI Oil price broadly represents how much energy is available now and into the future for sharing with business owners, after covering operating costs (including servicing capital debt, fixed costs and unit costs).

This ratio is the energy available for investment in future capital items and meeting energy income requirements of non-productive elements of the whole economy (i.e. Government spending to generate national and international capital assets such as roads, health systems, state pensions, and personal spending on life and lifestyle).

Rising up
As the ratio rises more energy is available for an increasingly affluent lifestyle, of course how that affluence is distributed globally and locally is a political issue.

Falling down
As the ratio falls the pool of activities shrinks such that essentials (driven by political concerns) take an increasing share of the free energy.

The reduction of availability of energy for non-essentials at a national and international level is analagous to the reduction in money available for distribution to shareholders rather than bondholders.

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