July 26, 2012

Climate change.

[dramatic pause]

I haven’t even said anything, yet you have already formed a dozen conclusions, adopted a defensive posture, and entrenched yourself into well-defined position.  Gloves up.  Few topics can do that with the mention of a single pair of words.  Amazing, no?  But that’s all it takes.  I just have to type two little words and every single one of you is ready for battle.

Somewhere along the line climate change stopped being a scientific issue and became instead an ideological one.

I don’t know exactly when, where, or how that happened.  It’s been this way for a while.  I can’t seem to find a distinct, obvious turning point.

The linkages between environmental causes and the Democratic party have existed for a long time — certainly before I arrived here on Planet Earth — and I’m not entirely sure where that linkage originally came from.  If you look back a little further, you have Teddy Roosevelt.  I challenge you to name a single president in U.S. history to do more for conservation efforts than him, and he was a Republican.

Red team: you have every bit as legitimate a claim to an environmentally conscious heritage as the other guys.

You’d think that both the free-love naturalists and hardcore constitutional conservatives who want the government and everybody else out of their lives would each want a healthy, productive environment upon which to sustain themselves and their grandchildren.  But somehow the history of it all evolved in a very different way, culminating in an era of irrational name calling and finger pointing.

Anyway, if I had to blame one guy for why climate change became such a contentious, divisive issue when it really should never have been, it’d be Al Gore.  He made that freakin’ movie.  You know the one I’m talking about.  From that moment on it stopped being a matter of scientific inquiry and became instead a debate.

Thanks, Al.

The brilliance of An Inconvenient Truth wasn’t the illustration of how average global temperatures are rising above normal cyclical ranges or why weather patterns are getting steadily more extreme.  That the greenhouse effect exists is elementary.  Seriously: we learned about the greenhouse effect in elementary school.  Mess with the atmosphere that surrounds an object, and you affect the conditions of the object on the ground.  You can’t tell a person that if you added a whole bunch of carbon dioxide to the atmosphere that you wouldn’t increase the average temperature on the ground because if you did, you would be lying.

We knew all this already.  The real genius of Gore’s crusade was that he showed everybody why it matters.  And what’s more, he did it in an accessible and entertaining way using language that the whole family can understand.  He got a lot of people to care more about the issue than they ever had before.

The problem, however, was that Al Gore made the movie.  Al Gore, the famous big-D Democrat.  The longest serving Vice President with a “D” next to his name since John Nance Garner.  Al Gore, the guy who almost became President, hated nemesis of George Bush and the Republican Right.  He whom conservative talk show hosts spent an entire decade decrying in every way, shape, and form.

The problem, was that there were only three reactions to the movie, drawn immediately along party lines:

• “You tell ‘em, Al!  I’ve been saying that for years!”
• “That was interesting.  I learned something.”
• “Al Gore is a loon.  Global warming is a hoax.”

An Inconvenient Truth could have been about how the climate is not changing and global warming is not a concern, and the 35.9% of the country whose faces are painted bright red would have still called him a fraud and denounced his conclusions.

Imagine if Ronald Reagan made a movie about global warming and how we need to stop burning fossil fuels?  What if Grover Norquist made everybody pledge to cut back on burning fossil fuels?  Or what if Teddy Roosevelt came back from the dead, kicked a bunch of pansy Democrat ass in Washington DC, and then said, “Listen up you yo-yos!  Take care of this friggin’ planet and get outside and get some fresh air before I come kick your ass too!”

Think about it.

Like the Capulets and the Montagues, the subject of climate change has now been folded into a centuries-old feud.  Neither the source of the feud nor the thing being fought over matters anymore.  The only thing that does is to get the other guy and get him good.

Today’s children of politics simply do not understand.

The Little Value I Can Add

In an environment like today’s hyper-partisan one, it’s hard to have a pragmatic discussion about climate change.  Even though it’s more challenging, it can also be more interesting.  If was talking with you today about the latest European debt accord, all I’d get would be yawns.  But today you’re paying attention.

I can’t add a single thing to the scientific discussion.  I am of zero value there.  All I know is that the scientific community, almost to a man, says that average global temperatures are rising and humans are the culprit.  It started around the industrial revolution and is slowly trending in one direction: up.  And I agree with this guy, who basically says, “all you environmentalists should give up on bashing people over the head with climate science because that strategy isn’t changing any minds and isn’t going to change any minds.”  The cognitive dissonance here is fascinating.

At some point, someone’s going to figure out how to cleverly re-frame the whole issue and allow the extremists to relax the positions they’ve dug themselves into.  Everybody will be free to get on the same page and maybe get something done.  Never underestimate the power of political legerdemain.

I can’t add much to that political discussion, either.  There’s nothing to say that hasn’t been said already.  There are alarmists, conspiracy theorists, and pragmatists like me in the middle.

All I can do is present some ideas about how to invest (for the long run) in a world where traditional sources of energy have fixed supplies and one where the climate is slowly changing.

Those are the assumptions we’re going to make today and both represent factually correct statements.  It’s a good foundation for our pragmatic discussion.

Where it gets murky is what happens if the current trajectory doesn’t change.  What are the consequences?  I happen to believe that the trajectory will change.  Back in the 70′s we started getting serious about air pollution and made dramatic changes to improve the quality of the air.

I don’t see why the same can’t happen in the coming decades with CO2 emission.  The costs of not changing the trajectory of climate change could someday threaten our very existence, and the closer a loss of that magnitude looms, the more quickly and severely humans will act to correct it.

In the meantime, unless some brilliant political magician re-frames the debate, I believe that the current basic trajectory will continue unabated.

The science of the today’s environment and the science of what could happen if things keep going this way may be ironclad.  But our proximity to those risks is still too small.  These risks simply aren’t “real” enough to inspire epic political leadership or massive public action.  Don’t worry.  That’ll happen someday, though I haven’t the faintest idea when or how.

Sorry, environmentalists.  None of this is to say that we shouldn’t (or won’t eventually) take this issue seriously.  I’m just saying that it ain’t happening soon.  Successful investing is about understanding the way that things actually are not the way that you want them to be.

Using that as our third fundamental pillar we can now assemble an investment strategy.

To recap:

1. The supply of traditional sources of energy is fixed.
2. The climate is slowly changing because of our burning of these traditional fossil fuels.
3. The status quo is going to persist until an uncertain date where a critical mass of political leaders and citizens become sufficiently concerned about the negative consequences of a trajectory of rising temperatures.

Investment Strategies for Global Warming

The first political-investment theme that I think we can all agree on is energy independence.

Republicans want to be energy independent for cultural/economic reasons and Democrats want it for environmental reasons.  The catch is that in order for the U.S. to be “energy independent,” it has no choice but to use cleaner, alternative methods of power generation.  We don’t have much crude oil left in this country and there isn’t enough coal to get the whole job done.

I see many Republicans get quite passionate and spirited about energy independence, and I wonder how many of them understand that in order for us to do that we have to lean increasingly more heavily on alternative fuel technologies.  The side of effect of doing so is a lowering of the threat that a changing climate represents.  Republicans, you cannot be pro-energy independence without also being in favor of technologies that are relatively healthier for the environment.

There’s also natural gas.  Democrats need to understand that this is the bridge.  Hardline Blue Teamers may want to consider a compromise whereby our natural gas production infrastructure is expanded.  I’d love to live in a happy wind/solar utopia as much as the next guy, but that simply isn’t realistic at present.  The production capacity isn’t anywhere close to where it needs to be and those technologies are still expensive enough to create unhappy economic consequences were we to switch to them overnight.  So while we employ a natural gas bridge, we should also incentivize the development of future technologies.

With respect to climate change, natural gas is much cleaner burning.  Do you guys remember your combustion reaction from high school?  [Fuel] + O2 –> CO2 + H2O.  Well, CH4 kicks out far less CO2 into the atmosphere than does C8H18 (gasoline) or the pure C in coal when you burn it.

The problem with Natural Gas, of course, is fracking.  And the problem with hydraulic fracturing is the same that exists in deep well drilling, banking, or the National Football League.  You need strong rules, strong regulation, and people need to be careful.  When people don’t follow the rules and act wrecklessly, other people get hurt.  The repercussions can be permanent.  There’s a lot at stake.

Our electricity in this country comes mostly from two places, natural gas and coal.  That snazzy electric vehicle you bought?  I know you’re excited because it doesn’t run on gasoline.  But I doubt the dealer told you that it technically it runs 42% on coal, 25% natural gas, 19% nuclear (!!), and about 14% renewables like hydro-.  But maybe you unplugged from the grid with your own backyard windmill and array of solar panels.  In that case, you’re my hero.

The 42% of electricity our country gets from coal is getting smaller and with the gargantuan supply of natural gas the United States is sitting on, it’s going to keep getting smaller every year.  Natural Gas is literally killing the coal industry.  And with the right incentives, NatGas is probably the only thing with a realistic shot at finishing it off completely.

Environmentalists, how do you feel about that?  Mixed emotions?  Maybe how I felt when the New York Giants — a team I hate as a lifelong 49ers fan — beat the New England Patriots — a team I hate even more for all the usual reasons — in last year’s Super Bowl.  I was glad the Pats lost, but wasn’t exactly thrilled with who beat them.  But I’ll take the outcome.

Reality is what it is.  There is zero political will for nuclear power and renewables are still too expensive.  So until either of those factors change, your Electricity Super Bowl is Natural Gas vs. Coal.  Sierra Clubbers, it’s 3rd and long: which one do you want?  Be honest.  Would you rather our big rigs run on diesel or natural gas?

So that’s investment strategy #1.  Overweight natural gas producers relative to coal producers specifically, the energy market generally, and even the broader market too.

There is perhaps no more depressing place to be invested right now than in natural gas and the natural gas stocks.  This sector has been eviscerated by an unfathomable oversupply and laughably cheap prices.  But I feel an inevitable, tectonic shift is underway.  I’m wildly bullish on this space.  I believe that the companies involved in the exploration, production, and distribution of natural gas are as good a bet as any to outperform the market over the next decade.  Just understand there’s going to be some volatility along the way.

This leads into investment strategy #2.

I can hear you all saying, “Well, if alternatives like wind and solar are eventually the future, why not buy alternative energy stocks?”

You certainly can.  But do it because it makes you feel good, not because it represent the best balance of risk & reward.  The distribution of outcomes for alternative energy companies is substantially fatter than that for natural gas or traditional energy companies.

I’ve said it several times in the past, but when evaluating the landscape of investments in upstart alternative energy companies, I fall back on one general principle:

There isn’t a single feasible scenario whereby alternative energy investments succeed where traditional energy investments do not succeed.  But there are a many scenarios where alternative energy investments fail and traditional energy investments do succeed.

I use the word “feasible” when thinking about scenarios because there does exist one scenario where alternative energy investments win and traditional energy investments fail.  It’s the scenario where the entire planet comes together, sings Kumbaya and, for whatever the reason, decides to stop burning oil and its derivatives.

Personally, I think that’s a zero-probability event.  Or sufficiently close to it.  But there are those out there who disagree.  So if you do think that it’s possible for the whole world to decide on its own accord to stop using crude oil and you do think you can assign some sort of probability to that event, then you can probably derive a long-term strategy for owning wind and solar stocks and avoiding everything else in the energy sector.

There’s also a final scenario where global warming has its Minsky moment and we are forced to confront the inevitability of a Manhattan that exists under three feet of water.  In that scenario, basically everybody loses.  Unless you have a few thousand acres of arable valley land in the Rockies.  That might be a contingency to think about.

Speculative… Fiction?

On the subject of cities under water, I’d encourage all of you who derive pleasure from reading great fiction to pick up a copy of Paolo Bacigalupi’s The Windup Girl.

It’s one of the smartest, darkest, sexiest books I’ve read in a long time.  It takes place in a sweltering Bangkok, 35 feet below sea level, the ocean held back by massive walls.  It features great characters, some nifty corporate espionage, and mind-bending suggestions about the various paths of technology.  It ran away with both the Hugo and the Nebula awards so don’t just take my word for its legitimacy.

The Windup Girl is a fascinating exploration of what life might actually be like in a “post-oil” world.  You might roll your eyes at yet another science fiction reference, but I’m not kidding around.  Investable ideas are all around us and sometimes the best ones come from strange, creative places.

In Bacigalupi’s epic novel, it is Big Agriculture who rules the world.  I’d never really considered what kind of companies would win in a world where global warming gets out of control.  But I think Bacigalupi has it dead on.

The companies that produce the food win if the environment gets more difficult in which to produce it.

As an example, the midwest is experiencing horrible drought conditions right now.  Depending on who you talk to, this is the worst summer there for agriculture since 1956.  But Monsanto is up over 20% since the middle of May.  Why?  They’re developing a drought-resistant corn.  Think that’ll be a big a seller some day?

Not every summer in the future will be as dry as this one, but if you subscribe to the view of a world that’s doing relatively little about it’s steadily changing climate, you can probably expect to see more summers that are more extreme.  Companies involved in the manufacture of products that help farmers deal more effectively with extreme conditions will probably be winners.

If you want to invest around long-term climate change, agriculture is another terrific way to do it.  You can own the equities of the major food producers, or, you can follow Michael Burry (he of The Big Short fame) and directly own raw farmland, particularly with good access to uninterrupted water.

And look, you don’t have to be a pinko Lefty to have a reason to own agriculture companies or domestic farmers cranking out goods labeled “organic.”  Food companies are also a direct play on inflation.  If all of you Austrian-school, anti-Keynesian, anti-Krugmanite Red Teamers are legitimately worried about the prospect of crazy inflation, why not overweight the agricultural sector?

These are ideas that blur party lines, ideas that both teams can agree on.  Who doesn’t want a more efficient, more sustainable agriculture industry?

The answer to that is technology, not subsidization.  There are companies that make money off of this.  You can invest in them.

Look folks, the planet’s getting hotter.  It’ll keep getting hotter until we run out of fossil fuels or choose to stop burning them and personally, I’m betting on the former.

So as an investor, I want to own the companies involved in supplying our economy with the energy sources it’s currently using.  These resources will only get more valuable as we get closer to their exhaustion date.  Plus, these companies aren’t stupid and have long-term outlooks.  As the supply dwindles, they’re already investing in whatever will eventually take its place.  I wouldn’t be at all surprised to see that world’s largest wind or solar producer in the year 2062 was in the business of burning fossil fuels in 2012.

And as the planet gets hotter, it’ll probably get more difficult to produce the food we need.  So I also want to be invested in the companies that make that process more efficient and more effective.  That’s certain pockets of biotech and Big Agra.  Agriculture is a good demographic play, too, at least until the middle of the century when the global population peaks.  Then I’m not so sure.

There are always names on the fringe that are involved in radical new technologies or alternative energy.  You can invest in these too, but I’m generally more comfortable dealing with skinnier probability distributions.  Most of those fringe firms will die along the way, and investing around a macro thesis like climate change is one that will take decades to fully play out.

This is about as much clarity as I can get right now on what climate change means for the markets.  This strategy won’t solve retirees’ need for yield, but this is something for conservative younger investors to take a look at.  If you’re not sure what to do with your IRA, maybe ask your financial advisor about what we discussed today.

At least it gives the pragmatically-oriented of us something to do while the alarmists and skeptics duke it out over ideology.

Tags: Climate Change, Commodities, Natural Gas, Strategy