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Natural Gas: The Real Alternative Energy


The only way to offset dependence on foreign oil.

Editor's Note: Jim Anderson founded Lantern Hill Capital in 1997, and has been an active trader since 1998. From 2001 to 2004, Jim, took a break from daily trading to return to his academic roots as an Adjunct Professor of Molecular and Cell Biology at the University of Connecticut, from which he earned his PhD in X-ray Crystallography in 1981.

We are pleased to welcome him as our newest Minyanville Professor.

President Obama wants to develop a new energy policy with a strong emphasis on solar and wind power, and of course, a desire to reduce our dependence on foreign oil. So if solar and wind are ramped up, exactly what's been accomplished?

The key question for any alternative-energy policy: What other fuel source is offset by its use? The answer: Solar and wind offset electrical production that would have almost always burned natural gas. Solar and wind do virtually nothing to reduce petroleum usage. Ethanol, switchgrass, biofuels, recycled cooking oil, and any other recycling efforts cannot be more than a few percentage points of our transportation needs. To put it simply, we cannot french-fry our way to petroleum independence.

To understand the potential for alternative energy, we need to look at electrical power generation and demand variation during the day. In the US, coal produces about 49% of the electricity, nuclear 19%, hydropower 6% , natural gas 22%, and petroleum 2%. Renewable energy generated 2.5% of total electrical generation in 2007.

Coal and nuclear plants tend to run day and night to supply electricity for base-load demand. Demand picks up in the morning and peaks in the late afternoon as people get back home and start turning on appliances. Utilities have to meet this demand variation by bringing up power plants that can quickly adjust their output. In almost all cases, these plants burn natural gas.

About 20 years ago, I worked for a major insurance company and was responsible for alternative-energy investing. Back in the early 1980s at the peak of that energy crisis, California came up with a novel system to promote the construction of alternative-energy projects that would offset the use of fossil-fuel electrical generation.

They created a series of standard contracts - the most popular of which was Standard Offer #4, which set a guaranteed payment rate for alternative electrical production for 10 years. After 10 years, the payment rate would fluctuate with the avoided cost of the local utility's cost of generating electricity, which usually was the cost of natural gas.

In the 1980s, an Israeli company developed a solar collection system using parabolic mirrors to focus sunlight onto a glass tube filled with an oil that was heated to over 500 degrees Fahrenheit. The hot oil was pumped into a boiler that generated steam, which drove a turbine that generated electricity. This is a perfect "green" electrical generating system. It produced electricity at the time of day that electrical utilities needed extra power, such as for air-conditioning.

Combining the Israeli technology (not anything close to cutting-edge photovoltaic technology), Standard Offer #4's economics for the projects -- with a 10-year guaranteed rate for electricity price and tax breaks for the equity -- seemed reasonable. We loaned senior debt to 2 of these projects and we felt very "green" despite a very attractive interest rate for our investment portfolio.

Nine projects were completed in the California desert, but then a problem developed. The Standard Offer #4 set rate ended and the avoided cost was natural gas, which had collapsed in price. Even the "free" energy from the sun didn't offset the debt and principal payments. Eventually, the local utility bought the projects in bankruptcy and they're still running.

There's a huge lesson here: Alternative-energy projects that can be financed by private capital have to be economic. Long-term debt lenders have to be comfortable that they'll be paid back if they finance alternative energy projects.
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