Crack This Code: EROEI
“I just want to stop and make sure we’re not on fire,” Brad said as we pulled over.
My friend Brad Farquhar is the co-founder and vice president of Assiniboia Capital, which invests in farmland. We had just driven through a canola farm some 50 miles outside of Regina, Saskatchewan. And apparently, the canola crop can get sucked in the car engine and cause a fire.
Worried about a smoky smell, we pulled over to check it out. But we were clean.
You may recall I wrote about Brad and canola investing in the August 2010 issue. (Note: Assiniboia’s canola partnerships are open only to non-US citizens. Blame the SEC and IRS for the draconian rules they impose.) What follows is an update, plus, a pair of new ideas from my Saskatchewan field trip.
The yellow flowers of the canola plant dotted the Saskatchewan prairies while I was there. The plants were full and tall under deep blue skies. Prices for canola are healthy. “This should translate into a net return to investors of between 20-25% for this year,” Brad told me. “We won’t know the final numbers until the crop is completely harvested and shipped, but about 80% of the variables are now removed. The final results may even edge up a bit more as some pretty good-looking fields get combined.”
Last year was a tough year, a kind of worst-case scenario. Excessive rains soaked the prairies. It tested Assiniboia’s business model, which aims to keep risks low by using crop insurance to cover the downside. The partnership broke even, a victory given the conditions. In a best-case scenario, the partnership could double its money in a season. Not a bad set of outcomes.
I like these kinds of ideas, and not only for the payoffs. Whatever happens in Europe or in the debt markets, the intrinsic usefulness of farmland and food crops seems to offer a relative safe house — with a good shot at making a lot of money as well.
There is another reason, though, to favor such assets. It has to do with something called EROEI, which stands for “energy return on energy invested.” It is an expression of the idea that it takes energy to create energy.
Stephen Johnston at Agcapita is another one doing similar activities up here. I know Stephen as well, and he pens an interesting free monthly letter. (You can get it here.) In his September letter, Stephen talked about “EROEI decay.”
“I feel confident that EROEI is an acronym that will receive much wider recognition over the next decade,” he writes. “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.”
Stephen points out that more and more of our energy is coming from sources that require more and more energy to extract. He gives us some approximate EROEI ratios for various energy sources:
1970s oil and gas discoveries: 30 to 1
Current conventional oil and gas discoveries: 20 to 1
Oil sands: 5 to 1
Nuclear: 4 to 1
Photovoltaic: 4 to 1
Biofuel: 2 to 1.
Currently, the world produces around 86 million barrels of oil per day. But 86 million from high EROEI sources is much different than 86 million from less-efficient sources. “Effectively,” Stephen goes on, “the net energy left over to drive economic growth is significantly lower in the latter scenario.”
Why does this matter? Simply put, a lower mix of EROEI sources means higher prices for many commodities, because it will take more energy to produce them. This doesn’t automatically mean commodity producers win, however, because people can adjust their behavior.
For instance, when gasoline prices get too high, people cut back on their driving and find ways to save on gasoline. Economists call this the “elasticity of demand.” It means that demand can give and bend, like an elastic band, limiting how high prices will go.
But not all commodities bend so easily. Food is one. EROEI predicts higher food prices, because modern agriculture depends heavily on fossil fuels for irrigation, fertilizers, herbicides, storage and transportation.
Stephen gives examples. The most striking is with irrigation. “Irrigation accounts for approximately 20% of US farm energy use,” Stephen writes. In areas where water is scarce, such as in India, over half of all farm energy use simply drives irrigation pumps.
So in a world in which EROEI is on the decline, those assets with lower energy intensity will enjoy an advantage over less-efficient competitors. Might Canadian prairie farmland, which has no need for irrigation and low fertilizer needs, thrive in such a world?
I believe so. And this is one reason I’ve directed readers of my Mayer’s Special Situations letter toward investments in the province. Most of my field notes on Saskatchewan wound up in that letter, because we own a pair of companies based there.
One is a company called Viterra. It is one of my favorite long-term agribusiness holdings. Viterra processes grain, getting it from the farm to markets worldwide, as well as storing grains in a network of silos and sheds. It also sells seed, fertilizers and equipment to farmers. It also turns raw materials into animal feed and food ingredients. The stock is under my buy price of C$11 per share and trades for about 12 times earnings.
Viterra’s headquarters are in Regina. In fact, its main building was only a few blocks from my hotel. But it has a global presence with trading hubs, terminals and processors in Asia, Australia and Europe.
I like Viterra as a play on Saskatchewan’s bountiful harvests. And recent market woes have put the stock on sale.