"We Need to Talk"

There is no geothermal fairy waving a magic wand and ZAP, you have electrons in the grid. From exploration to drilling to development to spinning turbines, you have to know what you are doing in the geothermal field. Byron King explains…

There is a looming problem for the renewable energy business. It affects the geothermal producers. As the expression goes, "We need to talk."

I have argued over and over that in an energy-short future, geothermal power will play a key role in meeting power needs. Geothermal systems are well-known technology, at least to people who follow the technology. And some geothermal fields have been making power for many decades. So there’s a real track record for geothermal, unlike for many other alleged technological "solutions" to the energy problems of our time.

Geothermal offers some unique benefits. It is "clean," emitting essentially no carbon dioxide (CO2). Plus, geothermal comes with its own fuel supply, namely the heat of the Earth. That is, once you drill the wells, you don’t have to buy coal or oil or natural gas over the decades of operation. In essence, when you set up a geothermal power system, you are "buying" not just the installation, but also the fuel upfront.

Keep that last point in mind. Geothermal has higher upfront capital costs. But it has far lower operational costs over the life of the project. It’s like buying a car and never having to buy any more gasoline.

So geothermal works. But like most good things in life, it requires a specific skill set up and down the industrial ladder.

And there is no geothermal fairy waving a magic wand and ZAP, you have electrons in the grid. From exploration to drilling to development to spinning turbines, you have to know what you are doing in the geothermal field. This includes accounting for the costs of operation and production.

OK, here is the issue. Under current U.S. tax law, a power producer gets an income tax credit (called a "production tax credit," or PTC) for producing electricity using renewable energy resources. This includes geothermal, as well as wind, biomass, low-head hydropower, landfill gas and even trash combustion.

The PTC is a key part of the economics of geothermal. The prospect of the eventual PTC helps get projects funded and developed. The PTC helps overcome the higher upfront capital costs to drill into the Earth’s hot spots.

So the PTC offers some serious incentive for geothermal development. A taxpayer can claim the PTC for 10 years, beginning on the date the qualified facility is placed in service. But under current tax law, in order to qualify for the credit, the geothermal facilities must be placed in service by Dec. 31, 2008.

In the past, Congress has set the PTC to last for two years, and has renewed it periodically. When Congress has not renewed the PRC, investment in renewable energy systems has crashed the next year.

Do you see the pattern? Boom-crash. Boom-crash. Boom-crash. Then Congress extended the PTC in 2006, so the installed base of power systems began to take off in the past couple years. Renewable power is gaining traction.

But for some strange reason, Congress has not extended the PTC beyond Dec. 31 of this year. So starting Jan. 1, 2009, the tax incentive for renewable energy in the U.S. will expire and go away. Poof. Gone. Adios.

Really, can you imagine anything more stupid than eliminating the PTC in the midst of the current round of skyrocketing energy costs? Oil hit $135 per barrel a couple weeks ago. Natural gas is in the midst of a stealth rally to over $12 per mcf. Coal is so expensive some producers are signing "open contracts," meaning they promise to deliver, but won’t tell you the price until you take the coal in a couple years.

And while fossil fuel costs are shooting up, Congress, apparently, wants to put at risk any new investment in renewable energy systems after the end of this year.

Whoever is the next U.S. president – of either political party – do you want him immediately to confront a crash in investment in renewable power systems? What a way to tie the hands of the next president as he tackles the nation’s energy problems.

The good news is that the Senate has passed a bill called S. 2821, the bipartisan Cantwell-Ensign Clean Energy Tax Stimulus Act of 2008. S. 2821 has 43 co-sponsors. It provides for the limited continuation of the PTC for renewable energy. The Senate vote was 88-8 in favor.

There is a companion bill in the House, called H.R. 5984, with 70 co-sponsors. There is another version of this bill called H.R. 197, the "Pomeroy bill." But both versions are being blocked by the "pay-as-you-go" (PAYGO) rule that prevents "tax cuts" without corresponding tax increases.

But wait a minute. Extending the PTC is not a "tax cut." The PTC is already in effect. So extending it will just be continuing the status quo.

And does the government really think it will raise more revenue if the PTC goes away? C’mon. It’s more like how much revenue will the government LOSE if investment in renewable energy systems takes its characteristic plunge when the PTC goes away. How many jobs will go away? How much progress will we just toss?

The logic of PAYGO governance at work in Washington, D.C., has Congress believing that extending the PTC to promote renewable energy development – in the midst of soaring costs for fossil fuels – is something that the U.S. cannot afford to do. Actually, we cannot afford NOT to develop renewable energy systems.

This makes so little sense that we could all have a good chuckle if it were not such a serious issue of national energy policy. What does it take for Congress to figure this out? Do the lights really have to flicker and die before the issue gets some attention?

So I’m asking you to contact your member of Congress and confront him or her with this issue. The future of the renewable energy industry in the U.S. depends on this.

Action to take: Contact your representative and urge him or her to support H.R. 5984 or the alternative H.R. 197, called the "Pomeroy bill."

You’ll be helping yourself, and helping the country,

Byron W. King
for The Daily Reckoning
June 10, 2008

Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. Byron is also co-editor of Outstanding Investments, and editor of Energy & Scarcity Investor.

Let’s begin with the news…and then a bet.

First, the stock market bounced yesterday…following Friday’s fall. The Dow rose 70 points. The dollar bounced a little too – closing at $1.56 per euro. Gold held steady at $898. And oil gave up $4.

Now the bet…

Fortune magazine reports that Warren Buffett has bet a hedge fund management business that it will not outperform the S&P 500 over the next 10 years. The firm, Protégé, is in the business of running hedge funds, and has done well. Since 2002, it has made investors 95% on their money – after fees. By comparison the S&P 500 is up only 64%.

But Buffett is confident that the combination of high fees and regression to the mean will doom Protégé. So the two bought a 10-year zero coupon Treasury bond. At a cost of $320,000, the bond will be worth $1 million when the 10 years are up and will be given to the charity of the winner’s choice.

Who will win?

Our money is on Buffett. We’ve described in these pages why hedge funds are a losing proposition for investors. Over time, the managers’ performance regresses to the mean of all investment advisors – which is to say, he gets about the same as the broad market itself. And over time, the effect of taking out large fees to pay the managers – typically, 2% of principal and 20% of performance – reduces the investor’s capital.

Mathematically, if you leave your money in a hedge fund long enough it will all end up with the manager.

But we will make a further wager: we bet that both bettors will lose. Here’s why:

The have bought a Treasury bond.

We did not look this morning, but the last time we took note of it, the yield on the 10-year Treasury was less than 4%. And the last time we looked, the official consumer inflation rate in the United States was over 4%. Of course, that’s just the beginning of the inflation story. The real cost of living is going up faster than the Labor Department numbers tell. Producer prices…import prices…raw material prices…oil prices – all the numbers that eventually make up the CPI are going up much faster than the official CPI rate itself. And every time anyone from outside the government tries to calculate consumer inflation, he comes up with a number considerably higher than those Labor Department statisticians give us. For example, when newspaper reporters bought the ingredients for a traditional Memorial Day cookout, they found them about 10% more expensive than a year before.

Inflation has gone global. It’s officially 8.5% in China. In Russia, it’s 14%. In Vietnam, it’s 24%. And in Zimbabwe – it’s gone to the moon.

How is it possible that inflation in the United States – which imports so much stuff from the rest of the world – can remain so low? "Seasonal adjustments" is the standard explanation.

But the seasons change. Our guess is that cold winds will soon blow across the borderline…and those greenback leaves will turn brown…curl up…and blow away.

Ben Bernanke and Hank Paulson both announced that a strong dollar was something America wanted. Bernanke even led investors to believe that perhaps rate hikes would follow. But then, last week, the unemployment rate in America jumped to 5.5%, its biggest increase since 1986. Central banks do not increase rates when unemployment is rising. Nor, speaking very broadly, do central banks increase rates when the government is $57 trillion in the hole.

Since Ben Bernanke is not going to defend the dollar, globalized inflation is bound to result in higher inflation rates in the USA…probably sooner, rather than later. And while it is impossible to predict the future…it is quite possible to imagine a world 10 years from now when the $320,000 Warren Buffet and Protégé spent on their T-bond will be worth less than $320,000 in today’s money. It is not such a stretch to think that $1 million in 2018 will be worth less than $320,000 today.

So, here’s our bet: Buffett will beat Protégé, but inflation will defeat them both. An ounce of gold is $898 today. At that price the two paid 366 ounces for their T-bond. They will have $1 million ten years from now. Our bet is that $1 million won’t buy 366 ounces of gold in 2018.

*** Pity the poor people who took the bait!

The New York Times says, "Rural US Takes the Worst Hit." They refer to people who need to drive long distances to work…or shop…or go to the movies.

Here in Europe, people tend to stay close to home. Partly because it is a small place…and partly because gasoline is $9 a gallon. But in America, it is not unusual to drive 50 miles to work…or an hour to go to a restaurant.

In Europe, towns tend to be densely populated…with little suburban sprawl. But in America, houses spill out onto the Great Plains…the deserts…and the farmland – far from the city centers.

The suburban movement began in Baltimore in the 1920s. Wealthy families moved up to higher ground, to benefit from fresher air and leafier settings, and to get away from the rabble of immigrants from Italy and Eastern Europe. Later, new immigrants from the South and from Appalachia – during WWII – encouraged another big wave of suburbanization after the war. Automobiles, tramways and low fuel prices made it possible for people to live several miles from the downtown area and continue working in the city.

In fact, the whole country was shaped by low oil prices…allowing people to travel, by automobile, freely and cheaply, wherever they wanted. Gradually, in the ’60s, the process of spreading out, like the bulge in American waistlines, intensified and went down the socio-economic scale. First, the wealthy moved out…then the upper middle class. But lately, the bottom of the middle class has been leading the trend. The lower middle class has been lured to buy big houses in the farthest-out suburbs. Why? Because land costs generally got cheaper as you went further and further away from the city centers. But when this trend was running hot, few people reckoned with $4 gasoline. And now, the people who live at the greatest distance from their jobs are often the people who can least afford a long commute.

But it’s worse than that. The furthest-out suburbs are also those that were built most recently. So, they tended to be sold at the top of the bubble…and they are also often the biggest houses. Not only do their poor denizens have to travel long distances at high fuel prices, they often have subprime mortgages…high heating bills…and have suffered the greatest loss of equity (who wants to buy a distant house when gasoline is $4 a gallon?).

The entire housing industry is in trouble, of course. But so is the whole trend in housing that has dominated the nation for the last 90 years. Suburbanization has run its course; it has peaked out.

KB Homes has already announced that it is going to build smaller, more modest houses. "Downsizing the American Home," is the newspaper headline.

Meanwhile, the Wall Street Journal tells us that LandSource has gone broke. The company owns 15,000 acres outside Los Angeles. Its largest investor is the California state pension system – Calpers – which has $970 million invested in the firm.

*** If houses planted in dirt are going down, those on wheels are going down even faster. It costs about $350 to fill up the tank of an RV, making the sector one of the worst performing areas of the stock market in the last 2 years. Coachmen, for example, was trading at $20 in 2004. Last week, the share closed at $2.81.

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning