The One Ratio Every Energy Investor Should Know… and Use

In Friday’s OEI, I began a discussion about the importance of a metric known as Energy Returned on Energy Invested (EROEI).

As our research disclosed in the “Your Future: The Ultimate Pyramid Scheme” documentary, the factor is becoming a substantial element in the availability and cost of energy in general. But oil is the most critical energy source in this discussion.

Our research has found that the situation will not be improving. We will be reaching a point when our need for exponential growth in energy, the environment, and the economy will become unsustainable. From there, we will experience a tipping point, and then a major collapse.

This will require that each of us change the way we structure our investments, secure our assets, and provide for our families.

However, in the interim, there will also be some amazing opportunities to make unparalleled profits in the energy sector. And, in all of this, EROEI will be figuring in important ways.

EROEI merely talks about the amount of energy it takes to produce energy, both measured in barrels of oil equivalent. Over time, the ratio has been going down, meaning it has been taking more energy to produce the energy we use.

If the ratio ends up being “1,” that means you have expended as much energy as you have produced (it would take one barrel of oil to produce one barrel of oil).

Unless it is an emergency, disaster, or wartime situation, that would make little sense. And, of course, any figure below “1″ would mean that we are spending more energy in the process than was gained as an end product.

As we discussed on Friday, the EROEI for oil extraction has been going down over the past century – from a factor of about 100 earlier in the twentieth century to perhaps 3 or less today. I also pointed out the even worse performance from alternative and renewable sources, especially if the cost of construction and regulatory delays are factored in.

What EROEI Means to Investment Structure

Today, let’s begin the discussion about what all of this means to the overall structure of our energy investments, using oil as the focus. As levels of demand come back into the market, EROEI will influence the energy available and its associated costs.

The demand curve has already been expanding in other parts of the world, an important consideration given that this is both a global market (especially for oil) and one where the price is actually determined by what is taking place in developing countries, rather than North America or Western Europe.

Even in the U.S. market, demand is increasing. That combined with a declining inventory base for both crude oil and oil products (especially gasoline) means both are going up, at least in the short term.

Here’s How EROEI Will Play Out

While EROEI does not determine such matters, it will affect the overall cost and pricing trajectory. And that has a most definite impact on energy investments. With oil, this will play out in three ways.

First, those investments most directly related to the direct cost of the raw material will realize the greatest increase in value when demand is increasing.

These would include exchange-traded funds (ETFs) tracking the price of crude oil – West Texas Intermediate (WTI) trading in New York or Brent in London – as well as crack spreads (the difference between the price of the crude and the main oil products from it), or those allowing you to play the spread between WTI and Brent. All of these are denominated in dollars, since that is the currency in which oil is priced.

Remember, there will not be any appreciable improvement in the EROEI for oil moving forward. This means that the ratio will not be improving. If other factors in the market are pushing prices up, EROEI will simply intensify that move.

Second, there will be some access to new technologies that allow wells to remain open and profitable over a longer time period. This will also allow companies to cut expenses in the early processing stages.

These are not going to reduce EROEI dramatically as a factor but could lessen its further short-term decline. This opens an area of investments in companies advancing ways to drill cheaper, control water separation (the single biggest expense once production reaches peak levels), enhanced oil recovery (EOR), attending to adverse environmental impact, better gathering and storage technologies, and a range of other advances.

This will oblige us to look carefully at equipment, engineering, and technology providers to the oil community, as well as to selected oil field service companies likely to apply new approaches to fields.

Third, EROEI is useful in selecting the actual operating (producing) companies that will be able to provide the best margins in extraction. These are not usually the largest companies, although the big boys do have an advantage in offsetting fields against each other in maximizing geographic, oil grade, regional market and field cost considerations.

As I mentioned on a number of occasions, well-structured, mid-sized producers will fare best in these conditions. These companies tend to operate only in given regions and markets, know them well, and have managed to establish an efficient network of wells, infrastructure, and support to restrain the impact of EROEI. This is especially important when it comes to maintaining profitability at maturing fields.

EROEI also brings a number of other elements into focus. These involve how to weigh a portfolio to offset its impact, playing the oil against natural gas tradeoff, and determining how to balance primary energy provisions (oil, gas, and conventional electricity production) with alternative, renewable, and unconventional (e.g., shale, coal bed methane, tight gas and oil, and oil sands) sourcing.

The broader portfolio balancing elements introduced by EROEI will be the subject of our next OEI.