"Young man, that's the thing. You have it - the self contained unit carrying its own fuel with it! Keep at it!"

Thomas Edison to Henry Ford during August 1886 meeting at the Oriental Hotel, Manhattan Beach, NY, as recalled by C.J. Cameron.

Alan Nevins
Ford: The Times, the Man, the Company
Scribners (1954)

On the seventh anniversary of 9/11, we are going to shift gears away from the continuing financial crisis and take a look at the energy market and what may actually be some good news in terms of America's energy needs and the long-term outlook for the US economy. On this day in 2001, thousands of Americans died because of our excessive dependence on foreign oil, especially oil from the Persian Gulf. If our fellow citizens could speak to us from the grave, we suppose they might kick our collective arses and tell us to get to work putting the Saudis and their oil producing neighbors out of business.

Energy price increases and volatility have become a huge source of risk for many companies and consumers, but thanks to the short-term thinking of petro-tyrants such as Venezuela's Hugo Chavez and the medieval mullahs who hold 70 million Iranians hostage, higher oil prices are slowly forcing the western industrial nations to move away from crude oil as a primary energy source. On the day when Americans can declare independence from foreign oil and relegate the Middle East nations back to the economic and political irrelevancy they so truly deserve, our martyred brothers and sisters will rest easier.

Last week, The IRA got to meet T. Boone Pickens on Bloomberg Television . We had an interesting conversation about shifting much of America's retail transportation need to electricity and natural gas. Along with Senator John McCain (R-AZ), Boone is one of the few people in America with a plan for energy independence. Pickens is leading a growing number of Americans who believe that having an energy policy and making it a national priority is among our most urgent needs. In our view, thinking of energy in strategic, national interest terms is an obvious and long-overdue development.

On Friday, we spoke to Jim Lucier of CapitalAlpha (www.capitalalpha.com) partners about the election, energy policy and the role that both electricity and natural gas of various types will play in America's energy future. Lucier is a long time observer of the Washington political scene, where he covers energy issues for his growing portfolio of Buy Side clients. He wrote recently:

"There's already much ink spilling about John McCain's apparent VP choice, Alaska Governor Sarah Palin. She is young, female, and socially conservative. She is an ice-fishing, moose-hunting, NRA life-member married to a native Yup'ik Eskimo who is the four-time champion of Alaska's 2,000 mile 'Iron Dog' snowmobile race. Palin drives a mean snowmobile herself. Described by Mike Allen of www.politico.com as a 'Pro-life rock star,' she is a mother of five who gave birth to her youngest child, a Down Syndrome baby, while serving as governor. Colorful biography aside: there are two key points in the Palin story. First, she built her political career as a whistleblower attacking corruption and wasteful spending in her own party. She defeated incumbent Alaska Governor Frank Murkowski in a primary election. She endorsed her Lieutenant Governor Sean Parnell in a bid to unseat incumbent Alaska Representative Don Young. She has called on embattled Alaska Senator Ted Stevens to come clean on corruption charges against him… But second and more significantly from an investor point of view, Palin can be see as pro-offshore drilling and pro-ANWR drilling even while she can be seen as a 'critic' of Big Oil to some degree."

The IRA: How did you react to the selection of Alaska Governor Sara Palin as VP to McCain?

Lucier: I thought she gave a solid speech. She avoided major screw-ups. It was a well constructed speech, not a brilliant speech, and thus perfectly filled the need. She had to stand up there, be comfortable, make no mistakes and basically show that she is a pro.

The IRA: Is this the dawn of energy politics in the US, a politics drive as much by the opportunity to produce as the need to consumer? Why was Palin selected in your view?

Lucier: The state of the economy is the number one issue in this election. Americans are very uneasy about the future. There is a lot of economic uncertainty and anxiety over global economic trends in an economy where personal consumption has risen every year but one since World War II. It's hard to put a finger on what's wrong. Outsourcing? The Rise of China? The real estate bubble? Seemingly unfixable economic disaster areas in states like Ohio and Michigan? I personally think that one source of anxiety is the huge status and income disparities, not so much among working-class Americans, but among the top 50% of earners, which includes our punditocracy. Whatever it is, the public has settled on energy prices as the Rohrschach blob that is telling them something is wrong. It's a proxy for everything else. Sarah Palin addresses it well. She's all about drill here, drill now-please drill in Alaska for gosh darn sakes. Republicans have a tarnished brand and not a single issue that works in their favor, except for energy and offshore drilling. But energy is the number one concern in some polls, and it's an issue where the pro-drilling side routinely commands 65 to 70% in the polls.

The IRA: Well access to cheap energy is part of the American culture. Gasoline was the choice made over a century ago, in conversations between people such as Henry Ford and Thomas Edison, as we note with the quotation above. Samuel Insull, Alex Dow and some of the other giants of the electric age also attended that meeting. Heavy, expensive electric cars were actually some of the earliest automobiles, but Edison encouraged Ford to embrace gasoline as a superior technology for energy storage. Are we now on the brink of the electric age that the giants of the 19th Century such as Edison and Nikola Tesla foresaw? Did gas prices go high enough to push this process forward?

Lucier: I think so. I think that oil prices did go high enough to get the public's attention and hold it. We can thank Uncle Alan Greenspan's dollar debasement as revised and extended by our good friend Ben Bernanke at the Fed for helping to bring us a clarion wakeup call. But there are a lot of other things happening too. Not only are China and India using more oil; they don't have the sophisticated refineries that we have here, so they are bidding up the price of top quality crude. It's not just Chinese and Indian demand for oil; it's Chinese demand for steel and other commodities and the global infrastructure boom that is driving up the price of everything used to produce oil. There are plenty of other factors in play. The bottom line is that I think oil prices have come down from their midsummer highs because the world economy is slowing, and more importantly, the price for a barrel of oil had risen well past the replacement cost for a new barrel of crude. But the replacement cost is still high enough that I think we will have to live with $100 oil long enough to keep the public focused on oil in general and foreign oil in particular. A friend of mine, Mike McKenna, does survey research. One thing he determined that it would take gasoline prices well over $3 a gallon for a sustained period of time to make even think about changing their driving habits. They weren't going to dump their SUVs for a seasonal blip. But once they price seemed here to stay, Mike was right and they changed their habits really fast.

The IRA: Well, in high tax states such as NY we're been there for a while. Low for us is $4. I just started to see regular at $3.99 for the first time in months. But back on point, your specialty is areas such as electricity and gas rather than petroleum, but where do you see the future of energy globally and in the US?

Lucier: I think the future of transportation is electricity. It is much more economically rational. Running passenger cars off centrally generated power is much more energy efficient and has a far smaller carbon footprint than independently powered vehicles.

The IRA: And by transportation, are you referring to personal conveyances as opposed to commercial vehicles? Boone made the point last week that you're not going to move an 18-wheeler with anything but kerosene or natural gas. A battery driven electric vehicle is not going to do it - at least not yet.

Lucier: Peter Huber talks about the seven-eleven energy economy. Every year we use seven billion barrels of oil equivalent for transportation and 11 billion from non-oil sources for everything else. At the margin, it makes a lot of sense to switch commercial and fleet vehicles from oil to natural gas. In other words, move from seven-eleven to six and twelve. The heavy vehicles need a dense source of power that only hydrocarbons give us now, and fleet conversion to natural gas isn't such a problem. For passenger vehicles, though, I just don't see compelling economics or the infrastructure needed. From an efficiency standpoint, we would want to move away from internal combustion engines in cars. One of the key points of thermodynamic efficiency is that efficiency is a function of temperature gradients. So if you have a gigantic, super-critical furnace running at 2,000 degrees Fahrenheit or hotter, that is an inherently more efficient way of converting fossil fuel into electricity, even if you have to cope with the massive loss of power through the transmission lines. That's why it is more carbon efficient to run cars on electricity produced by centralized generation systems than from internal combustion engines. We are also talking pennies per vehicle mile traveled rather than dimes.

The IRA: Exactly. So what does the future look like in terms of functionality? Everyone remembers the EV-1, but they had to take it off the road due to concerns about the battery - at least that was our guess. Many fans of the EV-1 thought that the global oil conspiracy had operated to kill electric powered consumer vehicles.

Lucier: The EV-1 was a fiasco that California brought upon itself. They wanted a perfect, politically correct car overnight regardless of cost, or practicality, or engineering. They got the mess they deserved. Even now, BMW (BMW.F) has a perfectly functional 7 Series car that runs on hydrogen, but it doesn't qualify as a Zero Emission Vehicle in California because it still retains the ability to run on gasoline if you flip a switch. We need to think about eliminating gasoline from our lives a little bit at a time. If the average person drives less than 20 miles a day, a great first step would be to develop a hybrid car that can run those 20 miles gasoline free. Then we will do 40 miles, then we will do more. Consumers don't want to buy a car unless it has the functionality they need to suddenly drive cross-country if the urge for a roadtrip strikes them. The odds most people will ever do that is zero, but no one's going to buy a car unless they know it can take them wherever and whenever they might want to go. In this country, we have a power grid that extends everywhere. And we have enormous generation capacity that lies idle at night.

The IRA: Americans work harder than any people on earth, thus recreation is important. But you make a good point about the grid at night. We keep the grid energized all night even though usage falls off to almost nothing.

Lucier: We can't store electricity. Not yet. We have to make it as needed. So we just build gigantic generating plants and line them up side by side until we have enough power to meet peak demand at noon on a summer day. One of these days, we'll get more control over the demand cycle, but until that happens, there is a lot capacity that just sits around waiting until peak load. The Energy Department, through its Pacific Northwest National Labs, calculates that we can easily run over 100 million cars just using the power plants already in place.

The IRA: Wow. So if we migrate most urban consumers to electric, plug-in type vehicles over the next decade, with or without hybrid capability, you are talking about a huge amount of energy savings by cutting out the use of fuel by internal combustion engines. It sounds like many people who live in cities could use a vehicle that was purely electric.

Lucier: We certainly have the capacity to do it and it is definitely more carbon efficient. The problem we face in order to get to this next level of sophistication is the national grid itself, which in many cases is just one step above dumb wires. We don't have an internet for power that lets you measure flow and bill it, maybe assigning different prices for different times or charging you for the power you use no matter where you plug in. From a pure technology standpoint, there is no problem in assigning a unique address like an IP address to every device in your house, including your car. Then you can have devices programmed to use power at an optimally efficient time and price. When you drive to work, you can plug your car in at a parking garage and still send the charge, so to speak, to your home power bill.

The IRA: We can remember people working on uniting the network function and the electricity supply going back two decades. What's going to make this happen? Who are the leaders in this area?

Lucier: The future of electric power is about the internet for power. Instead of pushing power out over wires from a central generating station in a one-way flow, the future model is a two-way flow of information.

The IRA: Isn't it interesting how this concept of a two way, data-exchange type model is proliferating in all industries. Your description of the two way data flow could be applied equally to securities clearing or financial data reporting or global supply chain logistics.

Lucier: They are, but with electric power you have some unique challenges. A lot of the basic laws governing today's electric utility industry incorporate the technology and regulatory model that were unique to the 1930s. It is literally built into the industry's DNA. So we have a hodgepodge of business models for electric utilities around the country - public power, electric coops, investor owned utilities - based on what Franklin Delano Roosevelt thought was politically expedient at the time. It is a deliberately balkanized regulatory regime where no one has a real incentive to bust loose. But busting loose is what we need to do. I think that, in time, market forces and technology will drive the unbundling of all the 1930s legacy, vertically integrated local monopolies. If you think about it, that's really the only way to bring distributed power, small-scale renewables, and point sources of power.

The IRA: Talk about the politics a little bit here. I think we all agree that the cost and availability of energy is now a significant economic and political risk. Assume, for the sake of argument, that McCain wins in November. What does a McCain energy policy look like? Is the Boone Pickens plan of using gas and electricity for US energy needs practical?

Lucier: McCain understands that you've got to build stuff if you are going to meet emerging demand. There is lots of technology which will boost efficiency, but we still need more power plants if we want power during the day. McCain supports a cap and trade system to reduce carbon emissions, but he also supports building modern, coal-fired power plants in the context of cap and trade. Regarding transformation and technology, McCain has a fairly aggressive proposal called the Lexington Plan. He has a big focus on electric cars. He proposes a research prize to help focus attention on battery technology, for example.

The IRA: Geoff Ballard, the Canadian entrepreneur who founded Ballard Power Systems (NASDAQ:BLDP) transformed pollution-free fuel cells from an exotic power source used in the space program to an everyday engine used in industry died a couple of weeks ago. An enormous amount of money has been spent on fuel cells and batteries, but with very slow commercial uptake. But what about Obama?

Lucier: Obama basically says no more coal. That's it. Not until we already have the technologies for carbon capture and sequestion. That means no more coal for perhaps ten to fifteen years, which is what one of his campaign guys said recently. Obama's not against nuclear power, but not really for it either. He wants a solution on spent fuel before we build more nukes. So that means a bigger relative emphasis on renewable power. It also means using a lot more natural gas. Obama talks about a smart grid, which is a good thing, but he doesn't seem to focus as much as McCain on building a backbone electric transmission network to move power from remote rural areas to urban demand pockets.

The IRA: So under a Obama government, Americans can expect to pay more for electricity and perhaps even face shortages. Boone proposed that the next president declare an emergency and use existing law to build electric transmission capacity on the interstate highway right-of-ways. I don't see Obama doing that.

Lucier: That would be the logical thing to do, but that takes us back to our historical model, back to the days of FDR, when you literally could not transmit power over long distances. They knew theoretically that it could be done, but since it was unlikely the FDR era politicians did not allow for an integrated national market for electricity. They were protecting the public by ensuring that large, centralized power monopolies could not fail and badly damage the economy, as Samuel Insull's company almost failed. Just like FDR wanted lots of little banks instead of a few big ones, he also wanted lots of little, vertically integrated, highly regulated, local monopolies so that if one company went bankrupt, the whole system wouldn't fail.

The IRA: It's a deliberately federalist model for power generation ownership imposed by the federal government in Washington? A kind of statist federalism.

Lucier: It was weird. On the one hand, FDR wanted small local power companies, if power was to be privately owned. His preference was for federal power projects like the TVA and Bonneville, or failing that, federally-financed coops. But on the other hand, the fact that there was no interstate commerce in electricity was a problem for FDR, because it meant he couldn't have the complete control of industry structure that he wanted. So he hit upon the dodge of regulating electric power federally by regulating access to the financial markets. It's no accident that after the Securities Act of 1933, and the Securities Exchange of 1934, the abominable Public Utilities Holding Company Act followed in 1935. FDR said you can't sell stock or issue debt unless you follow these conditions, which reflected 1930s technology and business model. But in retrospect, these were absurdly restrictive conditions that have stunted technological innovation in the power sector to this day. PUHCA wasn't repealed until 2005. That's why the partial unbundling that has happened today only occurred at the cost of great disruption to consumers and states, and is still a mess. Failure to think about siting electric transmission lines back in the 1930s or even in the 1940s has left the US with a largely obsolete electric grid. And yet when building natural gas pipelines became a problem during WWII, that Congress passed the Natural Gas Act in 1948. This is the major reason why we can't get power lines built now but pipelines are relatively easy and quick to construct.

The IRA: So is Boone right? Maybe we do need a declaration of emergency to override some of these Depression Era structures that might take years to amend?

Lucier: The way that we approach natural gas infrastructure in this country is not a bad model for electricity. We have an agency called FERC that oversees the electric market and has shown a lot of sensitivity to local concerns. They site natural gas pipelines very efficiently. I think that FERC, which sadly got only a fraction of the siting authority that it needed in the 2005 energy bill, could play the arbiter role of gradually rationalizing the electricity market.

The IRA: Boone Pickens mentioned that the majors such as ExxonMobil (NYSE:XOM) are largely out of the game when it comes to alternative energy, or even natural gas. Why is it that some of the largest players in the energy market are not engaged in this effort?

Lucier: I think Boone is wrong there. The major electric utilities are doing what they are allowed to do in the context of today's regulation. There is a wind power boom underway in this country. The electric utilities are a big part of it, to the extent they can be. But if you put companies in a cage, they learn to like the cage.

The IRA: Pretty scary lack of vision.

Lucier: The large electric utilities are basically regulated business that like stability and like to keep things the way that they have worked in the past. In many parts of the country, we still have vertically integrated monopolies for power generation, transmission and distribution. In some part of the country such as the southeast that works very well. Companies like The Southern Company (NYSE:SO) are very well situated. They have kept power prices low and have emphasized service. The legislatures in the southeast might rightly say why should we go through the trauma of California or New York by deregulating? You can argue that the states where the legislatures are not in session all year round fared better because there is less opportunity for the politicians to constantly revisit electric policy.

The IRA: Yes, we know that problem well in Washington with housing policy. It is amazing that Big Media can spend vast news resources covering the demise of the GSEs, but almost never focus on the role of political corruption and money flowing to members of both political parties from the banks and the housing industry in creating the subprime mess. For example, virtually nobody talks about the personal slush fund set up for House Financial Services Committee Chairman Barney Frank (D-MA) in the GSE bailout legislation, which is fed by a 4bp tax on GSE revenues.

Lucier: Technology may yet save us. If you look at the way technology is taking us, the internet or long distance telephone or any other type of communication technology has tended to break up vertically integrated monopolies. It has flattened these models. Thus we have seen telecom unbundled into the switching business, the transmission business and the delivery business. The future for electric power is to have a market for electricity where you have baseload providers ranging to marginal providers on the periphery of the network.

The IRA: Well, the states like CA and NY that have been through the hell of deregulation also have enabled/entitled the peripheral players to sell power into the public grid. All of the retail users of power who are installing small-scale solar are able to sell excess power to the distribution provider

Lucier: Yes. You can sell in or out of the network in those markets. The current market paradigm is one to many, with a centralized pricing system, centralized distributor. Power is pushed out to you and there are some minor variations in the model. The model of the future, however, is a distributed model again using the example of the internet with two-way communication between users and providers of power.

The IRA: The model you are describing looks an awful lot like an exchange where buyers and sellers are all dealing with a common, centralized counter-party.

Lucier: Yup. The supply of electricity is going to come from everything from giant, hyper-efficient coal and nuclear plants to wind farms to micro-turbines or solar installations in a house. The entire network supply will be variable and you can also have variable consumption, with tiered pricing and other features. It is really atomization of what is now an entirely integrated, but one way system.

The IRA: Going back to your earlier comment about the unused power being waste on the national electric grid every night, it is pretty mind-boggling to think that we could potentially eliminate a large portion of the fossil fuel energy usage current attributable to passenger cars. Is this really doable?

Lucier: Yes, if you have a smart, national grid and charge the vehicles at night, then there is a huge energy savings waiting to be captured. Remember, for special purpose vehicles using electricity or gas, we have the technology today. Large scale migration to electricity for passenger car use and gas for commercial vehicles requires some big infrastructure spending, but it is all possible today with existing technology. Passenger vehicles are really now more a function of cost rather than technology. I think we are going to see a large scale rollout of electric cars in the next three years or so.

The IRA: What players do you see leading the way in areas like electric power and vehicles.

Lucier: I am not an equity analyst and I don't issue buy or sell recommendations.

The IRA: Neither do we, but we do write journalistically about companies we like and dislike.

Lucier: From a purely philosophical point of view, you would have to like a company like Johnson Controls (NYSE:JCI), which is a large, diversified controls and components company that still has a heavy exposure to lithium-ion batteries and is a technology leader. One thing we learned, or should have learned, in the dot-com era is that technology companies with neat products but no earnings, and I won't mention any battery makers here, are purely speculative plays until some company that does have earning buys them as form of outsourced R&D. Plus, beyond batteries, JCI is into a lot of power electronics and component type parts that will be a big part of component-based cars in the future. Also, as a technology leader and a system integrator, I like Toyota Motor Corp (NYSE:TMC). Don't forget that for electric cars we will need metals like copper and lithium. I haven't researched those commodity plays, but I would definitely think in that direction.

The IRA: What haven't we covered?

Lucier: Here's the sorts of things I think about. Going back to your question about money politics, there is a new political paradigm coming with respect to offshore drilling. We could see a shut-down in Washington as the two parties fight over this issue the end of September. Specifically, when the appropriations bills for the current fiscal year run out, the prohibition on the US government spending money on offshore leasing also ends. That means, in effect, that moratorium on offshore leasing also expires. These is going to be a huge fight to restore the moratorium. There may be enough votes to do so, but there will be a huge fight from the Republicans, who will try to block it and tar the Democrats with the issue. This is not just a fight about will be have drilling eventually in ANWR or off the east coast of the US. This fight is about whether the moratorium will expire this year and the Republicans are going to use this issue to maximum effect. Is it worth shutting down the government to illustrate the issue? Will President Bush provide some supporting fire to McCain and use the veto to block the extension of the moratorium?

The IRA: Makes for good politics, especially given the poll results on support for drilling.

Lucier: Yes it does. And think too about the states and their financial needs. What motivations do state governments have to permit offshore drilling? If we look at the revenues that may be available to them offshore, they would be interested. Santa Barbara County's board of supervisors just passed a resolution calling for offshore drilling.

The IRA: They need the money

Lucier: Yes they do need the money. CA has a terrible fiscal crunch. We really have no idea what is out there in the coastal areas of the US. We have seismic data going back 30 years that suggest the presence of an enormous amount of natural gas. Thirty years ago last month, Texaco struck a 500bn cubic feet of gas deposit 90 miles off the coast of New Jersey. It was in 400 feet of water. Since then, the technology has improved to that we can operate at that depth easily and will full environmental protection.

The IRA: It goes entirely unremarked by Obama and the anti-drilling crowd that despite the damage from Hurricane Katrina, there were no significant oil spills in the Gulf. The industry did a tremendous job.

Lucier: Thanks to the North Sea and deep water drilling in the Gulf of Mexico, we can now operate at 10,000 foot depths. And consider this: methane hydrate. It's the same stuff from which that comets are made. We have enormous amounts of hydrates along the edge of the US continental shelf. We have a 10,000 year supply of natural gas in the form of hydrates, according to the US Geological Survey. Consider that we use 23 trillion cubic feet of natural gas every year. The hydrate reserves in the US based on old data are at least 320,000 trillion cubic feet. And there is more methane hydrate on the planet than all of the other forms of hydrocarbon combined. Japan has huge gas hydrate deposits, enough to become a supplier to all of Asia. Ireland could become a gas supplier to Europe. We never bothered with hydrates in the past, but at current prices focusing on hydrates makes sense economically. We have the drilling technology, we have the deep water technology. We have literally unlimited supplied of natural gas if we focus on hydrates as the next area of exploration and development.

The IRA: We like good news. Thanks Jim.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of RiskCenter or any other party. RiskCenter has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to info@institutionalriskanalytics.com. (www.institutionalriskanalytics.com)