Bridge over ocean
1 June 2016 CFA Institute Journal Review

Will We Ever Stop Using Fossil Fuels? (Digest Summary)

  1. Servaas Houben, CFA

Despite the increase in popularity of alternative sources of clean energy, those sources are not likely to replace conventional fossil fuels (i.e., coal, gas, and oil) in the short term. The supply of fossil fuels, especially gas and oil, has been remarkably stable over the past 30 years because of technological progress. Without greenhouse gas policies or subsidized R&D, emission cuts are unlikely.

What’s Inside?

The authors compare the historical development of the fossil fuel supply and energy costs with different energy sources. They conclude that significant decreases in price have taken place for clean energy but that energy storage remains a challenge. The latter is required because energy consumption is uneven during the day. Furthermore, the efficiency of clean energy is highly dependent on weather conditions, and a concentration of clean energy resources reduces their effectiveness. It is thus unlikely that a major shift toward clean energy will take place in the near future. Continuing the current energy supply policy could result in a significant increase in global average temperatures in the range of 10–15 degrees Fahrenheit, although the effects of future improvements in extraction techniques are difficult to estimate.

How Is This Research Useful to Practitioners?

Concerns about carbon dioxide emission started during the 1990s, and developed countries have put taxes and regulations in place to limit these emissions. But the increase in the consumption of fossil fuels in developing countries has been significant in the past 10 years. Increased costs of extraction or the lack of availability (supply theory) and cheaper alternatives could reduce this demand. But the authors show that during the past 30 years, the discovery of new fossil fuel reserves has equaled consumption, making the first argument less likely.

Estimating the cost of green energy is difficult because these sources usually require up-front costs, and making future projections of a reduction in costs as a result of technological innovation is difficult. The authors consider the specific case of the electric car replacing the conventional gasoline-powered car. Battery costs in electric cars have been reduced significantly over the past 10 years. Nevertheless, oil prices would have to increase from the current $55 per barrel to $420 per barrel and battery costs would have to decrease to make the electric vehicle cheaper. The authors conclude that it is unlikely that electric vehicles will gain great popularity over the next two decades; besides the higher expenses, electric cars have a limited range.

Changes in the economy’s mix of fuel consumption will have a major impact on a wide range of financial analysts’ specializations. Long-term investors, such as pension funds and insurers, might revise their asset allocations in light of trends in energy consumption. Professionals working in mergers and acquisitions departments or government institutions will likewise need to adapt their strategies.

How Did the Authors Conduct This Research?

By using historical data on the supply of fossil fuels and energy prices, the authors predict how likely a shift to more environmentally friendly energy is in the (near) future. They find that R&D in tar and oil sands started in the 19th century, but it took decades to make extraction economically sensible. A similar longer-term process occurred for rock foundations. The only fossil fuel for which reserves have decreased substantially is coal.

The supply of fossil fuels is affected not only by the availability of deposits, but also by the success rate in exploration. Despite there being fewer easy wells to exploit over time, success rates have increased, thanks to new technology. A vastly larger supply exists in resources that are not currently economical to extract, ranging from 2.8 times to almost 60 times current reserves. Oil shale and methane hydrates, which are not yet being developed, could further expand the available supply.

On the demand side, the authors examine the electricity and transportation sectors because of their prominence as energy consumers. Among renewable sources, they focus on wind and solar energy because the use of nuclear energy has decreased since the 1980s. To compare the various energy sources, the authors use a levelized cost of energy estimates—that is, the present value of future costs divided by the value of production. The US Energy Information Administration is the source of their historical and forecast data. They focus on a relatively short forecast period because success in reducing CO2 emissions will be relevant within the next decade and because it is difficult to produce accurate long-run cost estimates.

Abstractor’s Viewpoint

Energy consumption and production has been a central topic in foreign policy for decades, and hence, forecasting trends has economy-wide implications. The authors show that although remarkable progress has been made, it is unlikely that green energy will replace existing resources in the near future. They offer extensive data and graphs to back up their conclusions and their forecast. One issue that they only touch on is whether increased consumption in emerging markets might result in fossil fuel shortages, forcing people to look for alternative resources. Nevertheless, the article is a great introduction into a topic that is not deeply discussed and is a worthwhile read for every investment professional.

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