Increasing Energy Prices Good for Some Aussie Shares

We have been droning on and on about gold and the credit crisis to the neglect of the energy crisis... and most importantly... what to do about everything! Have we become the boring party guest who won't shut up about his vacation to Bali? Sorry about that. We'll do better today, and give you the fundamental case for being bullish on a certain call of Australian shares.

By the way, for the data wonks out there (and you know who you are) The Reserve Bank's Financial Stability Review comes out later today. Yummy. Look for a full report in tomorrow's Daily Reckoning.

How about we start today with energy? Crude futures in New York closed up near US$106. T. Boone Pickens, who went short oil for the first quarter of 2008, got his teeth kicked in on the trade. Pickens told CNBC "it was a mistake" to think oil would correct below US$100 and that he doesn't believe he'll see US$50 oil again in his life.

The first victim of chronically higher energy prices, we noted a few weeks ago, is aluminium production in countries facing power shortages. These countries (China and South Africa) rely heavily on coal-fired electric power (as opposed to hydro-electric). With demand outstripping supply, aluminium smelting-energy hog that it is-has proven to be the first casualty of higher systemic energy prices.

"China may become a net importer of primary aluminum by the fourth quarter of 2008 amid a slowdown in output growth and a projected surge in consumption, the official China Securities Journal reported," according to Forbes. You'd think this would bode well for Australia, the world's fifth largest producer of aluminium.

But wait. There are energy issues here, too.

"BHP Billiton will need nearly half of South Australia's current electricity supply to power its vastly expanded Olympic Dam copper and uranium mine," writes Jeremy Roberts in today's Australian. "The mining company wrote to potential suppliers this month revealing that power demand for the mine was expected to top 690megawatts when it reaches full production in 10 years."

"This 30 per cent increase on previous forecasts for the mine, 600km northwest of Adelaide, is equivalent to nearly 42 per cent of South Australia's total electricity consumption and nearly half of Adelaide's power supply."

Wow.

That's a lot of energy. But hey, it takes power to make things. A true cost of production for industrial goods and resources would include the "embedded energy" price, not just labour and capital. Some metals and materials have much higher energy costs than others.

Australia's aluminium smelting industry, "consumes over 25,000 gigawatt-hours (GWh) of electricity per year in Australia, or almost 15 per cent of all the electricity consumed in Australia," according to a report published by the Australia Institute in 2002. The smelters in New South Wells and Queensland each account for over 10% of total electricity consumption in both those states.

Source: The Australia Institute

So what?

Well here's the deal: Australia gets most of its base-load electricity from the country's rich supply of coal. The more coal burned here to produce power for metals, the less coal for export. This has an impact on earnings and the share market.

ABARE reported earlier this month that the value of Australian commodity experts would rise 30% in 2008-2009 to $189 billion. Coal-in its metallurgical and thermal varieties-is the second largest export earner (thanks to Australia's huge natural endowment and massive global demand.)

Source: Australian Bureau of Agricultural and Resource Economics

If takes more coal to produce metals for export, that makes for fewer coal exports. But given Australia's energy profile, it's not like there are a lot of ready alternatives to coal-fired power. As you can see from the table below, North America (especially Canada) has abundance of hydroelectric power. Oceania, not so much. The aluminium smelting industry here gets nearly 92% of its electricity from coal-fired power.

How can BHP expand production at Olympic Dam without a new source of power? Can Australia really increase production volumes in its minerals and metals industry without increasing the number of natural-gas fired plants that run on gas from the North West Shelf? These must be the questions that keep mine executives up at night, among other things.

Of course Australia has large and latent nuclear energy reserves in the form of all that uranium. But generating base-load power from nuclear is not something the country seems prepared to do. It takes time anyway. Even if the political consensus changed over-night, the installation of the infrastructure and networks to build a nuclear economy would take years.

Are there alternatives? Well, the Cooper Basin is home to a huge potential reserve of base load power from geothermal energy (heat trapped in the earth's crust converted to steam do drive turbines). Tapping this potential and turning it into real power for Australian industry is the business goal of several small-cap companies.

And here we are forced to make a slightly surprising confession to you, dear reader: we are bullish in a very narrow context. In fact, sometimes we get so excited about the alternative energy, biotechnology, and technology companies we research in ASI that we get downright giddy. But there's good reason to be giddy.

Despite the heavy dose of doom and gloom in the credit markets, we remain excited about the alternative energy and renewable industries here in Australia. For such a small population, Australia has a large number of successful innovators. These public companies don't provide silver bullets to the energy problem. But nothing will replace oil. You'll need a portfolio of solutions.

From solar to geothermal to wind, waves, biofuels and other alternatives, Australia has an amazing diversity of small-cap investment opportunities. Most will probably fail, to be fair. But it's the magnitude of the potential wins that interests us, not the frequency of the losers.

And from an investment standpoint, you want to invest when you have an advantage. Tracking Australia's small but thriving industry of small cap energy companies is not something many people bother to do. There are bigger fish to fry with conventional oil and gas or precious and base metals miners (Al Robinson's beat at Diggers and Drillers).

But we reckon that there are two markets in this part of the world that receive little analyst coverage: Indian stocks and Australian small caps. Seriously, we can tell you from personal experience that Australian stocks-despite compelling tangible value and real business prospects (in the alternative energy sector)-get no attention from Jim Cramer, Larry Kudlow, or the front page of the Wall Street Journal.

That's exactly the way we like our stocks, virtually anonymous and desperately lonely for some attention for patient analysts. It's part of the reason we moved here in the first place, to have an advantage in finding good stock stories that are two to three years away from being great business stories.

Dan Denning
The Daily Reckoning Australia

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