Countering peak oil conditions

MARKET INSIGHT

If alcohol and biodiesels become cash crops, the first impact is likely to be favourable.

Peak Oil (PO) Theorists have been around since 1956 when geophysicist Marion King Hubbert presented a classic paper at the American Petroleum Institute. Hubbert postulated petroleum production will hit peak levels and then rapidly decline.

His timeline suggested US petroleum production would peak between 1965-70 and global production peak about 50 years later. After the peak was hit, there would be a terminal decline "�if oil is assumed to be a finite, depleting resource.

US production did indeed peak around 1970 and PO theory is widely accepted. Optimists say better recovery techniques and new discoveries mean that the peak will be some time after 2020 "� perhaps even as late as 2040.

However, driven by India and China, the global demand for oil is growing at a Compounded Annual Rate of Growth of 2 per cent per annum. Indian consumption for example, will triple by 2020. That is more likely to trigger an earlier peak.

The implications are dire. Although renewable alternates for fossil fuels can be developed, global GDP may take a massive hit during the switch-over, which in itself, may last decades. The political fallout could be explosive. Since there is no consensus on the theory, the switch itself will also not be a concerted effort.

Brazil has been the most far-sighted in developing alternate sources - it uses alcohol in all internal combustion engines. The US is entering corn-based alcohols.

Jatropha and other biodiesels are gaining popularity. The Brazilian experience shows that it took decades of tax breaks to ensure Brazilian alcohol was competitive at crude costs of over $25 a barrel. At most wellheads, crude extraction costs are just $5-6 per barrel so differentials are huge. Tooling up an entire value chain to deliver alternate fuels is also a daunting task.

In India, if alcohol and biodiesels become cash crops, the first impact is likely to be favourable. Wastelands can be converted to Jatropha. Cane-growers are guaranteed offtake even in years of glut. If a barrel equivalent comes in at say, $50, that is still well below import prices of the past three years.

But there will be issues. Corn (Bhutta) prices have jumped in North America and Mexico due to gasohol demand. Cane is a very politically sensitive cash-crop "� prices influence voting across 80-odd Lok Sabha constituencies. There will be political hysteria if it starts being influenced by gasohol offtake.

Plus, if meaningful acreage is converted to fuel production, there could be a crunch in food supply and inflation in farm produce. Hence, political hysteria on the subject can be guaranteed.

Let's assume that the tool-up and switch over occurs. There could be say, a decade of pain and adjustment. During that period, inflation would jump globally.

Investors will therefore, have to find methods of generating returns that hedge inflation driven by rising energy and food costs. One traditional class of inflation-hedges is precious metals. Gold-bugs have already made a comeback since the US invasion of Iraq. The yellow metal and silver, which in many respects offers an even better hedging profile, could deliver very high returns.

The other class of instruments, if it can be called a class, is investments across the value-chain of alternate energy. The Vinod Khoslas of the world have already started betting on this.

Praj Industries has been one obvious beneficiary. There will be others. But many of the best investments will come in businesses that have not yet been dreamt of. Most jatropha-biodiesel models are at proof-of-concept stage. Delivery systems will need to be retooled to manage fuels, which are more explosive (alcohol) or more hygroscopic (biodiesel) than the traditional.

However, I cannot see a scenario where sugar-mills fail to gain from the switch-over. Mills generate alcohol from molasses, (which is now a semi-waste product); they control or have relationships (very fraught ones admittedly!) with growers. There are many listed companies in this space.

The sugar industry is at a cyclical low. If you're a very long-term player, buying sugar mills makes sense. At the least, you get an upside when sugar turns around. Ideally, you get a long-term hedge when alcohol plays fructify.

The certainty of political interference is the only unpredictable variable. Cane is arguably the most controlled and interfered with of all Indian commodities.

Cane-growing regions will gain substantially if the market is allowed to operate sensibly. But will Mayawati, Sharad Pawar, Deve Gowda, Karunanidhi and their successors allow that to happen?