Wednesday, July 20, 2005

Staying Power
A couple of weeks I ago I looked at some lessons learned from the energy crises of the 1970s. These included the undesirability of direct government intervention in markets, the value of supply diversification, and the nature of the market's response to high energy prices. But one of the lessons I neglected to mention deals with the importance of planning for an unexpected future, when investing in alternative energy projects. This is nicely illustrated by a recent article from MIT's Technology Review on the history of the Dakota Gasification Company.

Dakota started as an energy crisis project to turn coal into synthetic methane. As the article explains, it was built assuming the future price of natural gas in the US would be $9 or $10 per thousand cubic feet. Although it has approached or exceeded that level recently, the company had to survive almost two decades in which it was between $1 and $3. The original buyers of the gas canceled their contracts, the investment was written off, and Dakota essentially went bust. The reason it has survived and now looks like a model for the future is not just high energy prices, but an unexpected benefit from one of the plant's byproducts, carbon dioxide, which was also starting to look like a liability in a world increasingly focused on climate change.

In a classic lemons-to-lemonade story, Dakota is now selling CO2 to a Canadian oil company that will use it to enhance oil recovery from a declining field, and in the process lock up the CO2 geologically, preventing it from entering the atmosphere for millennia or longer. This is only possible because in gasification, unlike conventional coal combustion, the inevitable CO2 exhaust is concentrated enough to be handled in this way and create side-benefits.

Without realizing it, the original investors in this 1970s coal-to-gas plant also purchased an option on future sales of carbon dioxide. And that is precisely the lesson worth remembering for anyone investing in ethanol plants, wind farms, and new generations of alternate energy: the future might not be quite as green, or the price of energy quite as high as you expect. Prepare for volatility, and think about the other options your project can create at little or no cost today, but that might be the difference between success and failure in an unpredictable future. A project that is prepared to capitalize on a wide range of outcomes is a much better investment than one that requires a specific result to be profitable. And that's a lesson that's not just limited to the energy industry.

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