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Alternative-energy investments on back burner

Given current market conditions, Wall Street's focus on traditional energy isn't going away

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By Jeff Benjamin

March 22, 2009 6:01 am ET

Most people would probably rather not campaign against efforts to develop alternative energy, but from an investment perspective, the case for alternative energy is getting increasingly difficult to make.

Even after crude oil spiked 7% in one day last week on news that the Federal Reserve was buying $300 billion worth of long-term government bonds, oil's $52-per-barrel price range is still low enough to keep the focus on traditional energy.

"Everybody knows alternative energy is big on [President] Obama's list, but it is going to require huge tax credits, and the [investment] money is just not flowing into those areas right now," said Tom Lydon, president of Global Trends Investments of Newport Beach, Calif., which manages $75 million in assets.

Despite its mistakes, Wall Street will continue to be the closest thing we have to an efficient market. And that will continue to be the case for as long as every bet is directly linked to somebody's money.

"Wind and solar power are still about triple the cost of natural gas, and 80% of the parts that go into producing alternative energy are made overseas," said Clyde Harrison, president of Brookshire Raw Materials Group Inc., a Chicago-based firm that owns and operates the Brookshire International Raw Materials Index.

The bottom line is that alternatives are starting to look more like luxury items than necessities.

There are factors likely to drive up the price of oil, including summer travel and, even more significantly, the construction of a strategic oil reserve in China that will be larger than the one in the United States.

Even if crude oil climbs to the $60 range as some are forecasting, the price will still be 60% below the $147-per-barrel peak it reached in July.

That's the kind of peak-to-trough move that usually creates opportunities in the financial markets.

For example, over the past few years, when oil was making its record-level ascent, the energy exploration and production industries were in an acquisition mode to expand their reserve bases as the commodity became more valuable.

But in order to manage the risk that the price run-up might not last forever, the common practice was to hedge long exposure.

This typically was accomplished through the purchase of protective options strategies such as collars from investors who were betting that oil prices would remain high.

Now, as those hedged positions are expiring, many of these production companies are left with still-productive but money-losing properties from an investment standpoint.

This paves the way for a new stage of opportunities for some private-investment partnerships in the oil and natural-gas space.

"We're buying producing wells at today's prices, and I think this is a good trend for the next three to five years," said Mark Plummer, founder and chief executive of Chestnut Petroleum Inc.

Chestnut is a Richardson, Texas-based oil and natural-gas exploration and development company that offers private-investment partnerships.

"As oil prices rebound, it increases the cash flow for the properties, and it makes those properties worth much more money," Mr. Plummer said. "If oil prices go to $90, I've doubled my revenue and value over that time."

Chestnut builds portfolios of production companies inside limited partnership funds that are structured in a manner similar to private-equity partnerships.

The structure typically includes 1% management fees plus performance fees in the 20% range and a lockup period of between five and 10 years.

"Everybody is for alternative energy except when it costs them more money, and that's why alternative fuels just don't make sense yet," said Mr. Plummer, who added that alternative energy won't start making economic sense until oil prices reach $180 or more per barrel.

If private equity is not your thing, this strategy might also be employed less directly but with greater liquidity through exposure to a few ex-change traded funds.

The United States Oil Fund LP (USO), offered by United States Commodity Funds LLC in Alameda, Calif., is an ETF designed to reflect the spot price of intermediate light, sweet crude oil.

Then there is the iPath S&P GSCI Crude Oil Total Return Index ETN (OIL), offered by Barclays Global Investors of San Francisco, which is linked to the performance of the Goldman Sachs Crude Oil Return Index.

This year through Thursday, the USO fund was down 8.2%, and the OIL fund was down 15%, which compares with a 13.2% decline by the Standard & Poor's 500 stock index over the same period.

Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com.

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