BUBBLE, BUBBLE, TOIL AND TROUBLE – OUR TAKE ON A RECENT ECONOMIST ALARUM

Some months ago we had a meeting with an industry analyst with an interest in energy issues. When we announced that we were planning on launching an information service in the area of alternative fuels, he pronounced, “no one will buy it. You can get all the information you need on alternative energy by reading The Economist.”

We might be inclined to take issue with that remark, but we shan’t. As The Economist itself would say, the market will decide. Still, we can’t refrain from commenting on a recent article in the Economist which says that renewable energy is a bubble in the making, and which notes a quadrupling in investment in this area over the course of the last two years. “Too much money chasing too few opportunities,” says Douglas Lloyd of Venture Business Research in a quote cited in the article.

Now we happen to consider ourselves something of an authority on tech bubbles. We were badly injured when the telecom bubble exploded in 2001, and we resolved never again to place ourselves near the epicenter of any similar explosion. So we began an extensive study of the history of technology driven bubbles to see what we could see.

Bubble Bath or Total Immersion in the Bubble Phenomenon

Very few movers and shakers in the financial industries are students of financial history. Why should they be when “everything is different now”—a phrase which, incidentally, is resurfacing in the financial community as the memory of the tech collapse of five years ago recedes. Few profess to believe that recurrent patterns exist in technology adoption or diffusion or that business cycles of boom and bust obtain any longer in the area of technology investment. And there are reasons behind such a set of disbeliefs. To acknowledge that financial enthusiasm is followed by depression is to dissuade the financial markets from bidding up one’s properties. After all, no one wants to buy an overvalued security, so the seller needs to convince everyone that prices will just keep going up.

That being the case, most financiers retreat into mystique. They rely either upon intuition or some complex series of arcane equations that can only be run on a supercomputer.

Nevertheless, we believe that recurring patterns do manifest themselves, patterns that the financial industry often misses but which may be evident to those who have analyzed the past with a critical eye.

A Few Sips of the Bubbly

It turns out that full blown tech bubbles are not awfully common. Most investment bubbles in the past have involved real estate or mining and other extractive industries. If we look at the seminal technical innovations of the past two hundred years, few have engendered bubbles. Steel manufacturing, the telegraph, dynamite, repeating firearms, steamships, plastics, electronic television, electrical appliances, mainframe computers—none of these innovations resulted in an investment bubble.

Those innovations that did bubble over include railroads, automobiles, mechanical office machines, petroleum, the telephone, electrical generation, radio, airlines, an almost forgotten phenomenon known as mechanical television, and, of course, the Internet. It is interesting to note, however, that within this second group the number of innovations that created bubble economies and not just local bubbles confined to the industry in question is far smaller. Railroads and the Internet are the better known examples, but we would argue that the overcapacity and overinvestment in the auto industry had a role in the stock market collapse of 1929 and in the subsequent severe Depression that followed. But the fact is that few industries really drive financial markets. Railroads and automobiles, two that really did drive markets, both absorbed a considerable portion of the total industrial capacity of the U.S. during the periods of their respective dominance. None of the other industries has had this singular ability to entrain other industries, including the Internet whose pull on the overall manufacturing sector has been fairly insignificant.

So what are the characteristics of the bubble industries? For one thing, they tend to involve a high degree of uncertainty as to their growth potentials. Most bubbles arise in technologies that are fundamentally new rather than replacement technologies and thus hard to predict. For example, the steam powered stage coaches that preceded railroads in England—a classic replacement technology—gave rise to no financial bubbles, whereas railroads, a fundamentally new form of transport, did. The telephone industries bubbled during the first two decades of the twentieth century when the Bell System could no longer enforce its patents and countless independents vied with Bell operating companies in major cities across the U.S. In clear contradistinction, television, which in a sense was a replacement and enhancement of radio, did not bubble although radio—again, a fundamentally new technology—did. And, almost invariably, industries where the replacement technology is embraced by incumbents, as television was by the major radio broadcasters and manufacturers, are not going to bubble.

Fundamentally new products tend to bubble for another reason as well. Most go through a period of initial design diversity followed by the establishment of a dominant design. Those companies associated with subordinate designs don’t generally survive and thus much investment goes for naught. We must mention, however, that in terms of functions realized in software the dominant design concept has less validity. To cite one example, large numbers of audio and video CODECs vie for acceptance in the electronic marketplace with no one having achieved a commanding position. We believe that this discrepancy has to do with the fact that hardware manufacturing entails clear economies of scale whereas software duplication does not.

An especially interesting example of how the emergence of a dominant design can rock an industry can be seen in the electrical utility industry in the first decade of the twentieth century. For the previous two decades Edison Electric and Westinghouse had been locked in a “war of the currents”. Edison advocated direct current generators whereas Westinghouse championed three phase alternating current. The clear superiority of the latter in industrial applications robbed Edison of that increasingly important market, but the fact that most electric trolley lines—the dominant mode of urban transportation at the time—ran on DC, ensured Edison’s survival for a period of time. But with the decline of the streetcar lines, and the spread of electrification to whole communities where the poor scaling attributes of DC proved critical, the Edison system became doomed, and all of the thousands of Edison substations distributed around the country represented wasted investment dollars.

The degree to which a new technology enlists other industries in production also determines its propensity to bubbles. Obviously, when other industries are engaged, the new industry is exposed to someone else’s business cycle and to someone else’s problems with raw materials, labor, regulations, and so on. One sees this particularly in the automotive industry which places heavy demands on steel, glass, rubber, and electrical component manufacturers, and also in the electrical component and appliance industries which are vulnerable to increases in the price of copper. In 1907 when the manufacture of electrical equipment was just getting to be a major industry, a move on the part of certain banking interests to corner the market for raw copper and thereby drive up the price of electrical equipment was enough to precipitate a serious financial panic in the U.S.

Collective decisions by private equity also play a part in the formation of bubbles. When major investment banks, and, more recently, venture capital firms, get behind a new technology, that movement signals overall market approval and prompts further financial activity in behalf of the new industry. Almost inevitably, investors end up subsidizing a horde of aspirants in a market that can only support a handful and a bubble forms. Very shortly thereafter it will burst.

Is Alternative Energy Effervescent?

When we try to examine renewable or alternative energy industries for these attributes, we find that industry segments are individually too variegated to support generalizations. Some segments seem prone to bubbling, others do not. Indeed, some already appear to have bubbled.

So let’s scrutinize a few:

Wind ain’t bubbly if appearances are to be believed. Big wind, the business of one megawatt turbines sold to large electrical utilities, is characterized by mature designs, well funded, well established manufacturers, and steady market growth over the course of two decades. Furthermore, most of the big companies are public, not venture funded, and they aren’t experiencing tremendous price volatility or over-valuation. It looks to us like a healthy industry with much growth ahead.

Solar is definitely an edgier business. Although there are a handful of fairly dominant players, there are also a lot of venture funded startups boasting laboratory technology and purported performance breakthroughs. Most of those startups aren’t going to make it, while one or two could potentially turn the entire industry on its ear.

The end user market for solar is a lot harder to call as well. Solar is a remote power and residential market, not a utility play. Solar has been expanding steadily due to a near Moore’s Law price erosion in the panels themselves, but it has yet to achieve the breakthrough economics that would prompt explosive growth. We think at some point solar will experience strongly accelerated growth, probably as a result of further price drops and steep rises in the price of utility electricity, and at that point may experience something of a bubble market.

Alternative fuels, mentioned prominently in the Economist piece, are much more likely to bubble and burst though we don’t hold this to be a certainty. Certainly fossil fuels have had their bubbles. Coal never experienced a bubble in the nineteenth century, but the oil industry, from its earliest days in Pennsylvania was characterized by an unending series of shocks. True, the industry as a whole grew steadily, but individual companies rose and fell in a textbook example of casino capitalism. We attribute this volatility both to the relatively low barriers to entry, the very high profits accruing to the relatively few who were successful, the ease of attracting the necessary investment to drill a well, and the high risk of any given well failing to produce. In addition, the industry was thoroughly ad hoc, and lacked a comprehensive distribution infrastructure and a consistent product.

Alternative fuels, of course, form a fairly heterogeneous grouping, one in which generalizations may not be entirely applicable. Still, we will attempt a few.

Alternative fuels’ progress in the marketplace is heavily conditioned by the price of oil. Right now they’re beginning to look attractive because oil prices have remained quite high for a protracted period, but any long term downward adjustment could render most of the alternative fuels business uncompetitive. This is less true in the cases of biodiesel, which sells primarily on the basis of its “green” attributes, and ethanol, which is mainly positioned as a fuel additive today rather than a primary fuel. But in the case of shale oil, heavy oil, gas-to-liquids, and coal-to-liquids, a long term decline in oil prices would render current investments in production capacity worthless.

In alternative fuels one also has a lot of unproven extraction and production technologies chasing investment dollars. More than likely, most of these experimental won’t prove out and the investors. That’s normal in any emerging industry.

The worst case scenario for alternative fuels is if oil prices remain high for several years hence, prompting billions of dollars of investment in alternative fuels production capacity, and then, of a sudden, oil prices descend again and stay low. Could that happen? If a lot more conventional oil is discovered or recovered, or if a lot of huge new projects are initiated that validate the highest estimates of conventional oil reserves, then alternative fuels will prove to be a tremendous bubble and will take down hordes of investors, and could even precipitate a global economic downturn if enough heavy construction is involved.

Investments in new forms of energy are definitely not for the fainthearted.