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The Energy World is Flat by Daniel Lacalle and Diego Parrilla

Open-access content Tuesday 2nd June 2015 — updated 5.13pm, Wednesday 29th April 2020

The Energy World is Flat by Daniel Lacalle and Diego Parrilla

2

Publisher: Wiley
ISBN- 10: 01118868005
RRP: £24.99


If you are concerned about the impact of fossil fuels on the environment, or believe that the supply rate of fossil fuels (or at least oil) has reached its peak, you may get too angry with the early part of the book to read the rest… but you should.

The authors have taken some of the core ideas from Thomas L. Friedman's The World is Flat, applied them to the energy markets and used them to highlight some guiding principles for an investor in these markets. The principles easily lend themselves to other resources and, in fact, are relevant to anyone more interested in investing in the wider economy. The book structure is simple: a scene-setting beginning; a middle, setting out 10 'flatteners'; and an end, setting out those investment principles.

At the heart of the 'flat' concept is the idea that geographical or temporal differences in availability and cost of energy, as well as differences in the relative price of energy sources, are being flattened by evolving mechanisms for transfer from peak to trough. Unfortunately, these ideas are also where the book's content contradicts its title. However, The Energy World is not Flat but is Tending to Flatness in the Long Run is not quite as snappy, and the poetic licence can be forgiven as we drill into the ideas. For example:

? Geopolitics causes short-term fluctuations in prices as producing states tussle with consuming states over energy security; meanwhile, producers look to diversify their markets and consumers look to diversify their supply.

? There are a lot more natural resources and reserves than we have grown to believe. This has led to over-investment on the supply side, which, over time, will push energy prices down globally. This is accelerated by new technologies and other approaches to substitution or demand displacement. 

? However, governments have been distorting the picture by stimulating investment in production as well as demand both for hydrocarbon-based and alternative energy. They then overlay further distortions through regulation and mandates. 

At best, these are necessary where the markets are ignoring externalities; at worst, the interventions themselves ignore other externalities or unintended consequences.

? Middle men add value. So while global pricing may be flattened through the financial markets, the price of a barrel of oil is less relevant if you cannot access oil: hence pipelines and tankers. Similarly, the price impact of temporal peaks and troughs can be addressed partially through financial instruments, but if you sell a future that you cannot roll, or close, out, you are faced with a delivery problem in the real world: hence storage.

And this brings us to a lesson that is not at all specific to energy and its markets: that the behaviour of the real economy and investing in it are very different propositions from the financial instruments derived from them. Worse still, the gap is being exacerbated by monetary policy in most western economies. As I was reminded at the recent Sessional Research Event on sustainability and the financial system, the more actuaries who engage with the real economy on behalf of our clients, the fewer externalities will be ignored in the allocation of financial capital.

So what of the investment principles that all these insights support? Well the author works for a hedge fund so suggests some strategies that are only for the brave or well-capitalised, but the key points are of interest to us all: be sceptical of financial valuations without understanding performance drivers; look for scarcity and bottlenecks in the supply chain as well as companies that service the energy sector; buy into new investment by companies that invest well; avoid debt.

In all, this was an easy read by an author on the inside of the energy sector, made the more entertaining because it challenged several of the views that I have formed over the years.


Tony Brooke-Taylor is internal audit director for Aviva's general insurance business

Filed in
2015

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