Oil and gas incumbents: the upside of cleantech collaboration

The global transition a low-carbon economy is now inevitable. There will be winners and losers. Under pressure from institutional investors, energy incumbents (including recently ExxonMobile) are starting to reveal their ‘carbon risk’- traditional reserves left as stranded assets due to carbon constraints. One way to release that pressure is to find low-carbon energy assets to replace traditional reserves. Cleantech collaborations — partnerships between traditional energy companies and emerging cleantech stars — offer new ‘cleanfield’ developments with significant upside to both parties. It’s no longer ‘us’ and ‘them’ — it’s just ‘us’.

Think of clean energy projects as new oil or gas fields to develop, and an equity investment as exploration costs. Just like a test well provides visibility into project risk and economics, so does an equity investment.

Exploration costs to uncover incremental traditional reserves increase carbon risk — a bad deal for investors. Cleantech exploration costs reduce risk -with more upside, since it comes with ownership of the intellectual property that unlocks those new clean energy projects. Seems to me fiduciary duty requires board members of incumbents to consider seriously this new class of assets …

But here’s the kicker — next-generation clean energy assets have higher IRRs than traditional fields.

Early movers like Enbridge — who invested ‘exploratory’ money in Morgan Solar and Hydrogenics — are already reaping the rewards of profitable partnerships. Hydrogenics’ stock has increased almost seven-fold stock since Enbridge invested, as they developed electricity-to-gas projects across Germany. Morgan Solar’s projects will generate IRRs in excess of 35% (more than 60% ROE), and Enbridge has earned a front-row seat.

Here’s a great collaboration waiting to happen: Woodland Biofuels. Their commercial plants produce ethanol from cellulosic fibre — agricultural, forestry and municipal waste. And at $1.15/gallon they’re positioned to be the lowest cost fuel producer in North America. Their IRR is comparable to, or better than, oil & gas development, with a lower risk profile and higher long-term upside. They don’t need subsidies to be profitable, have de-risked the technology, but need the financial heft and market access of an incumbent.

Here’s an apples-to-apples comparison of a 25,000 bpde oil or gas field development versus a financing of Woodland’s equivalently sized ‘field’ of ten commercial plants:

Woodland compares favourably on a project finance basis, but it’s when we look at ongoing risks and future upside that it really comes out ahead. See Notes below. The financial picture becomes even more compelling when compared to a typical oil sands development, with carbon risk incorporated. See below.

A collaboration with Woodland starts with a small equity investment — equivalent to a $10 million ‘exploratory’ cost associated with a small oil & gas field — to allow engineering partner AMEC to complete the final stages of commercial plant development, including detailed engineering. Here’s the icing on the cake: Woodland’s patents also cover conversion of reformed natural gas to ethanol.

Cleantech has matured. Many emerging stars — like Woodland and Morgan Solar — can compete head-to-head with fossil fuels, without subsidies and at scale. Incumbents who partner with them stand to benefit from the transition to a low-carbon economy by creating a new class of low risk, high value ‘cleanfield’ projects. The cost of entry is a small equity investment. The potential upside is huge.

Notes:

Woodland’s demonstration plant in Sarnia is producing cellulosic ethanol with a highly efficient proprietary three-step catalytic process.

Exploratory costs: A typical oil or gas field requires geophysical survey and a couple of test wells to define the risk and resource. Woodland’s equivalent of an initial well — their $14 million demonstration plant in Sarnia — is in production today, demonstrating commercial plant economics. Woodland requires a further $10 million to refine operational data to be fed into the final stage of detailed commercial plant design. In this model it’s assumed to be an equity investment in the technology itself, not a single project. This allows, in addition to risk and economic assessment, significant future upside in the form of licensing, royalties and further project development.

CAPEX: Commercial engineering partner AMEC confirmed CAPEX of approx. $5–6/gallon.

IRR: The IRR on a Woodland plant is expected to exceed 25%, unlevered. Assuming 50% debt, the return on equity rises to nearly 60%.

Technical Risk: Woodland’s risk profile is very different from other biofuel plays. Aside from an operating, well-scaled demonstration plant, much of their core technology — a three-step catalytic process from syngas to ethanol — has already been commercially proven by partners like Air Products and Eastman Chemical.

Regulatory Risk: While Woodland appears to face regulatory risk in the form of reduced ethanol mandates, it’s mitigated by the highly competitive nature of their ethanol compared to dominant corn-based ethanol, which is much more expensive. Cellulosic ethanol will displace corn ethanol, and so faces a very large market even without increased regulatory support. Fossil fuels face increasing regulatory scrutiny, particularly in the North American context.

Reserves Risk: All geophysical fields have risk associated with remaining reserves. In Woodland’s case, geophysical risk is replaced by contractual counter-party risk on the part of fiber suppliers. Multiple suppliers and long-term contracts are readily available.

Price Sensitivity: Woodland produces a final, retail drop-in fuel replacement and thus faces risk at the retail price level. This is lower risk than upstream product pricing risk.

Carbon Risk: All fossil fuel producers face the risk of carbon pricing, either in the form of a domestic price that increases the cost of production, or in the form of external tariffs as contemplated by jurisdictions like Europe and California. Woodland’s carbon risk is negative — as markets price carbon, Woodland’s product becomes more competitive.

Future Upside: There is negligible future upside to a depleting oil or gas field. On the other hand, the initial equity investment (here ‘development cost’) provides significant upside on sales and licensing agreements (directly and with third parties globally) — including not just cellulosic ethanol, but ethanol from reformed natural gas.

The IRR of a typical oil sands development, showing affect of both domestic and downstream carbon risk on IRR. Taken from Andrew Leach’s analysis in MacLean’s magazine.

Originally posted Mar 19, 2014 on the ArcternVentures.com