A former student at Trinity sent me a Facebook message recently. He linked to an advertisement message for an investment advisory company that emphasized the importance of ‘rebalancing’ one’s investment portfolio every quarter or every year.
I realized I had not taught that principal at Trinity in our personal finance course last Spring. When the link came in on Facebook with the simple query from my student: “What is rebalancing?” I thought “Uh-oh, I missed that one.”
To make it up to that student, as well as to anyone else who might have the same question, here’s the quick explanation of rebalancing.
Rebalancing is one of those investment things you should do regularly, like brushing your teeth (only less frequently) or going to your college reunion (only more frequently). Once a year rebalancing is fine.
The point of rebalancing is to avoid two big No-Nos of investing:
1. Overexposure to one particular type of risk; and
2. The “Buy-high, Sell-low” investment behavior that everybody unwittingly does.
I’ll illustrate the simplest form of rebalancing with an example, assuming you have just two types of investments in your portfolio: a stock mutual fund and a bond mutual fund.
Let’s say you and your investment advisor agreed that you needed the 60/40 allocation to stocks and bonds that 98.75 percent of all investment advisors inevitably urge on their clients.
[Quick aside: I totally disagree with this allocation, and I’m not an investment advisor, so for both reasons please don’t think I’m recommending this for you. In fact I wouldn’t recommend it for the vast majority of people, but that’s a whole other column – or series of columns to come – in the future.]
Ok, back to my example, which will happen to match up – by pure coincidence! – with how 98.75 percent of your investment advisors have set up your portfolio.]
After one bad year in the stock market in our example here, let’s say stocks have dropped by 12 percent and bonds have returned a positive 5 percent, and now your portfolio allocation has shifted due to the market.
The new portfolio at the end of Year 1 now has a 56 percent stocks to 44 percent bonds allocation.
Here’s where the rebalancing part comes in.
When rebalancing at the end of the year you would sell some of your bonds – in my example 9.6% of your bond allocation so that it only makes up 40 percent of your portfolio again. With the proceeds of the bond sale you would purchase stocks, also returning stocks to just 60 percent of your portfolio. You would now begin Year 2 with your previously agreed-upon 60/40 asset allocation.
Next year, let’s say the stock market rebounds, returning a positive 18 percent, while bonds return just 1 percent overall.
Using numbers from my example, you end up with a 0.66% larger portfolio at the end of Year 2 through rebalancing. That may not seem like much, but those little amounts add up over time. If you have a $100,000 portfolio you would be $660 richer after just one rebalancing.
Let’s extend the example one more year. At the end of Year 2, before rebalancing, you have a 63.6% stocks and 36.4% bond mix. We’ll have to sell about 5.6 percent of our stocks to return to our preferred 60/40 mix.
In Year 3, let’s say stocks return a positive 8 percent and bonds return positive 3 percent. You will now have a portfolio 2.1% higher than if you had never rebalanced, or $2,100 on your original $100,000 portfolio. The math works in your favor this way with any asset allocation in which assets have different returns in different years. It also works just as well with more than two types of assets.
A screenshot of the spreadsheet I used for calculations
I’d like to list a few more important points about rebalancing, why it works, and also some caveats.
First, the act of regular rebalancing forces you to “Buy-low, Sell-high,” at least on a relative basis. Whichever asset class has outperformed the others will be the one you sell (high) and whichever asset class has underperformed will be the one you buy (low).
Second, while regular rebalancing makes sense, I doubt it makes sense to do this more than once a year. If you have a taxable account (a non-retirement account) then the tax costs of selling winners may outweigh the benefits. Also, frequent trading is always a mistake, so rebalance with moderation.
Third, because of point number two, if it’s possible for you, the best way to rebalance is not through selling existing investments, but rather through new investments. If you regularly contribute to an investment account, you can ‘rebalance’ your portfolio without tax consequences by simply purchasing more of whatever has become underweighted in your portfolio. This has the happy effect of allowing you to buy (relatively) low with your new investments, rather than to do what everybody else does, which is chase whatever hot sector has recently outperformed.
This may seem super-duper obvious and it is indeed super-duper easy to do.
But!
Most people don’t do it. After Year 1 of losing 12 percent in the stock market, for example, few people have the guts, rebalancing discipline, or a nudgy-enough financial advisor to remind them that their allocation is out of whack. Simple rebalancing will help correct that whack.
We get scared to buy something down 12 percent. After Year 2, we also have a hard time selling something that just soared 18 percent in a year. “Ride that winner!” we tell ourselves, to our later regret.
The U.S. stock market got quite volatile last week, and I couldn’t be happier.
Let me explain why, by way of the analogy of the 2011 fire at Lost Pines State Park.
Scorched earth and equity markets
Two weeks ago, I drove with my family near Lost Pines Forest, the ground zero of a devastating forest fire in 2011 that Wikipedia tells me was the most destructive wildfire in Texas history.
I had passed through Bastrop just weeks after that fire on our way to College Station, and I remember how utterly desolate the roadside forest appeared. Just a terrible vista of charred chimneys, missing their houses. Blackened trunks perched on scarred ground.
Now, however, the ecosystem is roaring back.
Fire leads to new growth
A friend of mine who teaches biology at Trinity University in San Antonio — she studies grassland ecosystems in particular — confirms what you can observe now at Lost Pines. The incredible rate of regrowth of the Lost Pines Forest happens because of the devastating fire.
In many areas, grass and forest ecosystems depend on periodic fires to remain healthy. The fire spurs growth. No fire in the past leads to less healthy growth in the future.
Regrowth of scorched earch
The forest fire stock market analogy
Just like periodic forest fires keep ecosystems healthy for grasses, plants and trees, periodic market crashes keep stock markets healthy for you and me, as long-term investors.
I credit Morgan Housel at the finance website Motley Fool for introducing me to this idea first — that stock markets must crash periodically in order to provide a decent return for the rest of us.
We typically complain, or fret, about stock market volatility. But you know what? That’s the wrong approach. The crashes help repel other people’s money from the market, which allows us long-term investors to earn a positive return.
To be perfectly clear about what I mean with my analogy: We need markets to crash periodically in order for them to “do their job” for us, which is to provide a decent positive return on our long-term surplus capital.
This positive view of market crashes — the financial equivalent of devastating wildfires — is so counterintuitive to our way of thinking and talking about the stock market that it just may alter the way you view the peripatetic ups and downs of equity markets. I hope so. That’s the point of this post.
Now, how exactly does it work that crashes and volatility are the keys to a decent positive long-term return for you, the long-term investor?
Think for a moment what the investment world would be like if stock markets always stayed stable. Zero volatility. Zero crashes. And let’s say in that stable world that stocks initially returned an average of 6 percent per year.
The only rational thing to do, with a market that provided that kind of positive return and perfect stability, would be for everyone to empty their bank accounts and pour money into the stock market. If people felt safe, they would put all their money into the stock market.
That decision by everybody would raise the price of stocks so much that future returns on stocks would decline, to something much less attractive. Given perfect stability, the market would attract as much money as it could take until future returns would approach the returns of other stable, store-of-value vehicles, like bank accounts.
Which is to say, if stocks were completely stable, we would all buy them until they offered a roughly 0 percent future return, just like bank accounts.
But the fact that you can get burned in stocks is exactly why not everybody empties out their banks accounts to bid up the prices of stocks. This relative scarcity of stock market capital leaves space for growth, like a forest that’s been cleared by a fire.
Stocks, thankfully, are not stable. People don’t feel safe. And that’s a good thing.
Do you need your money back before five years? Don’t bother with stocks. You may get burned.
The fact that people who need their money back within five years shouldn’t go anywhere near stocks — due to volatility — is part of the reason why stocks provide longer-term investors with a return above 0 percent.
Without crashes, the stock market would attract too much money. The periodic crash is therefore not a failure of markets or a glitch in the system. On the contrary, the periodic crash — like the forest fire — is a key to the whole system working correctly.
Here’s the topsy-turvy — but nevertheless true — logic of the relationship between volatility and stock market returns: Total stability would lead to “pricing for perfection,” which in turn could be destabilizing when underlying companies and the economy failed to achieve perfection. A volatile market, by contrast, stays just unattractive enough for short-term and speculative investors to allow for predictable, positive, long-term returns for long-term investors.
Long live the forest fire! Long live the volatility!
Teen romance novels for girls are not exactly the bread-and-butter of Bankers Anonymous book reviews, but stick with me for a little while, I’ve got my reasons.
Going Going by San Antonio poet and novelist Naomi Shihab Nye is not your typical teen romance novel, although it does follow the arc of a sixteen year-old downtown girl, Florrie, falling for an uptown boy.
Our heroine Florriedoes not shy away from political stances, nor does the novel Going Going. The political stance dominates the novel more than the romance.
Sixteen year-old Florrie asks us, the reader, one of life’s big questions: “What makes for a good city? Indeed her question is just another way of asking: “What makes for a good life?”
In real life, I live about 6 blocks away from the author of Going Going, so it turns out I know and love many of Florrie’s places too. Her protagonist bikes with arms outstretched down her favorite street, just as I have done, on that same street.
I picked up Nye’s Going Going (at San Antonio’s homegrown The Twig Book Shop) because the City of San Antonio – just like Florrie – is currently in a deep conversation with itself over “What makes for a good city?”
And Florrie has the answer, at least for her: The old mom-and-pop stores, the place-specific homegrown businesses, make for a good city. Chain businesses, by contrast, hurt the city and make life worse.
Florrie pores over old black-and-white postcards, which she collects avidly. She thrills to memories of her Lebanese immigrant grandfather, who founded the family’s Mexican restaurant. In Florrie’s statement of purpose, written for a school project, she writes about herself:
She loved Old Ladies, Elderly Men, Old Houses, Old Spoons, Old Books, Old Bowls, old Maps, Lace Curtains, Antique Bedspreads, Recipes, Remedies, Stories (but not the dumb stories about knights and battles, which did not interest her in the least), Vintage Postcards and Tintype Photographs, Doilies, Velvet Pillows, Black-and-White Movies, Rocking Chairs, and Vintage Toys, and best of all, she loved Old Buildings and Businesses run by Real People. She loved things that were Fading and Disappearing. How could she protect them in the World?
The enemy of all that she loves, Florrie writes, are “Big Business Corporations, Urban Development, and basically People with Too Many Dollar Bills.”
Florrie’s plan, which drives the story, is to organize a teenage, guerrilla-protest movement against chain stores. She enlists her family-and-friends circle in a boycott of the Wal-Marts, the Gaps, the Home Depots of San Antonio – any store not locally-owned. She then hosts a series of rallies against chain-store corporations in the city’s historic Main Plaza, later in front of a Wal-Mart, and finally on the touristic San Antonio River Walk, with mixed success.
In the end, the teenage activist achieves some media notice and notoriety through her protest, but not necessarily lasting change in the city.
Sympathy with Florrie
The author Naomi Nye clearly has tremendous sympathy with Florrie’s aesthetic and moral view of what makes for a good city. So do I.
Florrie is right to decry the homogenization of urban life.
Ever since the 20th Century combination of automobiles and air-conditioning made vast swaths of the American Southwest newly attractive, the cities of Texas, New Mexico, Nevada and Arizona have boomed in population.
Florrie and I don’t want this
What we’ve built – efficiently and affordably – to service these new populations are indistinguishable commercial strips filled with chain stores. Drive down any commercial-zoned highway in these Southwest cities and you’re assaulted with the same exact signage as any other highway – because it’s lined by the same exact chain stores. Their buildings look exactly like buildings in other places, their menu and service offerings fine-tuned to repeat the menu and service offerings of Anywhere, USA.
Where is the sense of place? Where is the sense of a local community?
You need to exit the main highways and turn onto the smaller streets to feel the interesting heterogeneity of locally-owned businesses. From these one-off buildings – with their store owners greeting you from behind the counter – neighborhoods and communities emerge.
San Antonio, TX – Florrie’s city, Nye’s city, my city – exploded upward in population in the past 50 years but imploded in terms of interesting cultural offerings. The blocks around the Alamo, to take the most high-profile and obvious example, are blighted with the same chain-owned Ripley’s fun-house and Rainforest Café offerings you can find in any place in the nation where tourists congregate in bored, hungry numbers.
As I’ve written before, I deeply admire Jane Jacobs’ view of successful cities, which is that a mix of the new and the old – even old shabby outdated buildings – help urban areas remain flexible and innovative.
Change in the last 10 years
Written 10 years ago and published in 2005, the interesting – maybe ironic – thing about reading Going Going in 2014 is that San Antonio has already changed quite a bit since then. The Mission Drive-In, identified in the novel as one of the last operating outdoor theatres, has since been converted to merely a visual – albeit attractive – simulacrum of itself. No more outdoor movies there.
Thousands of housing units have sprouted around Florrie’s neighborhood, utterly altering traffic flow and density in the near-downtown neighborhoods of San Antonio, and this looks to continue apace in the foreseeable future.
Going Going, among other things, is a love poem to San Antonio.[1] I thrilled to recognize many of Nye’s favorite places as my favorite places, from Liberty Bar to El Mirador, from San Fernando Cathedral, to the Rose Window at Mission San Jose.
She profiles real-live personages of Florrie’s neighborhood, like bow-tied Mike Casey on his bike, or movie rental Planet of the Tapes owner Angela pushing her baby, Wiley Francisco, in a stroller.[2]
The dangers of a museum mindset
Although I’m simpatico with Nye’s Florrie, I also found myself arguing quietly against a version of Florrie’s view in real-life San Antonio, which I’ve come to call the ‘museum mindset.’
Nye depicts Florrie as a zealot – albeit a sympathetic, spunky zealot – pushing the limits of the patience of her family and friends in the furtherance of her cause to save old buildings and locally-owned businesses.
Despite the fact that Florrie is only sixteen, she represents a deeply conservative[3] strain of thought.
Because she values old things and old ways and old technologies, her frame of reference naturally resists change. New developments, even beautiful or thoughtful or desperately needed ones, spark in her an instant nostalgia for a soon-to-be lost better age.
This deeply conservative attitude – the museum mindset – surrounds us in San Antonio, and has a big voice in the debate about the future of the city.
For every new development – and there are quite a few going on right now – there is an equal and opposite reaction of “Well there goes the uniqueness of my city,” “gentrification will naturally push out diversity,” “new businesses threaten residential life,” or “here come the Yuppies.”
I’m not in the real estate development business nor do I applaud every new change, but I’ve seen enough opposition-for-opposition’s-sake fights in the name of historic preservation to see the museum mindset as a threat to the city as well.
Preservationists sued, picketed, and went to jail to keep this 1950s-style gem from demolition
Examples of the museum mindset in San Antonio today
Five doors down from where I live, a “house-museum” somehow manages to preserve its 501c3 tax-exempt status, despite the fact that it opens to the public a mere 10 days out of the year. Except for those ten days, the building is totally empty all year, forming a hole in the neighborhood structure. It will not even open this year.[4]
The preservationist group that owns this house has a similar empty-old-house-as-museum project in Hudson Valley, New York. The board of trustees for the preservationist group that ‘runs’ the house-museum – a lawyer for Exxon Corporation and his two sisters – ran afoul of its neighbors in Hudson New York who grew tired of their house-museum charade in the Hudson Valley,[5] but so far my neighborhood in San Antonio allows it to continue.
Hudson Valley “museum house”
The building would make a lovely residential home, but for the past forty years it has been a C-grade museum instead. My best guess is this happens because of the incumbency of the museum mindset.[6]
In downtown San Antonio, this museum mindset favors preserving an old building, however decrepit, unused, or blighted, owned by the local school district, from demolition, removal, or renovation to make way for its current highest and best use. Preservationists have successfully check-mated the neighborhood school – a leading light in a struggling inner-city urban district – into eliminating green space for its kids. In order to preserve this haunted house in the school’s backyard – and ‘haunted house’ is literally how school administrators refer to this building privately – next year the kids will have zero yard space. Will teachers plan on encouraging jumping jacks next to desks in their classroom, or in between the cafeteria tables? I don’t know. I do know that blighted house will keep my kid indoors all next year, while bringing down property values all along its street.
So in my opinion the museum mindset, though helpful in fighting homogenization and strip malls, also hinders progress.
This debate in San Antonio will continue as the city figures out what makes for a good city, and what makes for a good life.
Hey kids! Want a haunted house instead of a playground?
Nye’s spunky character Florrie provides a useful answer as a starting point to the conversation, although Florrie and I would not agree on everything.
Florrie’s romance
To my pleasant surprise, Going Going does not resolve happily. The teenage Florrie does not keep the boy and live a mythical teenage romance. The relationship ends uneasily, with Florrie a little bit hurt, and a little bit wiser for the experience. Kind of like a real teenage romance.
I suppose the romance reflects unease with what Florrie’s boyfriend represents. He comes from the recognizably wealthier, sophisticated, more corporate part of town. Despite the kissing and their bike-riding adventures together, Florrie returns ultimately to the comfort of her parents, her brother, and a humble-but-more-loyal boy from her own neighborhood.
San Antonio’s debate
In growing into its adolescence over the past 50 years[7], San Antonio lost much of its unique character, a process so traumatic to its earlier roots that I don’t blame preservationists for seeking the comfort of the familiar and the loyal.
The older areas of town will struggle with this pull to a wealthier, sophisticated, and possibly more corporate future, and the conversation will not be easy. My guide in these things, Jane Jacobs, would say we need to keep some of the old buildings, but we also need to build some new. The best places, and a good life, consist of preserving a sense of history and place, while not stagnating or fetishizing the old ways. Resisting all change means stagnating and ultimately being left behind, and left out of the transforming process for urban landscapes.
I salute my neighbor Naomi Shihab Nye for adding to this conversation with Going Going.
[4] If you’d ever been inside this house museum you’d know this is no big loss to the public. I’d link to their website to give you a virtual tour, but of course, they don’t have one. That alone tells you what you need to know about their mission to serve the public. But hey! 501c3 status!
[5] From the Wikipedia entry on the Hudson Valley house owned by the same “preservationist” group that owns the house-museum five doors down from me: “Robert Perry, a Texas lawyer and friend of the family, named the trust the Perry-Gething Foundation. Local preservationists have filed complaints against Perry with the state and the Internal Revenue Service, angry that he keeps the house closed most of the year and resides in it himself for several weeks in the spring and fall. Perry responds that when he is present, the house is open by appointment. The tax code, he says, requires only that the foundation maintain the property and says nothing about it making the museum open to the public.”
[6] And possibly, Texans are more polite to their neighbors than New Yorkers.
[7] In this analogy, the creation of Hemisfair Park in 1968 kicked off the city’s adolescence with an horrific bulldozing of an historic neighborhood, to make way for the unapproachable, awkward, sullen park it is today. Here’s hoping the H-Park group will turn this ugly duckling into a swan. The presence of immovable, unused, empty, historic buildings in the park hinders rather than helps this process.
Below is the second in a series of 6 videos introducing the idea of using Excel to track your small business information. This series was created to support the educational mission of Accion Texas, a regional micro lending organization, but I hope it has value to others starting out with their own business who may not have used Excel in the past.
Do you find yourself eating your morning granola, hunched over the financial news, stopping in the middle of a paragraph, feeling your eyes glaze over as your BS-meter tilts red in 0.6 seconds, and then looking up at the window to start mumbling like a deranged person to yourself about the absurdity of that business story?
Grumpy investor reading the news!
You do?
What a coincidence, because so do I! That’s so weird! It’s like we’re twins!
Well, ok, not so weird, because you read Bankers Anonymous and you understand that’s one of our conditions – the daily, and perhaps hourly frustration with the Financial Infotainment Industrial Complex’s faulty depiction of events that affect our lives.
Why do I bring up our common condition today?
I’ll tell you why.
The Natural Gas Revolution in South Texas
I live in South Texas, where the development of fracking fields is in the process of revolutionizing energy production in the US. I believe the consequences of this process, for everything from renewable energy, to regional job creation, to potential environment liability, to geopolitical and Middle Eastern politics cannot be exaggerated.
As a result, I read what I can about business developments in my regional back yard, both in the local paper – The San Antonio Express News – and the Wall Street Journal.
The local paper’s coverage has its flaws[1], but I want to pick a fight with a story today in the Wall Street Journal. I have found that of the two papers, only the Wall Street Journal covers the Eagle Ford Shale stories from the perspective of national and international public and private equity firms, and I appreciate this, since it’s missing from my local paper.
I should also say my following rant pertains not particularly to the oil and gas or fracking industry, but rather practically any industry covered by the Financial Infotainment Industrial Complex.
What gets my goat is a quote buried in the middle of the story by “Wells Fargo energy analyst” David Tameron. Tameron says:
If you are private[2] right now and you can sell yourself, you do. If I’m a buyer and there are a lot of people who want out the door, it’s a good time to be buying.
Maybe this quote was taken out of context, and if so, I apologize to David Tameron, Wells Fargo energy analyst, for what I’m about to say.
My interpretation of Tameron
I interpret Tameron’s statement as:
“If you’re selling an oil drilling company, it’s a good time to do that. Also, if you’re buying an oil drilling company, it’s a good time to do that.”
This is an absurd ‘analysis,’ by David Tameron, Wells Fargo Energy Analyst.
Tameron’s statement goes unchallenged by the Wall Street Journal as the self-serving, churn-inducing statement that it really is.
In the real investing world – not currently occupied by either David Tameron, Wells Fargo Energy Analyst, or the Wall Street Journal reporter on this story – there are attractive times to invest $6 Billion in an oil and gas drilling company, and there are less attractive times.
Most of the time, for real investors, we can not be sure whether it’s an attractive time, or not, to be making a $6 Billion investment in an oil and gas drilling company. Because it really depends on a lot of unknowable future factors, not least of which are the future input costs and output costs for oil and gas, both of which are volatile.
Some time in the future, we may eventually know whether it was a good time to be a buyer of GeoSouthern Energy Corp for $6 Billion, or not. The answer may even change a few times in the future, again, because markets fluctuate.
From an investor’s perspective
What I do know, however, is that it’s not simultaneously a good time to buy and a good time to sell.
Wait, I need to be more specific. For investors in the transaction, it is not simultaneously both a good time to buy and a good time to sell. From an investor’s perspective, it will end up being a good time for one side, and a bad time for another side, some time in the future.
From the brokers’ and the Financial Infotainment Industrial Complex’s perspective
But the investor’s perspective is not shared by brokers or the Financial Infotainment Industrial Complex.
For financial intermediaries (brokers) who buy and sell companies – or stocks, or bonds, or currencies, or real estate – its always simultaneously a good time to buy and sell the same thing, since this is how they make money.
And for members of the Financial Infotainment Industrial Complex, of which the Wall Street Journal is among the most important and sophisticated, it’s always simultaneously a good time to buy and to sell. Because transactions create events, which in turn gives them something for them to talk about. They are not investors but rather cheerleaders.
This Eagle Ford Shale example this morning – like the several or dozens of financial transactions a day we vaguely witness passing through the peripheral transom of our financial mindshare – just reminded me of the different incentives we have when compared to the united front of brokers and the Financial Infotainment Industrial Complex.
The Financial Infotainment Industrial Complex needs to churn a story every day, that’s how they get revenue.
And brokers – represented in this example by David Tameran, Wells Fargo energy analyst – need to try to churn a transaction every day.
As consumers (victims?) of the Financial Infotainment Industrial Complex we get hit with somebody else’s strong bias – the need to constantly churn transactions.
The truth that this does not help us think straight about investing – in fact it undermines our ability to think about investing – is rarely mentioned.
You and me, I guess we know this. We are, somewhat, occasionally, immune. But what about the rest of the folks out there, fed the disturbingly wrong, the self-servingly biased line, that it’s always simultaneously a good time to be buying and selling?
Sigh. Time to finish my granola.
[1] Fine, since you asked, what’s wrong with the local paper? The local paper only covers the Eagle Ford Shale with three themes. A) Fracking = Lots of Jobs! B) We need to invest in the roads in south Texas that are being hurt by super-heavy truck traffic! C) There are plucky wild-catters trying to make money here. Of these, stories A and B are true as they go, and C is absolutely, totally, and completely misleading, since wildcatters comprise approximately 0.0001% of the activity in the Eagle Ford. As far as the other potential stories of the Eagle Ford, the local paper does not cover them. These might include: a) Environmental impacts b) The national and international businesses doing deals in South Texas, and their relationship to high-profile public and private equity firms c) Technological innovation in the fracking process in the past 10 years and d) the revolutionary impact of 90 years’ worth of affordable energy on our lives as well as on the renewable energy business.
[2] “private” in this sense meaning the fact that GeoSouthern Energy Corp is owned privately, it has no public shares outstanding.
Here’s my hypothesis[1]: The abundance of cheap domestic natural gas – what I’m calling the Natural Gas Revolution – makes “renewable” energy sources like wind and solar financially untenable, and possibly unnecessary, for the next 90 years.[2]
I can’t prove my hypothesis because energy pricing is complicated.
Figuring out the ‘price’ of energy derived from traditional fuels such as coal, natural gas, and nuclear is not as straightforward as it may seem. I’ve made an attempt based on a conversation with an official at my local utility company. But every financial assessment depends on a series of assumptions: from the future price of input fuels, to regulatory changes, to models that take into account the depreciation of assets such as a nuclear or coal plant.
We know that energy produced from nuclear and coal plants has relatively low prices, partly because, in the case of my local utility, it bore the cost of building the nuclear and coal plants long ago. As a result, we can afford that energy. We also like the price of natural gas, because both plant construction and current market prices are low.
On the other side of the ledger, my local utility in recent years added solar- and wind-derived energy to its energy portfolio, both of which cost considerably more. At a free-market price, wind power would be about 50% more expensive than natural gas energy, but a federal government Production Tax Credit (PTC)[3] brings the wind-energy price within the range of natural gas-derived energy.
Solar power is even more expensive than wind. Solar may cost three times as much per KW hour as natural gas – assuming current technology – but with a federal subsidy through tax credits,[4] solar energy can be priced at a cost about twice as expensive as natural gas.
The energy provider of my home city targets a ‘portfolio mix’ by 2020 of 20% ‘renewables’ – at this point primarily wind and solar energy.[5]
As a retail consumer, I pay 9 cents/Kilowatthour on my energy bill. This retail price reflects a blend of energy costs from the utility’s primary sources of nuclear, coal, natural gas, and renewables, plus the cost of administration and delivery to my house. The price per KWhour could be brought down, somewhat, by prioritizing energy sourcing purely on a cost basis, which would favor coal and nuclear, and increasingly – given the natural gas revolution – natural gas. Wind and solar make less sense on a pure cost basis without the federal taxpayer subsidies that make them feasible for the local utility.
My local utility has chosen to build a portfolio to include wind and solar energy; as a person with environmental sensibilities, I see the benefits of this and I feel good. In addition, from a risk-mitigation perspective, the utility wants to stay ahead of regulatory changes which may make coal production more costly[6], or periodic events that make nuclear untenable[7], or market prices that would increase the cost of energy from natural gas.
So the local utility embraced wind and solar in part as a reasonable portfolio hedge against the risk of high natural gas prices.
But the future price of natural gas, and the likely range of prices for gas[8], just shifted massively with this natural gas revolution. Folks I’ve spoken to in the natural gas sector forecast 90 years’ worth of known, accessible, cheap natural gas in shale rock formations. All of this natural gas we really had no way of bringing to market just 4 years ago.
As a result, from a purely financial perspective I fear we’re locked into paying extra for renewables in a way that makes much less sense than it did just a few years ago, before the natural gas revolution started.
Fans of renewable energy are not going to like this message, I know. In the largest sense, however, it should be seen as good news, and I’ll explain why.
It’s a huge economic boon to the entire country.
So why is cheap natural gas such good news? For the majority of consumers the natural gas revolution will benefit their pocketbooks in subtle but important ways.
A drop in the price of energy impacts the price of nearly everything, keeping goods and services cheaper than they otherwise would be. Just as expensive oil during the Oil Embargo of the 1970s kicked off a round of intense inflation, cheap natural gas will act to keep inflation contained in the future.
To ask people to throw away cheap energy and adopt expensive energy is a lot like asking everyone to throw away cheap food to consume expensive food.
The closest analogy I’ve come up with for renewable energy is the organic food movement.
Organic food works on a small scale, with a dedicated group of true-believers who eat food as an expression of their values. It’s interesting to think about, but I’m not betting on widespread adoption.
Of course I’m in favor of organic food, and I serve it to my daughters whenever I can. I’m happy to pay a little extra for the pleasant feeling of using fewer chemicals on the earth, or to support happy, free-range chickens. The vast majority of food consumers in this country, and the world for that matter, however, do not have the luxury of paying more for food today for some intangible or unvalued long term benefit, even if it ‘costs’ more in terms of health or environmental impact in the long run. The organic food movement pushes against the immutable logic of the wallet.
Similarly, renewable energy has required people to express their values through their energy consumption, paying more for something that impacts the earth less.
I’m generally in favor of renewable energy, and I would love for more things to be powered from solar and wind generated energy. Unfortunately renewable energy is a luxury, and it just became even more so with the natural gas revolution. The risk of future natural gas price spikes decreased dramatically with this revolution, making a portfolio including renewables less financially relevant than it was until recently.
Most people live in a resource-limited world, where cheap food or cheap energy is not a choice, but a necessity. In my city, San Antonio, for the 25% of residents and 30% of children who live with daily food insecurity, the organic food movement exists in a parallel, irrelevant universe.
Most people I talk to don’t seem aware that the natural gas revolution of the past 4 years has made renewable energy untenable, financially. for the next century.
I see two reasons not to mourn the financial marginalization of renewables right now.
The first is purely financial since the tax subsidies needed to close the gap between wind and solar and more ‘market-based’ energy sources such as natural gas would have to grow in the future rather than shrink.
The second is more political. This next point is more my instinct than provable fact. But here goes: Whenever you have an important business – like renewable energy – wholly dependent on government subsidies, the opportunity for power-brokering by public officials and ex-public officials becomes extremely tempting. More than tempting, it’s inevitable.
I have a real issue with ex-government employees who go out and create ‘green energy’ investment companies, which fund companies whose major source of income is government guaranteed contracts for expensive energy in the form of wind and solar. Since it’s all divorced from market prices, there’s a huge opportunity for influence peddling and government favors for former public servants.
There may be some of this going around in my city of San Antonio, but there are also big national examples of this. Yes, I’m looking at you Terry McAuliffe and your GreenTech Automotive. Most egregiously, I’m looking at you, Al Gore, and your New York Times-reported net worth over $100 million, largely built on this power-brokering technique,[9] earned in just 12 years since leaving office. I’m very sorry you weren’t president, but your way of making money since then disgusts to me.
As the gap between the cost of natural gas energy and government-subsidized renewables grows in the coming years, one of the main externalities of the renewable energy sector is the opportunity for government graft. So I’m not just concerned that we’ll pay more than necessary for energy, but I’m also convinced some of our public servants will make sure that the green energy industry pays them back handsomely for their support.
[1] I can’t prove this with data, hence it’s only a hypothesis to be tested over time. But I still think I’m right.
[2] The natural gas revolution is happening mostly in the United States right now, in the Eagle Ford area of Texas, as well as the Bakken in North Dakota, and the Marcellus Shale of the Eastern US.
[3] Created by the Federal Government’s Energy Policy Act of 1992, which allows energy providers an income tax credit of 2.2 cents/KW hour. Assuming a current natural gas energy derived price of 4 or 5 cents/KW hour, we can estimate the ‘market’ price (before PTC subsidy) of wind energy for the local utility at around 7 cents/KW hour.
[4] Solar tax credits tend to be Investment Tax Credits (ITC), providing 30% of the cost of development of a solar plant.
[5] With a minimal amount of ‘landfill’ gas supplying a third alternative source of renewables. My local utility’s published description of their mix of energy sources now and in the near future can be found here.
[6] If environmental regulation made utilities pay out of pocket for ‘carbon offsets’ for example, coal could become much more expensive.
[7] Like periodically happens, e.g. 3-Mile Island, Chernobyl, Fukushima.
[8] At the risk of stating the obvious, I believe the natural gas revolution means low natural gas prices at low volatility for decades, perfect if you’re a utility company forecasting your energy portfolio needs.
[9] No, I don’t have a breakdown between fees he’s earned on his movie, speaking fees, and his income from serving on the board of private equity firms that value his power-brokering to the ‘green-energy’ industry. Kleiner Perkins made him a partner in 2007 and it wasn’t really for his investing acumen. I just don’t think he’s rethinking the entire private equity business with his Generation Investment Management Fund, the way he describes in this WSJ Op-Ed. Instead, I think he’s probably doing the same old power-brokering that becomes available anytime a big industry becomes completely dependent on government contracts and subsidies.
A former student at Trinity sent me a Facebook message recently. He linked to an advertisement message for an investment advisory company that emphasized the importance of ‘rebalancing’ one’s investment portfolio every quarter or every year.
Teen romance novels for girls are not exactly the bread-and-butter of Bankers Anonymous book reviews, but stick with me for a little while, I’ve got my reasons.
