The government and environmentalists often reference efficiency and conservation, but necessity is the mother of invention: Simple economics has historically driven energy efficiency and conservation more than any environmental argument or government mandate. 

One of the best measures of a nation’s energy efficiency is energy intensity, a measure of energy consumption per dollar of gross domestic product (GDP). Lower energy intensity implies greater energy efficiency.

Between 1990 and 2000, a period when domestic energy prices generally fell, US energy intensity declined at an annualized rate of roughly 1.4 percent. But energy prices climbed between 2000 and 2008, and energy intensity declined at an annualized rate of over 1.8 percent. Companies became more energy efficient and innovative because the cost of using energy rose.

Countries with few domestic resources of energy–Japan being a classic case–also tend to be far more energy efficient than nations with plentiful domestic supply. Japan’s energy intensity is around 6,492 British thermal units (BTU) per US dollar of GDP compared to 8,841 BTUs in the US.

When energy prices rise, the cost of doing business increases; any firm that can reduce those costs will enjoy higher profit margins. And the higher energy prices head, the cheaper and more valuable energy efficiency and conservation initiatives become. That’s the basic economic incentive that drives innovation. With crude oil prices hovering around USD80 per barrel and likely to hit USD100 this year, investment in efficiency measures has picked up.

This publication often focuses on the business of producing more energy to meet growing demand. But sometimes it’s a good idea to step back and look at the same puzzle from a different perspective; this issue focuses on companies that are at the forefront of reducing energy consumption in key industries.

In This Issue

The Stories

Together, the transportation and industrial sectors account for around 86 percent of global oil use. I discuss the benefits of BTU substitution and explain why improving efficiency is an important investment trend. See Transportation Efficiency.

I discuss trends in the airline industry and the names that stand to benefit from spending on next-generation planes. See The Friendly Skies.

Smaller cars are only one way to increase the efficiency of passenger cars on the road. Palladium and platinum producers as well as companies levered to the production of lithium ion batteries should benefit from favorable long-term trends. See Passenger Cars.

Railroads deliver goods and passengers on time and consume less energy relative to trucks. Here are my favorite plays in the railroad industry. See Rail and Freight.

BTU arbitrage is also taking place in the petrochemical industry. Here’s how to play it. See Industrial Efficiency.

The Stocks

Spirit AeroSystems Holdings (NYSE: SPR)–Buy @ 26, Stop @ 15.75
Delta Airlines (NYSE: DAL)–Hold, Stop @ 11.85
Hexcel Corp (NYSE: HXL)–Buy @ 16 in Alternative Energy Field Bet
Titanium Metals Corp (NYSE: TIE)–Buy in How They Rate
Stillwater Mining (NYSE: SWC)–Buy in How They Rate
North American Palladium (AMEX: PAL)–Buy in How They Rate
Anglo Platinum (South Africa: AMSPP, OTC: AGPPY)–Buy in How They Rate
Ener1 (NYSE: HEV)–Buy in Alternative Energy Field Bet
Sociedad Quimica y Minera (NYSE: SQM)–Buy in How They Rate
Wabtec Corp (NYSE: WAB)–Buy in How They Rate
Alstom (Paris: ALO; OTC: AOMFF)–Buy in How They Rate
Guangshen Railway (NYSE: GSH)–Buy in How They Rate
Enterprise Products Partners (NYSE: EPD)–Buy @ 33

Transportation Efficiency

Together, the transportation and industrial sectors account for around 86 percent of global oil use.

As you can see in the pie graph below, remaining demand for liquid fuel is evenly split between electric power generation and heat in residential and commercial applications.

Source: Energy Information Administration

Of all of these uses, transportation is the most important from an oil demand perspective; natural gas, nuclear and coal are all well-established alternatives for electric power generation. In addition, coal and natural gas are both widely used in industrial applications; as I explain later in today’s issue, natural gas liquids (NGL) derived from gas will play a larger role in satisfying industrial demand in coming years.

Finally, natural gas, propane and electricity can all replace oil in residential and commercial heating demand. But the global transportation market lacks immediate and established alternatives.

Natural gas will play a larger role in meeting global transportation demand in coming years, but this market is in its infancy: Of the roughly 28 quadrillion BTUs the US transportation consumes each year, 26.8 quadrillion comes from petroleum and just 0.03 comes from compressed natural gas (CNG) burned in buses, cars and trucks. Natural gas plays a greater role in countries such as Argentina and Brazil, but these nations are tiny markets compared to the US, Western Europe and China.

Oil’s dominance of the global transportation market is the primary reason crude consistently trades at such a huge price premium to most fossil fuels. Readers often ask why natural gas is cheap relative to oil and why the long-term historical relationship between the two fuels has deteriorated in recent months (see graph below).

Source: Bloomberg

To create this graph, I converted the price of West Texas Intermediate (WTI) crude oil and UK-traded gas prices into US dollars per million British thermal units (MMBTU) to make them comparable to gas prices at the Henry Hub. For example, the current price of oil is just under USD14 per MMBTU compared to USD4.9 per MMBTU for natural gas (based on the 12-month gas strip). In other words, natural gas currently commands roughly one-third the value of oil on an energy-equivalent basis–near record levels. The average going back to the end of 1998 is a discount of less than 24 percent.

Why has the traditional pricing relationship deteriorated? The short answer is that US natural gas supply has increased substantially thanks to strong production growth from unconventional gas plays such as the Marcellus and Haynesville Shale.

But the root cause is that natural gas has yet to penetrate the transportation market; if it were possible to immediately substitute cheap natural gas for expensive oil in transport, you can bet it already would have happened on a broad scale. Wherever this substitution is possible–such as in electricity generation and petrochemical production–it’s already occurred. If this substitution were possible globally and on a large scale, the price gap between the two commodities would close.

Rising oil prices coupled with the lack of readily available substitutes raises the value of any steps a company or individual can take to reduce crude oil consumption. Here’s a look at three key transportation markets, the company’s benefiting from energy efficiency spending and how to play the trend.

The Friendly Skies

Air traffic plummeted during the 2007-09 global recession and financial crisis. Leisure air travel is highly sensitive to consumer spending; rising unemployment and falling disposable incomes prompted many consumers to stay at home or travel locally. Much the same can be said of air freight; the volume of goods shipped by air declines with consumer spending.

And declining corporate spending is a huge negative for business air travel. This is even worse news for the airlines, as business travelers are usually their most profitable customers.

The graph below tracks the year-over-year change in US revenue passenger miles, a basic measure of air traffic that encompasses passengers traveling through US airports on both domestic and international flights.

Source: Bureau of Transportation Statistics

As you can see, the recent downturn in air travel is the only period that rivals the months immediately following Sept. 11, 2001, in severity. And unlike 2001, the recovery in travel demand hasn’t been particularly robust.

That being said, passenger miles have stabilized on a year-over-year basis. Severe winter weather across much of the US likely weighed on results in January and February, but business had gradually improved heading into the weather; the industry should post consistent year-over-year growth by midyear.

Airlines have also reported a tentative recovery in business traveler volumes. In its fiscal third-quarter conference call, British Airways’ (London: BAY) management noted premium passenger volumes had rebounded on longer flights, especially in the transatlantic market. Transatlantic routes are among the busiest in the world, and business travel between London and New York dropped off during the financial crisis. Recovering demand for these flights suggests that a tentative recovery in business travel is underway.

And although recovery and stabilization are the airline industry’s bywords in the developed world, demand for air travel in emerging markets continues to grow.

Source: Bloomberg, Civil Aviation Administration of China

This graph features two different scales because China reports passenger volumes in millions and freight volumes in ton kilometers, or one metric ton of freight transported for a distance of one kilometer.

China’s air traffic volumes hiccupped slightly between late 2008 and early 2009, before recovering to new highs. This reflects a pattern I’ve written about extensively in The Energy Strategist: Emerging economies were the first to exit the global economic funk of 2007-09.

Although declining traffic was bad news for the airlines, companies that manufacture aerospace parts and equipment suffered even more. Most of the world’s airlines rely on debt and aircraft leasing arrangements to procure new aircraft. The collapse of the credit markets in the latter half of 2008 prompted many airlines to delay or cancel orders for new planes. In 2009 alone, Boeing (NYSE: BA) suffered 121 order cancellations and approved 271 aircraft deferral requests from customers.

But with business picking up again and jet fuel prices on the rise, airlines are focused on preserving or expanding profit margins. Legacy carriers are replacing older, less-efficient aircraft with lighter, modern airplanes that use significantly less fuel. Newer airlines in Asia and other high-growth markets are also adding aircraft to handle increasing demand.

Do not underestimate the importance of fuel efficiency in air transportation. Gushers Portfolio recommendation Delta Airlines’ (NYSE: DAL) total operating expenses in 2009 totaled $28.4 billion. Fuel expenses were by far the largest single operating cost center–accounting for $7.4 billion–followed by salaries and related compensation expenses of $6.8 billion. And that $7.4 billion fuel expense was actually a bit of a relief; in 2008, Delta paid $12.3 billion in fuel expenses, compared to $6.5 billion in wages and compensation.

In 1999, fuel expenses accounted for 3.9 percent of FedEx Corp’s (NYSE: FDX) total operating costs; in fiscal year 2008, fuel costs had more than tripled to 12.3 percent of total operating expenses.

Mounting evidence suggests that the aerospace cycle is turning and that airlines’ interest in more fuel-efficient planes is growing. On March 19, 2010, Boeing announced that it would step up production of both its 777 and new generation of 747 aircraft. The company plans to produce seven 777s per month, up from the prior schedule of five per month by mid-2011. Management also indicated that monthly production 747s would increase from 1.5 to two planes per month by mid-2012. Boeing has secured agreements from suppliers to accelerate production of both aircraft.

Boeing’s management believes that the airline industry will recover in 2010 and expects carriers to generate profits in 2011. This forecast suggests that demand for aircraft will likewise pick up.

Boeing’s new 747-8 aircraft replaces the 747-400 currently in service and will compete with Airbus’ jumbo A380. The new plane boasts 16 percent more cargo capacity, 17 percent lower fuel costs and 16 percent lower overall operating costs than its predecessor. These efficiencies resulted from evolutionary rather than revolutionary changes, including better engine design and a new wing shape that features swept-back tips.

Boeing’s plans to accelerate production of the 747-8 and 777 series suggest that air and freight companies have renewed interest in modernizing their fleets. It’s also worth noting that Airbus stepped up the production schedule for some of its smaller, narrow-body aircraft.

Although the A380 and 747-8 are superior to older aircraft, a truly revolutionary change in aircraft design is at hand. I am referring to Boeing’s 787 Dreamliner and some new Airbus designs that expand the use of light, ultra-strong composite components.

Composite materials are made from two basic components: a reinforcing material for strength and a matrix material that bonds the two components together. Fiberglass is one example of a popular composite material. The composites in aircraft are extremely strong, lightweight materials that use carbon fiber as a reinforcing material and replace aluminum and other metals.

Development of the 787 Dreamliner has been plagued by a series of delays and missteps. But these challenges aren’t entirely unexpected when you consider that the Dreamliner is the most revolutionary aircraft design in decades; although carbon-fiber composites have appeared in commercial and military airplanes for years, the 787 is the first to make such widespread use of the material.

For example, the Boeing 777 aircraft went into service in 1995 and consists of 12 percent composite materials and 20 percent aluminum–roughly double the composite content of its predecessor, the 767. The 787, on the other hand, consists of 50 percent composites and 20 percent aluminum.

Source: Boeing

Boeing has officially stated that the Dreamline should be roughly 20 percent more fuel-efficient than aircraft of similar size. And thanks to the plane’s new flight-control systems and the use of fewer fasteners and other components, Boeing estimates that maintenance costs could be as much as 30 percent lower than the current generation of planes.

By the time Boeing hosted its fourth-quarter conference call, the company’s two test Dreamliners had completed over 15 flights, logged 60 hours of flight time and achieved their initial airworthiness certificates. Boeing expects all six test aircraft to be flying by the end of the second quarter and plans to deliver its first 787 to a customer late in 2010. By the end of 2013, Boeing plans to be producing around 10 Dreamliners per month.

And although Boeing is the first aircraft manufacturer to make such widespread use of composites, Airbus has plans to follow suit. The company has steadily increased the composite content of its planes for years–composite materials represent 23 percent of its A380–and the planned A350 extra-wide body (XWB) is likely to be more than 50 percent composite.

The revolution in aircraft design bodes well for a number of companies that produce the materials and parts used in the next generation of fuel-efficient aircraft. Here’s a rundown of some of my favorites.

Spirit AeroSystems Holdings (NYSE: SPR) is the world’s largest independent manufacturer and supplier of commercial aircraft components. Although Boeing spun off the company in 2005, Spirit AeroSystems works closely with its former parent and Airbus under long-term supply agreements related to a specific aircraft series.

A plane’s fuselage is the body that houses the crew, passengers and freight. Spirit AeroSystems currently has contracts to supply fuselages and components for existing and next-generation aircraft. And the company will emerge as a big winner regardless of which composite aircraft gains the upper hand in the marketplace; because the company is a leader in composite fuselage and aerostructure design, the firm is a key supplier for both the Dreamline and Airbus’ A350.

The company also manufactures nacelles, the structure that surrounds aircraft engines; wings and struts that attach engines to them; and flight control surfaces such as flaps and fins. Spirit AeroSystems supplies all of these components under long-term agreements and has leveraged its experience and reputation to secure key contracts for new planes such as the 787. For these reasons, Spirit AeroSystems is the latest addition to the Gushers Portfolio and a buy under 26. Investors should put in a stop-loss order at 15.75.

I recommended Delta Airlines in 2008 as a play on falling energy prices and US air carriers’ efforts to cut capacity, idle less-efficient planes and end unprofitable routes. The airlines also managed to negotiate better compensation terms with their employees as a result of the weak environment.

I reiterated this recommendation in the spring 2009 as a play on improving demand for air travel.

As I noted when I recommended the stock, the US passenger airline business has a long history of unprofitability; most of the major carriers have declared bankruptcy multiple times. But for those willing to stomach the volatility, the group can offer outstanding returns for shareholders from time to time.

Shares of Delta Airlines have experienced a fair amount of volatility since my initial recommendation, but the stock is now up over 70 percent and has traded above my buy target price for some time. The easy money has been made; rising oil prices will become a bigger headwind in coming months.

I am cutting Delta Airlines to a hold and recommend that readers institute a stop at 11.85. If the stock sinks to the stop, we’ll have a gain of over 50 percent. Otherwise, I plan to increase the stop gradually as Delta Airlines’ share price move higher.

Hexcel Corp (NYSE: HXL) is the world’s leading manufacturer of carbon-fiber and composite materials–the inputs that Spirit AeroSystems and other manufacturers use to make aircraft components.

Hexcel is the only pure play on aircraft-grade carbon fiber and composites. Although Zoltek (NSDQ: ZOLT) produces some of the same materials, it primarily supplies industrial companies and, in particular, wind-power companies.

As I explained in Minding the Alternatives, the outlook for wind and solar power companies isn’t bullish right now. To make matters worse, these stocks were terribly over-hyped in 2009, as investors sought names that would benefit from an Obama presidency and the potential regulation of carbon dioxide emissions. I warned against investing in stocks leveraged to solar and wind power for over a year now, and these groups have underperformed traditional energy names handily. High-quality wind and solar names eventually will enjoy strong growth, but 2010 won’t be the year.

Overcapacity in the wind industry, particularly in Europe, will continue to pressure sales of carbon fiber to Vestas Wind Systems (Denmark: VWS) and Gamesa Corporacion Technologica (Spain: GAM). But Hexcel is far more leveraged to the expanded use of composite materials for aircraft manufacturing, particularly for Boeing’s Dreamliner.

Already a member of the Alternative Energy Field Bet (see the Dec. 23, 2009, issue), Hexcel Corp rates a buy under 16.

Titanium Metals Corp (NYSE: TIE) is one of the world’s leading integrated suppliers of titanium, boasting operations at all levels of the supply chain–from titanium sponge, the basic raw material, to titanium ingots and milled products. Roughly two-thirds of the firm’s sales are to the commercial aerospace sector.

Boeing’s Dreamliner aircraft contains a sizable amount of titanium; expanded use of composite materials tends to require more titanium. Titanium has a high strength-to-weight ratio and performs well at high temperatures–highly desirable characteristics for the aerospace industry.

The oil and gas industry is home to another emerging application for titanium, chiefly in deepwater drilling. As I explained at some length in the Oct. 7, 2009, issue of The Energy Strategist, The Golden Triangle, pressures and temperatures encountered in deepwater oil and gas fields are extreme–titanium has what it takes to hold up in these conditions. I’m initiating coverage of Titanium Metals Corp as a buy in How They Rate.

Passenger Cars

The cheapest way to increase fuel efficiency in passenger cars and other light-duty vehicles (LDVs) is to increase the number of, smaller more fuel-efficient cars on the road. Crude oil prices are a major driver of car-buying patterns. For example, when retail gasoline prices soared above $4 per gallon in the US in summer 2008, sales of trucks and sport utility vehicles plummeted while sales smaller cars soared.

An acquaintance of mine buys and sells used cars at auction in the Washington, DC area. He indicated to me in the summer of 2008 that sport-utility vehicles (SUV) were tough to move and often sold at discounts, whereas smaller cars such as Toyota Corollas and Honda Civics were easy to sell and fetched strong prices. Although this anecdotal evidence hardly constitutes a scientific survey, this is a sure sign that record oil prices were encouraging conservation and efficiency.

Diesel fuel is another beneficiary of the search for efficiency in passenger cars. Diesel-powered vehicles get as much as 40 percent more miles per gallon compared to similar-sized gasoline engines. Moreover, with the advent of turbo direct injection, diesel cars offer performance that’s comparable to or better than equivalent gasoline engines.

In the US, diesel has never been a popular fuel for passenger cars and currently accounts for less than 2 percent of the market. However, other modes of transport such as freight rail and trucks use diesel extensively.

The US Energy Information Administration (EIA) projects that diesel will grow in importance in coming years.


Source: EIA

This graph depicts the EIA’s estimates for how much gasoline and distillates (mainly diesel) the US transportation will consume. As you can see, the group expects gasoline consumption to decline and projects demand for diesel to pick up. The EIA assumes that diesel-powered vehicles will increase from 1.7 percent of total LDV sales in 2007 to around 10 percent by 2030.

And regardless of what happens in the US, diesel is a key fuel in international markets. In Europe, diesel-powered vehicles accounted for less than 30 percent of LDV sales in the late 1990s and more than 50 percent by the end of the last decade. And diesel remains the most important crude-derived fuel in China and India, the world’s fastest-growing major oil consumers.

Source: BP Statistical Review of World Energy 2009

This graph divides Chinese fuel consumption by light distillates, middle distillates and fuel oil. Light distillates would consist primarily of gasoline and some aviation fuels; middle distillates would include diesel and heating oil; and fuel oils would include marine bunker fuels.

Two trends are evident in this graph: Chinese oil demand is soaring, and middle distillates account for much of this growth.

There aren’t many direct plays on increasing global use of diesel fuel. But investors should keep their eyes on companies involved in platinum group metals (PGM), particularly platinum and palladium. These names are a play not only on rising demand for diesel but on stricter global environmental standards for both diesel and gasoline engines.

Catalytic converters used in the automobile industry are the largest single source of demand for palladium and one of the two top sources of demand for platinum, the other being jewelry demand. Modern three-way catalytic converters are so named because they’re designed to control three different types of emission: carbon monoxide, volatile organic compounds (basically un-combusted hydrocarbons) and nitrous oxide. Platinum and palladium are catalysts in the process of removing these harmful pollutants.

Generally speaking, palladium is considered the better catalyst for use in gasoline-powered engines because it works well at higher temperatures. Platinum usually features in diesel engines because it’s a more effective catalyst at lower operating temperatures. But these generalizations aren’t necessarily set in stone; technological advancements have made it practical to use palladium in some diesel applications as well. This substitution is likely to continue wherever possible; palladium is cheaper than platinum.

This nuance is somewhat less important for investors, as PGMs–including platinum, palladium, rhodium and ruthenium–typically occur together naturally; companies that produce platinum also tend to produce palladium.

Two other trends support demand for PGMs. For one, global demand for automobiles should enjoy a cyclical recovery following the vicious 2007-09 recession. As I’ve explained in previous issues of The Energy Strategist, sales of automobiles in emerging markets like China and India remain robust after a brief slowdown in late 2008. In fact, by the end of 2009 China surpassed the US to become the world’s largest car market.

But don’t underestimate the cyclical recovery in the US auto market from depressed conditions. The graph below provides a closer look.

Source: Bloomberg

Although this data includes plenty of noise, the broader trends are clear. US car sales collapsed from over 16 million annualized units in late 2007 to less than 10 million units in early 2009.

The spike in sales that occurred last summer is largely due to the US government’s Cash for Clunkers program, a stimulus measure that allowed consumers to trade in older, less-efficient cars for inflated amounts and apply the proceeds to the purchase of newer vehicles. These big subsidies encouraged demand, effectively borrowing auto sales from the future.

Sales again slumped in September 2009 after the subsidy expired. This decline may have been exacerbated by buyers who accelerated their purchases to take advantage of Cash for Clunkers.

But note how car sales improved slowly but steadily in the months leading up to the Cash for Clunkers program. Sales showed signs of improvement through January 2010, when annualized sales reaching their highest levels in over a year. Sales slipped a bit in February due to severe winter weather across much of the US. But even accounting for a vicious winter, US car sales remain well off their lows and are showing signs of a rebound.

The second catalyst for PGMs is the introduction of two exchange-traded funds (ETFs)–ETFS Physical Platinum Shares (NYSE: PPLT) and ETFS Physical Palladium Shares (NYSE: PALL)–both of which are designed to track the prices of their respective metals. Both ETFs buy the targeted commodity and make it easier for individual investors to play these markets, which pushes up demand–at least in the short term.

Although both platinum and palladium prices are up considerably since late 2008 and early 2009, price appreciation slowed earlier this year when investors took profits in both metals. That being said, the metals enjoy a lot of short- and longer-term upside catalysts. It’s hard to call the charts of either commodity anything but a steady uptrend.

Source: Bloomberg

Stillwater Mining (NYSE: SWC) and North American Palladium (AMEX: PAL) are two ways to play PGMs.

Stillwater Mining extracts and sells PGMs from mines in south-central Montana, in addition to recycling PGMs from spent catalytic converters. The firm is the largest North American producer.

Roughly 80 percent of Stillwater’s palladium production is sold under a long-term contract to Ford Motor Company (NYSE: F) that provided for price floors and caps on the metal, but this agreement expires next year. A long-term contract with General Motors accounted for about 20 percent of the firm’s palladium production, though this contract was terminated last year when the automaker declared bankruptcy.

But with PGM prices on the rise and other producers experiencing disruptions, Stillwater may fare better selling its PGMs on the spot market or negotiating better terms with auto producers. Stillwater is a pure play on strengthening PGM prices and, in particular, on the palladium market. For now, Stillwater Mining is a buy in How They Rate.

North American Palladium mines PGMs from the Lac des Iles mine in northern Ontario, Canada. The company also mines gold from the Sleeping Giant Gold Mine in Quebec.

The company suspended mining operations in late 2008 due to terrible PGM pricing conditions but decided to do a limited restart in late 2009. Lac des Iles should begin ramping up production again at some point in the coming quarter.

The company has been doing some exploratory drilling at both Lac des Iles and Sleeping Giant and should announce results in the second quarter–another potential catalyst. Given the amount of activity underway, such an announcement would likely increase the company’s estimated reserves and eliminate a key cloud hanging over the stock–some analysts fret over the company’s ability to maintain production at planned rates over the long term. North American Palladium is a high-risk play, but I’ll track it as a buy in my How They Rate coverage universe.

At this point, some readers are likely wondering why I haven’t mentioned South Africa, the world’s dominant producer of PGMs. South Africa and Russia produce roughly the same quantity of palladium annually; together the two countries account for three-quarters of global supply. South Africa alone produces about 70 percent of the world’s platinum.

South African operators face several challenges that will restrain production. First, high power costs and widespread outages have plagued the nation in recent years. South Africa didn’t build enough power plants to meet the needs of its fast-growing economy and periodically cuts power to the mining industry and other industrial users. Strength in the nation’s currency has also been an obstacle in recent years, raising local producers’ costs in US dollar terms.

Anglo Platinum (South Africa: AMSPP, OTC: AGPPY) is the world’s largest producer and will benefit from rising prices despite these obstacles.

And given the importance of South African production, any loss due to power disruptions would likely cause a spike in the price of PGMs; ironically, weak production might be a good thing for the bottom line. I’ll Anglo Platinum as a Buy in How They Rate as well.

Impala Platinum Holdings (Johannesburg: IMP; OTC: IMPUY) is another big South African producer. Impala has some exposure to mines in Zimbabwe, the country famous for its hyper-inflation–not exactly something that gives an investor a great deal of confidence.

Impala might be an interesting speculation if and when Zimbabwe’s politics and economy stabilize, but for now I won’t be adding the stock to my coverage universe.

Increased use of diesel and the need for PGMs is only one part of the efficiency story when it comes to passenger cars. The potential game-changer for passenger transport is what I call “BTU arbitrage.”

As I noted earlier, oil is expensive on an energy equivalent basis because it’s the only energy source that can be used in the transport sector. But imagine if we could power our cars with electric energy or natural gas. These cheaper BTUs would reduce demand for and cost pressures from rising oil prices. In the passenger automobile market, hybrid and plug-in hybrid vehicles have substantial growth potential. Hybrid vehicles offer greater fuel efficiency because they allow for some BTU substitution; electric energy is partly substituted for energy from oil.

Although hybrids have gained in popularity in recent years, this market remains tiny; hybrid electric vehicles account for only 0.6 percent of the global automobile market, a total of around 350,000 vehicles. The plug-in hybrid electric vehicle (PHEV) market and all-electric market are even smaller; most estimates put sales of PHEVs at less than 4,000 in 2010, and sales of electric-only cars are near nil.

But these figures are projected to increase significantly in coming years. The EIA predicts that sales of plug-in electric hybrids will jump to 90,000 units annually in 2014, boosted by generous tax credits provided under the Energy Improvement and Extension Act. The EIA estimates that PHEVs will account for 2 percent of total US auto sales by 2030.

And analysts estimate that annual global sales of HEVs, PHEVs and electric vehicles will exceed 15.2 million units by 2020. Annual sales of these vehicles currently hover near 350,000; by these projections, the market is poised for eye-popping growth.

Companies involved in producing lithium ion batteries are one way to play this growth. Lithium ion batteries weigh relatively little relative to the amount of energy they’re capable of storing and they can be partially charged and discharged many times before it begins to effect performance. You may remember that first-generation mobile phones had to be discharged completely before recharging to prevent battery life from degrading.

And HEVs and PHEVs won’t be the only products that employ lithium ion batteries; the technology is common in a wide range of consumer electronics from cell phones and media players to laptop computers. The need for lightweight and long-lived batteries bodes well for demand, though electric cars would really help the industry take off. The graph below tells the tale.

Source: Credit Suisse

Analysts forecast that demand for lithium ion batteries will grow the fastest over the next five to 10 years thanks to aggressive subsidies for HEVs and PHEVs. Growth slows as subsidies expire and battery prices decline; as mass production techniques take root, costs will drop.

This trend offers significant opportunities for investors. However, it’s important not to confuse strong percentage growth rates with investing nirvana; overcapacity can still occur in fast-growing industries. The solar and wind power industries have served as a reminder of this phenomenon in recent months.

In Minding the Alternatives, I discussed Ener1 (NYSE: HEV), the only battery company with an automobile-grade lithium ion manufacturing presence in the US. As I noted then, the stock is only for the most aggressive investors and exhibits a great deal of volatility.

Shares on Ener1 took a hit recently over near-term fears of overcapacity in the global lithium ion battery market, as it will take a while for this market to achieve scale and there are a number of producers outside the US.

Potential upside catalysts include the announcement of new deals with manufacturers to supply batteries and the announcement of a $200 to $300 million loan from the US Dept of Energy–management recently expressed confidence that the loan would come through as planned. The stock remains a buy in my Alternative Energy Field Bet but should be considered a triple-or-nothing opportunity suitable only for the most aggressive investors.

For another play on growing demand for lithium ion batteries, consider Sociedad Quimica y Minera (NYSE: SQM), a Chilean producer of fertilizer and lithium carbonate.

Lithium is produced in two ways: mining ore rich in lithium or evaporating brines. Mining is an expensive and relatively energy-intensive process. Although there are few attractive lithium-rich brine deposits in the world, this is the lowest-cost means of production.

Brines rich in lithium carbonate are found in dry mountainous areas of Chile and Argentina. The brine occurs just below the surface and is pumped into pools where it’s allowed to evaporate naturally. What remains is rich in lithium and relatively easy to produce.

Sociedad Quimica y Minera’s Salar de Atacama brine mine accounts for close to one-third of the world’s lithium production capacity, and the company is one of the lowest-cost producers. The firm has an agreement with the Chilean government that gives it access to the mine through 2030.

Demand for lithium dropped in 2009 amid the global economic slump, resulting in excess lithium capacity for the first time in years–prior to the financial crisis, growing demand for batteries had kept supply and demand in a tight balance. To compensate, Sociedad Quimica y Minera and other major producers idled capacity to alleviate the overhang.

Despite that discipline, prices have continued to come under pressure; the Chilean firm has cut prices to maintain market share. The supply and demand equation balance should tighten steadily in coming years with strong demand growth offset by planned increases in global capacity. In such environments, the lowest-cost producers generally prevail, as they’re able to maintain margins in weak markets and reinvest profits to scale up capacity and meet demand in stronger markets.

Operations were undamaged by the recent earthquakes in Chile. I’ll begin tracking Sociedad Quimica y Minera in How They Rate as a buy.

Rail and Freight

I won’t spill too much ink writing about rail as it has been a longstanding and ongoing theme in The Energy Strategist. Suffice it to say that the average train can carry a ton of freight 450 miles on a single gallon of diesel fuel, making rail about four times more fuel- efficient than freight trucking.

On-time delivery is another issue. Given the increasing congestion on US roadways and recent investments in improved railway capacity, rails have an easier time moving goods over long distances in a timely manner. As a result, freight rail has been taking market share from trucking in recent years–a trend I expect to continue.

From a cyclical perspective, US rail carloads collapsed between 2007 and 2009, but that trend has been reversing. The most recent weekly data from the Association of American Railroads shows total carloads up 3.2 percent compared to a year ago and 13 of 19 carload categories posted year-over-year gains. Even coal, a category expected to be weak–see Feb. 3, 2010, issue, Earning Their Keep–has held up better than anticipated. This bodes well for first-quarter earnings.

I wrote extensively about the rails in the Feb. 3 issue and am looking at both West Coast outfit Union-Pacific Corp (NYSE: UNP) and East Coast leader CSX Corp (NYSE: CSX) as potential additions to the model Portfolios as a play on the recovery in traffic.

Passenger rail also shows promise. Ridership on metro and passenger rail systems worldwide soared in 2008 amid high energy prices. Passenger rail systems in Tokyo metro, New York City and London all reported record traffic in mid-2008. Most metro travel is employment-related, so traffic has fallen a bit–but far less than many had expected.

Meanwhile, traffic in emerging markets continues to grow, and governments are spending billions to encourage passenger rail in both the developed and developing world.

Three plays to watch are Wabtec Corp (NYSE: WAB), Alstom (Paris: ALO; OTC: AOMFF) and Guangshen Railway (NYSE: GSH). All three have been profiled in The Energy Strategist before, but here’s a recap.

Westinghouse Air Brake Technologies, now known as Wabtec Corp, manufactures components and equipment used on both passenger and freight railroads. Its product lineup includes railway braking equipment, door assemblies, gears, air compressors, positive train control (PTC) systems and other railway electronics.

In 2009, 42 percent of Wabtec’s total revenue came from the freight side of the business, two-thirds of which is generated by US operations. Sales of after-market parts are another important business line and constitute two-thirds of the company’s freight revenue. Given weak freight volumes, the big US railroads put around one-third of their locomotives and railcars into storage, reducing demand for both new equipment and replacement parts.

But stored railcars are returning to the rails as traffic improves; Wabtec’s after-market parts business will recover gradually.

The government mandates that all railroads install PTC equipment on their cars by the end of 2015. PTC equipment monitors the position of railcars and automatically applies the brakes if trains get too close together. Wabtec is the only supplier with a PTC product approved by the Federal Railroad Administration (FRA) and expects orders to ramp up in 2011.

The passenger rail side of Wabtec’s business has held up better than freight amid the recent downturn, driven largely by government spending on transit rail systems.  Several transit systems plan further expansions for 2010, including Miami and Washington, DC.

And the US federal government has allocated about $8 billion for spending on high-speed rail and received proposals for more than 200 projects with a total price tag of $100 billion competing for that funding. Many of the projects are for upgrades to existing infrastructure; Wabtec, as a supplier of parts and equipment, has opportunities to take advantage.

In addition, Wabtec has more international exposure on the transit side of its business–roughly half of sales come from outside North America. The company has three separate joint ventures in China and is expanding its manufacturing operations in India to take advantage of local demand. Wabtec Corp rates a buy in How They Rate.

Alstom (Paris: ALO; OTC: AOMFF) is the company behind the Train à Grand Vitesse (TGV), the French train system that was among the first high-speed train systems in the world, capable of running at speeds up to 175 mph. Alstom remains the world leader in high-speed trains and is developing a successor to the TGV that can reach speeds in excess of 350 mph.

In addition to high-speed trains, Alstom also manufactures locomotives and equipment for conventional train and metro systems. In most of its key markets, Alstom is either the world’s largest or second-largest competitor.

And Alstom’s market reach extends beyond France. The company recently won a 200 million euro ($275 million) contract to supply 23 trains to the Amsterdam metro system. And in early March, Alstom signed a deal to acquire a 25 percent stake in Transmashholding, Russia’s largest railway equipment manufacturing firm. The company has also designed metro systems in the US, Mexico, China and Australia.

In addition to designing and manufacturing locomotives, Alstom builds new railway lines and extensions, provides ongoing maintenance and sells train control, electronics and track signaling systems. Alstom rates a buy in How They Rate.

Guangshen Railway (NYSE: GSH) operates both passenger and freight rail services in Southern China.

The company’s main railway link is the 300-mile long Shenzhen-Guangzhou-Pingshi railway located in Guangdong Province, one of the most economically developed parts of the country. The company’s network also includes the only rail link between mainland China and Hong Kong.

Guangshen’s railway consists of four parallel track lines that allow the company to operate both freight and passenger trains. However, the primary business is passenger transport, which accounts for around 60 percent of revenue and consists of about 240 pairs–trains making a roundtrip journey–of passenger trains per day.

In recent years, Guangshen has upgraded its passenger service to include a high-speed intercity rail link between Guangzhou and Shenzhen capable of traveling at 125 miles per hour.

On the freight side of the business, Guangshen’s most important cargos include energy products, construction materials and containers. Unlike US utilities, Chinese power producers have relatively tight inventories of coal and have struggled to keep pace with China’s rapid growth in demand for power. Guangshen Railway rates a buy in How They Rate.

Industrial Efficiency

I recently penned a piece for MLP Profits discussing the BTU arbitrage underway in the petrochemical industry. Given its relevance to this week’s issue, that article is reprinted below.

MLPs and Natural Gas Liquids

Cars and airplanes don’t run on crude oil; crude must be refined into products like gasoline, diesel and jet fuel before use.

The same is true with natural gas: Raw natural gas produced from a well isn’t the same as the natural gas that you burn in your home or the gas that’s used to produce electricity in power plants. And natural gas produced in different regions of the US or different parts of the world can have varying properties, characteristics and economic value.

Natural gas, once processed and shipped to your home for use, primarily consists of methane, a simple hydrocarbon molecule that’s a single atom of carbon bonded to four hydrogen atoms (CH4). But methane doesn’t usually occur in a pure form in the nature; CH4 is normally found with other hydrocarbons and mixed with other gases.

Often, natural gas–known as associated gas–is found dissolved in crude oil. Associated gas remains dissolved as long as the oil is under geologic pressures, but as the oil is produced, it tends to bubble out of the crude. The action of natural gas bubbling out of crude aids in oil production in much the same way that carbon dioxide bubbles in your Coca-Cola or sparkling water can power the liquid out of a bottle. The oil industry refers to this action as bubble drive.

In other parts of the world, natural gas isn’t associated with oil but contains significant quantities of impurities such as carbon dioxide, water vapor, nitrogen or hydrogen sulfide that must be removed before the gas is suitable for use. The latter impurity, hydrogen sulfide, is a poisonous and highly corrosive gas; natural gas that contains a large amount of hydrogen sulfide is known as sour gas, and the removal process is known as sweetening.

Natural gas also occurs naturally with a series of hydrocarbons known collectively as natural gas liquids (NGLs). These can be differentiated by the number of hydrogen atoms they contain–for example, ethane (C2H6), propane (C3H8), butane (C4H10) and natural gasoline (C5 and higher). The table below offers a rundown of the typical composition of raw natural gas from a well.

Source: NaturalGas.org

This list is far from exhaustive; gas from different fields can have very different characteristics in terms of NGL content and composition. For example, gas from the deepwater Gulf of Mexico is typically wet or rich gas, meaning that it contains a high volume of NGLs. Meanwhile, gas produced from the Haynesville Shale is often dry gas, meaning that it is low in NGLs and high in methane content.

This is a meaningful distinction for producers. Historically, the price of a barrel of NGLs has tracked the price of crude oil more closely than the price of natural gas. When gas prices are low relative to oil–a condition that prevails today–the sale of NGLs produced from gas can offer a meaningful and often overlooked boost to profitability.

The existence of NGLs and impurities in natural gas is also of great importance for MLPs.

MLPs own natural gas treatment and dehydration plants that remove water, sulfur and nitrogen from the gas stream. And MLPs are among the largest owners of natural gas processing and fractionation facilities; processing involves the removal of NGLs from raw gas, while fractionation involves the separation of the NGL stream into distinct hydrocarbons. For example, a fractionation plant would isolate and separate the ethane, butane and propane in the NGLs stream for individual sale.

Finally, NGLs are transported via dedicated pipelines and stored separately from natural gas. NGLs can also be liquefied into liquefied petroleum gas (LPG), loaded onto ships and exported abroad or to other parts of the country. MLPs own significant NGL transport, storage and export infrastructure.

The Shale Opportunity

In the Dec. 18, 2009, issue of MLP Profits, Shale Infrastructure, we explained how the boom in gas production from unconventional natural gas plays is opening up attractive growth opportunities for MLPs in a number of areas. One such opportunity is the construction of pipelines to transport gas out of fast-growing unconventional plays such as the Haynesville Shale of Louisiana.

But the build-out of natural gas treatment, processing and fractionation infrastructure is just as important. As I explained earlier, the composition of raw gas from different regions differs widely.

Source: “Compositional Variety Complicate Processing Plans for US Shale Gas,” Oil & Gas Journal, March 9, 2009, pp. 50-55.

The table details the composition of multiple wells for both the Marcellus and Barnett shale plays and a single “average” level for the Haynesville, listing the percentage of methane and a handful of key NGLs and common impurities.

The Marcellus Shale is located in Pennsylvania and West Virginia; the Barnett is located near Fort Worth, Texas; and the Haynesville is located in Louisiana and across the border into east Texas. At the time this data was compiled, the Haynesville Shale was still relatively early in its development compared to the Marcellus and Barnett. Since then, the Haynesville has become one of the hottest and fastest-growing gas plays in the country.

In the case of both the Marcellus and Barnett Shale, the composition of gas from wells varies widely between different parts of the play. In both areas, the gas is drier on the eastern side of the play and richer in NGLs in the western reaches. The major difference between the Marcellus and Barnett Shale wells listed is that the Marcellus wells have a lower concentration of impurities such as carbon dioxide and nitrogen. Thus, Marcellus gas wouldn’t require much treatment but does require processing to remove NGLs.

In addition, natural gas from conventional gas fields in Appalachia is extremely dry; historically, these wells haven’t required much treatment or processing. Because gas from the Marcellus is high in NGL content, the area requires the construction of substantial processing and related infrastructure.

The average Haynesville well consists of dry gas, though it’s relatively high in carbon dioxide; it would require treating to remove CO2. Comments from some producers suggest that wells in certain areas, particularly east Texas, have higher NGL content.

Just as it’s important to build gathering systems to collect gas in emerging shale plays and pipelines to move that gas to market, producing these areas also necessitate the construction of additional processing, treatment and fractionation infrastructure. This build-out is already underway in several parts of the country, and MLPs are leading the charge.

Processing and Fractionation

The economics of the processing, treating and fractionation business depend on commodity prices. Most MLPs in the industry have fee-based arrangements with producers that guarantee some revenues even when processing economics aren’t attractive. And most use extensive financial hedging to shield against near-term swings in oil, gas and NGLs pricing.

Nonetheless, MLPs involved in these businesses have varying degrees of exposure to processing economics; it’s important to understand the trends underway if you’re going to invest in the group.

One of the most useful price relationships to keep in mind is the ratio of natural gas prices to crude oil. We’ve published this chart before in MLP Profits, but here’s another look.

Source: Bloomberg

To create this graph, I converted oil prices from their traditional quotation of dollar per barrel ($/bbl) to dollars per million British Thermal Units ($/MMBTU). In this way, crude oil prices can be compared directly to natural gas prices. I then divided the price of oil per MMBTU by the price of gas. A ratio of 2-to-1, for example, means that oil costs twice as much per BTU as a BTU from natural gas. 

As you can see, the current price of oil is close to three times that of natural gas on an energy equivalent basis. This is a near-record level for this ratio.

Why is this important? The price of a barrel of NGLs has traditionally tracked the price of a barrel of crude more closely than it has natural gas prices. Accordingly, when crude oil prices are high relative to gas, NGL prices are likely high relative to gas; in such an environment processing and fractionation services would be in high demand, as companies seek to maximize their NGL output and take advantage of those high prices.

MLPs can be compensated for their processing services in a number of different ways.

Under fee-based contracts, a processor receives a straight fee based on the volumes of gas it processes. In this instance, there’s little direct exposure to processing margins, but demand for gas processing can drop when NGL prices are low. That’s because companies don’t have to remove all of the NGLs and impurities in the gas stream; they only have to remove enough NGL content to comply with pipeline requirements.

In addition, one way to make wet gas compliant with pipeline standards is to blend it with dry gas, diluting the NGL content; when NGL prices are low, volumes of gas processed can still drop. Nevertheless, fee-based deals are considered the least commodity-sensitive type of processing contract.

Under keep-whole deals the producer sends a certain amount of natural gas to the processor, and that gas contains a certain amount of energy on a British Thermal Unit (BTU) basis. Some of those BTUs are in the form of natural gas (methane), while others are locked up in NGLs that are part of the gas stream. 

With keep-whole contracts, the processor accepts natural gas from the producer but retains title to the NGLs it removes from the gas stream. In exchange, the processor gives the producer the value of natural gas with the same BTU content as the original raw gas. For example, assume a producer sends a processor 2 million BTUs of gas consisting of 1.5 million BTUs of natural gas and 0.5 million BTUs worth of NGLs. Under a keep-whole arrangement, the producer would retain the value of 2 million BTUs of pure natural gas, and the processor would own and sell any NGLs removed.

When the price of NGLs is high relative to the price of gas, keep-whole deals generate significant margins for the processor. That’s because the value of the NGLs they keep is worth more than the natural gas they return to the producer.

In percent of proceeds (POP) contracts, raw natural gas is processed and the resulting gas and NGLs sold. The producer and processor agree on how to divvy up total proceeds of NGLs and gas. For example, the producer might accept 80 percent of the total value of the gas and NGLs sold and pay the processor 20 percent for performing its services.

Under POP deals, processors benefit from higher gas and NGLs prices; the processor is less interested in the relative values of gas and NGLs–the total value of the products is key.

Most MLPs mix and match these different types of contracts to limit their commodity exposure, but under all of these arrangements, a high crude-to-gas ratio is desirable.

The price of NGLs tends to track crude in a normal environment; the relationship traditionally has been so tight that processors have routinely used crude oil futures, swaps and options as a proxy for NGLs when hedging their exposure. But as every investor knows, the past 18 months have been far from normal. The graph below provides a closer look.

Source: Bloomberg

This graph tracks the price of a barrel of crude oil and NGLs since late 2004. The latter price is based on a common mixture of ethane, propane and butane. 

Note that the graph uses two different scales to illustrate the tight relationship between the two commodities; this does not mean the prices are identical, but that they are closely correlated over time.

At present, the price of a barrel of NGLs is worth just under 60 percent what a barrel of crude oil is worth. The long-term average is around 62 to 63 percent; the current crude oil to NGL ratio is at a normal, healthy level.

But in late 2008 and early 2009, this relationship broke down on a few occasions. The lowest recorded ratio occurred in October 2008, when the price of a barrel of NGLs sank to 45 percent of the price of a barrel of crude–perhaps a product of weak demand for NGLs from the petrochemical industry.

It’s clear that the ratio of oil to gas prices is now favorable and the ratio of NGLs to oil prices has reverted to traditional levels–great news for MLPs involved in gas processing and fractionation.

These fundamentals are consistent with the bullish comments that Enterprise Products Partners’ (NYSE: EPD) management made concerning its fractionation and NGLs business during its recent conference call. We discussed those comments at length in the Feb. 26, 2010, issue of MLP Profits, Distribution Upside. To summarize, management noted that demand for ethane from petrochemicals producers remains strong and that inventories of propane and other NGLs are relatively low.

In addition, check out the graph below for a look at export demand.

Source: Energy Infromation Administration

In its conference call, Enterprise noted strong demand for exports of NGLs in the form of liquefied petroleum gas. Data from the US Energy Information Administration (EIA) indicates that, at least through December, demand for NGLx exports from the US has been near historic highs. Strong domestic and export demand for NGLs is good news for pricing–and for the economics of any MLPs involved with the NGL supply chain.

How to Play It

Many MLPs have some exposure to processing and NGLs supply, but only a few names offer significant leverage.

Enterprise Products Partners (NYSE: EPD) is one of the largest players at all levels of the NGL supply chain, from processing to NGL marketing. As we noted in Distribution Upside, this segment of Enterprise’s business was the key to Enterprise’s better-than -expected performance in the fourth quarter.

Although exposure to processing and fractionation would normally mean significant commodity sensitivity, Enterprise Products Partners is an exception. That’s because partnership favors a conservative mix of processing and fractionation contracts with a heavy fee-based component. And after last year’s acquisition of TEPPCO diversified Enterprise Products Partners’ operations; when processing margins are weak, it has plenty of other business lines to pick up the proverbial slack. Buy Enterprise Products Partners up to 33.