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Why are energy calculations suspect? Go back to my column of two weeks ago--where I stated and you agreed in our quiz that "Energy is always political." One cannot do a solid calculation on what seems to be an economic or engineering set of facts if those facts can be altered at the whim of politicians.

I once worked at a mill that had developed a fuel oil tank farm thirty-five miles away on the Mississippi River because they thought they were going to run out of natural gas (that was a bad guess as to the future--they shut it down and sold the land by 1981). In the 1990's, my consulting company did quite a bit of work as banker's engineers on mill sites where natural gas turbines and HRSGs (Heat Recovery Steam Generators) were installed. This was a good guess. In the mid-2000's, I was involved in a project where the lender demanded a hedge on natural gas in order to fund the facility--at a time when natural gas was at the highest historical price it had ever been. This was right before fracking took off. It took years and cost the mill tens of millions of dollars to get out of this bad guess.

In just the last six months Iran has come back into the oil market, the US EPA has begun really to put the squeeze on coal (Peabody Coal has filed for bankruptcy) and now we have the monstrous fire in Fort McMurray, Alberta. Who knows what this fire is going to do to long term energy consumption patterns. The only one of these items that could have been predicted with any certainty was the EPA's squeeze on coal, but what is unknown at this time is what a next president of the United States might do about this.

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In the forty-six years I have been in this industry, it seems like the latest and greatest thing in energy has happened about every six months. If your company has ROI guidelines that demand you only do projects with a return of less than three years, be aware that those guidelines are useless when it comes to energy projects. No one, and I mean no one, can tell you what energy economic conditions will exist three years from now. You can more accurately predict the demand for newsprint. If you are "down in the trenches" there is not much you can do about setting ROI guidelines, but you can certainly run several scenarios to see what might be the many possible ways energy costs can go.

So, in this column, have I merely provided a statement without an answer? I don't think so. The take away is that energy projects have to be looked at from many angles, particularly if they are a significant investment as compared to the depreciated value of the assets they serve. Don't develop a cost overhang situation that will sink the mill if you guessed wrong (and you can count on guessing wrong). This is why you have to develop several scenarios--explore not only the upside of your energy project but the downside as well.

In the project development business, we develop scenarios based on the source of funds. For equity players, we develop upside scenarios--what is the likely return on investment and what is the possible return on investment if everything goes great. For debt players, we develop downside scenarios--what can go wrong that might cause the debt not to be repaid? Debt players do not care about the upside, because they are blocked from participating in the upside under any conditions.

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Is the industry doing all it can with cheap energy and cheap money? Check out the latest edition of Strategic & Financial Arguments.

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For energy projects, act as if you are a debt lender to the project. Forget the upside; play defense, not offense.
Has any industry ever figured out how to predict energy costs? Yes--one that is totally dependent on energy costs: the airline industry. It took these companies decades, but they have developed sophisticated models to predict and hedge jet fuel costs. One, Delta Airlines, even bought a refinery to produce their own jet fuel--a decision that was derided in Forbes (21 Jan 2015), praised in the Motley Fool (27 Aug 2015) and praised in Air Transport World in October 2015.

With that, I will say this: proceed with caution when looking at energy projects. And don't forget, this is one area where I say mothball, do not dismantle, unused energy generating assets. They may be back in fashion next week.

What do you think? You may take our quiz this week to let us know your views on energy ROI calculations. It is here.

For safety this week, we are focused on saving your job. But be sure when you are crawling around those energy facilities you are focused on preserving a healthy life as well.

Be safe and we will talk next week.

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