It is certainly true that you can extract carbon from the atmosphere (at great energy expense) and split water into hydrogen and oxygen (again, at great energy expense) and then react them to produce fuel (also at a huge capital cost). But I can also use nothing more than air and water as the raw materials to produce fertilizer, pharmaceuticals, plastics, and even synthetic diamonds. The chemistry is well-understood. I can produce something like ibuprofen out of thin air — but it’s going to be costly because of the cost of the energy inputs.

Here is a way to visualize what the media reports have mostly overlooked. Think of fuel as a rock at the top of a hill. It has a lot of potential energy. Roll the rock down the hill and that potential energy is released. This is similar to burning fuel to create carbon dioxide and water. Now, if you want to turn that carbon dioxide and water back into fuel, you have to carry the rock back up the hill. That takes energy. How much? According to the laws of thermodynamics, it always takes more energy to carry that rock up the hill than you get from rolling it back down. In other words, the process is necessarily an energy sink. It is a dead certainty that more energy is required to produce this fuel than can be released by burning it.

But there are certain cases in which it could make sense to consume more energy to produce a fuel than can be obtained from its combustion. Imagine for a moment that there is a process that takes 10 units of solar energy input to crack water into 1 equivalent unit of hydrogen, which can then be burned for fuel (and which converts the hydrogen back into water in the process). Yes, this would be an energy sink, but one using a nearly limitless source of energy.

This is essentially the claim being made by Audi. By invoking “ecological power generation”, Audi is suggesting it can produce the fuel in a way that is cost effective and carbon neutral. But because the process is an energy sink (another way to say this is that the process produces net negative energy) if fossil fuels are used to generate the required energy their emissions are multiplied. In other words, using fossil fuel inputs in this process would produce more carbon dioxide emissions than just burning the inputs directly for energy.

The press release states that Audi will sell this clean fuel to the public for between 1 and 1.50 euros per liter, “dependent on the cost of renewable electricity.” Diesel in Europe is currently priced at about 1.50 euros per liter, which works out to be $6.37 per gallon at the current exchange rate. I have actually worked through the economics of the process, and even using generous assumptions the true cost of this miracle fuel is going to be at least four times the current spot price of diesel in the U.S. The phrase “dependent on the cost of renewable electricity” appears to mean “if renewable energy were really, really cheap, then we could produce cost-competitive fuel.”

So, while this is interesting research, as is often the case the hype has become disconnected from reality. For investors, it’s always important to be able to distinguish between what’s real and what’s not. Failing to do so can separate you from your hard-earned cash or, far less likely, cause you to miss out on a once-in-a-lifetime investment opportunity. In this particular case, don’t rush out to buy Audi on the basis of this research. This process won’t be displacing a drop of oil any time soon.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Chevron Spending on Borrowed Time

In comparison with Wall Street’s modest expectations, the first-quarter results reported Friday by Chevron (NYSE: CVX) looked adequate. Earnings per share excluding items easily trumped analysts’ average estimate, while production volumes rose more than 3% in a year’s time, faster than any other integrated oil giant has managed lately.

The stock dipped 2%, but kept near its lows from mid-October, when a barrel of crude still fetched more than $80.

But for all the outward trappings of normalcy, only a dramatic borrowing spree enabled the company to keep paying a dividend yielding 4% annually while investing billions more in future production.

With oil and gas prices down more than 50% in a year’s time, cash flow from operations slumped 72%. Excluding changes in working capital, as Chevron would prefer, left it down “only” 46%.

That meant that of the nearly $9.6 billion spent by Chevron on dividends and investments in the latest period, only $2.3 billion was earned. The bulk of the spending, $6.1 billion, was newly borrowed, expanding total company debt by 22% in just three months to nearly $34 billion.

Chevron simply can’t afford too many more quarters like this, no matter how “solid” in terms of operations.

The company is counting on contractor discounts and other efficiencies to cut its capital spending tab by 13% this year. This is a fraction of the cost savings being realized by the smaller U.S. shale drillers, but Chevron has much more inertia as a result of the multiple massive production projects already in progress.

Once most of these come online by 2017 the company expects to be able to cover dividends and capital spending out of operating cash flow.  In the meantime, it will continue selling assets to slow the accumulation of debt, provided it can get prices to its liking.

This forecast assumes crude averages $70 a barrel next year after $60 in 2015, which is what it’s selling for currently. A significant shortfall from those projections would place the current dividend in jeopardy. Dividend increases have been shelved until further notice in an acknowledgement of the current cash crunch.

Chevron is hardly the only producer struggling to make ends meet and slowing drilling as a result, one reason we expect higher oil prices in the long run. It’s well positioned to profit from such a move in a couple of years as high-margin production expands and spending shrinks.

But it will likely take significant further borrowing in the meantime, and investors can expect little near-term upside. For those reasons, CVX remains a Hold in the Conservative Portfolio.

                                                                                                                                               — Igor Greenwald