In this episode of Industry Focus: Energy, host Nick Sciple chats with Motley Fool contributor Jason Hall about the renewable energy industry. Coal is being replaced by renewable energy sources, but the industry is facing some challenges. They also discuss some investment opportunities in the space and much more.
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This video was recorded on Aug. 20, 2020.
Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. Today, we're continuing our exploration of the renewable energy industry. Interestingly enough, with a look at coal. We'll have to see what the final numbers come in this year, but it looks like this year will be the first year where renewable energy production in the United States overtakes electricity energy generated via coal power plants. We'll discuss what this says about the investment opportunities available in renewable energy today, and Jason will share his elevator pitch for Vestas Wind Systems.
My guest today, as I just mentioned, is Motley Fool contributor Jason Hall. Jason, welcome back on the show.
Jason Hall: It's always great to be on with you, Nick. I know we're not going to have a lot of time to talk about football, but I'm sure we'll work in a line or two. Give us an opportunity, we'll find it.
Sciple: [laughs] We'll find a way to get into it. But, yeah, as we talk about renewable energy, obviously, people are very excited about investing in renewable energy right now. If you look at estimates from the U.S. Energy Information Administration, energy use worldwide is expected to grow by about 50% by 2050. That's a lot, but if you annualize that out, that's only about 1% a year or so. So, when you're investing in renewable energy production today, you really need to be making a bet on renewables taking share. And if you look at the variety of energy generation that's losing share today, that's coal. So, really, if you're buying renewable energy today, you're kind of making an implicit bet against coal.
As I mentioned off the top of the show, this year is the first time that the EIA is projecting renewable energy production will overtake coal. Jason, just high level, what has been behind this fall in coal's share in energy production in the U.S.?
Hall: So, I think there's really three things that are driving it. So, No. 1 is really cost. I mean, that kind of underpins a lot of it. So, it's not really -- don't think renewables are competing directly against coal. Energy producers look at this entire spectrum of how they can generate electricity in the most cost-effective manner, right. And the reality is that, natural gas in the United States, our access to natural gas has grown enormously over the past decade and change. And natural gas power generation costs have fallen dramatically. The technology has gotten better. And natural gases have really started to chew into coal, at a point where I think we've seen coal plants starting to get retired 10, 20 years ahead of schedule, just because we have so much natural gas and it's so cheap. So, that's essentially the big thing that's driving the closure of coal generation in North America.
Sciple: Right. I mean, that's an important point to note, as we hear a lot about, the Green New Deal and economics and incentives for renewable energy. But even without some of those things in place that a lot of advocates would like to see, the economics alone are making a lot of this transition take place. As you say, hydraulic fracturing, all that sort of thing has enabled an 80% increase in U.S. natural gas production since 2006, and a 50% decrease in price.
Then you look at renewable energy, as I was preparing for this show, I came across what's called Swanson's law which is a derivative of Wright's law. It's a fundamental effect you'll see in economics. And this is the observation that the price of solar photovoltaic modules tends to drop 20% for every doubling of cumulative volume shipped. And so, obviously, we've seen over the past 10 years massive ramp-ups in production of solar. Just since 2016, solar generation is up over 100%. So, as those scale advantages kick in, the cost of solar is getting cheaper and cheaper.
And as you mentioned, coal is a 100-year-old industry, so there's really not that much more efficiency to squeeze out of that technology, as well as there is a little bit of a slippery slope mentality that as more and more coal plants are retired, the economics of mining for coal, which is an operating leverage-type business with a lot of fixed costs, those economics get worse and worse and worse the quicker this coal decline accelerates.
Hall: Well, and the cheap coal has already been dug out of the ground, right; that's another factor. So, you think about, there's only so many more technical advantages that coal producers can find. Automation is a big thing that's already in play. The industry employs a bare fraction of the people it did at its peak. And yeah, the demand is falling. So, it's just the technical ability to, on top of the loss of scale, is huge. And on the other side of that, you have renewables. Yeah, sure, let's not beat around the bush. Subsidies have certainly played -- tax credits have certainly played a big benefit in the acceleration. But the industry is far more mature, and it's gained from additional scale. And this is solar and wind both; they've gained a lot from adding massive manufacturing capacity and scale that has helped drive those costs down enormously. So, I think that's a really important factor to look at, too, is, it's simply getting to a point now where it's cost effective to bring alternatives in, renewables in, in addition to natural gas. They're competitive now.
Sciple: Right. I think we're at an inflection point, I think, from an economic point of- view. And I think, you know we mentioned subsidies, aren't fully driving what's going on, I think an important stakeholder group to consider is investors. I think that we're, kind of, reaching an inflection point among investors on this willingness to invest in these types of companies. We've seen this rise of ESG investing more and more types of institutional companies pushing these large businesses to get out of these polluting subsectors. So, one example is BHP Group, formerly known as BHP Billiton; that's ticker BBL, one of the largest miners in the world, announced this past week they're going to exit some of their investments in thermal coal, as well as divest some of their other coal-related investments after being urged to by investors. And so, you combine these dynamics in the industry for coal, that it's already less economic, there are factors that as coal utilization rates of plants go away, it becomes even less economic. You've got volumes ramping up of renewables that are reducing costs there. And then finally, it's really difficult to find a constituency of investors if you are a coal or one of these hydrocarbon-producing companies, which limits your access to capital and limits your ability to grow.
On the other side, we've seen massive performance from a lot of these renewable energy stocks this year, which lowers their cost of capital and lets them be more competitive. So, a lot of these factors are all working together to make it very, very difficult for coal.
So, I think one important thing to note though, is, all right, renewables are cost competitive with coal, which has traditionally been a significant source of energy production. Natural gas is cheap, but as the years go on renewables get more and more competitive there. But we can't go all-in completely on renewable, though, Jason. And we saw some news just this past week as well about rolling blackouts in California, seeing their first rolling blackouts since 2001, which was related to the Enron debacle, for folks who are -- some trivia stuff there. Jason, you live in California, what's been behind these issues? Which actually comes back to renewable energy, when you look at it.
Hall: Right, they do. Actually, we have a colleague that's temporarily living a few hours north of me, due to the birth of his son. And they have a newborn kid and they're subjected to these rolling blackouts. They lost power for several hours. And the short version is, I think it gets to the massive -- you know, California has been a real leader in pushing the grid to renewables. And that's great, except that state actually imports a fairly substantial amount of electricity, especially during peak demand periods. And a lot of that power that's getting imported is running off of hydrocarbon plants; so, coal or gas plants in neighboring states.
The challenge has been that we're at this point right now where we have this massive heat wave going on that's rolling across the West for the past couple of weeks. And what happens, you have the duck curves. So, I encourage people to Google the duck curve and check out this thing that shows how, you're kind of at the end of the day, right about dusk, the grid demand is actually, kind of, at its highest point, right, because there's still lots of economic activity going on, but people are also going home and they're kicking the air conditioner on the home and they're turning on the TV and the stove and all this stuff is happening, right? So, grid demand is actually really, really high, kind of, right at dusk, which is right when solar falls off; you lose that capacity. And because of all of this demand that was happening across all of our neighboring states, you know, [laughs] we had to have rolling blackouts just because there wasn't enough capacity to be acquired to power everything. So, it's kind of a Third-World effect of this leading the charge in renewables.
But this underpins what has continued to be the biggest challenge for renewables, and that's the ability to meet 24/7 demand, right? The ability to baseload, as they say, across the entire power demand spectrum.
Sciple: Right. I mean, these constraints that are in place, you know, that's a little bit of a pun, but it's not as simple as flipping a switch, there's no magic bullet here, all these things, kind of, have to play together. And one of the things noted, so that study that came out that gave us some of the background on what has caused these blackouts was from the California grid operator CAISO [California Independent System Operator] and some analysts from Wood Mackenzie, and they had talked about, how there's still a shortage of grid-scale battery storage capacity. Over time, if we can build out a battery scale that solves some of this intermittency problem, I think it's worth noting that that's a real constraint on the speed with which we can accelerate renewable energy generation.
Now, this is a very niche situation. There's this big heatwave in the Southwest, but the quicker or the more dependent that our grid becomes on intermittent energy, like wind and solar, the higher there is a risk of these sorts of things taking place whenever there is unexpected surges in demand; particularly just given the way those things are produced.
Which is why, one other issue I wanted to bring up, which is why we're seeing, in some countries, like, India and China, still continued investment, lots and lots of continued investment in coal-fired power plants for a couple of reasons. No. 1, as Jason mentioned earlier, we've got a whole lot of natural gas in the U.S., which makes our natural gas prices significantly lower than the rest of the world. In a perfect world, you'd like to use natural gas because it's cleaner, you can turn it on and off faster, it's just economically better from a lot of perspectives. But not everybody has the amount of natural gas supplies the U.S. has, and so coal is a little bit more readily available.
Then No. 2, the point that we mentioned earlier about the duck curve; you have to align your production with demand. So, while we're still seeing these issues, we're still seeing renewable energy become more and more competitive with coal, we're not going to see coal totally disappear from the market. And whenever you hear these types of things, there's underinvestment in an area because of constraints on capital flowing to it. A lot of people, that are value type investors, Jason, might have their antennas going off saying, hey, is there going to be a value play in these companies, these coal companies left over? There'll still be some role in the market for some period of time, that last puff of the cigar butt, that you might be able to go get out of these coal companies. I know there's been a lot of value investors who've talked about this sector over the last several years. What do you say to our listeners who think, hmm, maybe there's some value here in coal?
Hall: You know, I think there could be, but here's the real challenge. So, the coal industry is, even if you think about India and some of the other developing parts of the world. And let's think about the thesis there, let's just kind of underpin it a little bit more. You know, as much as the middle class in the United States continues to struggle, and that's a generational challenge that we deal with in terms of income inequity here, on a global basis, the middle class is blowing up. I mean, it's going to grow like a billion people [laughs] over the next decade. And it's going to be in places, like, India and Africa and China that still have substantial coal reserves. And they're going to need to have cheap, reliable electricity.
So, here's the challenge with coal on a global basis. It's going to continue to be in decline, because like Nick and I were talking about, Nick used the term "inflection point." We're at a point where coal is just not really competitive. And renewables are going to continue to get cheaper, you know, there's a constant arms race for the wind and solar technologists to improve them to be more competitive to take market share from whoever they're competing with. So, those costs are going to continue to fall on a per watt basis.
And then you have, you know, we just briefly touched on the battery side, that we're talking about, you know, quadrupling the addressable market for renewables just as battery costs continue to fall and the global manufacturing scale grows to be able to provide those utility-scale storage. So, it's at a point now where, if I'm an electricity producer with a large [...] plant, that I'm not always -- you know, in the middle of the night, right? I have all this capacity to generate power super, duper cheap, before I build a gas peaker plant or a coal plant, to the point where I'm looking at buying batteries to store that cheap power I can already produce from my existing gas plants to use during peak times, right, so. And you carry that over and you start really digging in, and the point is this, there are so many headwinds that coal faces, is that, unless you are an insider in the industry and you are investing a tremendous amount of time on a regular basis to know the trends, to know where the value is and where the opportunity is, this cigar butt investing idea is, I think it's just too hard and too time-consuming for retail investors, considering that there are so many great opportunities that have tailwinds that are going to, kind of, lift all of the participants and you can just generate far better meaningful returns. I just think it's a wasted effort to generate marginal gains on these businesses that are just losing any meaningful value over time.
Sciple: Right. I agree, Jason. For me, definitely in the "too hard" pile. And it's one of these where the amount of effort you needed to expend, [laughs] you know, relative to the potential upside you have, probably just isn't there to make it a reasonable use of your time. Now, when you mention the opportunity that battery storage, stationary storage presents for renewable energy, it makes me think about, you know, [laughs] you said earlier, we're going to find a way to get football in there, I think it's a Vince Lombardi quote it's "the obstacle is the way," right? So, the obstacle to really renewables taking off is intermittency problems, how do we match the generation with demand? And the way is, is you solve this problem of battery storage.
And so, I think one area to watch over the next few years for where renewables can really take off and become the biggest portion of energy generation on the grid is, to what extent can that battery storage supply chain gets stood up, be economical, be done in a way that's environmentally friendly itself, right? I mean, if all of a sudden we're generating tons and tons and tons of emissions from all of the mining operations we need to do to stand up the battery supply chain, those are some potential hurdles to adoption there. But, yeah, I think the batteries, "obstacle is the way," Vince Lombardi; there's your football quote.
Hall: Well done, Nick.
Sciple: So, one other topic I wanted to talk about today, you mentioned wind energy a little bit and I wanted to talk about Vestas Wind Systems. Now, it's a company we've talked about a little bit, Jason, privately. I'm not super deeply well-versed in this company, but I know it's one you've been paying a lot of attention to lately. Can you give us your elevator pitch for Vestas Wind Systems?
Hall: I can. And actually, I learned something maybe a month or two ago. I was on the Motley Fool Live with Tom Gardner. And he actually mentioned, Vestas is a company that he had learned more about in recent years and really, really liked. I don't think it's actually been recommended in any of the Motley Fool services. But it, kind of, intrigued me that I feel like I found Vestas before Tom. So, I felt pretty good about myself there.
But the short version is Vestas is a European company. I think they're Denmark, right, they're based in Denmark.
Hall: They're unique, because they're a pure-play wind turbine manufacturer, onshore wind turbine manufacturer. They have some offshore joint venture things that they do. But they're the global market share leader in this. They compete against -- so, Goldwind is a large Chinese wind turbine manufacturer, and then you have industrial conglomerates, General Electric and Siemens, that are also really large players in this space. But for a number of years, Vestas has had the largest market share. And they're just really dominant.
And here's the thing, like, you go back to, you look at the company's long-term performance, and you go back about 10 years ago, and you look and you see these massive swings in operating cash flows, where they'd swing from really big profits, big positive cash flow periods, and then two years later they'd be burning cash; it would go negative. And in a way, it's kind of, think about like, you know, steelmakers. These really high fixed-cost industries go through these really big cycles. As much as renewables demand is growing every year, wind production, I think, surpassed coal -- I think just wind surpassed coal, didn't it, last year or this year, I think, that's the big number? But the point is, the utility buyers of the equipment, they don't just throw an order out that's the same order every year and then they add another 10% every year -- the swings in orders can be pretty large, it can be significant. And it affects the wind industry more than it affects solar, because with solar you have the residential side that kind of helps provide more stability; with winds, it's just one year to the next, there can be a pretty big swing in demand.
So, you go back to around 2014 and Vestas went through some major changes, went through some big changes in management, and really had to, kind of, reorganize the business and really refocus on its manufacturing structure. And they, sort of, took a bit of an Apple approach, right, to a certain extent. They focused on what they're really good at, which, No. 1 is design. They're innovators here, their R&D is fantastic. Designing the turbine blades to manufacture to the best efficiency. So, they really, kind of, focused on that. And then they maintained core manufacturing of that really high-value intellectual property of those specific things. But then they sold off a ton of their manufacturing capacity that were things that weren't necessarily part of the core. And they divested those assets to a contract manufacturer that could use those assets for manufacturing across multiple industries, so those assets were better leveraged. And it's really provided a lot more stability to its cash flows. Sure, they still swing up and down, but the difference is you don't see these big cash burn periods when the cycle slows down and demand for orders falls off. And that's really rewarded investors, because the company's stock price has just continued to rise and rise from there.
Revenues have continued to grow. Another thing the company is really focused on is increasing its services revenue. So, again, because panel or buying turbines from one year to the next can shift pretty significantly, the company realized that a really smart thing to do would be to become a services leader. So, if you think about these utility producers, the companies that own the turbines, they want a good partner to be able to maintain them. Especially during periods of economic uncertainty, where they may not be so aggressive about signing a contract to buy another 100 new wind turbines, providing some ballast with services revenues can really, kind of, help balance out the business and smooth out the results.
What Vestas has actually found is that it gets better margins [laughs] on those services revenue. And if you look at its backlog of orders and its contract backlog of service contracts, it actually has a bigger services backlog than its equipment backlog right now. The combined backlog is the highest that it's ever been right now too. So, there's really, really a lot to like about this business.
Sciple: Yeah, you always like to see, when you have these businesses that look like commodity businesses, where they can overlay on top, either a services-type segment or software or something like that, that's super-high margin, that sticks with the product after you sell it, that's always something that I like to see as an investor.
Jason, I wanted to go back to something we talked about last week about -- especially, as we look in solar panels, how it can be really tough for these panel-makers because of the supply/demand shifts in the market, and you've mentioned the cyclicality that Vestas has had to deal with in the past in wind. How is the wind market different when it comes to that cyclicality, the leverage in the market between suppliers and people selling power purchase agreements and that, sort of, thing? Walk me through the market dynamics in place there and maybe how they compare to solar.
Hall: So, again, the biggest thing is that, this is entirely driven by utility-scale customers, whereas still around a third of the -- between a quarter and a third, depending on where you are, of solar demand comes from distributed solar, so that's like, residential rooftop solar or a Walmart doing a commercial installation on their roof. As opposed to utilities scale, which is people buying it to generate electricity that they're using, right, that's going into the grid. They're either selling to a utility or that's the utility that owns that asset.
So, with wind, it's entirely driven by utility scale. You know, people aren't sticking a 260-foot-high [laughs] wind turbine in their backyard. So, that's the difference, is that, because of that, equipment orders are more cyclical from year to year. And if you look at Vestas' operating cash flows, you can see that there still are those swings.
But also, it's been a little bit less of a political football than solar manufacturing, right, because you've seen solar panel manufacturing tends to get stuffed into places where costs are lowest in terms of labor costs. So, Southeast Asia is a massive place for manufacturing of that. Wind turbines, again, these things are gigantic. This is not an operating model where you manufacture them in the cheapest place and then stick them on boats to get them wherever you need them. The manufacturing does tend to be a little more localized. So, they have manufacturing in Europe, North America, South America, so that -- shipping costs are a bigger portion. So, those are some dynamics that come into play.
And there's a little bit of a competitive advantage for these players that are already at scale there, because it makes the cost to enter those markets a little bit higher. So, it's not completely durable, but it is a little bit of a competitive advantage that a big player like Vestas has because of those dynamics of the way that the market works.
But again, in terms of cost and in terms of thinking about the dynamics that are driving the demand, wind power is cheap. I mean, on a levelized cost per watt basis, it's competitive with anything in the world except for the very newest gas plants. And even that, I think five years from now, I think they're going to be cheaper. And again, the big dynamic, to me, is the ability to store the energy coming off of these assets, is going to just change the addressable market over the next decade pretty significantly.
Sciple: Okay. Jason, you know, we talk about this trend, obviously lots of demand when you look at the numbers, it points to continued adoption of renewables; you turn on your news, that points to continued adoption of renewables. So, I think it's pretty well a consensus view here. You look at the stocks, obviously, the stocks are doing quite well in alignment with that. Vestas this year is up 45% year to date. When you look at the stock going forward from where it is today, you still see value, still see an opportunity to make solid returns on this stock over the next five years or so?
Hall: Yeah, I think you have to look plus five years out. Again, because if you look at Vestas by just about any measure right now, it is quite expensive. The operating cash flows, they've actually come down a little bit over the past couple of years, just because, kind of, a little bit of -- you know, there is some increased competition, the company has been spending a lot of money to grow its core manufacturing capacity. So, there has been a little bit of a squeeze there.
And if you think about valuations, I own a lot of Vestas right now, but I look at it, and I have to look at it every time I look at the price, and just say, I have to accept the fact that this could be 25% cheaper in a year, because the volatile nature of the industry, it's hard to predict what's going to happen. But I continue to own it, because I know five years, 10 years from now, this is still going to be a leader in a services business that's so valuable. It's such a well-run company that it's one that I think is worth starting a position in, if you don't have one and continue to monitor and look for opportunities to add to it over time.
I think there are better places to invest and benefit from wind right now than Vestas, but it's still one of my favorite companies in the space.
Sciple: Oh, well, that begs the question, where are those places?
Hall: [laughs] So, you know, the question here, wind or solar? Here's where you go, and I say, both. I think the reality is, you know, I own some First Solar, which I like because they have a great balance sheet and they're really good in that utility scale on the solar side. But really, the place that I always continue to come back to, the more that I look at, is who can benefit from every aspect of the tailwinds, who can benefit from falling cost the most, and who has the least exposure to the cyclical nature of the business? And it's always those renewable energy yieldcos. And the one that always comes to top of the list for me is Brookfield Renewable, just Brookfield Renewable floats right to the top every time.
You have BEPC. BEPC is their corporation ticker. Their limited partnership ticker is BEP.
I continue, this is a stock that's also done incredibly well this year, but it's just so high value, they own and operate wind, solar, hydroelectric, and some transmission. They're just such a good business, the capital allocation, they're just so good at it. It pays a great dividend. Their dividend growth track record is spectacular. And, again, this is an international business. So, you look at those long-term trends, where the world's population is growing and where those energy demands are going to start shifting to renewables, this is one of my top stocks, full-stop, right, not just where I like to invest in renewable energy, I would say.
And look at the other yieldcos, too. So, you have Atlantica Yield, Clearway Energy, NextEra Energy Partners, there's a good half-dozen of these companies that are all pretty solid companies. And I would pick any one of them over the best pick in the coal industry any day, just because of the tailwinds, and you don't have to waste time figuring out which one is going to suck less [laughs] over the next five years, right? That's what you're doing with coal. And that's why I like this particular sector in renewable energy. They benefit from all the tailwinds, and they have the least to lose when things aren't good.
Sciple: Yeah, so we talked about Brookfield Renewable last week. And I think we'll keep walking through it on this show, different from these subsectors in renewable energy, so we can kind of give our listeners an overview of the different opportunities in this space and what we think about them and what's driving the market. Jason, I hope to have you on when we do that.
Hall: I hope to be on. Wait, we're about to finish a show in less than 30 minutes, Nick, that's never happened before.
Sciple: It's a Christmas miracle.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stock's discussed, so don't buy or sell anything based solely on what you hear.
Thanks to Tim Sparks for mixing the show. For Jason Hall, I'm Nick Sciple, thanks for listening and Fool on!
Jason Hall owns shares of Atlantica Sustainable Infrastructure plc, Brookfield Renewable Partners L.P., Clearway Energy, Inc. (A Shares), First Solar, and NextEra Energy Partners. Nick Sciple owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool recommends First Solar. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.