The Energy Futurist

What EROI tells us about ROI

What EROI tells us about ROI

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Energy futurist Chris Nelder explains why you can run from EROI, but you can't hide, and why savvy energy investors should use it as a guide instead of ROI.

One of the key deficiencies of "unconventional" fuels is their low energy return on investment relative to conventional fuels. Many analysts have ignored this factor because investment decisions are made on the basis of the financial, not energy, return on investment. But a growing literature suggests that the two are intimately related.

But before I get into that, a quick note on terminology. The financial return on investment is known as ROI. The analogue in energy, the energy return on investment or EROI (also expressed as EROEI, for "energy return on energy invested") is a ratio of the energy produced to the energy invested in its production. Some, including me, have also referred to EROI as "net energy," but that really confuses the terms. For parallelism with the language of finance, net energy should refer to energy produced minus energy invested, whereas EROI should refer to energy produced divided by energy invested.

How EROI begets ROI

The relationship between ROI and EROI is actually very simple and logical. The more energy you have to invest to produce a fuel, the lower your EROI will be. The energy you invest has a cost. Therefore, the profit on the same barrel of oil will be higher when it's produced from a high EROI source than when produced from a low EROI source.

This simple concept gets lost, however, in the complex accounting of fuels in the real world. The financial return on all unconventional fuels is distorted in one fashion or another by subsidies designed to encourage new development, debt acquired to finance the projects, and complex accounting of the investments and returns. For example, as I discussed previously, the accounting methods used in shale gas development allow operators to roll over gains and losses creatively and amortize them across older and newer wells, wet and dry wells alike. Initial development costs tend to be intermixed with long-term operational and maintenance costs, debt servicing expenses, and so on. Initial exploration costs and even production itself can be offset by tax credits. Ultimately, the profitability of production tends to resemble a picture of cash flow more than pure ROI, and the EROI of some fuels becomes very murky indeed.

Corn ethanol offers a fine example of the problem. More than $20 billion in subsidies over the past three decades have ultimately turned nearly 40 percent of the U.S. corn crop into less than 10 percent of the country's fuel needs by volume, and less than 7 percent by energy content. In 2009, the U.S. taxpayer subsidized 75 percent of the price of each gallon of gasoline replaced with ethanol. It has proven to be an expensive way to make a low-quality fuel (ethanol has about two-thirds the energy content of gasoline) which reaches its scaling limit at a fairly low level.

Careful observers who did the math on the EROI of corn ethanol knew it would run into cost and scalability limitations literally decades before legislators and investors did. With a generally accepted EROI of around 1.4 (also variously estimated between 0.8 and 1.6), it was just barely a net energy-positive fuel at best. In the pithy observation of veteran energy analyst Robert Hirsch six years ago, making ethanol from corn is a process in which a certain amount of energy in the forms of natural gas and diesel fuel are used to create an equivalent amount of energy in the form of ethanol, with the primary output being money from government subsidies (not to mention soil erosion). Such a low EROI would imply a low profit margin, thin enough to be swamped by the volatility of both corn and oil prices, as indeed it was in recent years. However, only the ROI, in the form of increased "energy independence," was taken into consideration in the politically-motivated push for biofuels.

With the tax credit finally expiring at the end of 2011, we should now see the real costs of producing corn ethanol begin to be priced in to the cost of gasoline. Its EROI has been "hidden away in the attic like a crazy aunt," as my friend Gregor Macdonald quipped to me this week. Without subsidies, the ROI of corn ethanol must begin to converge upon its EROI.

The EROI tipping point

A small cadre of academic researchers have calculated the EROI of various fuels and explored their relationship with the economy—most notably, Charles Hall, Cutler Cleveland, Robert Kaufmann, David Murphy, David Pimentel, Robert Costanza, Carey King, and Adam Brandt—and the body of research is growing rapidly. Some of their recent papers have attempted to describe in mathematical terms how EROI translates directly into price and profitability, and how it can inform policy.

King and Hall (2011) established some critically important principles:

  • As EROI decreases, price increases.
  • EROI implies both profitability, and a price limit. A few examples: At $61 a barrel, oil production can be profitable at an EROI of 5 but not at 2. When EROI is less than 10, natural gas prices must be above $6 per thousand cubic feet to be profitable. A realistic EROI of 3 to 4 for tar sands implies a price of at least $50 to be profitable.
  • The decreasing net energy and increasing capital intensity of our energy production have likely contributed to the economic downturn.
  • When EROI remains above 10, the relationship between prices and EROI is fairly linear and steady. But when EROI falls below 10, it can force prices to increase at a dramatic and nonlinear rate, to much higher absolute levels.

The latter point is key. One example King and Hall offer is that a 60 percent drop in EROI from 25 to 10 resulted in a 150 percent increase in oil prices, from $19 a barrel to $48. But a 60 percent drop in EROI from 5 to 2, likewise with a 150 percent price increase, causes the price of a barrel to jump from $96 to $240.

Heun and de Wit (2012) found similar results: EROI and producer prices are indirectly and inversely connected, and while the correlation is weak while EROI is over 10, prices can still be projected from EROI trends.

Declining EROI has a "nearly inconsequential" effect on prices until it reaches about 18, then has an increasing effect until EROI falls below 10, when prices jump dramatically.

This finding meshes nicely with the "net energy cliff" model proposed by geologist Euan Mearns, which shows an exponential decline in the energy available to society as EROI falls below 10:

And this should send a chill up your spine, because the EROI of domestic U.S. oil production is now approaching 10, having fallen from around 100 in the early days of oil (Cleveland, 2005). Even in the few prospects where we can still drill a well that will produce over 100,000 barrels of oil per day, like the deepwater Gulf of Mexico, the EROI varies from 4 to 14 (Moerschbaecher, 2012).

Hall and Murphy have also found that a given fuel must have an EROI of at least 3 to deliver a net benefit to society because of the associated infrastructure needed to support and use the fuel, and that an overall EROI of at least 10 may be required to sustain a complex society. It takes a significant energy surplus to support things like higher education, entertainment, personal vehicles, a middle class with health care, outsized amounts of credit, and yes, subsidies for low-EROI fuels.

You can run from EROI, but you can't hide

All of these studies come to a similar conclusion: As we continue to substitute unconventional fuels for conventional fuels and the overall EROI falls below 10, it's going to be very difficult, if not impossible, to continue running our complex society. Prices will go too high for the economy to tolerate and kill demand before unconventional substitutes can scale up to replace declining higher-EROI fuels. Biofuels can't do it; tar sands can't do it; oil shale (with an EROI between 1 and 2.5) can't do it. There is still too little work on the EROIs of shale gas and shale oil (like that produced from the Bakken Formation) to know how far they can take us, but given the growing acceptance of the notion that they can sustain us for decades, the need for academic inquiry is urgent.

In the words of Heun and de Wit, "There are not perfect and scalable substitutes for oil at the present time." In so many ways, conventional oil is special. We are losing the race between oil depletion and the pursuit of substitutes and better extraction technology. Drilling technology cannot overcome depletion, because depletion is giving us declining EROI and intolerably high prices for substitutes. The researchers conclude that a smooth transition away from oil is unlikely without a deliberate policy effort to steer us toward alternative energy sources and manage the economic effects of depletion.

None of these insights should be particularly startling, yet most observers and policymakers continue to miss them entirely. Bedazzled by the sheer magnitude of unconventional resources—trillions of barrels of oil equivalent!— they cannot see how the low energy return of some (not all) of those resources will ultimately force us to leave them in the ground as their cost of production proves intolerable.

ROI cannot escape EROI forever. The magic of credit, government subsidies and creative accounting can forestall the recognition of ROI for awhile, but eventually the true cost of producing energy, both in dollar and energetic terms, becomes a limit on production. As ROI converges with EROI and the profit picture worsens, investors start bailing out and production falls.

In short: EROI ultimately determines ROI, but because investors and policymakers don't realize it until late in the development cycle when ROI finally proves weak, we continue to invest in fuels with poor EROI. To navigate the future of energy, investors should be looking to EROI, not ROI, as a guide.

All researchers on EROI and economics point up the need for additional studies, particularly on shale gas, oil shale, and effects on the economy as a whole. The existing body of work suggests that as EROI falls, disposable income does too and leads to recession. To prove it, we need models that include both the economic effects of resource substitution and the geological effects of depletion across the entire energy sector. I only hope that the academy is up to the task, because so far, our official energy agencies have failed to build any such models. We are simply drifting ever closer toward the net energy cliff, in blissful ignorance of EROI limits, with visions of unconventional resources dancing in our heads.

Photo: The business model of the underpants gnomes, from the instant-classic South Park episode.

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Chris Nelder

Columnist (Energy)

Chris Nelder is an energy analyst and consultant who has written about energy and investing for more than a decade. He is the author of two books on energy and investing, Profit from the Peak and Investing in Renewable Energy, and has appeared on BBC TV, Fox Business, CNN national radio, Australian Broadcasting Corp., CBS radio and France 24. He is based in California. Follow him on Twitter. Disclosure