Profit From This Energy Paradox

I'm about to contradict everything you've ever heard about energy efficiency. In short, energy efficiency doesn't work, at least not the way you've been led to believe.  

While efficient products may reduce energy consumption on a per-use basis, they actually allow us as a group to use even more energy than we otherwise would have.  It's called Jevons paradox. I'll explain the relevance of this paradox and which companies are poised to profit from its implications. Plus I'll give you access to three stock picks from our top analysts.

What is Jevons paradox?
Jevons paradox explains a fallacy of composition, also known colloquially as the folly of crowds. In other words, it's wrong to conclude that the collection of individuals' actions achieves the same result for the group as a whole. Think of sports fans in a stadium standing up one by one to get a better view. Soon, everyone is forced to stand up just to get the view they had when sitting down. I'll give you an example from the energy and automotive worlds to illustrate Jevons paradox more concretely.

While drivers now bemoan the arrival of $4 gasoline, gas prices in real terms (i.e., inflation adjusted) are only on par with the all-time highs achieved in the 1970s oil shocks and World War I. With the exception of the 1970s, gasoline prices from the Great War until 2000 continued on a steady downward path in real prices. The upshot? A perpetual expansion of the number of miles logged by the nation's drivers, until about 2005.

You can see low gas prices ultimately result in the massive expansion of the suburbs, especially from the 1950s on. Ever-cheaper gasoline simply lowered the per-mile cost of moving to the suburbs, allowing cities to build out instead of up and suburbanites to commute. And with cheap gas, a car culture emerged. The key point here is that lower gas prices led to more consumption.

Efficiency-promoting technology accomplishes exactly the same feat, reducing prices and allowing you to increase consumption, as we see with consumers' consistent decision to increase miles driven over the last six decades. In effect, lower prices led to more aggregate energy use, a result predicted by economist William Stanley Jevons in 1865. In Jevons paradox, he points out that demand for a resource (coal, in his case) increases because efficiency improvements lower the resource's relative cost. Moreover, higher efficiency means higher economic growth, leading to still higher resource use.  

In short, energy efficiency by itself can't be a way to reduce energy consumption unless accompanied by group conservation (i.e., limiting aggregate consumption to a given level). If the U.S. ever intends to wean itself off oil and have energy independence, the last thing it needs is lower oil prices. In fact, the higher the price, the better for kicking the oil habit -- whether foreign or domestic. High oil prices make other renewable energy sources competitive and perhaps even make oil ultimately obsolete.

With scarcely a politician claiming that we should actually limit the oil we consume, we should expect the proliferation of more efficiency technology, leading to individual energy savings but higher energy consumption overall. And that supports oil prices, especially as the global economy increasingly backs up against supply constraints.

So where do I invest?
With that said, I want to find companies whose competitive advantage strengthens as resources become more constrained. So I think the best strategy is to dedicate a portion of your portfolio to energy, consisting of makers of energy-efficiency products and energy producers.

I'm less inclined to buy automotive companies such as Ford (NYSE: F  ) and General Motors, not because they don't have growth opportunities (have you heard of China?), but rather because they face the dangerous long-term headwind of rising energy prices. Ultimately, this probably forces them into producing a more European-style car -- smaller and more efficient. But that's not where the high margins are. And with the industry's need to recoup massive R&D costs by cross-licensing technology, rivals are able to access key advances, helping to eliminate or mitigate any one company's dominance. If energy prices grow too high, consumers can also begin to reurbanize, moving back to cities, as we've seen recently.

I think safer longer-term plays are oil majors such as ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) , which can leverage their scale and finances into new energy areas. As energy prices move up because of increasing supply constraints, these companies can make outsize profits and therefore are able to invest in the next wave of alternative energies. ExxonMobil has already made a move in that direction with its 2009 purchase of gas-rich XTO Energy, while natural gas prices are low. You also see it in the recent move by France's Total (NYSE: TOT  ) to snap up a majority share of SunPower (Nasdaq: SPWRA  ) , a player in the solar space.

The low-cost producer in a commodity industry is usually the safest bet, especially when prices are at historical lows. That's the case with Ultra Petroleum (NYSE: UPL  ) , which plays in the natural gas arena. As my Foolish colleague Dan Dzombak explains, Ultra is also in a great position now because of the management's focus on creating value. So that looks like an intriguing buy.

I'm also interested in EnerNOC (Nasdaq: ENOC  ) , an early leader in the demand response industry. EnerNOC monitors, coordinates, and reduces the energy use of its customers, which include factories, warehouses, malls, and many others. Utilities and grid operators pay the company for reducing its customers' power use when demand is high, and then EnerNOC passes a portion of that revenue on to its clients. As constraints on utilities increase, EnerNOC gains a competitive advantage. Over the last three years, revenue has increased 66% annually, and the company is buying up rivals with its sizable cash hoard.

Foolish bottom line
So those are a few plays that I think will thrive in the coming years. While energy prices are volatile and may go down in the near term (or not), the long-term trend is solidly up. Looking for more ideas? The Motley Fool has created a new, special oil report, and you can download it today at no cost to you. In this report, Fool analysts cover three outstanding oil companies, including the stock Fool analyst David Lee Smith calls the "energy king." To get instant access to the names of the three oil stocks, click here -- it's free.

Jim Royal, Ph.D., does not own shares of any company mentioned here. EnerNOC is a Motley Fool Rule Breakers selection. Ford Motor is a Stock Advisor recommendation. Chevron and Total are Income Investor recommendations. The Fool owns shares of EnerNOC, ExxonMobil, Ford Motor, and Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On May 12, 2011, at 4:19 PM, XMFTom7 wrote:

    Wasn't there a big debunking of Jevons paradox just recently? http://climateprogress.org/2011/02/16/debunking-jevons-parad...

  • Report this Comment On May 12, 2011, at 5:37 PM, gkirkmf wrote:

    For oil, "The Tragedy of the Commons" is a better way to frame the problem I think. Read all about it at:

    http://en.wikipedia.org/wiki/Tragedy_of_the_commons

    When one person conserves ( buys an over priced Prius for instance) There is more gas for the Dodge Ram pickup guy... It just works that way. Libertarians say "stop the tax subsidies for the oil companies and let the chips fall where they may" I agree. If we had $8 a gallon gasoline as they do in Japan things might be different. For those who are really interested in this topic, try James Kunstler's blog out for size and try Stephen Leeb for interesting investing ideas and books.

  • Report this Comment On May 12, 2011, at 5:48 PM, TMFDiogenes wrote:

    The linked to article doesn't debunk Jevons Paradox -- it just notes that it may not imply that usage will "rebound" all the way back to its previous rate.

    The example he gives is that the Jevons Paradox is not necessary to account for increased air conditioning usage, which doesn't really debunk the paradox in other contexts.

    One reason why energy might be more prone to the paradox than air conditioning is that it's much more substitutable a commodity than air conditioning. We may not decide to commute 5 hours to work just because gas is cheap, but we might start buying more imports if those savings are passed onto shippers.

    There could be arguments for why the paradox doesn't apply to energy usage, but this doesn't appear to be one. And if the paradox does apply to energy, that doesn't mean individual conservation is a bad thing, just that it alone isn't going to reduce aggregate consumption -- you'd need aggregate caps for that.

    My 2 cents.

    Ilan

    (Jim's editor)

  • Report this Comment On May 12, 2011, at 5:54 PM, TMFRoyal wrote:

    Hi, Tom,

    Here's my understanding of that author's point about Jevons. He takes the position (what he calls the strong form) that Jevons says that decreases in resource cost "force" increases in consumption. I'm not sure that's the accurate reading on Jevons claim, though. And there seemed to be plenty of debate.

    My understanding is that increasing energy efficiency removes the constraint on further consumption. So even if we don't decide to increase our driving more (for example), that allows more energy to be consumed for the production of other goods. In short, more energy efficiency allows faster economic growth allows more energy use.

    Interesting link.

    Jim

  • Report this Comment On May 12, 2011, at 6:00 PM, mythshakr wrote:

    We need to do quite the opposite and outlaw petrofuel companies involvement in alternatives. In the 1950s the railroads started to get into both freight and passenger airlines. The fledgling airline industry said they could not compete with the railroads because to the resources at the railroads disposal and proven history of bowling over competition for long term market dominance and subsequent price manipulation. So the Feds outlawed the railroads owning airlines.

    To watch the airline predicted history unfold, allowing petrofuel companies using their profits to take over alternative energy will lead to the same type of price manipulation by the petrofuel companies in both markets as was expected by the railroads to continue increasingly profitable petrofuel consumption at the expense of alternatives until such a time when petrofuel scarcity becomes reality.

  • Report this Comment On May 12, 2011, at 6:00 PM, TMFRoyal wrote:

    Hi, gkirkmf,

    Thanks for the sources.

    I didn't want to get specifically into an environmental issue, although it clearly rides on something like this. Still, I'm definitely of the mind that Jevons doesn't exculpate us from reducing environmental damage, etc.

    Fool on!

    Jim

  • Report this Comment On May 12, 2011, at 6:12 PM, jrsofsd wrote:

    Simply correlating miles driven to the price of gasoline is well, too simple. As the price of OIL changes, the ratios of consumer driving, flying, and riding (a train) change in non-linear ways.

  • Report this Comment On May 12, 2011, at 6:13 PM, TMFDanDzombak wrote:

    Good title

  • Report this Comment On May 12, 2011, at 7:45 PM, MegaEurope wrote:

    "The linked to article doesn't debunk Jevons Paradox -- it just notes that it may not imply that usage will "rebound" all the way back to its previous rate. "

    And Jevons Paradox states that rebound is 100% or greater. Hence, debunked.

  • Report this Comment On May 12, 2011, at 7:48 PM, MegaEurope wrote:
  • Report this Comment On May 12, 2011, at 7:53 PM, MegaEurope wrote:

    However, I'm sure it applied perfectly well to the 1860s coal market.

  • Report this Comment On May 12, 2011, at 8:08 PM, hbofbyu wrote:

    @mythshaker

    It would be futile to try and keep the oil companies from alternative options. We are not living in an isolated US economy of the 1930s. This is a world economy. You can't pass any kind of legislation to stop this. Why doesn't congress pass legilslation to ban OPEC from price fixing?

    Exxon brings in more than a billion dollars in one day of operation. With a net income more than double that of the so called "biggest" company in the world, Walmart. Oil companies have a lot more margin to play with than alternative energy companies. If Solar or Wind or Hydrogen ever becomes cheaper than oil the only effect is that the price of oil drops - but remains the dominant player.

    I'm waiting for a miraculous paradigm shift - but I don't see it in our lifetime. In the 1970's we were certain there would be alternatives by the year 2000. It's been 40 years and our source of energy remains the same. There's plenty in the ground for 100 more.

  • Report this Comment On May 12, 2011, at 8:31 PM, hbofbyu wrote:

    I like the analogy of the sports fans standing up one by one to gain a better view. I've been thinking of a name for this for years. I would use the term "playing your trump card". When one person lays it down everyone else has to play theirs just stay in the game. In the end everyone is worse off.

    Women entering the work force in the 60's and 70s had the same effect. It was a financial boom for the initial families but thereafter eveyone else had to "stand-up" as well just to afford the same house in the same neighborhood. And in a lot of ways we are worse off.

    Which leads me to my last aphorism: There is no need or want to to be rich - only to be richer than your neighbor.

  • Report this Comment On May 12, 2011, at 9:00 PM, TMFDiogenes wrote:

    MegaEurope,

    Great link. Doesn't necessarily rule out the possibility that the weaker form of the paradox this article Jim discusses (price support) won't occur for oil consumption. But certainly a strong argument.

    It's hard to say for sure how strong the effects would be in the future for the oil market, but some form of aggregate cap may be necessary, particularly if one thinks there's a time constraint because of environmental or security concerns for energy independence from the middle east.

    Interesting stuff.

    Ilan

  • Report this Comment On May 12, 2011, at 9:14 PM, TruffelPig wrote:

    I have quite a diverse bunch of energy stocks in my portfolio because one doesn't need a paradoxon to see that energy demand is rising and alternative energy is nice and needed too for various reasons. I have a couple of the Bakken etc. oil explorers and drillers, some energy conservation (AMRC), some wind (...waiting for that to pick up, stock isn't going much lower but much upside = BWEN). Sun doesn't work for me thus far because too expensive, maybe GE will change that with going into efficient plastic solar sheets. Right now I am not thinking of going NatGas because it isn't green and there is too much and it is right now too cheap. I rather buy oil then. I had WPRT for a while (nat gas vehicles) but that stock went up too fast too much and I had to say buy to it for a jummy profit.

  • Report this Comment On May 12, 2011, at 11:51 PM, Alg0rhythm wrote:

    The argument presented here is extrapolating a behavior representative of specific form of energy consumption- gas prices to all forms.

    Yes, if gas is cheaper, people will travel more.

    Why?

    Traveling is fun.

    But if my light bulb uses less electricity, I'm not prone to leaving it on more.

    If my house is better insulated, I'm not going to leave the door open.

    People aren't not buying things because of the energy cost.

    This argument doesn't hold up.

    I'm a little sensitive on the topic, because there's a

    technology that can reduce your home energy bill by 70%, and a 12 year mortgage on the job would be completely offset by the energy savings, as well as giving the house an aesthetic makeover, for free.

    Turning that into a mass movement would create millions of jobs, and billions worth of financing deals.

    If you know an investor who's a bit of a risk taker, I remember favors.

  • Report this Comment On May 13, 2011, at 1:11 AM, phillman5 wrote:

    I think a parallel article was recently published about lighting. It argued that more efficient LED lighting would not decrease electricity usage. People would just use more lights and more often.

  • Report this Comment On May 13, 2011, at 8:32 AM, TruffelPig wrote:

    That is a complete nonsense. Since I replaced all bulbs in my house and eliminated all vampire devices, I save 30% of electricity.

  • Report this Comment On May 13, 2011, at 1:44 PM, JeanDavid wrote:

    I do not know about the paradox, or how it really works in practice. I know that if my telephone bill were cut in half, I would make no more telephone calls. If my Internet bill were cut in half, I would download no more stuff. If my gasoline bill were cut in half, I would not drive more. I got a more efficient heating system for my house -- somewhere between 30% and 50% less gas consumed. I do not heat the house any hotter; in fact I maintain my former level of comfort heating it 2 degrees lower. I have replaced some of my bulbs with CFLs, and notice no change in electricity usage. I still run the incandescent ones in places where I cannot tolerate the slowness required to get full brightness, where I cannot get sufficient brightness with CFLs, or where I need to dim them.

    It may be that I am so rich I can drive as much as I want (about 6000 miles a year), have few people to telephone, have more Internet capacity than I need or want, etc.

    If someone gave me $1 million tax free, I know what I would do with it, but about half would be given to charities and similar endeavors, 20% to investments. I would have my garage door painted. I might replace my 40 year old stereo. Maybe visit some friends on the west coast. Help some young friends with college tuition and therapy bills.

  • Report this Comment On May 13, 2011, at 2:49 PM, eldetorre wrote:

    Energy efficiency and energy prices are related but not directly. Jevons paradox applies to usage of a commodity when price is the controlling factor. It addresses efficiency only as it reduces net cost for end users. Net price decreases are a peripheral outcome of efficiency which only result from lower utilization.

    The idea that people are chomping at the bit to have energy guzzling orgies and leave their lights on all the time, for example, due to efficiency increases is just silly. Most of us use what we need when we need it regardless of prices. We'll perhaps gripe a bit less if our devices are more efficient.

  • Report this Comment On May 17, 2011, at 8:34 PM, borneofan wrote:

    Makes perfect sense to me. I have 3 almost 20 year old CF light bulbs I have had in continuous use in gloomy old houses. I would never have done it with standard incandescent bulbs. They cost me nothing so I leave them on all the time.

    I also set my thermostat higher in the winter now that I have insulated the house thoroughly. The more thermally efficient the house is, the more comfortable I set the thermostat, since I know the financial cost is minimal.

    Jevon's paradox is just a commonsense take on typical human behavior.

  • Report this Comment On May 19, 2011, at 12:32 AM, MRBillsnutjob wrote:

    I like the article but presently I drive no more than I have to. use no more heat than is necessary to remain comfortable. Usually have lights on only in the same rooms I am in and practical to have on. I believe we are creatures of habit which can be altered but in general likely to fall back in a comfortable existence with our habits. my self I don't care to drive for driving sake. I would love to own a hybrid but until the cost of the vehicle can be off set by the savings and then some i can not justify it.

    So thank you for food for thought

    Fool on all

  • Report this Comment On May 20, 2011, at 2:20 PM, ruggedcrosspro wrote:

    I fear that as individual conservationists we are always subject to the greater greed of the masses as a whole. Maybe living in Lost Angeles has jaded me a bit, but all I see happening when when gas (and other energy) prices go down is more traffic and more wealthy, obnoxious, "entitled" people acting in a wasteful manner. Oddly enough, many of the Prius drivers I see around here drive in a manner that is anything BUT fuel-saving. I'm sure that many of the individual conservationists who have posted about this article, truly do try to conserve and realize their savings as a result - but unfortunately, it seems to me that there are just as many out there that simply use twice as much because it's cheaper.

    As an example with LED lighting (which I'm a huge fan of, btw): now that the lighting is cheaper, the usage costs allow businesses who normally would only use a small amount of lighting, to use far more lighting than they originally did when they had incandescent lighting (to compete with the neighboring businesses - or just to stand out, because we have a serious "peacock" issue here in LA) ..... I've been involved in examples of this

  • Report this Comment On May 20, 2011, at 6:50 PM, 650nm wrote:

    @luthert

    I don't think common sense/conventional wisdom is, strictly speaking, apropos in those two examples.

    In the first, as others have said, using CFLs did let you leave them on all the time, but it didn't make you buy more CFLs.

    In the second, a thermostat is just a trigger. If your house isn't losing much heat, it doesn't take a lot of BTUs to maintain a comfortable temperature because the insulation does its job.

    In both cases, your total consumption should have gone down even as your habits have "gotten worse". But there is a plateau to how much you can consume. Lighting and heating every square inch of a thermally well-insulated house with CFL/LED 24 hours a day simply doesn't take as much energy as it used to.

    There is a plateau to this comfort. Consuming more energy may be possible, but it won't be comfortable.

  • Report this Comment On May 20, 2011, at 11:08 PM, 2Eyes wrote:

    Great article. The paradox makes perfect sense to me. If anyone is interested in a book that supports the paradox, and offers other thought-provoking energy related concepts, read "The Bottomless Well: The Twilight of Fuel, the Virtue of Waste, and Why We Will Never Run Out of Energy," by Peter Huber and Mark Mills. You'll enjoy it!

  • Report this Comment On May 22, 2011, at 7:03 PM, tomd728 wrote:

    Writing non-paradoxically but trying to stay with Jevon's concept let us not forget the great fuel "shortage" of the 70s.

    The user of gasoline was not so much a consumer

    but a moving storage facility within his auto, truck,

    machine, etc., as a full tank of fuel became a pacifier

    for those who choose panic over constraint.

    The fact that so many of our autos were being topped off whenever the lines abated increased the outflow from refiners to retailers in a fashion that was never truly measured.

    Fear changed habits and appetites.We became the great contributer to the shortages.Gas level down but the typical trip not endangered ? "Fill 'er up Johnny".

    It's a habit born of that time that I believe still exists today that while for now presents little problem.

    "For now" is a time span I hope lasts a long time.

    Tom

  • Report this Comment On May 23, 2011, at 12:23 PM, krystoff wrote:

    It seems fairly obvious to me that, if free non-polluting energy from nuclear fusion were perfected, the human population would soon explode like ants on a sugar cube. The ozone layer would be eliminated from the methane our intestines produce and the only other animals left on the planet would be whatever is needed to produce chicken MacNuggets. Unless instead we used fusion bombs to wipe ourselves out.

    What this has to do with stock market investing, I have little idea. Except that if more people shunned the stock market and went for a mostly-bond portfolio, perhaps this does almost as much for a so-called "sustainable economy" as solar energy. Because bond appreciation is sustainable, stocks are not. It is the relentless demand for ever-yielding unrealistic appreciation that in turn causes inflation with forces people to invest in stocks to protect their savings. This vicious cycle in turn causes economic instability and the "drill baby drill" popular mentality whenever oil prices go up 50 cents.

    Yet, even if we eliminate any concern for the environment, logically the USA should be hoarding its oil and gas reserves for the same logic that so many people are hoarding gold and silver. In all common sense, we should want the world's reserves to run out "before" our own run out, not vice-versa! Secondly we should increase long-term capital gains taxes on stocks by 1% while decreasing the capital gains taxes on bonds by 1%. Then in addition to preventing WWIII, we might just balance the budget.

    But of course, our chances of finding three or four voters for a rational long-term policy are no better today than in the time of Sodom and Gomorrah. Individual actions indeed can make no dent in the situation. Yet perhaps if you want to feel your hands are a bit cleaner, perhaps just prefer bonds over stocks. Numerous bond funds have averaged 10-14% appreciation over the past 15 years, some with reduced volatility as well. That's plenty of gain with no pain, I would say.

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