GLG News by Lewis Gaines

Implications: Higher diesel prices relative to gasoline reflect the growing use of this more energy efficient transportation fuel. Increasing volumes of diesel fuel are generating good profits for the fuel additive companies and enhancing their already attractive current margins.

Analysis: Increased diesel usage is supported by cleaner (low sulfur) fuels, increased penetration of bio diesel blends and better diesel engine operability. Refiners will eventually respond to the increased margin potential and bring relative fuel pricing back into line.

In the meantime, growing diesel volumes and the complexities associated with generating acceptable operating performance with bio diesel blends are producing strong margins for the fuel additive companies.

Publicly traded additive companies benefiting from this situation include Lubrizol, Newmarket and Innospec. For the past few years these companies have delivered exceptionally strong operating results as structural changes in the competitive environment have increased both their margins and their outlook. Lubrizol and Newmarket are also benefiting from improved lubricant additive trends, while Innospec is the most highly leveraged to growth in diesel fuels.

Implications: 1Q and 2Q margins for additive companies including Lubrizol, Newmarket and Innospec were strong. Significant changes in industry behavior and technology are combining to position these businesses for even higher future earning power.

Analysis: Due to a concentrated customer base, commodity like large volume products and historic market share growth seeking behavior, lubricant and fuel additive margins have historically lagged other specialty chemical companies in spite of the sophistication of their products.

Higher future margins are more likely because of the following shifts in industry dynamics:

1) The past 10 years were a period of basestock quality improvement, the next 10 will be years of change in additive performance

2) Growth of the DIFM oil change volumes and the weakening of oil company branding power

3) Higher performance oil, segmentation of the additive market and an increasing role for the equipment manufacturers in defining and marketing oil

4) Growth of diesel fuels in North America, which will require more higher margin additives than gasoline.

5) Migration to a higher service content marketing model with concomitant higher margins.

I believe the outlook for sustaining and improving current margins is favorable.

Implications: Toyota has delayed producing vehicles with lithium ion batteries based on concern about fire and explosion risk in these large systems. GM on the other hand continues to work with A123 Systems on extended electric range lithium hybrids. Extended electric range vehicles, a poor economic concept, suffer from safety issues as well. GM's effort, which I consider to be mostly PR in nature, will also not deliver and will have significant impact on A123 Systems.  

Analysis: Large lithium batteries present difficult thermal management problems and are vulnerable to local overheating and short circuits. In large systems ,with lots of stored energy and reactive lithium, the results of a fire can be deadly.

In additionm extended range electrics (with 20-30 miles of electric capacity) are very expensive and would add at least another $10K to the existing hybrid premium.

Fire risk and bad economics make a poor combination which Toyota has recognized.

GM is still nominally moving ahead with extended range hybrids based on lithium ion technology from A123 Systems. Although the GM effort is predominately for PR purposes, potential vehicle sales have been incorporated into A123's future perceptions. Eventual deferment of the GM program will have a bigger impact on A123 than on GM.

Implications: The expensive and capital intensive parts of coal upgrading to cleaner and more flexible fuels are gasification followed by conversion to synthesis gas. Fuel generation from synthesis gas (whether to liquids or to methane) is straight forward by comparison. We should let the market place decide the optimum fuel product and encourage any needed government help to focus on the gasification section. Allowing political leverage and entrenched infrastructure interests to heavily influence the final fuel product will not produce the most effective fuel mix.

Analysis: The demands for transportation, power generation, chemical production and heating set different values for different fuel types. A BTU is not a BTU as some fuels are more valuable than others. Coal and residual oil have the lowest BTU value, since their use is limited to large installations. Liquid fuels for transportation and home heating have significantly higher BTU values because of their flexibility and unique suitability for transportation. Natural gas is typically somewhere in the middle, but tends to be more volatile due to storage constraints and variable seasonal demand. Growing LNG imports will tend to normalize natural gas price swings.

Coal gasification requires the bulk of the investment and operating cost, while conversion of synthesis gas to fuel is simple by comparison. The higher the product value (eg liquid diesel versus natural gas) the better the return on the project will be.

Coal gasification can be justifiably subsidized by government incentives and funded research since the lead times are long, the capital investment is very large, and ultimate fuel prices are uncertain.

However, a politically dominated process to select the final fuel will not produce the best economic result. There are many competing interests with varying degrees of leverage: coal producers, pipeline owners, LNG importers and liquid fuel refiners and distributors. As a metaphor consider subsidized ethanol. Is it the right energy choice or is it the product of farm belt political leverage?

Conoco and Peabody have announced a program to evaluate a project to produce pipeline gas from coal. The key word in the release is feasibility. It not clear if the project can stand by itself in the current energy cost environment. If it cannot, a subsidy request would be logical.

I don't believe continued congressional legislation on fuel subsidies will encourage the best economic choices. Allowing the market place to decide the best use for expensive and capital intensive synthesis gas is the best approach. The more domestic coal we use the better, however I would hate to have the end result be subsidized fuel gas when the liquid fuels might be able to stand on their own.

Implications:

In addition to confirming the phantom nature of large scale lithium batteries, Toyota is restricting the electrical range of its demonstration plug in vehicles to 8 miles. A very logical decision which reflects the economics of battery storage. A hybrid's current 2-3 mile battery costs on the order $3000 and its cost will be proportional to its range capability. Lithium battery costs for comparable cycle life to Ni-MH batteries are even higher. Toyota recognizes that a hybrid vehicle cost premium approaching $10,000 is perhaps too high for the market to tolerate.

Analysis: A favorite of environmentalists and failing Detroit OEM's like General Motors, plug hybrids sport impressive fuel mileage. Depending on how you calculate the number you can even approach infinity which is great for newspaper headline and politicians. However the economic realities are harsh due to the high cost of putting battery capacity on board. There is limit to how much more a car can cost versus liquid fueled vehicles (especially if you put diesel into the mix). Toyota has correctly assessed the situation and is moving very carefully.

Implications: A project to gasify coal for the purpose of converting it to pipeline quality gas is a good example of incentivized research that makes little economic sense. Coal gasification is the expensive part of the process with excess carbon dioxide emissions and high capital costs. The far better end products would liquids that can garner premium prices as transportation fuels or chemical feedstocks.

Analysis: Coal gasification plants have two major sections. Gasification which converts carbon to synthesis gas (carbon monoxide and hydrogen). This step is followed by product production which is typically a range of liquid fuels, but can also can be focused on methane instead.

Most of the investment and operating cost in these processes is associated with the coal gasification section. The gasification process is very capital intensive, generates large quantities of carbon dioxide and has significant BTU losses interms of carbon content.

The upgrade of synthesis gas to fuels on the other hand is much simpler and relatively efficient.

The proposed project converts the synthesis gas to methane for use as pipeline fuel. In this application it competes directly with emerging supplies of imported LNG.

By failing to capture the inherently higher BTU value of transportation fuels and chemical feedstocks versus pipeline fuel, the project make little sense from a capital allocation standpoint.

What drives the concept is a belief in the long term decline of domestic natural gas production, the existing pipeline infrastructure, large coal reserves and a desire to maintain domestic gas supply without reliance on LNG from the traditional energy exporting regions.

I believe this process concept is an example of vested interests (e.g. coal producers and pipeline owners) focusing on government incentives for increased domestic energy sources. While it makes sense from that narrow perspective, it is not the highest economic use of coal reserves which could be converted to liquid transportation fuels.

Implications: Speciality chemical companies are attracting more interest from private equity. They are also consolidating in typical synergy seeking industry fashion. Although perhaps counter intuitive, rising energy costs raise margins for these companies. Energy and feedstock costs are relatively small  (as compared to commodity businesses) while the added value of their products is becoming higher. Crude's higher trend line is good news for these businesses which improve the effectiveness and economics for a wide range of petroleum based products.

Analysis: For commodity petrochemical producers rising crude cost is a major strategic concern as it not only suppresses product sales but encourages switching to plant based products. For fungible products like polyethylene and polypropylene margins are driven higher mostly by industry capacity shortages. Declining demand due to rising feedstock cost represents a key long term worry.

Specialty chemicals are sold mostly on the value added they bring to the user. As the cost of feedstock grows, the performance enhancements offered by these technology differentiated products makes them more valuable to the user and allows for higher margins for their producers.

Expect valuation expansion and increased LBO activity in this business segment, if crude price continues its recent trend.

Implications: As the US Diesel market switches to mostly ULSD, commercial users are accelerating their rollover to the lower sulfur fuel. The railroad lubricant market has historically been slow changing due to the large capital investments in locomotives and a long history of reliable operation with current technologies. The switch to ULSD will provide additional sales opportunities to the lubricant and diesel additive suppliers as they introduce additional components to compensate for the loss of intrinsic sulfur's fuel lubricity.

Analysis: The EPA, by forcing truck and light duty diesel stations to supply only ULSD fuel, has laid the groundwork for a complete rollover of the diesel and heating fuel market. Refiners have installed the desufurization equipment and adjusted their operations to emphasize the large road transportation segment, making production for currently non regulated uses such as railroad diesel less attractive. The switch was to be enforced for railroad in 2013 but Metro North will switch in 2008.

Removing virtually all the sulfur from diesel permits not only reduction of the "diesel smell"  but significantly reduces acid emissions. Sulfur removal also allows reduction in NOx and soot by extending the emissions system performance and operating life.

The downside in the loss of sulfur's intrinsic fuel lubricity which must be compensated by additional additives in the fuel and lubricant. The new formulations will provide not only additional additive volumes, but will open up the railroad market to market share shifts as the additive suppliers respond with modified railroad formulations. These new formulation should provide oil and engine lifetimes comparable to or better than today's oil and high sulfur fuels.

Among the publicly traded additive suppliers,  Innospec will likely receive the most benefit from the increased fuel lubricity additive volumes due to their current large share in diesel additives. Lubrizol should benefit the most from any railroad lubricant additive share shift due to its strong technology position and experience in the railroad market. 

Implications: While stating the hydrogen is only a "vector" to transfer energy from one form to another, Dr. Kajumulo continues to stress its value as part of a global electrification scheme. Ignoring thermodynamics may fill up UN sessions with verbiage.  However, ignorance will not help the world find new sources of energy. Creating hydrogen out of anything, transporting it, and then converting it to electricity consumes far more energy than can be delivered for mobility. There are plenty of better answers for a world becoming increasingly desperate for transportation fuels: coal to liquids. nuclear energy to electricity, LNG and even conversion of biomass to fuel with future catalysts.

Analysis:  'The debate about transport should not be left to experts or to engineers', suggested Dr Anna Kajumulo Tibaijuka, Executive Director of the UN-Habitat urban development programme.

While I sympathize with Dr. Kejumulo's desire to insure that urban railway systems are well supplied with electricity, I find her emotional argument a little silly (or self serving). Her suggestion that railway systems should switch to hydrogen fuel cells in areas where the capital cost of track electrification simply can't be justified.

Hydrogen fuel cells do work. However they are cost and energy justified by reason of unique circumstances such as the space station.

Implications: Small fuel efficient vehicles have never been an easy sell in the US with our historically low gasoline taxes and long driving distances. The success of the Toyota Prius is perhaps more associated with the high recognition factor of its distinctive bubble design rather than the actual economic benefits of its fuel efficiency. If you are marketing to early adopters, it pays to have a distinct design which reinforces the owners' mind set and provides facile public recognition of their values.

Analysis: Consumer anecdotal comments suggest that a major reason for the success of the Toyota Prius is due to its distinctive design. The bubble shape screams "I am green and I care enough to do some something about it". Retrofit of hybrids into conventional vehicle shapes by Ford and Honda have been much less successful. Nobody has to lecture Apple about the cool factor but apparently some of the auto companies still need some marketing lessons.

Many studies have shown that the total ownership cost benefits of gasoline electric hybrids are underwhelming in the absence of a large proportion of stop and go urban driving. Most Prius purchasers react more to the concept of fuel savings and want public recognition for their beliefs. A small hybrid logo on a conventional body just doesn't have the same visibility and benefit.

As the auto OEM's move towards introducing the next generation of fuel efficient vehicles (including diesels) I hope they pay as much attention to the exterior and marketing strategies as they do to engineering a value added product.

Implications: Legislative consensus building is never easy to watch, however it is apparent that the climate change lobby will likely be successful in limiting major subsides for coal to liquids plants. At the same time Detroit, which can ill afford sudden changes in product mix, will benefit from kid glove treatment on CAFE standards. What is surprising is Detroit's inability to communicate when it does something well, like introducing more diesel engine capacity in the US.

Analysis: It is perhaps no surprise that the anti energy forces where able to effectively use increased greenhouse gas emissions as a lever to severely limit subsides for coal to liquid plants. Their point with regard to increased carbon dioxide omissions is at least logical. The bottom line is that without subsides, these CTL plants will not be built as uncertain future liquids prices cannot justify the massive capital investments required.

Unwilling to further damage GM and Ford's precarious market position (especially just prior to UAW negotiations), Congress has little appetite for major changes in CAFE standards. A more logical policy of a sustained program of regular future fuel tax increases to encourage conservation and ease product planning is politically impractical.

What is surprising is the weak PR offered by General Motors and Ford in support of their fuel efficient product offerings. Last week, GM announced that their Tonawanda plant would retrofitted to produce 1 million 4.5 liter diesel engines. These engines will be offered in SUV's and light duty trucks starting in 2010. A 25% fuel efficiency improvement in an important part of their product line is something to crow about, yet publicity on the strategy has been limited.

Implications: About 70% of consumers now rely on others to change their oil, a proportion which is expected to increase. DIY oil sales are declining with a loss of oil brand market impact. This trend favors the additive suppliers as customers rely increasingly on specific oil quality recommendations from OEM's and service providers. In response to this complexity, the oil companies are increasingly relying on the additive suppliers to customize and differentiate their product offerings leading to higher margins.

Analysis: Historically the weakest margins in the lubricant additive business have been associated with the very large engine oil segment. These products have always been sold to broad industry standards which ensure good quality. However these standards have limited product performance differentiation, as most additive purchase decisions in this segment are price focused.

Consumers are increasingly relying on others (service shops and OEM's) to recommend oil quality and brand. In 1995, 65% of consumers changed their own oil. Today almost 70% have someone do it for them.  As a result, engine oil is increasingly becoming a niche market opportunity with many brands now going beyond minimum performance and delivering specific attributes required by modern engines including longer change intervals.

In most cases these niche oils are developed by the additive companies, not by the lubricant marketer. These custom packages are sold at higher margins and over time should account for an increasing share of the engine oil business.

I believe even better times are ahead for Lubrizol and Newmarket as their margins approach those more typically seen in other value added speciality chemical businesses.

Note: The original article title should read "Reaching Today's Do-It-Yourselfer".

Implications: The growth of biodiesel as a blend component in US and European diesel fuels will improve the outlook for the public additive suppliers: Lubrizol, Newmarket, and Innospec. Biodiesel significantly increases the complexity of the combustion process and has the potential to reduce engine life and operability. Unless the fuel and lubricants are managed with an increasingly complex additive slate, consumer satisfaction will suffer. I expect these companies to transition their fuel additive businesses towards a more service rich offering which will further increase the already high margins of this niche.

Analysis: Infineum comments on the growth of biodiesel as a blend component in diesel fuel and points out some of the complex interactions that can result from even the addition of small (5%) quantities of biodiesel in conventional diesel fuels.

Biodiesel (derived from plant oils and animal fats) is now an accepted diesel component when used at the 5% level. As the raw materials can be domestically sourced or obtained from locations with less political risk, there are considerable government incentives to increase both the volumes and the allowable blend concentration.

However the properties of the blended fuels are different in several ways including: 1)low temperature flow, 2)accumulation of more fuel in the lubricant sump and 3)a more corrosive engine environment which could reduce engine life and increase expensive maintenance.

Lubricant and fuel additives can manage these issues, however the complexity of the numerous fuel blends will require a higher level of customization than currently seen in the additive business.

The additive industry will benefit not only from increased sales of lubricant and fuel additives but a transition to a more service oriented sales approach with substantially higher future margins.

Implications: Behind competitors in electric hybrid technology, General Motors is pursuing a self destructive strategy while dreaming the impossible dream of an electric vehicle with 40 miles of range. Put simply, is there a market for a smallish car with a minimum battery price premium of $10,000 over liquid fueled vehicles and an uncertain range and cycle life. General Motors should spend more technology effort on bringing modern diesel technology into their fleet before it is too late.

Analysis: In an effort to bring forward a fuel efficiency strategy at all cost for the public and its shareholders, General Motors is persuing a plug-in/small engine hybrid vehicle with 40 miles of range. This large a light weight battery system has yet to be demonstrated commercially. Furthermore, even if possible to build, the cost for the required 15 Kwhr of energy storage will exceed $10,000 without massive and unknown changes in battery construction techniques and materials.

General Motors is skipping several generations of technology and talking about what is essentially vaporware when their strategy should be short term.

Their emphasis on E-85 fueled vehicles while not useful in terms of energy conservation is at least appropriate from a political standpoint since the fuel is domestic and vehicles easy to build.

Bringing forward more diesels into their fleet would be a much more logical step.

Implications: The Accord Hybrid was a poorly conceived car which failed to generate  significant consumer interest. Rather than focusing on fuel economy, Honda chose to market higher performance, pairing the electric motor with a large 6 cylinder gasoline engine. The resulting small improvement in fuel economy versus the popular 4 cylinder Accord could not justify the hybrid's significantly higher purchase cost. Look for Honda to switch to new clean diesels (with and without hybrid drives) in their mid to larger cars and light duty trucks.

Analysis: Honda has historically lagged Toyota in hybrid design concepts and sales. Failure of the Accord hybrid in the US confirms the trend. The failure was in the marketing plan which stressed improved acceleration with only a slight fuel economy improvement. Well behind the Toyota Prius in fuel economy, and only slightly ahead of its very popular sister 4 cylinder Accord, the Accord 6 cylinder hybrid did not really have niche.

Honda needs to develop new fuel efficient approaches to compete effectively against Toyota. A logical response would be to accelerate introduction of high performance diesels into the North American car and light duty truck markets. Diesels, which offer a 25% fuel economy improvement over comparable gasoline engines now offer low emissions in addition to attractive driving characteristics.

A major beneficiary of accelerated diesel growth will be the fuel additive suppliers since diesel fuels require significant amounts of additives to perform properly. Publicly traded companies include Lubrizol, Newmarket and Innospec.

Implications: The IPO of Clean Energy was weakly received reflecting a lack of profit visibility, a long ramp up for distribution and a lack of specific future demand. The problem is not energy economics which favor LNG and compressed natural gas over gasoline. It is a combination of the lack of political sponsorship as compared to ethanol and the fact that no US auto OEM is pushing natural gas as a domestically sourced transportation fuel. General Motors and Ford should be paying more attention to this concept instead of ethanol and hydrogen.

Analysis: Natural gas fueled vehicles are popular in urban areas outside the US where their favorable reliability, low emissions, good economics and a reasonable commercial delivery structure make them attractive versus gasoline fueled cars and trucks. US penetration is much lower due to lack of an infrastructure for delivering natural gas or LNG to vehicles. Clean Energy is attempting to introduce the approach starting with fleet cars and light duty trucks.

The lack of a supportive political base has pushed the natural gas concept well behind the much less attractive ethanol as the preferred domestically sourced transportation fuel. In addition, Ford and General Motors have chosen to promote ethanol (E-85) fueled cars as the answer to foreign energy dependency. Introduction of mass market  natural gas fueled cars would be a much better choice for them and of course Clean Energy.

Implications: Fearing continued loss of car and light truck market share due to the absence of fuel efficient hybrids and diesels, GM is has made a board level decision to sell sizzle rather than steak. Ramping up design studies on vehicles where cost effective commercial technology is lacking (hybrids with extended range batteries) or simply silly (hydrogen fueled cars) puts nothing new on the road. GM appears to hope consumers will be confused by their press releases and buy the noncompetitive vehicles they are forced to build.

Analysis: At least GM knows they are in trouble:
 
"We saw how quickly the mantle of environmental leadership had been seized by Toyota because of the Prius," said GM Vice Chairman Bob Lutz. "The Board knew that if Toyota continued unchallenged, then this would sooner or later doom our sales"

However their response is hardly marketable product focused.

According the the Journal, GM decided on a dramatic idea for addressing global warming and oil consumption- an environmental "halo" vehicle that would cast a glow over GM's entire product line.

Their concepts include (1)an extended range (40 mile) hybrid with a large battery and a very small engine (2) hydrogen fueled cars using fuel cells.

The extended range hybrid (with currently undefined batteries) will be very expensive due to the battery cost and suffer the fixed range limitation of all pure electric vehicles. I don't believe this concept is particulary advantaged over today's conventional electric hybrids with about 3 miles of electric range and a small engine.

Hydrogen fuel cars make little sense in the absence of a very expensive distribution infrastructure and abundant nuclear power to generate the hydrogen.

What should GM do? How about emphasizing the diesel engine technology they have in Europe and introduce competitive light duty diesels into the US market. Diesels offer a 25% fuel efficiency improvement with no sacrifice in driveability. Sound like the basis for a reasonable marketing campaign to me. They could probably sell a few more cars rather than trying to confuse potential customers with press releases describing products they can't buy.

Implications: Coal to liquids projects have always suffered from the high capital investment combined with an uncertain product value. Global warming activists have now introduced excessive carbon dioxide production into the mix, making it even less likely that a consensus can be developed for the subsidies needed to make coal to transportation fuel a practicality.

Analysis: This article portrays a swarm of global warming believers surrounding plans to move coal to liquids plants forward through essentially a political process. If you believe carbon dioxide emissions are a problem, your concern about these plants is well placed as they will emit significantly more carbon dioxide than refining crude to gasoline or diesel.

These projects because of their long lead times and high capital investment will require some form of subsidy to deal with the vagaries of crude pricing. Historically, a subsidy consensus could be built around abundant US coal and independence from foreign crude imports.

However the emergence of green house concerns makes building this consensus significantly more difficult. The coal companies and their political advocates will have a much harder time in the current environment

Implications: Urban taxis present an ideal opportunity to demonstrate the fuel efficiency of liquid fueled hybrid electric cars. New York's policy decision to fully convert their taxi fleet is a wise decision that will offer fuel savings to the operators, air quality benefits to the city and an opportunity to demonstrate hybrid reliability and performance to future consumers both commercial and individual.

Analysis: Congested urban driving is the ideal environment for demonstrating the fuel savings capability of electric hybrids. The driving cycle is severe with long idle times, extensive low speed operation and repetitive stops. In addition to severity, the annual mileage is often close to 100K per year due the intensive shift use of the vehicles. 

Because of this severe service pattern, taxi fleets have historically been used to demonstrate life cycle performance of new automotive components and engine oil lubricants.

Urban taxis are the ideal environment for demonstrating the idle time efficiency and braking energy recovery of hybrid electrics. Hybrid use in public taxis will encourage more consumers to consider them, and the results of the demonstration will provide useful marketing material for the auto suppliers.

I expect the auto OEM's to compete heavily to ensure their vehicles are part of the fleet. Honda and Toyota have the strongest existing hybrid vehicle lineups. GM and Ford can't afford to be left out, but their lack of commercial  hybrid technology puts them at a disadvantage.

Battery suppliers will also benefit both near term from exposure and longer term from incremental sales. Most commercial hybrid batteries are supplied by joint ventures with the Japanese auto OEM's. However this opportunity will be too important to pass up for some of the smaller battery companies with opportunities to partner with the Detroit OEM's.

Implications: Toyota's commitment to battery electric hybrids continues with further extension into their luxury models. Toyota correctly judges that the combination of electric and liquid fuel propulsion offers improved fuel efficiency whatever the liquid fuel source (gasoline, diesel or future biofuel). Growth in hybrids will increase the growth potential for firms supplying batteries, electric power systems, and their raw material suppliers including copper and lithium.

Analysis: Hybrid electrics provide the attractive ability to efficiently load level a relatively smaller fueled engine and also recover the energy normally lost during braking. The approach can be combined with any fuel  to allow the use of smaller engine and to generate substantial fuel savings.

As Toyota correctly states, the type of fuel is not critical to the concept. While all commercial hybrids now use gasoline engines, the concept will be introduced with diesel engines into light duty passenger cars and delivery trucks.

The hybrid concept has staying power and companies supporting the partial electrification of vehicle propulsion will benefit. Expect future growth in battery production, electric power control systems and raw materials such as copper and lithium.