(A version of this post also appeared at GigaOM.)
tl;dr: Cleantech VC is receding because of poor short-term performance – no surprise in a post-bubble field with outsized time and money requirements. The category is about to go on a walk in the woods, where innovators will blaze a new trail.
In late 2011 I decided to write up an internal analysis I’d done at Venrock about the state of cleantech venture capital and make it available broadly. I’m a fact-based, research-driven guy, so I tried to shine the light of data on myths and realities in the field. My macro conclusion was that while it was really early, investment returns to date were on par with VC overall.
Much has changed since then. With 2012 numbers done and dusted, I figure it’s time to revisit this topic – again, under the light of data. I’ll frame this analysis with the questions I’ve gotten from VCs and entrepreneurs who’ve asked me for an update.
What’s happening to cleantech venture capital?
Why is this happening?
Cleantech VC performance is substantially lagging venture capital as a whole. This wasn’t true in 2011, but things changed fast in 2012.
I arrive at this conclusion by comparing two data sets. On one hand, we have data on the interim performance of 19 cleantech-only VC funds as reported by the California Public Employees’ Retirement System (CalPERS), a big LP. On the other, we have equivalent data for the entire universe of VC funds from the National Venture Capital Association. (The data are expressed as “value to paid-in capital, net to LPs,” which means “the current value of the funds divided by the money put into them, accounting for what VCs pay themselves.”) By comparing cleantech-only fund performance with the full VC universe at the same points in time, we can see whether cleantech is doing better or worse than the asset class.
The answer is that cleantech went sideways in 2012 while VC overall did well. In September 2010, the cleantech VC funds were worth 0.90x the money paid into them while comparable VC funds overall were at 0.96x – roughly the same. Six months later the gap had widened, but both had risen in value and remained within spitting distance. By June of 2012, however (the most recent data available), the cleantech funds had declined slightly while the overall VC universe climbed to 1.23x.
This is why investment is stalling, LPs are hesitating, and cleantech VCs are thinning: Capital invested in other domains is showing a greater near-term return.
If minimal money had gone into cleantech, or if the macro environment were rosier, there might be more willingness to forge ahead. But today, fund managers assess the $25 billion worth of cleantech VC invested since 2003 against a backdrop of shale gas and climate apathy – and tighten the purse strings.
OK, but why is that happening? What’s driving weak cleantech VC performance?
Two factors. First, there have been too few exits.
Let’s consider the gold standard of VC wins – an IPO on a major exchange. When I last did this analysis, cleantech was overperforming on the IPO front: In 2009, 2010, and 2011, cleantech’s share of VC-backed IPOs exceeded its share of VC funding. (Note: One must apply an appropriate time lag to the latter – I used five years, which is informed by deal-by-deal fundraising data by cleantech start-ups).
This ended in 2012. Just as in the prior year, three cleantech IPOs took place out of about 50 VC-backed IPOs in total (6%). But cleantech’s corresponding share of VC funding rose to 10% – so cleantech was now underperforming on exits relative to capital invested, instead of overperforming.
(Of course, most VC-backed companies exit through acquisition, not an IPO. But the M&A front looks no better for cleantech. When merchant bank Jane Capital counted up every acquisition of a VC-backed cleantech start-up worth more than $50 million in the last 10 years, it found just 27 of them.)
Second, the winners have disappointed post-IPO. When a start-up goes public, its VC investors rarely get to sell their shares immediately: They have to wait out a lockup period that typically lasts six months. Of the nine VC-backed cleantech start-ups that have done major-market IPOs since 2010 and have been public for more than six months, eight were trading below their IPO price at the 180-day mark.
In four of those cases, the 180-day share price was also lower than the price at the last venture round. That means VCs who bought shares in that round were under water when the lockup expired.
So is the pullback in cleantech VC justified?
Well, it’s certainly expected. The cleantech gold rush of the late 2000s saw hundreds of start-ups funded – many with identical propositions – that greatly exceeded the carrying capacity of their industries: For example, there’s no way that more than a handful of the 219 solar start-ups counted by Greentech Media in 2009 could possibly succeed. This dynamic isn’t unique to cleantech. The Internet VC bubble of the late 90s was the same story, albeit on a much larger scale.
But just as the boom-and-bust in dot com investment didn’t mean this whole Internet thing was a waste, the same is true for energy and environmental technologies. It’s very likely that multiple billion-dollar companies lurk among today’s cleantech VC portfolios. The question is – given the current retrenchment of capital from the field – how many of them will get the fuel to reach the finish line.
In the main, energy and environmental start-ups need outsized time, money, and risk tolerance to reach a big outcome. (That’s not true of IT-meets-energy “cleanweb” companies like Opower or Venrock-backed Nest Labs, but it holds for the deep-tech start-ups that comprise most of the category.) As our case study, let’s take First Solar, the pioneering thin-film solar maker. The company’s first instantiation was founded in 1990; it took 12 years to ship a product, was restarted in 1999, and consumed $150 million of equity investment (all Walton family money) before its 2007 IPO. But at that outcome, First Solar was worth $1.4 billion valuing the Walton stake at 8.4x. Two years later at the peak of the solar boom, it was worth 199x!
If this is what success looks like – that is, if the majority of cleantech start-ups will need more time and money to reach big outcomes compared with VC-backed companies overall – a few conclusions follow:
Cleantech VC now is like Internet VC in 2001: on the downward slope of a bubble, albeit with a more gradual climb and a gentler descent. Note that Facebook was conceived in 2003 – the lowest point for Internet investing post-bust – and that in 2004, Google’s IPO kicked off the renaissance that persists today.
So is the cleantech pullback justified? The data says it’s too early to call. However, it also suggests that the time frame required to reach a conclusion will greatly stretch 10-year closed-ended funds.
(A diligent reader may point out my own numbers showing that when VC-backed cleantech start-ups have gone public, they’ve mostly done so in less than 10 years. My take is that most of these companies were rushed to public markets before they were ready – explaining the awful aftermarket performance.)
What happens now?
Cleantech innovation is about to take a walk in the woods. Justified or not, the established path of VC-backed investment is narrowing for a generation of start-ups. Some of those companies – and some of the investment managers that have backed them – will break off into the wilderness to find a new route.
In this environment, I see opportunities in:
tl;dr: U.S. hybrid vehicle sales were up 61% in 2012. It’s unclear why.
Riddle me this: Why did U.S. hybrid sales take off last year?
Prior to 2012, hybrids looked like something between a fad and a niche. Sales peaked in absolute terms way back in 2007 and hybrid market share maxed out in 2009. Despite rising gasoline prices, it seemed that Americans cared neither about getting 50 miles per gallon or the environmental benefits thereof.
Then last year happened.
Hybrid sales rose 61% to 434,498 cars in 2012 – the biggest absolute increase ever and the biggest percentage gain in seven years. Hybrids accounted for 3.0% of new vehicles sold, up 42% from 2011.
The big question: Why?
It wasn’t new choices. While nine new hybrid models were introduced in the States in 2012 (of a total 44 available), they accounted for only 9,708 hybrids sold (2.2%) – and the Prius took half the market like it has since 2009.
It wasn’t a price drop. Prius sticker prices fell $2,500 last year (about 11%) as Toyota restocked post-Fukushima, but prices of conventional non-hybrid cars from Japan dropped too.
It wasn’t higher gas prices. Retail gasoline prices were nearly flat from 2011 to 2012. (And if the gas price determined sales, hybrids should have peaked in 2008 and plummeted the year after; neither one happened.)
It wasn’t an improving economy. Real GDP growth was 2.2% in 2012 and 2.8% in 2010. Yet hybrid market share blew up in 2012 and shrank in 2010.
It wasn’t more driving. In fact, annual vehicle miles traveled per person fell slightly in 2012, extending a trend that started in 2004. “Peak car,” anyone?
tl;dr: To successfully target VCs, view your deal through their eyes.
I got an outstanding piece of advice in my first job: “Always see the world from the other person’s point of view.”
If you’re trying to sign the pivotal customer, think from their perspective about what price they can accept. If you’re trying to recruit the killer engineer, understand how she weighs moving her kids when they’re halfway through elementary school.
And if you’re trying to raise capital from a VC – someone who invests other people’s money, and is out of a job if there’s insufficient return – analyze your own deal the same way he will.
I learned this the hard way.
In 2007 a somewhat younger and substantially less gray-haired Matthew was out raising a venture capital round for my previous company Lux Research. The good news is that it ended well – we were fortunate to bring on west coast VC firm Catamount Ventures, where partner Mark Silverman brought a rare combo of vision and pragmatism to the board. The bad news is that I wasted a lot of time pitching to firms that I should have known weren’t a good fit in advance, because the returns math couldn’t work for them.
My mission today is to arm you so you don’t make the same mistake.
When a VC investor hears your pitch, he’ll do math in his head to figure out if your company is in-bounds. (While bigger factors like team and market determine a “yes,” the math can rule out a “no.”) Typically, he’s answering two questions:
1) Can this investment move the needle? A venture investor can only attend to so many portfolio companies at once. To earn one of these limited slots, an investment has to be “needle-moving:” A successful outcome must be big enough in absolute terms to warrant a spot (regardless of the ratio of dollars out to dollars in).
As you can imagine, what’s needle-moving depends on the size of the fund that’s making the investment. A billion-dollar fund needs billion-dollar IPOs to return a profit; while investing $1 million into a company and getting $10 million back would yield a phenomenal 10x return multiple, you’d need 100 such outcomes just to break even! On the other hand, the same $10MM-for-$1MM return would be massive to a $10MM seed fund, where that single investment would put the fund in the black.
While there’s no magic number, a decent rule of thumb is that a needle-moving investment must return at least 10% of the fund to the VC in the success case. Here’s a close-to-home example: At Venrock we’re currently investing out of a $350MM fund. “Needle-moving,” according to this heuristic, is therefore $35MM. We tend to own 20% or so of the companies we invest in on average, so any one of them must be capable of being worth $35MM / 20% = $175MM when it’s bought or goes public – at an absolute minimum. If a successful outcome for your company would be getting acquired for $20-30 million dollars, you should not pitch me; target other investors with more appropriately-sized pools of capital who would view this outcome as a big win.
2) Is the return multiple big enough? After assessing the absolute return, the math moves on to the return multiple, which is a relative measure. If everything goes right, how many dollars will I get out for each dollar I put in?
The return multiple that a VC investor seeks depends on the stage at which it invests, because of the time value of money: You earn about 8%/year if you make 2x your money over 10 years, but you could earn the same 8% by getting 1.08x in one year. As a result, early-stage investors (who invest at company founding and go 5-10 years before seeing an outcome) target higher returns than growth-stage investors, who aim to put in money shortly before the acquisition or IPO. Also, early-stage investors fund younger, riskier companies, most of which fail. Therefore they seek higher multiples in the success case than do growth-stage investors, who make some profit on most of the companies they back.
Again, there’s no magic number, but a good rule of thumb is that an early-stage VC needs to be able to envision a 10x return multiple if everything goes right. (A growth-stage investor, on the other hand, may see 2x to 5x as the target to hit.)
Armed with these principles, you can model the investment returns that a VC would get by putting money into your company, and use that information to target your investor search. Use the spreadsheet template that you can download here (which I’m archiving on the tools page) to do the math and model the return from the VC’s perspective. As inputs, you’ll need your financial projections (revenue, cost of goods sold, and opex); your capital plan (how much money you’ll need to raise and when); and a valuation metric (the spreadsheet uses price-to-sales, but you could also use price-to-earnings – in any case, set the metric by looking at comparable companies that have gone public or been acquired, and use a conservative consensus number in the model). What you’ll get out is the VC’s absolute return and return multiple.
As an example, consider this case:
Let’s say that this company is an energy analytics start-up trying to figure out if it should pitch to VC X, an early-stage investor with a $300MM fund. The company is raising a $10MM Series A aiming for a $15MM pre-money valuation, and thinks it will need another $25MM in two years to get to profitability. It believes it will have $80MM in revenue at year six, and an analysis of comparables shows that similar companies have been bought or gone public at 5x revenue. VC X would do half the A round ($5MM, purchasing 20% ownership) and invest its pro rata amount of the round to follow (i.e., 20% of the $25MM B round = $5MM more in two years), for $10MM invested over the life of the company (if everything goes right).
The good news is that, from VC X’s perspective, the investment clears the “needle-moving” hurdle. If the company hits its $80MM revenue target in six years, it’s worth $80MM x 5x = $400MM; VC X will own 20%, so its absolute return of $80MM is well above 10% of VC X’s $300MM fund size.
The bad news is that VC X can’t quite see its way to a 10x return. It’s going to put in $10MM in total ($5MM now and $5MM later) for an $80MM absolute return, yielding a multiple of $80MM / $10MM = 8x. This is good, but not excellent if it’s an upper bound; if it represents a true maximum it may not be enough. There would likely need to be compensating positive factors (phenomenal team, opportunity to expand to other markets, a pivotal early partner, demonstrably active acquirers) for this opportunity to compete against others.
A secondary point worth noting: The $10MM invested over the life of the company would be 3.3% of VC X’s fund – big enough to be a “real” investment worth a partner’s time, but not so large that it sucks up too much of the fund (VCs generally avoid putting more than 5%-10% of a fund behind any one company).
When you go through this exercise, run multiple scenarios – the VC you’re pitching certainly will! See what things look like with a slower revenue ramp, a lower valuation metric, a higher capital requirement (Venrock lore holds that companies typically require 2.5x more money over their lives than they anticipate at first fundraising), etc. However, I don’t recommend putting this kind of analysis into your pitch deck – it presupposes too much knowledge of the other party’s motivations and comes off as kind of arrogant. Keep it to yourself and use it to inform your financial plan.
tl;dr: Nest Labs performs magic – making energy efficiency awesome, even for the nontechnical and non-green. We’re delighted to invest in the company.
Back in February I acquired a Nest Learning Thermostat, famously designed by Apple’s original iPhone team. Looks cool! Learns your habits! Controlled from your phone! At the time, I felt the product was something of an overhyped fetish object for energy nerds, but I was happy to get one as I sit squarely in that demographic. (Plus, while the Honeywell thermostats in our home were nominally programmable, their interface was so obtuse that we never set them and thus wasted money.) Behold the tweet:
And then it sat in the box for four months.
It’s not that I didn’t want a beautiful piece of industrial design on my wall – it’s that I believed installing a thermostat was a perilous project that would consume a weekend afternoon. Every time Mrs. Nordan and I thought “you know, we really ought to put that thing up,” we quickly found a reason to do something else. And so it sat in the box.
Until June, when my colleague Matt Trevithick came over for dinner and asked me how we liked our Nest. I sheepishly responded that it hadn’t made it to the wall. Matt assured me that the setup was super-easy (he had one) and declared that we’d be doing the installation that very second.
Mrs. Nordan and I accepted the challenge. The ground rules: she’d 1) do the whole thing, 2) use only what came in the box, and 3) time it (it’s supposed to be a half-hour job). If you want the details, see this photo log, but the bottom line is that Matt was right. The entire process was simple; every conceivable thought was given to user-friendliness (down to the bubble level built into the backplate, so as not to install the thing crooked); and the network and app connectivity “just worked.” We clocked in at 22 minutes for the install, followed by 15 minutes’ worth of software updates (that’s what I get for waiting months to activate the thing).
Done. Niche nerd product: operational.
But in the two months that followed, it became clear that this was not a niche nerd product. I had underestimated Nest. As I used the thing, I saw that:
I concluded that I wasn’t looking at a better thermostat. This was something else: the reinvention of an unloved category via thoughtful design. Nest was to its ilk what the Prius was to cars, what Tivo was to VCRs, or – best comparison – what Dyson was to vacuum cleaners (20% market share in the U.S. at 4x the average price point just three years after introduction). And if this team could make a thermostat (of all things) into an engaging product, who knows what else they’d come up with?
Shortly thereafter our energy team at Venrock evaluated Nest Labs as a venture investment. I’ve written before in this space that the smart grid has been a failure for consumers because it’s all too complicated and no one cares. To change the input/output ratio of consumption, the experience has to be awesome, winning on merits instead of getting by on shame. Having looked at this field for many years we’ve seen a ton of consumer energy propositions; Nest was the first one to clear this essential bar.
tl;dr: Mrs. Nordan vs. Nest thermostat! Will it take an afternoon to install? Will we ruin our house in the process? No on both counts!
In June we installed a Nest Learning Thermostat in chez Nordan; I helmed the camera for the obligatory unboxing post, but promptly got occupied with other things and left the pics to languish on my laptop. Better late than never? For context on why I’m posting this months after the fact, see “Installing a Nest, Investing in Nest.”
What’s in the box. What you can’t see here (because we were speeding through it and/or I am a lazy photographer) is that the screwdriver, wall screws, anchors, etc. needed to get the thing mounted are in the box too.
On the chopping block: The inscrutable Honeywell thermostat that we’re replacing.
Honeywell with the faceplate off. See those wires? They provide power and talk to the HVAC system. Our mission is to get them plugged into the right spots on the Nest.
The Nest box includes little labels to wrap around the wires as you unplug them, so you won’t forget which is which when you have to plug them back in. We duly attach them.
Penciling in holes where we’ll put the anchors for the wall screws. More user-friendliness: Note that the Nest’s backplate has a level built into the front of it so you won’t mount the thing crooked.
Drillin’. We probably could have just bored a hole, but, you know, completeness.
In go the anchors.
Attaching the backplate.
Good. Now time to plug the wires into the tabs. The labels on the wires have letters on them that match up to the tabs, so even we can’t screw this up.
Done. Once the wires are plugged in you moosh them back before attaching the faceplate.
Faceplate goes on…
…and we’re up! Note that the display doesn’t actually look like that – it looks like a normal LCD display – it just showed up with these artifacts when captured through my camera.
Connecting the Nest to WiFi. Once we’ve done this, the stopwatch reads 22 minutes, at which time we’re done with the physical install. But, this being 2012, we wouldn’t be done without…
…software updates, of which we got three, totaling 15 minutes altogether; the Nest rebooted itself between each. This was the only annoying part of the installation and one that took longer than I expected (how big can a thermostat firmware update be?) I presume that if we hadn’t waited four months between getting the thing and installing it we wouldn’t have had three of these in a row. While it’s downloading, let’s get the iPhone app running:
App store entry. Confidence-inspiring rating.
On its way…
The app finds the Nest automatically; we have to click the thermostat itself to complete the enrollment. (I find myself wondering if/how/when this could be hacked. Be ever vigilant, Nest Labs.)
tl;dr: Winning cleantech start-up teams are complete at founding, have strong pre-existing relationships, and include the inventor of the core technology.
A year ago I published a post called “What It Takes to Build A Cleantech Winner” based on an analysis of 18 cleantech success stories – venture-backed start-ups that executed big IPOs. The conclusion was that it’s not the technology (the best one rarely wins) and it’s not the market (if the market’s already big and attractive, you’re probably too late); instead, it’s the team that determines success.
That begs the question: What makes a great team?
To answer this question, you’d need to do two things. First, you’d need to analyze the personal histories of core team members at a slew of successful cleantech start-ups to figure out what they had in common. Second, you’d need to compare these people against their peers at unsuccessful companies in the same domains, to learn whether the winning teams differed from the losing ones.
Taking up the challenge was Josh Rogers – then a student at Tufts’ Fletcher School of Law and Diplomacy – who interned with me and conducted this research for his master’s thesis. Josh went about it like this:
When Josh began his work, we joked that maybe he’d crack a hidden code: Perhaps I’d hear “Well, Matthew, at all the winning start-ups the CEOs were in their 40s and joined from large companies, while the CTOs hailed from the following five universities.” If so, I could simply ignore all the other business plans I get and focus on the ones that matched the template. Hey, a man can dream, right?
That didn’t happen.
In fact, when we looked at the winners, we found that nothing at all seemed to correlate with success. Founding team members’ ages were all over the map, from Genomatica CEO Chris Schilling (26 years old at company founding) to First Solar impresario Harold McMaster (an octogenarian at 83):
No variety of undergraduate education dominated (although Ivy League degree-holders should perhaps beware):
Among graduate degree-holders, no university stood out. In fact, across the 51 successful team members with advanced technical degrees, 39 universities were represented with only three appearing more than twice (MIT, U. Illinois, and CMU):
And so on. In fact, the only interesting correlation we found was that team members at winning companies tended to be industry outsiders: A mere 28% of them had direct work experience in their start-up’s industry. However, this attribute didn’t predict success because it was the same for our sample of failed companies too (where 26% of execs had prior direct work experience).
At this point, we changed our approach. Perhaps we were asking the wrong questions? Instead of studying the individuals, Josh began looking at the relationships between them. It’s here that we found the trends hiding in plain sight:
Winning teams were complete at company founding. Of the 88 key executives profiled in the 27 successful companies, 74% were present at founding and another 9% joined during the first year. Only one out of six joined after that.
CEOs changed rarely. MBA orthodoxy holds that different stages of a company’s life require different leadership skills, so the CEO should be swapped out as companies develop. Our data didn’t support that. Eleven out of 27 successful companies had a CEO at founding who stayed through the IPO or S-1 filing; another eight were founded without a CEO, but recruited one (usually in the first year) who stayed for the long haul. Only eight winning companies changed CEOs, with only one clearly hostile transition (namely Elon Musk’s takeover at Tesla).
Successful founding teams had strong pre-existing relationships. At 74% of successful companies, at least two of the founding team members had strong relationships before the company was formed – either from working together in past lives (e.g. the four Color Kinetics co-founders, who shared lab space at CMU) or knowing one another well outside of work (e.g. Solazyme’s CEO and CTO, who became close friends as freshmen at Emory).
Winning start-ups included the accomplished core scientist who invented the technology as part of the founding team. Two-thirds of the winning companies exhibited this trait – think Frances Arnold at Gevo or Yet-Ming Chiang at A123Systems. I frequently see start-ups out of universities where the key technologist declines to join the founding team, choosing to remain in academia instead and consult with the company at most; this behavior doesn’t seem to correlate with success.
When Josh examined our matched-pair set of failed companies, they exhibited the opposite trends:
The conclusion: Great founders hail from every age, background, and school. What differentiates winning teams is their relationships. Successful cleantech companies tend to be bands of brothers and sisters – including the core inventor – that come together on their own, form a complete team, and have a leader fit for the long haul. In contrast, here’s the recipe for a failure: Find an interesting technology, assemble a team of competent people around it who didn’t previously know one another, and don’t worry about bringing the original inventor along.
tl;dr: Life is about to get a lot better for demand response and energy efficiency companies.
One of the challenges of venture capital is that you invest in companies now based on what you know now, but the world may look very different by the time the company exits (i.e., when it’s bought or goes public).
When people talk about this, they usually cite the investment bets that look dumb in retrospect – where investors deployed capital at a time of heady expectations and woke up to cold reality later on. (Amidst dot-com hysteria, otherwise-smart people could envision their morning coffee delivered by Kozmo and paid for with Flooz; afterward, not so much.)
However, one can also make the opposite blunder: Deciding not to place bets in a downer environment, and then missing the opportunity to reap returns when things look up.
This is the milieu that demand response and energy efficiency start-ups face today.
Whether they are reducing electricity demand at peak times (Enernoc, Gridium), deploying energy-efficient retrofits (NextStep Living, Ameresco), or doing high-tech real-time stuff to balance the grid (Enbala, CUE), these companies all have one thing in common. They traffic in what I call marginal megawatts – the MW at the very top of the load curve that determine whether the peaker plant gets turned on or whether a new transmission line must be built. The demand response players do this by clipping peaks while the energy efficiency ones do it by dropping the baseline, but they deliver a similar net result. (You could add grid-scale energy storage to this grouping if you wanted to.)
Such companies are poorly valued today. Public stocks tell the tale – for example, as I write this, Enernoc, Ameresco, and PowerSecure are all trading at less than 1x sales and 12x EBITDA. (For those of you who don’t often think about valuations: That’s bad for a growth company.)
This situation is about to change.
What’s the value of a marginal megawatt? In my mind, it should be proportional to two things – 1) the cost to deliver that same MW from conventional generation resources, and 2) the amount of free capacity that’s available to do the generating. Both are hitting inflection points right now.
First, let’s take the marginal cost per MW. For this analysis, let’s consider the market for “frequency regulation,” a horrible misnomer of utility-speak that means “injecting or removing power on the grid over fine time scales to balance supply and demand.” (The name comes from the fact that imbalances cause the grid to deviate from its 60 Hz AC frequency.) Frequency regulation is traded in open marketplaces on a $/MW/hr basis, and its price is probably the purest measure of a marginal megawatt.
As it turns out, the price of frequency regulation correlates very closely with the price of natural gas, because gas plants are usually the market price-setters. See the chart below, which plots the clearing price for frequency regulation (in the United States’ biggest electricity market, the 13-state PJM region) against the price of natural gas (as measured at the Henry Hub distribution center). The r2 on this is 0.80, meaning that natural gas accounts for 80% of the variance in frequency regulation price:
Natural gas prices started plummeting in 2008 due to the hydrofracking revolution and reached a 12-year low of $1.82/MMBtu this past April. As that price was below most producers’ breakeven levels, many folks speculated that drilling only continued because the exploration companies would lose their land leases if they didn’t keep making holes. Since then, new drilling in gas plays has cratered and the price has started climbing back up – it’s at $3.15 as of this writing, and the futures market has it north of $4 by the end of next year.
As the price of natural gas rises, so will the value of marginal megawatts. And there’s reason to believe that the price will increase sharply beyond 2013 if U.S. natural gas starts getting used in new ways – like being exported. Export applications currently filed at the DOE would ship out 16 billion cubic feet per day, which is two-thirds of current U.S. shale gas production!
So higher gas price = more valuable marginal megawatts. Now let’s look at generating capacity.
As goes GDP, so goes electricity demand. When U.S. GDP peaked in 2007, so did our electricity consumption. And when the economy tanked, electricity consumption fell. 2012 should be the first year that these indicators exceed their 2007 levels.
When there’s idle generating capacity around, the companies that own it get hammered. Consider independent power producers, the companies that operate conventional power plants. Their share prices closely track total electricity generation, which in turn tracks GDP – all of which dropped sharply after 2007:
So do I need to write this next paragraph? Only now is electricity demand getting back to its 2007 peak. Doubtless there were new plants getting built five years ago which were completed but unused, so excess capacity will likely persist for a couple more years. But, inexorably, that capacity will get mopped up as GDP rises and electricity demand grows with it, and sooner or later we’ll find ourselves bumping into a new ceiling. Just as predictably, the value of companies that resolve this supply/demand imbalance – those that deliver marginal megawatts – will jump. Note that when Enernoc went public right before the 2007 electricity demand peak, it did so at 20x the previous year’s revenues. It’s now trading at 0.6x. I’ll bet that looks really different in, say, 2016.
The kicker: Demand response and energy efficiency companies will slaughter conventional generators on cost. A new fossil generator costs $1 million per MW in capex, plus or minus, and requires fuel and transmission on top of that. Setting a big user of electricity up to curtail its demand by 1 MW costs maybe $50k – and that’s it. As we climb to a new electricity peak, generators will lose the battle for the marginal megawatt.
For this year’s ARPA-E Summit I was asked to give a talk about different ways to finance an energy start-up. The challenge as it was given to me was “cover all sources of financing – VC, angels, grants, debt, everything – in 45 minutes.” The ARPA-E folks have now posted the presentation publicly, embedded below.
tl;dr: Arrogant humans think we have the natural world all figured out. We don’t.
I spend a small but meaningful amount of my time at Venrock intentionally looking at crazy stuff. If you are developing a cold fusion generator or a zero point energy harvester and you have spoken to a venture capitalist, there’s a high probability that it’s me.
These topics account for, at most, a few percentage points of my investment scouting activity. But they’re enduring percentage points. There’s a lot of this kind of work out there, and I recognize that 99%+ of it falls somewhere on the spectrum between experimental error and deliberate fraud – so I narrow the funnel very quickly, much more so than in other domains. With that said, I endeavor to treat innovators with integrity and respect throughout, and on those exceedingly rare occasions where extraordinary claims hold up under initial scrutiny, I dig in with the same diligence I’d devote to the most-credentialed academic. (Of course, sometimes it’s a credentialed academic who brings the crazy idea.)
There are a few fellow travelers in the venture capital/angel financier community who share these investment interests and devote resources to them. Most, however, view these possibilities with derision – or simply feel they’re so improbable that every last second of one’s time is better spent elsewhere.
Let me give you an example of why I choose to suspend disbelief.
I got my first dose of middle-school biology in the mid-80s. And the living world as I learned it was pretty simple: DNA makes RNA, RNA makes proteins, and proteins do stuff. Information flows only in one direction, so the idea that you could pass on a characteristic that you acquired during your life was silly talk. We’d already figured out the handful of letters in the genetic code (easy!) and the sequences that corresponded to each amino acid (no prob!), so the only thing left was to decode the genome and the proteome, and then match the DNA up with the proteins.
Congratulations, you’ve solved life! Stanley Cohen and Herbert Boyer’s creation of the first recombinant organism in 1973 seemed to drive the point home – if we could insert foreign DNA into a living being to make it do what we wanted, certainly we had everything figured out? There were a few little things left to clear up – it wasn’t obvious why DNA was so often chemically modified, or why it was wrapped around these things we called histones, or why so much of it appeared to be non-coding junk – but surely those were minor points.
As we now know, that view of the world wasn’t wrong per se. It was just radically oversimplified.
The holes in the story began appearing almost immediately after Cohen and Boyer’s landmark achievement. In 1975 Robin Holliday and John Pugh (and independently, Arthur Riggs) observed that the methyl groups regularly seen hanging off cytosine and adenosine weren’t, as previously thought, errors in DNA’s signal: They formed a vital mechanism by which cells ramped expression of genes up and down. Shortly thereafter Michael Grunstein and his collaborators demonstrated that the histone proteins around which DNA winds were not simply passive spools, but that histones regulated gene activation depending on how they were chemically altered. In 1999, David Baulcombe showed that short strands of RNA could silence the effect of otherwise-activated genes – information flowed backward; the product of genetic expression could affect the expression itself! Finally, in the last decade, work by researchers such as Larry Feig and David Sweatt has controversially suggested that a mother’s life experiences can endow her developing fetus with features that weren’t in the fetus’s DNA at conception.
I have a sneaking suspicion that physics today is something like biology in the 1970s.
Once you split atoms with such destructive force as to kill tens of thousands of people, it’s pretty easy to convince yourself that you’ve got it all figured out. And, as I see it, that’s what the academy did post-World War II after the nuclear genie left the bottle. Sure, there were some minor details to clear up – like the particulars of the units of matter and force that shape atomic interactions, and how to harmonize the way things work at large scales with how they work at small ones – but for the most part, we had it nailed.
Half a century onward, our list of known and suspected subatomic particles exceeds 200, and it continues to grow. We can’t precisely predict the size, structure, or properties of anything more complex than hydrogen. We’re no closer to integrating quantum mechanics with general relativity than we were when I was a child. (Flame shield up: I realize there will be healthy disagreement on these points).
Perhaps these anomalies aren’t anomalies at all. Maybe they are evidence that we don’t, in fact, have everything figured out.
Improbable, yes. Impossible, no. So with a wink to Jean-Baptiste Lamarck, who is doubtless shaking his fist from the grave – mocked for decades for suggesting that inherited characteristics could be acquired, and now facing an ounce of vindication through epigenetics – I suspend disbelief. I trust that there are improbable breakthroughs in the physical sciences yet to be made: breakthroughs which will transform how energy is produced and used. I’m with Bill Gates – we need more crazy energy entrepreneurs!
tl;dr: Saw it coming. Didn’t act. D’oh.
I did a podcast recently about water treatment in oil and gas for Platt’s, the veteran trade publisher in the sector. We focused specifically on flowback water and produced water from shale sites. You can listen to it here:
I’ve spent a lot of time hunting for new technologies that address shale oil and gas, water treatment included. I think it’s possible to build large, independent technology companies in this domain – most likely with services business models – and we’re eager at Venrock to deploy some capital into the sector. But putting my professional life aside, I missed my opportunity to make a personal buck here three years ago.
I first realized that something was up in shale plays back in mid-2008 (prior to joining Venrock, when I was at Lux Research). I’d been tracking two numbers – on one hand, the Baker Hughes rig count for natural gas rigs (which tells us how much drilling for natural gas is going on in the U.S.), and on the other hand U.S. dry natural gas production (which tells us how much gas is coming out of the ground). Based on that data, I started presenting the following two charts (originally sourced from The Oil Drum, which I read daily and you should too):
On the left, you see the number of natural gas drilling rigs in operation. The x-axis is months, so every year is a line. And every year the number of rigs goes up – until late 2007, when it’s flat.
On the right, you see the amount of natural gas extracted. Same deal; every year is a line. And every year gas extraction is roughly flat – until late 2007, when it kicks upward.
Huh? Less drilling, but more gas?
This, my friends, is the impact of a technology disruption – specifically, the combination of horizontal drilling and hydraulic fracturing applied to shale formations.
I vividly remember presenting this data in the boardroom of a prominent east coast venture capital firm in early 2009. The partners there knew a lot more than I did about the oil and gas industry, so I approached the talk humbly. If this increase in supply persisted, I said, think of the possibilities! The 10-year average price of natural gas was about $7/mmbtu, but the price going forward could be more like $4.50:
And if that occurred, it would have a big impact on the world:
It was at this point that my hosts started shaking their heads. As much as they wanted to believe my thesis, they said, they’d heard it all before. Every time the price of natural gas dropped into the $4-5/mmbtu range, they patiently explained, everybody thought it would stay there forever. But it never did – it always went back up, dashing hopes, dreams, and business plans.
I listened carefully. And as I did, I mentally shelved my plan to short UNG, the exchange-traded fund that tracks the price of natural gas – because my expectation of long-term gas pricing in the $4-5/mmbtu range clearly wouldn’t come to pass.
That was three years ago. As of this morning, natural gas was at $2.11/mmbtu. The futures curve currently has the price under $4.50 through 2015, and it even pegs the 2020 price at a mere $5.33. (I keep this market data permanently open in a browser tab window.)