This week, I’m very happy to present an interview with David Anderson, partner and investment analyst with Palo Alto Investors, a $1.3 billion private equity hedge fund in Palo Alto, California, with a strong focus on fundamental research in undervalued technology, healthcare, energy, consumer products, and financial services companies. Anderson is an alumnus of the California State University at Sacramento, and earned his MBA at UC Berkeley’s Haas School of Business. He brings 17 years of experience in oil and gas exploration and in investment banking, and currently manages the Palo Alto firm’s roughly $400 million energy investment arm. I’ve been corresponding with David for a few weeks, and as the resident PA Investors energy and oil expert, he’s been kind enough to write back with some thoughtful insights on a few energy industry questions.

Before you joined Palo Alto Investors in 2001, you spent eight years with Chevron. What industry knowledge did you gain there that helps you with your current investment approach?

My Chevron days provided me with the basic understanding of oil and gas exploration, the economics of project development, and the underlying knowledge of how a company in an extractive industry works to grow and prosper through business cycles. Having worked in various sectors of the company, albeit mainly in North American exploration and production, I got a view of just how large the global energy infrastructure is. Most people really don’t realize just how much effort, time and capital it takes to bring on a major energy project, whether that is a new oil field, a new natural gas project, a pipeline, refinery expansion, or new shipping capacity. That knowledge allows me to understand that our global energy issues are not going to be solved in any short time period. I often like to point out to students the scale of the oil business by saying this: With global oil consumption of 85 million barrels PER DAY, that means that if you stacked up those barrels each day you would reach the moon about every four days. The size of the system to support that massive daily business is something that will not be replaced any time during my life. Knowing this makes me value those companies that help make it happen and gives me perspective on where the opportunities are. Finally, I’d say my experience allows me to recognize when I see a company that has significantly superior economics, a better business model, and differentiated operational leverage. Those are the things that can translate into superior investment performance over time.

What kind of assets does the fund hold? What kind of investing do you do in energy, and what alternative energy projects are you involved with?

Our firm manages about $1.3 billion in assets, with about 25% of that dedicated to energy investing currently. Most of what we do is traditional energy: oil and gas exploration and production, oilfield services, etc. We also look at energy technologies that enhance the core energy businesses–from 3-dimensional seismic technology for exploration to enhanced drilling technologies and what I call “chemical tech.” In pure alternatives, we divide our views into “transportation” alternative energy and “power” alternative energy. Those are two very different opportunities. On the transportation side, we have done a great deal of research into biofuels and on the power side we have researched and invested in solar, wind, as well as ancillary technologies that enhance distributed energy capabilities. In the transportation market, specifically the market for “alternative” diesel, we have also researched companies in both gas-to-liquids and coal-to-liquids markets.

Kohlberg Kravis Roberts and Texas Pacific Group just worked out the largest private equity leveraged buyout ever, for TXU Corp., which provides power to 2.2 million people in Texas. TXU agreed to scrap several planned coal plants and invest in renewable energy projects to get the blessing of Environmental Defense and the NRDC. Do you think it’s a signal that investors want to see the big energy companies move away from the status quo and focus on conservation and renewables?

My view on the deal is that power producers make for great private equity investments as they can be levered and have very visible cash flow streams. As for moving away from the status quo, I don’t see that. The plants to be scrapped aren’t really significant in the grand scheme of TXU and, in my opinion, represent a small sacrifice to allow regulators and environmental groups to “get something” out of the deal.

Since 2000, solar photovoltaics and wind power revenues have grown from about $6.5 billion to $30 billion annually. Do you think the renewables niche is driven mostly by environmental ideology and state policy, or do you believe there is a decent chance that a genuine market will evolve in the near future?

Wind is relatively competitive on a cost basis, but cannot be relied upon for baseline power. That means it is often a redundant investment and so can be hard to justify without significant incentives. Solar is definitely hard to justify for an average consumer, even with large incentives it may take eight to twelve years for the upfront investment to pay off. The advantage to any of these is that new distributed power generation allows us to stave off building incremental power projects in the short-term. Long-term I believe these will continue to be niche plays. As many energy analysts will tell you, there is no silver bullet that will replace the very large coal, natural gas, and nuclear power infrastructure that supplies about 90% of U.S. electricity. In the end, the opportunity for renewables is defined by the cost of the incumbents. If you tripled the cost of natural gas and coal, many renewables are still challenged.

Mike Morris, CEO of American Electric Power – the nation’s largest utility – was recently quoted saying that it is time to develop more sustainable, clean-coal technology for commercial use. Tell us how the coal-to-liquids process works, and what energy companies are doing with it.

We believe that the vast U.S. deposits of coal will be key to addressing the combined goals of energy growth, energy price moderation, increased energy independence, and potentially, improved emissions. Coal-to-liquids (CTL) is a process that first gasifies coal, then turns that gas stream into an ultra-clean diesel or jet fuel using Fisher-Tropsch technology. That can potentially provide some new sources for diesel fuel in the U.S. Rentech and Sasol are both companies involved in that area. On the power side, if the need to sequester CO2 becomes great, then coal power plants in the U.S. would benefit by using Integrated Coal Gasification technology, where coal is gasified and then the gas stream is burned in a gas turbine to create power. By gasifying the coal, the CO2 can be taken off the process in elemental form (rather than going up the stack of a coal burning plant). Burning gas creates about half the CO2 output of burning coal, so capturing the excess CO2 in the conversion process makes a big difference. Then you have to do something with the CO2–either inject it into old oil fields to increase the ultimate recovery of oil in the reservoir, or sequester it for some other purpose. A company could potentially create a power plant that starts with coal, gasifies it, and not only produces power from the gas turbine, but that can divert some of that gas to create liquid fuels using the Fisher-Tropsch process. One company calls that a “polygeneration” plant and it might even start with some other biomass other than coal, since lots of different feedstocks can be gasified.

Do you think ethanol or other biofuels stand a good chance to serve as a short-term solution if and when oil producers are no longer able to meet world energy demand?

Well, I believe oil producers can meet demand, but the price at which they can do that is the real issue. I am not a big believer in current corn-based ethanol economics, and that is not a unique view. Ethanol from cellulosic material may have a chance, but that is years away and ethanol as a product still suffers from other issues (difficulty in pipeline transport, etc.). Given that diesel engines are more efficient than gasoline engines, we believe this is where we should start. If we produce bio-diesel or alternative diesel from other biomass, then every gallon we produce gets used more efficiently. Also, diesel doesn’t suffer many of the infrastructure issues that ethanol faces.

What advice do you have for college students who are interested in a career in the energy industry?

Work in the industry for a few years, network all you can, find what you are passionate about, and don’t be afraid to fail. Keep an open mind and don’t accept other people’s views (including mine!) as gospel. There is much to be done and in my opinion there is not a single more important sector to devote your mind to right now.

Thank you so much for spending the time to give your thoughts on these questions and share your experience in the energy industry with us, David! You can follow many of David’s personal thoughts and research at his blog, Dave’s Energy, which he co-writes with research professional Grant Fox.