First off I must make a brief plea. If you find the times we live in very strange, with all the culture wars and fake news flying around – I know I do – then please seek solace by revisiting the original master satirist of all this nonsense Chris Morris.
I have just finished rewatching for the fourth time his 1990s classic Brass Eye and I have to say that it doesn’t even remotely age. And if you have some spare time please do watch his wonderful new film The Day Shall Come, which was panned by the critics but I found very funny and terrifyingly plausible.
Anyway with that out of the way if you have any time left this weekend after binge watching Chris Morris ( I especially recommend the Brass Eye episodes on animals and separately paedophilia), do have a listen to the podcast interview with Tamsin Freeman from PI Investor. I have to say I rather enjoyed it, especially the questions from the audience.
The link to the recording is HERE:
They also produce it as a podcast, via here:
One my key observation is that I think the energy system is due a massive reboot and that conventional oil stocks are stuffed long term. All the stuff you’ve heard about stranded assets and ESG investing is real. But I don’t think I fully explained why I think the sector is in trouble long term.
So, here’s my take. First off I completely accept that the oil sector might prosper again if oil prices rise in the next few years. We have seen epic capacity destruction and I sense that if the global economy rebounds strongly we could see oil prices back above $50 a barrel. That increase might come at an unfortunate time if inflation rates are picking up.
But that potential for increasing prices might have a feedback effect. If prices do start rising again, we’ll see yet more impetus to replace (more expensive) marginal oil with (increasingly less expensive) renewables.
Ah but what happens if oil prices stay low, won’t that undercut the push to renewables. At the margins maybe but I see two consistent drivers. The first is that government policy worldwide is slowly having a chilling impact on demand for oil and its derivatives. With more and more developed world authorities targeting carbon neutrality by 2030 to 2050, more and more businesses will start subtly changing their capex plans over the next five years, with the impact snowballing as demand for oil declines.
But I also see another driver for change even if oil prices stay low. Carbon pricing. I know we liberals always witter on about this as do most economist. I also know the massive challenges at the electoral level. But we really have no other choice than to put a sensible price on carbon emissions. The red greens might like to talk about system change and compulsion but unless we intend to replace capitalism imminently – which I think unlikely – then pricing in these externalities simply has to happen, as the EU has recognised. Low oil prices provide a fantastic opportunity to sneak these carbon taxes in the back door with few noticing.
So oil faces a double jeopardy in price terms. Either it shoots back up in price, crimping demand, or it stays low and becomes a target for carbon taxes.
But my worries don’t stop there. I talk a great deal to institutional investors and I’m truly stunned by the growing push towards ESG and worries about climate change amongst these big investors. I think a growing number of these heavily regulated entities are now under the internal cosh to do something drastic. If the ESG brigade don’t do something, then the compliance police or the risk managers will. This is a profound shift and is in effect a form of institutional divestment which starts off as a simple diversification of risk. Lobbying group Carbon Tracker put out a key report this week called Decline and Fall: The Size & Vulnerability of the Fossil Fuel System. Obviously this outfit has its own agenda but I echo its main argument : the assets are huge in the energy industry and the risks growing. According to Carbon Tracker the “ three main assets are the 900bn tonnes of coal, oil and gas, valued by the World Bank at $39tn; supply infrastructure of $10tn and demand infrastructure (electricity, transport and heavy industry) of $22tn; and financial markets with $18tn of equity (a quarter of the total), $8tn of traded bonds (half the total) and up to four times as much in unlisted debt, much of it to the banks. Each asset has an annual flow. The key flows of the system are $1-3tn a year in economic rent to the petrostates from the fossil fuels; capital expenditure of $1tn on supply infrastructure and $3-4tn on demand infrastructure; and profits of $1-2tn.”
Risk managers within the big institutions will be looking at those flows – and assets – and starting to worry about systemic risk. As Carbon Tracker elegantly put it – “in one sector after another these are driving peak demand, which leads to lower prices, less profit, and stranded assets. Flows and equity are vulnerable first. The flows of economic rents, capital expenditure and profit are damaged first. And these losses are anticipated by equity markets long before they show up in the write-down of physical assets. “
My view is aligned with Carbon Tracker which is that “there is far more risk inherent in the fossil fuel system than is conventionally priced into financial markets. Investors need to increase discount rates, reduce expected prices and volumes, curtail terminal values and account for the clean-up costs.” If that happens, we will find the marginal buyer of energy shares in short supply. Thus, energy stocks might stay cheap not just for years but for decades. In fact, they could turn into value traps. Private investors beware. Winter is coming for the energy industry, and whether it starts now, next year or next decade, be under no illusion that valuations might stay low or even continue to decline.