The Luxury of Not Knowing, Green Energy

February 8, 2021

Have you noticed the tone change, the subtle shift?  The shoulder shrugs and the noncommittal language?  We have.  There’s the vague acknowledgement at fundamental data that a year ago would’ve made their hearts flutter.  The sideways glances when macro-analysts contend that a falling dollar caused by an unprecedented injection of liquidity, coupled with possible inflation caused by the release of pent-up demand will force money managers to snap-up commodities.  That’s nice they say . . .  we’ll see. 

Where do you think oil prices will be at year end?  It depends.  Shouldn’t falling inventories lead to an energy shortage?  Perhaps.  It’s coming from fund managers we’ve known through the years who’ve been the most vocal about an energy crisis.  Consensus leading price forecasts previously shouted with confidence are now trailing and middling.  Probe further, and you’ll get their honest take, but those higher figures are only whispered about. 

It’s too risky, too exhausting, and too demoralizing to continuously assert that an energy crisis is brewing.  They’ve been humbled and cowed by the industry’s penchant for profligate spending and fooled by their own psychological biases.  They’ve been battered by diving black swans spreading a global pandemic.  Never would most have imaged that oil prices would dip into the negative territory.  Fall dramatically?  Yes of course, outlier events do lead to outlier consequences, but negative?  No.  

Yet, the world works mysteriously, and a pandemic coupled with a Saudi-led price war has forcibly realigned the energy industry from a financial perspective.  Unsurprisingly, the energy sector has now adopted restraint, reining in their free-spending ways to emphasize balance sheet stability and shareholder returns.  Analysts at Mizuho project that US E&P producers will reduce spending from 120% of operating cash flows to 70-80%, a near 40% reduction of what used to be spent drilling for oil.  US production, mind you, is what kept prices from springing to triple digits these past 5 years. Nonetheless, the reduced investments mean reduced production and downward supplies go.  Now critics will say that’s okay because we don’t need the oil now because demand is forever COVID handicapped. Even if not, the industry’s track record for maintaining these types of pledges is nonexistent, so they’ll be back. Maybe, but then again, consider what the industry faced last year and will face in the near future.  The end of days.  

Change

Because that’s what’s coming.  Change is coming.  Change has begun.  Climate change has been thrust to the forefront of our collective consciousness.  A political sea change in the White House and Congress means that climate change initiatives have now morphed into a tsunami.  From rejoining the Paris Climate Accords, to advancing an infrastructure stimulus bill and increasing regulations on the fossil fuel industry, the push is obvious . . . end the use of fossil fuels quickly.  Co-opt the transportation industry, car manufacturers, unions and state and local authorities, and we begin to “align interested stakeholders.”  Even the financial croupiers on Wall Street smell the green money.  Many banks have begun saying “no more bets” on fossil fuel as the green ball drops on the roulette wheel.  With Larry Fink leading the charge, we’d cynically say, always bet on BlackRock.   

The Cost of Climate Change . . . and Capital

What we really think is happening is that political/regulatory/social pressures are increasing the cost of capital for the fossil fuel industry, and lowering it for renewables.  Without external pressures, capital in financial markets will seek the highest returns (fossil fuels over green energy projects).  So politicians, regulators and environmentalists need to increase the cost of fossil fuels and decrease their returns, forcing a shift in what we use for energy via the financial markets.  Said another way, they are pricing in the cost of climate change into the fossil fuel sector, making it less attractive of an investment environment and making the very product more expensive.   

Concurrently, they’re fertilizing the green space.  In addition to today’s low interest rate environment, the Biden administration plans to advance a multi-trillion dollar infrastructure bill that provides generous funding for the electrification of America.  We’d anticipate this is a full-blown expansion of former-President Obama’s previous efforts to provide subsidies, loan guarantees and grants to a multitude of green energy projects via the Department of Energy.  Despite the debacles of Solyndra, there were many successes stemming from the original program as we saw the funds help develop solar farms and even assist Tesla in its infancy.  So overall these programs do work, though dumping trillions into a small sector will have unintended consequences, but what are bubbles compared to the threat of climate change? 

Besides it’s already beginning to work.  Per Goldman Sachs, hurdle rates for today’s longer-term fossil fuel projects are 20% whereas renewables are in the 3-5% range.  So see?  Tweak the cost of capital and we can change the hurdle rates before investors even embark on a project.  

While we effectively favor one runner over the other, we’re forgetting that track conditions are ever-changing, and it’s currently in a state of flux.  Many of the conditions/assumptions we’re using to underpin this energy transition may not last, low interest rates/inflation, lower demand for fossil fuels going forward, rapid adoption of green energy, successful scale-up of renewables and EV production, and sufficient supplies of fossil fuels to bridge us to a greener future.  Excel sheets and the real world may not jive.

So Many Questions

If we are right, if energy prices begin to increase significantly (take your pick of reasons: supply shortage, growing demand, rising cost of capital, US dollar weakening, or inflation), will the current Goldilocks environment persists for green energy investments?  What if inflation begins to ramp, forcing interest rates higher?  We’re discounting the forecasted earnings of these high-tech/green energy companies using historically low interest rates to justify their lofty valuations.  What if those conditions reverse?  Doesn’t the cost of capital, well . . . become more costly?  

What about that tailwind?  What happens to the government’s largess if the federal reserve is forced to reckon with higher inflation?   Do rising interest rates tighten federal budgets?  For that matter, what about the resolve of our political leaders?  Restraining US oil production is already creating political challenges among Democrats in moderate states.  President Biden will need to thread the needle here, placating both environmentalists and constituencies dependent on oil and gas drilling (e.g., New Mexico, Texas, and Pennsylvania).  Also, let’s not forget that if the price of gasoline, diesel, etc. rise, it becomes a regressive tax, disproportionately affecting the poor.  How will the Democratic majority in Congress respond?  How will the administration?  Certainly, the Republicans will gleefully highlight this in the coming mid-term elections because despite the show of solidarity you saw during the inauguration, this is still a deeply divided nation where we almost witnessed the reelection of a polarizing President and the Republicans gaining seats in the House of Representatives and state legislatures.  Even with the turmoil, the Republican party is alive and well.   

Hard Pivots

We’re not saying an environmental pivot doesn’t need to happen, what we are saying is hard pivots are . . . hard.  It should take us more than a decade to transition our energy sources, but what should be a measured and methodical shift is being accelerated by external forces.  Green energy has sprinted out of the gate this year benefited by a considerable tailwind and artificially lowered hurdles, but fossil fuels, originally left for dead, is reasserting itself.  The faster it gains in price, the larger its shockwave.  If oil prices continue its climb to $100/barrel because of an energy shortage, the potential aftershock of higher inflation could negate the fact that higher oil prices makes green energy projects more “affordable” in comparison.  In the end, we believe an energy crisis has been in the making for years now, and as we reopen our economies, that supply shortage will collide with inflecting global demand. 

If we are correct, we’ll know the consequences by year-end, well before our energy transition has started its sprint. Perhaps then we’ll see another tonal shift by long-suffering energy analysts.  Perhaps then we’ll need A Few Good Men (and women) realistically charting a course through this energy transition.

“You weep for the environment and you curse oil.  You have that luxury.  You have the luxury of not knowing what I know.  That the decay of the environment, while tragic, probably saved lives.  And my existence, while grotesque and incomprehensible to you saves lives.  You don’t want the truth because deep down in places you don’t talk about at parties, you want me on that rig, you need me on that rig.”  

Colonel Jessup, if he were an oil worker, in A Few Good Men.