The Bear’s Lair: Low oil prices mean few assets will be stranded

Bank of England Governor Mark Carney, in an exercise of warmist wishful thinking a few weeks ago, warned banks and by extension energy companies of the problem of “stranded” assets, left without value by environmental regulation. Naturally, this was just part of the threats and bluster designed to change behavior ahead of the Paris global warming conference. However I thought it worth considering whether the concept of stranded assets had any validity, and in what circumstances. My conclusion is that the stranded asset concept is valid but that current low energy prices greatly reduce their danger.

In essence, the concept of stranded assets is similar to the Austrian economic concept of “malinvestment.” In every economic cycle, some investments will be made which turn out in retrospect to have been a mistake. Those investments have to be liquidated at a loss or in some cases for no return at all, and the debt secured against them is generally lost.

There are three major reasons why malinvestment takes place. One is sheer bloody stupidity on the part of the investor, generally when a stock market or real estate bubble is in effect, pumped up by artificially easy money and low interest rates. A gigantic amount of malinvestment will undoubtedly have been caused by the zero interest rate policies of the Fed and other central banks since 2008. For example, the hotel sector has seen year after year of massive investment in new properties, with supply running far ahead of the most optimistic realistic projections for vacation and business travel demand.

Capitalism cannot work if the risk free real cost of capital is negative, because in that case any investment, even one with zero return, is attractive. As I discussed in an earlier piece when looking at the possibility of the Fed abolishing cash and pushing interest rates substantially negative, it would then be attractive to build ziggurats or other religious buildings with no monetary return and no resale value – you could live off the interest you received on the debt used to finance them.

A second form of malinvestment is that incurred when prices move dramatically and unexpectedly, as with the recent halving of oil prices. In this case, the investors are unlucky rather than stupid; if oil prices stay at $100 a barrel for several years, and everyone in the market has endless reasons why their future trend will be up, not down, then it is not necessarily foolish to make heavy investments in fracking opportunities that require an oil price of $70 per barrel to be viable. However the result is the same as if you had been foolish; if oil prices drop to $40 a barrel and stay there, as appears to have happened, then all that fracking investment has been wasted and needs to be removed from the market and written off.

The combination of these two forms of foolish and unlucky investment is currently causing severe problems in the junk bond market, which are likely to continue. Energy related investments that depended on $70 oil have neither value nor cash flow, and if they are dependent on fracking technology also have a relatively short lifespan, of around 18-24 months. Empty hotels produce a heavy cash flow drain, so will cause bond defaults pretty quickly. As bonds default, the value of other bonds goes down and bond mutual funds become more difficult to sell – we saw this dynamic play out with subprime mortgages in 2007. Consequently a junk bond market meltdown, in which the market seizes up altogether and credit becomes unavailable, is very likely at some point before the middle of 2017.

This is not however what Carney was talking about. The junk bond meltdown and massive financial panic that is shortly about to occur has not been deliberately caused by the world’s central banks; they are foolishly under the impression they have done all they can to avert it. On the other hand, Carney at least hopes that by dire warnings of “stranded assets” he can prevent energy companies from investing in fossil fuel projects, thus producing the carbon-free future the naïve little man imagines we ought to want. Like all government bureaucrats since the glory days of Gosplan, he hopes to prevent investment in areas he does not favor by warning potential investors of the costs of acquiring assets that cannot be utilized because of government regulation.

Energy companies considering new projects must therefore consider the probable future course of the world’s political/economic system, as well as the likely future trend in energy prices. If they believe today’s low prices are the new normal, then they probably won’t invest much in unconventional energy, developing only assets in which they have a lot of confidence, perhaps deep-sea assets in politically stable regions for which they have paid a great deal of money (probably too much, at current energy prices) for the leases. At low prices it is thus very unlikely that the oil companies will have much in the way of stranded assets; they will invest only modestly, so consumption will keep up with production, Even if an effective control or “carbon pricing” mechanism is introduced, the low-risk investments they are currently making are likely to pay their way so long as the oil deposits last.

The problem becomes more difficult if oil prices rise again (almost inevitable given the majors’ current reluctance to invest and Small Oil’s massive flirtation with bankruptcy.) In that event, investment projects will be more potentially profitable, but also located in more difficult areas and taking more time to come to fruition. These are the projects that can become stranded; if the regulators force down the use of oil by higher taxes or simple bullwhips, high-cost projects with heavy capital investment and long lives will become unviable, as it will become impossible to exploit them fully.

If prices rise, energy companies will have to engage in a two-pronged calculation: will prices stay high enough for the new investments to be profitable, and will the fad of global warming regulation last long enough for regulations against fossil fuel use to become effective.

The answers will differ depending on the project. For coal projects, the popular hatred for coal may just be sufficient to keep heavy regulations in force, whether or not the global warming problem is fashionable. Coal is in this sense like nuclear power; it can make a great deal of sense as an energy source but the political risk of hysterical reactions by a population driven mad by the media and by opportunistic politicians makes investment in it always a high-risk prospect. The only coal projects that are truly politically viable are those in countries like India and China, where the growth in energy demand is rapid and Western do-gooder politicians and regulators are even more unpopular than coal companies.

For oil and gas, on the other hand, the chances of Carney’s “stranding” appear pretty slim. If the world was not able to come up with binding climate change targets with the most environmentally committed President the U.S. has ever had or is ever likely to have, then it will be politically impossible to get the populace out of their petrol-driven cars, even if the ineffable Elon Musk brings down the cost of his alternative to say $40,000 before any subsidies. Budgetary constraints, which will increase exponentially after the next recession, will prevent the government from granting large enough electric car subsidies to overcome popular reluctance to spend that kind of money.

Accordingly, oil companies will continue to claim their product is essential (as indeed, it will be) and therefore politicians won’t be able to shut it down. Indeed, it seems likely that the Paris conference marked the point of “peak climate change” after which it becomes increasingly difficult to gain popular support for the increasingly Draconian regulations the Carneys of this world consider necessary. Energy companies (outside the coal sector) will be able to invest in full confidence that their assets can only be “stranded” by technological change, or by to the assets purchased being overpriced, either directly or in terms of the output they produce. The decision, in other words, will become once again a business one, of the type these highly analytical MBAs at the top are paid exorbitantly to take.

Mark Carney should concentrate on raising sterling interest rates, as far and quickly as possible; that is where his duty lies. Collapsing the British housing market is not a “bug” in this recommendation, it is a feature. The sooner real interest rates are again positive, and the detritus of regulation imposed in the last decade is swept away, the quicker will the global economy return to the rapid pace of growth which the world’s inhabitants demand. With rapid global growth and positive real interest rates, very few assets will be “stranded” either by Mr. Carney or by the market.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)