Study of fossil fuel investment prospects

This morning money …abandoning fossil fuels will be costly … capital cycles and underinvestment … fossil fuels and the all-or-nothing approach … and much more …

When I was walking this morning with coffee wrapped in a sweater and coat, I was thinking about energy …

Energy needed to heat homes in winter and cool homes in summer.

The energy needed to keep us all moving.

Energy sustains much of our modern life, and it shows how well the system works that we rarely need to think about energy.

But recent price spikes, exacerbated by the war in Ukraine, have brought this issue to the fore.

More precisely, Russia’s invasion of Ukraine has made the issue of our dependence on fossil fuels more relevant.

If we inevitably switch to renewable energy, what do we do with fossil fuels – and at what cost?

Abandonment of fossil fuels will be costly

There is no such thing as a free lunch.

The energy transition is no different.

Our future of renewable energy has great benefits – and costs.

But we may have neglected the expense book in the pursuit of cleaner energy.

In June 2020, the Brookings Institution summed up the optimism about the potential of the pandemic to accelerate change:

‘Some experts are now asking whether this crisis could be the impetus for the world to move away from oil. One asked, “Could the coronavirus crisis be the beginning of the end of the oil industry?” Another: “Will the coronavirus kill the oil industry and help save the climate?” Meanwhile, annual greenhouse gas emissions in 2020 are projected to be reduced by 4-7% as a result of the virus, and some of the world’s smogiest cities now have clear skies.‘

And in November 2021 The Guardian there was a scary headline: “Half of the world’s fossil fuel assets could become insignificant by 2036 at zero.”

The article referred to the article in The energy of naturewho claimed (emphasis added):

‘In the worst case, people will continue to invest in fossil fuels until suddenly the demand they expected has not been met and they realize that what they possess is worth nothing. Then we could observe the financial crisis in 2008.‘

However, the worst-case scenario now looks quite the opposite.

People do not invest in fossil fuels enough and suddenly the supply of energy we expect does not materialize.

Yesterday the BBC reported that the shortage of coal in India coincided with a heat wave that caused major power outages:

‘According to more than 21,000 people in 322 districts surveyed by LocalCircles, two of the three households said they faced power outages. One in three households reported outages lasting two hours or more each day.

‘The main reason for this lack of electricity is the lack of coal.‘

The US is also in pain.

Last week, Wall Street Journal issued a warning from US grid operators that power capacity is lagging behind demand.

Current capacity is heavy and can lead to “continuous power outages during heat or other peak periods once this year.‘

This is also not a temporary problem.

How Financial Times As reported last night, some think that global energy problems will be inevitable in the years to come:

‘“We don’t see wholesale prices returning to pre-crisis levels by the 2030s,” adds Tom Edwards of Cornwall Insight. “The world has changed, and rebuilding our energy system will not be cheap.”‘

How did we get here?

Capital cycle and underinvestment

The same story warns of a shortage of electricity in the United States Wall Street Journal pointed to the problem (highlighted):

‘There is a growing risk of electricity shortages across the United States traditional power plants are shutting down faster than they can be replaced by renewable energy sources and battery storage. Power grids are under load as the United States makes a historic transition from conventional coal-fired and natural gas-fired power plants to cleaner energy …‘

Economist Nouriel Roubini expanded the logic earlier this year (emphasis added):

‘The policy of fossil fuel destruction and the demands of aggressive decarbonisation led to insufficient investment in carbon-based capacity before renewables reached a scale sufficient to compensate for the decline in hydrocarbon supplies.

‘In these conditions, sharp jumps in energy prices are inevitable.‘

And so far the article is out The energy of nature it is projected that half of the world’s fossil fuels will be insignificant by 2036, assets in 2022 will be nothing.

Bloomberg reported this week that the five largest oil companies in the West together posted $ 36.6 billion in free cash flow in the first quarter.

That’s about $ 400 million a day, the second-largest quarterly free cash flow of all time:

Usually such large profits attract competition and increase production.

The high return on capital catches the eye of competitors who are trying their luck to grab a piece of the pie.

But attracting more competition usually leads to lower returns on capital as business rivalry lowers prices.

This is neatly discussed in a wonderful book by Edward Chancello entitled Return on capital.

In the book, the Chancellor describes the “capital cycle”, which postulates:

‘Capital is attracted to high-yield businesses and leaves it when profits fall below the cost of capital. This process is not static, but cyclical – there is a constant flow.‘

The Chancellor made sense of the capital cycle in the chart below:

But the capital cycle is unlikely to function properly in the context of fossil fuels.

Policies and incentives to abandon fossil fuels repel desire competition, ending the cycle and leaving current executives with bundles of spare money.

After all, what company would invest in fossil fuels in today’s climate, even if profits grow?

What company wants to take the risk of building a new plant – which takes years – when some predict that fossil fuel assets will become insignificant by the next decade?

As a Bloomberg spokesman said earlier this month:

‘“In previous cycles of high oil prices, large companies have invested heavily in long-range deepwater projects that have not expected production in years,” said Noah Barrett, lead energy analyst Janus Henderson, who manages $ 361 billion. “This type of project is not used now.”‘

The last time crude oil consistently exceeded $ 100 per barrel was in 2013.

However, that year Big Oil’s capital expenditures rose to $ 158.7 billion, almost twice as much as companies now spend.

Some companies are even actively curtailing some longer projects.

In February, Origin Energy announced “accelerated coal recovery”, Closing Australia’s largest coal-fired power plant seven years earlier.

Origin CEO Frank Calabria admitted:

‘The cost of renewable energy and batteries is becoming more competitive, and the proliferation of renewables is growing and changing the shape of wholesale electricity prices, meaning our energy cost is expected to be more economical through a combination of renewables, storage and Origin Peak power plants .‘

Fossil fuels and the all-or-nothing approach.

And here’s the mystery.

In the long run, renewable energy is the future.

Even people like Origin see it.

But fossil fuels may be needed to facilitate unimpeded travel office this is the future, especially given Europe’s likely accelerated abandonment of Russian energy resources.

Consider the recent March quarterly issue of Whitehaven Coal (highlighted):

‘Although uncertainty remains as to whether Russia’s actions in Ukraine will result in a temporary or sustained shift in the high-CV coal market, the potential for structural change is growing. Sources of substitution for supplies of Russian coal with a high CV ratio are difficult to identify with the increasing potential of coal prices to find new highs for longer.‘

How Wall Street Journal aptly noted in April:

‘Another political issue is the need to encourage companies to make significant investments in fossil fuel projects, while stating that the country’s goal is to make these projects obsolete.

‘It’s hard to persuade a company to make a multibillion-dollar investment in a pipeline that pays off in 30 years when the U.S. began trying to make the gas it carries unnecessary in 10 years.

‘Opposition to the creation of such “special assets” is a problem that will require creative policy.‘

The transition to cleaner energy is constant.

No question about that.

But given a clear idea of ​​what awaits us, what do we do in the meantime?

The abandonment of fossil fuels should include more coordination: fossil fuels complementing transition to renewable energy.

In 2016, three economists published an article for the National Bureau of Economic Research.

In it, the authors concluded that the push for clean energy continues, ‘it will be important to recognize the need – and cost – of additional fast-responding fossil backup technologies.‘

Sincerely,

Kirill Prokopenko,
For Morning money

PS: The global transition to clean energy and the associated abandonment of fossil fuels is a major shift in the axis. These events do not happen so often, but when they do happen, they shift the world along its axis. This provides opportunities for those who can anticipate these shifts before anyone else.

Few are better at anticipating such shifts than Jim Rickards. Fortunately, he recently created a portfolio to use the latest axis shift. Go here to learn more about the Rickards portfolio and book a venue.