VALUE AT RISK, OIL PRICES CRUSHED – A SYSTEM ON TRIAL

In any moment of crisis, it’s easy to be pulled two ways, between the immediate and the fundamental. But it helps when, as now, we can recognise that both themes meet at the same point.

In this sense, “the 2020 Wuhan crisis” (or whatever it ends up being called) has acted as a catalyst for severe risks built into the system over a protracted period of mismanagement, incomprehension, self-interest, hubris and sheer folly.

Just so that you know what’s coming, this discussion is going to concentrate on two issues.

The first of these is the scope for value destruction in the current situation. Here I believe that the use of an independent benchmarking system – based on energy economics – provides an advantage over the monocular, ‘the economy is money’, way of looking at these things.

The main theme here, though, is energy in general, and oil in particular.

On the one hand, the consensus assumption is that we’ll be doing more of every sort of activity (including driving and flying) that depends on having more energy (and more petroleum) in the future than we have now.

On the other, however – and even before the recent slump in oil markets – crude prices simply can’t support even the maintenance of oil supply, let alone the 10-12% increase seemingly required by consensus expectations.

What I aim to do here is to explore this contradiction.

Before we start, though, I’d like to apologise to anyone who, over the past two weeks or so, has wondered why their comments seem to have vanished into the ether, or why there seems to have been much less debate here than usual. What appears to have happened – for no apparent reason, and wholly outside my control – has been that most notifications of comments awaiting approval have ceased to reach me. For the time being, and as frequently as possible, I’m going to review the list of outstanding comments manually.

Short shock, long folly, value exposed

Right now, as markets and sentiment gyrate wildly, we’re watching a fascinating intersection between the immediate and the fundamental playing out before our eyes.

The system that’s being shocked by the coronavirus crisis was a system that was already in very bad shape, and we can be pretty certain that, if the catalyst hadn’t (or maybe hasn’t yet) come from Wuhan, it would have (or assuredly will) come from somewhere else.

As somebody might have said, ‘if you build a monster, don’t be surprised if it bites you’ – and as somebody once did say, “some days you eat the bear, some days the bear eats you, and other days you both go hungry”. I’ll leave it to you to decide what roles greed, incomprehension and sheer folly have played in the building of the financial monster.

One of the critical issues now has to be the potential for ‘value destruction’ in the current crisis. Amongst the advantages of having an alternative, non-financial (energy) approach to economics is that it provides a second basis of measurement (in this case, the SEEDS prosperity benchmark) for just this kind of contingency.

‘Value’ really falls into two categories. The first is largely ‘notional’, and covers assets such as equities and property. Since nobody could ever monetise the entirety of either asset class, these ‘values’ are functions of the changing narratives that we tell ourselves about what things are ‘worth’. No money actually leaves somebody’s bank account because of a slump in the market price of his or her property or share portfolio.

‘Real’ value, on the other hand, consists of defined commitments which may become incapable of being honoured. The obvious example now is debt, on which businesses or households may be forced to default because their sources of income have dried up.

My approach here has been to use the Surplus Energy Economics Data System (SEEDS) to scroll back through the long years of financial excess in search of reference point ratios more sustainable than those of today.

Without burdening you with too much detail on this, SEEDS-based calculations suggest that up to 60% of the world’s private debt could be at risk, with the exposure of the broader structure of other financial assets at about 70%. My calculations are that up to $70 trillion of debts, and as much as $190tn of broader financial commitments, may be exposed.

Huge though they are, it must be emphasised that these are estimates of the scope for ‘value destruction’ – and how much of this scope turns into real losses depends upon many variables, chief amongst them being the duration and severity of the virus crisis, and the policies adopted by the monetary and fiscal authorities.

Assuming that these authorities act with more wisdom than they’ve exhibited so far – and stop firing off their scant remaining rate policy ammunition before the target comes over the hill – then the outcome isn’t likely to be anywhere nearly this bad, and a full-blown cascade of defaults can be avoided. Meanwhile, it’s possible to see stock markets settling perhaps 40% below their pre-crisis levels, with property prices down by 30%.

This, of course, presupposes that decision-makers don’t resort to putting so much gas back into the balloon that it really does detonate, leaving us scattered with the fragments of exploded hubris. In essence, do we use this event to re-group, or do we insist on ‘irrationality as usual’, regardless of cost?

After all, with the levers of the system in the hands of people who actually think that over-inflated stock markets, and over-priced property markets, are both ‘good’ things, there’s almost no degree of folly that can wholly be ruled out.

Energy – cutting away the foundations

Properly considered, there are two separate market crises happening now, both of them linked to the Wuhan coronavirus event.

One of these is the wave of falls in global stock markets, which the Fed and other central banks are trying, Canute-style, to stem. It would be far better if markets were left to get on with it, with the official effort concentrated on getting businesses and households through the hiatus in their cash flows.

The other crisis – linked to the epidemic by the anticipated sharp fall in petroleum demand, though triggered by a spat between major producers – is the sharp fall in the price of crude oil.

Some observers have suggested that the fall in oil prices will offer some relief for consuming economies, whilst others point out that the oil sector itself is going to be hit by a wave of financial failures, just as much the same thing might be poised to happen across vast swathes of the rest of the economy. The real issue, though, is how much damage this is going to inflict on the oil and gas industry, and where it leaves the industry’s ability to invest.

For those of us who understand that the economy is an energy system, the link between these events takes on a fundamental significance. Oil may be “only” 34% of global primary energy consumption, but it continues to account for a lot more than 90% of all energy used in transport applications. Fossil fuels (FFs), meanwhile, still provide more than four-fifths of world energy supply, a number that has changed only fractionally over decades.

Enthusiasts and idealists might talk about a post-fossil economy, just as the airline industry tells us that it can continue to grow whilst moving towards zero net carbon emissions. But, in both of these instances, as in others, there’s a very big gap between aspiration and actuality.

In search of neutral ground, we can do worse than look at long-range energy demand projections from the International Energy Agency (IEA), the U.S. Energy Information Administration (EIA) and OPEC.

All three publish central case forecasts, essentially mixing consensus-based economic assumptions with the mix of policies in place around the world. In broad terms, all three are agreed that, unless there are changes to these central parameters, we’re going to be using 10-12% more oil in 2040 than we use today.

‘Please sir, can I have some more?’

If you look at these projections in greater detail, it further emerges that we’re going to be doing a lot more of the things for which oil, and energy more broadly, are pre-requisites.

We are, for example, going to be driving more, even though electrification should keep the rise in oil demand for road use pegged at single-digit percentages. By 2040, there are expected to be more than a billion (74%) more vehicles on the world’s roads than there are today. It seems to be assumed that, by then, about 40% of the global fleet will have been converted to EVs, but that will still see us using more oil on our roads – not less.

We’re also, it seems, going to be flying a lot more than we already do, requiring a lot more petroleum, despite an assumed pace of energy efficiency gains seemingly running at about 1.5% annually. My interpretation suggests that passenger-miles flown are expected to rise by about 90% over that same period, though, thanks to compounding efficiency gains, petroleum use in aviation is expected to rise by “only” about 38%.

Within the overall energy position, the expectation is that our consumption of primary energy will be about 28% greater in 2040 than it was in 2018. Within this increment (of 3,900 million tonnes of oil equivalent), about 12% (450 mmtoe) is expected to come from hydro, and 44% (1,720 mmtoe) from wind, solar and other forms of renewable energy (RE). Nuclear might chip in another 5% of the extra energy that we’re going to need.

But the remaining 39% or so of the required increase is going to have to come from expanded use of fossil fuels, some of it from oil though most of it from gas (though it’s also noteworthy that no reduction in our consumption of coal seems to be anticipated). From the above, it will hardly be a surprise (though it is certainly disturbing) that annual rates of CO2 emissions from the use of energy are expected to carry on rising.

If any of this is remotely likely, though, why are oil prices languishing around $30/b?

To be sure, we know that demand is going to be impacted by Wuhan, and that producers including Saudi and Russia are scrapping over who should absorb this downside. But oil prices were hardly robust, typically around $65/b, even before the epidemic became a significant factor.

The fact of the matter is that we simply cannot square oil prices of $30, or $60, or even $100, for that matter, with any scenario calling for increases in supply.

We all know that global oil supply has been supported by American shale production, which has in turn relied on subsidies from investors and lenders. Now, though, it’s becoming ever more apparent (as was set out in a recent official report from Finland) that even ‘conventional’ oil supply is in big economic trouble.

It’s a sobering thought that, were capital flows to dry up to the point where there was a complete cessation of new drilling, US shale liquids output would fall by about 50% within twelve months. But it’s an even more disturbing thought that, unless capital investment can be ramped up dramatically, conventional oil supply is going to erode, less spectacularly, perhaps, but relentlessly.

So here’s the question – how, under this scenario, are we supposed to find sources for an increase in oil supply going forward? More broadly, and with oil and gas generally produced by the same companies, can we really increase the supply of natural gas by more than 30% over the coming twenty years? And can we – and, for that matter, should we – be using just as much coal in 2040 as we do now?

No ‘get out of gaol free’ cards

Two suggestions tend to be offered in answer to such questions, so let’s get both of them out of the way now.

One of these is that the use of renewables – whose output is currently projected to rise from 560 mmtoe in 2018 to more than 2,280 mmtoe by 2040 – can grow even more rapidly than is currently assumed.

But the reality seems to be that meeting current assumptions – boosting hydro-electricity supply by 50%, and quadrupling power from other renewable sources – is already a tough ask. The unlikelihood of these ambitious targets being beaten is underscored in the figures.

Energy transition has been costed by IRENA at between $95 trillion and $110tn, the latter equivalent to 720x today’s equivalent of what it cost America to put a man on the Moon. This time, of course, it isn’t just rich countries that have somehow to find this level of investment, but poorer and middle-income nations, too.

Annual capital investment in REs was, in real terms, lower in 2018 than it had been back in 2011, mainly because prior subsidy regimes have tended not to be scalable in line with expansion. Yearly capacity additions, too, stalled in 2018.

The really critical snag with “big bang” transition is simple, but fundamental. RE technology has yet to prove itself truly “renewable”, because capacity creation, and the building of the related infrastructure, cannot yet be undertaken without the extensive use of fossil fuel energy in the supply of materials and components.

The second notion – which is that we can somehow “de-couple” the economy from the use of energy – is risible, even in an era in which we often seem to have “de-coupled” economic policy from reality. The EEB was surely right to liken the search for “de-coupling” to “a haystack without a needle”.

Until somebody can demonstrate how we can drive more, fly more, manufacture more goods and ship them around the world, build more capital equipment, and supply more of basics such as food and water, without using more energy, “de-coupling” will continue to look like a punch-line in search of a gag.

This is really a matter of physical limitations – and there’s no “app” for that.

Stand back………….

On the principle that “what can’t happen won’t happen”, we need to stand back and consider the strong possibility that the consensus of expectations for future energy supply is simply wrong.

Let’s assume, for working purposes, that RE supply does, as expected, expand by 2,170 mmtoe by 2040, and that hydro and nuclear, too, perform in line with consensus projections. In this scenario, supply of non-fossil fuel energy would, as specified, be higher by about 2,370 mmtoe in 2040 than it was in 2018.

At the same time, though, let’s make some rather more cautious assumptions, well supported by probabilities, about fossil fuels.

For starters, let’s assume that shale oil production doesn’t slump, and that other forms of oil production remain robust enough to keep total supplies roughly where they are now. This would mean that oil supply won’t have fallen by 2040, but neither will it have delivered the widely-assumed increase of 10-12%. Let’s further assume that gas availability rises by 15%, rather than by 30%, and that the use of coal falls by 10%.

In this illustrative scenario, fossil fuels supply remains higher in 2040 than it was in 2018, but by only about 300 mmtoe (+3%), instead of the generally-expected increase of 1,540 mmtoe (+13%). This in turn would mean that, comparing 2040 with 2018, total energy supply would be higher, not by the projected 28%, but by only about 19%.

…..and do less?

My belief is that this is a more realistic set of parameters than the ‘more of everything’ consensus about our energy future. If energy supply does grow by less than is currently assumed, growth in many of the things that we do with energy is going to fall short of expectations, too.

Let’s unpack this somewhat, to see where it might lead. First, if expectations for RE are achieved, we can carry on using more electricity, though not at past annual rates of expansion.

But less-than-expected access to oil would have some very specific consequences. With population numbers still growing, we’ll need to keep on increasing the supply of petroleum products to essential activities, such as the production, processing and distribution of food. You’ll know that my expectations for “de-growth” anticipate a lot of simplification and ‘de-layering’ of industrial processes, and there’s no reason why this shouldn’t apply to food supply. But it remains hard to see how we can supply more food from less oil.

In short, there are reasons to suppose that oil supply constraint is going to have a disproportionate and leveraged impact on the discretionary (non-essential) applications in which petroleum is used. At the same time, faltering energy supply – and a worsening trend in surplus energy, reflecting the rise in ECoEs – is likely to leave us a lot less prosperous than conventional, ‘economics is money’ projections seem to assume.

From here, it’s a logical progression to question, in particular, whether the assumption of continued rapid expansion in travel might, in reality, not happen. We could take – but, so far, haven’t taken – ameliorative actions, including limiting car engine sizes, and promoting a transition to public transport. My conclusion – which is tentative, but firming – is that we might be a lot nearer to ‘peak travel’ than anyone yet supposes.

The assumption right now seems to be that, as and when the virus crisis is behind us, we’ll go back to buying more cars and using them more often, flying more each year than we did the year before and, perhaps, rediscovering a taste for taking cruise-ship holidays.

Let’s just say that such an assumption might well prove to be a long way wide of the mark.