Chancellor: Going green is everything except easy

Less than two weeks ago, Boris Johnson told the General Assembly of the United Nations that “when Kermit the frog sang ‘It’s Not Easy Bein’ Green’, I want you to know he was wrong.” Perhaps not since Neville Chamberlain returned from Munich in September 1938 declaring “peace in our time” has a British prime minister said anything so spectacularly mistimed. At least it took a year before Britain was at war with Nazi Germany. Within days of Johnson’s comments, energy problems were surfacing around the world, from natural gas shortages in Europe to power cuts in China. The global energy crisis changes everything. Not least, it will make the cost of going green a great deal trickier.

Even before the pandemic, global energy production was failing to keep up with demand. U.S. shale output – the world’s main source of extra oil supply over the past decade – was in decline. During the Great Lockdown, demand for energy collapsed, and a lack of storage facilities sent oil prices into negative territory. Producers cut investment by 30% last year. Global oil and gas “upstream” capital spending has fallen from nearly $800 billion in 2013 to below $350 billion this year, according to the International Energy Agency. Leading shale oil producers Chesapeake Energy and Whiting Petroleum have gone bust. Survivors are playing it safe. The number of oil rigs in the Permian Basin has fallen to half the 2019 level. Outside of the United States, the rig count is also around half its pre-Covid level, according to Goldman Sachs.

The collapse in capital expenditure in oil and gas has accelerated with the rise of environmental, social and governance investing. Since the start of the year, green activist investor Engine No. 1 has captured three seats on the board of Exxon Mobil (XOM.N). The Biden administration has cancelled the Keystone XL pipeline, which would have transported Canadian oil across the United States. The oil majors won’t embark on expensive new projects for fear that they will end up as “stranded assets”. The head of the Organization of the Petroleum Exporting Countries, Mohammed Barkindo, recently lamented “a global campaign (against) the oil industry to crowd out investors of oil and gas.” Royal Dutch Shell predicts that global oil output will fall by 1%-2% a year.

Activists may have their hearts in the right place, but many seem to overlook the fact that investment in renewable energy is itself highly energy intensive. What this means is that, in the short run, we’re going to need more of the black stuff. Environmentalist Jeremy Grantham (my former boss at GMO) points out that it typically takes 4 to 5 years to recoup the energy that goes into making wind turbines and other renewables. John Hess, the chief executive of the U.S. independent oil producer bearing his name, predicts that $16 trillion of planned green investments will “turbocharge” demand for oil in the near future.

At the same time, conventional demand for oil is recovering faster than expected. American road traffic is back above its 2019 level. There’s more to come as the global airline industry reopens. Oil inventory drawdowns are accelerating. The fact that oil futures have been trading below the spot price (what is known in the market as “backwardation”) has made it uneconomical to store oil. Cushing, Oklahoma, the main U.S. oil storage facility, is operating at half capacity. Goldman predicts that Brent crude could reach $90 by year-end but adds that the rise in long-dated oil could prove “non-linear” if storage runs out. Oman’s energy minister, Mohammed al-Rumhy, suggests that what he calls “energy starvation” could send the oil price to $200 a barrel. Still, OPEC is in no hurry to help out – at its meeting earlier this week members declined to increase supply.

An oil price spike anywhere close to $200 a barrel would halt the global economic recovery dead in its tracks. Central bankers are literally powerless in the face of an energy crisis. Printing more money at such a time would only fuel inflation, as occurred during the 1973 oil crisis. The “Everything Bubble” in stocks, bonds, cryptos, non-fungible tokens and baseball cards would burst. Higher energy prices would raise food prices. “Few people understand that cheap food, clothing and housing depend on cheap energy and that potatoes are really made from fossil fuel,” wrote the late Howard T. Odum in his book “Environment, Power, and Society”. Europe’s natural gas shortage has already darkened Dutch greenhouses and forced the UK government to bail out a fertiliser producer.

Odum believed that all economic activity involved the transfer of energy. He coined the term “emergy” to describe the amount of energy required to generate a given level of output. The standard of living, he said, was best estimated by the annual emergy use per person. Reduce the amount of energy pulsing through the system and its output will decline. Renewable energy may one day replace the cheap energy supplied by hydrocarbons. But, contrary to what Prime Minister Johnson says, the transition won’t be easy.

In the face of energy shortages, the global economy will have to restructure. Supply chains must contract and many businesses that depend on cheap energy (or cheap labour) will become unviable. Odum believed that real wealth is stored energy. Cash and nominal bonds are mere claims on wealth. Much of this paper wealth would be at risk of evaporating. As the economy contracts and consumer prices rise, inflation-protected bonds yielding negative rates may prove a safer bet. Gold, which has the highest embedded energy content of any natural material, according to Odum, looks especially attractive – it’s no coincidence that the 1979 oil crisis was accompanied by a bubble in the barbarous relic.

High oil prices should incentivise more investment. But before that happens, the share prices of traditional energy suppliers will have to rise. Oil companies may not exist as we know them in several decades time. But in the meantime, they should be viewed like tobacco companies. Spurned by ESG investors, their cost of capital has risen. But Finance 101 teaches that a high cost of capital equates to high returns. For those who can’t bring themselves to invest in oil and gas production, there is always the futures market. With oil futures currently in backwardation you even get paid to speculate.