COVID-19 and the Post-Pandemic Economy: Energy Impacts, Winners and Losers — Implications for Energy Financing and Capital Access
In the second episode of a special three-part series, BRG Managing Directors Brad Cornell and Peter Keller talk with host Michael Whalen about how COVID-19 has affected the financial markets and clean energy efforts. They also talk about how investors steering away from the establishment of capital could affect the environmental sector.
TRANSCRIPT
00:02 [music] Welcome to BRG's ThinkSet podcast. I'm your host, Michael Whalen, an expert in BRG's Energy and Climate practice. BRG is a global consulting firm. We help organizations in disputes and investigations, corporate finance, and performance improvement, and advisory. We're a multi-disciplined group of experts, industry leaders, academics, data scientists, and professionals. Around the world, BRG delivers the inspired insights and practical strategies our clients need to stay ahead of what's next. For more information about BRG, please visit thinkBRG.com.
In this, part two of a special three-part series, we'll discuss COVID-19's effects on the financial markets and clean energy efforts. Joining us from Los Angeles is Brad Cornell, a financial expert on valuation and green energy initiatives. And from New York, we have Peter Keller, a longtime energy banker with more than three decades in oil and gas finance. With that, let's get started. Brad, welcome back to BRG's ThinkSet podcast. You've appeared before to talk about the financial realities of global warming, and how a transition to renewable energy might occur. Can you give us a quick recap and explain how things have changed as a result of COVID-19?
BC 01:24 If anything, COVID 19 makes it more difficult. The problem that I was referring to in my previous podcast was just the scale and scope of the transition to non-carbon forms of energy. As of 2018, carbon forms still accounted for well over 80% of total energy usage. So the capital costs of transitioning away from that are going to be immense. And with a disruption in the financial markets due to COVID, it's likely to make those problems even larger and to postpone them.
MW 01:58 You've been clear that one element of being able to address the capital-raising effort for climate change and for the economic investment required is to get the price signals right on carbon, to hasten the adoption of cleaner fuels. As you know, prices for carbon-based fuels, crude oil, and other liquid fuels have plunged, as a result of the lower demand in the global economy, as it stalled out. What should policymakers do in the current environment?
BC 02:25 Well, I think one thing they can do right now is to place a tax on the burning of carbon, so that it reflects all the externalities, including global warming and pollution. That's always been politically difficult. But with prices so low now, I think there's a real opportunity to do that.
MW 02:43 Is there going to be a consensus for that level of establishing taxes and prices on carbon?
BC 02:50 Well, that's the million-dollar question. I would hope so. But everyone seems to be so distracted right now, that debate isn't even beginning. So I hope that, as COVID starts to wind down, we will see a real serious addressing of that question. But whether it's going to happen, that's anybody's guess.
MW 03:08 Peter, you're on top of the corporate financial markets for US utilities and energy producers. Let's look first at corporate utilities, who have traditionally been what is characterized as widow and orphan-style investments. How have they been faring during the market disruption?
PK 03:24 Michael, so far the utilities have had pretty much wide-open access to the capital markets. Again, there have been no equity issuances in the last couple of weeks. But there've been an awful lot of debt issuances. And this, primarily, reflects the typical model in periods of crisis, where people look for credit quality. Utilities are among the most capital-intensive industries, and so they need capital markets access. Regulators recognize the importance of capital markets access. So highly rated utilities have been issuing debt in record levels over the last couple of weeks. I think there was over $20 billion of IG issuance in the month of March, and has continued in the first two weeks of April.
MW 04:01 Is that also true for the integrated energy companies, like the majors?
PK 04:04 No. It's been tougher for the majors. There have only been a couple of issuances over the last several weeks of oil and gas companies. They've had access, but they've certainly paid higher spreads. Well, spreads have widened a little bit. Underlying treasuries are so low that, even with higher spreads, you've got all-in costs that are quite attractive. And we've seen on the utility front, issuances as long as 31 years. In the corporate front, I've seen a 40-year deal. So there is an appetite for a longer-dated paper. And people are doing 30s and 40s at under 4% all-in.
MW 04:33 Peter, let's focus in then on the riskier side of the energy market. And one element, which is under tremendous stress it would seem, is US shale producers, who have really relied on the financial markets for enormous capital requirements, and at the same time, have been slammed by the drop in oil demand and the overproduction threats coming from Saudi Arabia and Russia. So what's the outlook for these companies in business continuity or in restructuring?
PK 04:59 Again, it's a fairly bearish near-term outlook. Among the shale companies, you tend to have not the large integrated majors. An awful lot of the activity we see is in the mid-market-sized companies. And there, what you see is an awful lot of companies that are reasonably highly-levered, an awful lot that are dependent on bank borrowing, and were about to enter the semi-annual borrowing base re-determination level. And I would expect that bank borrowing bases will cut dramatically, which will limit smaller companies' access to bank capital. In the last big downturn, there were an awful lot of private equity players who came in in very significant ways. And they were very large investors. By and large, those investors have been burned pretty badly. They're not likely to be back. So I would expect then, we've seen some in the last couple of weeks. I think we'll see an acceleration of bankruptcy filings. I think we'll see more restructurings and asset sales. A number of the large offshore drillers have missed interest and principal payments over the last several weeks. Right now, we're seeing a situation where the better-capitalized companies will survive. I think we'll see some asset accumulation by the better-capitalized companies. Getting to the shale players you mentioned before, we've actually seen a couple of the better-capitalized domestic shale players actually up in this market. I think largely on the expectation that, as the majors stop drilling in the Permian Basin, oil-directed drilling, where there's an awful lot of associated gas, there'll be a reduction in gas production, which should benefit the shale drillers in the Marcellus region. So we're seeing a more aggressive price deck for gas over the fourth quarter of this year. So we've actually seen a couple who have actually rallied, and they're an awful lot less than the majors, and certainly a lot less than a smaller, more highly leveraged companies.
MW 06:36 Peter, are we going to expect any delay in restructuring from the effective commodity hedges that might allow some companies or certainly allow their creditors to prolong more radical restructuring activity?
PK 06:49 You're right. But the hedges do delay. Most companies hedge out a year or 18 months or so. So a lot of this depends on the length of this downturn. When we've seen massive disruptions before, and I think particularly of 9/11 or Superstorm Sandy, as soon as the crisis has been over, we've started rebuilding, and started recovery. What's unusual about the COVID crisis is, we don't know how severe it will be. We certainly don't know the duration. The governor of New Jersey was talking about mid to late summer. And so the longer this goes on, people will have hedges rolling off, and there'll be more and more market exposed. And that will have a real cash flow impact. And then secondarily, if demand stays off as much as it is, then I think we're going to have a slow airline recovery, which is going to reduce demand for distillates. It's hard to see how we have a recovery in oil prices in the near-term.
MW 07:37 Peter, one of the issues that the energy sector faced, particularly the carbon-intensive element of the sector, was investors shying away from those deployments of capital because of concerns about environmental impacts. Have you seen that in the markets, in terms of pricing? And do you anticipate this being an issue in a post-COVID environment?
PK 08:00 Yes I do. One of the things in the early days of ESG investing, it was more a feel-good sort of thing. And you skewed your portfolio towards sustainability because it felt good. It now is having real market impacts. All of the three major ratings agencies are incorporating sustainability into their ratings, so that companies that are less sustainable, companies that are not taking socially responsible steps, will, in fact, get dinged. And they're going to find that they are going to pay a higher price for capital. It's put into the ratings calculations at S&P and Moody's. So it'll have a longer-term impact. I agree. But as Brad mentioned earlier, one of the tough things about decarbonization is, because fossil fuels are so cheap right now, it makes it tougher. We were in a period where solar and wind were cost-competitive for electric generation. But now, we're finding that renewables are not really cost-competitive right now. And we're making great strides. But certainly, this has an impact on the trend of decarbonization. The solution that Brad alluded to earlier is a carbon tax. And really, every economist I know, and most of those economists are Republicans, are free-market people, are supportive of a carbon tax. It is, of course, a market-based approach. Because all you're trying to do is internalize externalities and make the users pay the real cost of burning fossil fuels. But what we've lacked over the last decades has been the political will.
BC 09:20 And a simple tax would also be much more simple and transparent. We have this problem now. We have investment tax credits and production credits. And they have horizons, and they come on, and they come off. All that complexity just makes it more difficult for the market to operate.
PK 09:37 You're right. And they very definitely distort the markets. I mean, we see this with the production tax credit and the investment tax credit. You have people selling commodities, selling wind power at negative pricing. Now, no rational person would ever sell something at a negative price. But if you've got a volumetrically determined tax credit, you're going to say, "I don't really care. I just want to get my credit." So you're right. There are all these perverse side effects. And a real carbon tax that simply tries to match the tax to the social cost of carbon is far more efficient. It's far better than having some bureaucrat decide, "We want to incentivize wind this week or solar next week." It would be simple to administer. Before the COVID crisis came along, the real proponents of a simplified carbon tax were all Republicans. It was Jim Baker and George Shultz and Hank Paulson; all three of them are Republicans who wanted a carbon tax and dividend plan, where you would use the tax to decarbonize, but would rebate all those revenues to the general public, so it was revenue neutral. I suspect now, having seen a multi-trillion-dollar stimulus package, at a time when we already had a trillion-dollar deficit, we're going to need to use that revenue. Hopefully, we can use it for something constructive like infrastructure. But a carbon tax - Brad alluded to this earlier - at a time of low prices, would be far less visible, far less painful, when we've got low oil and gas prices.
MW 10:53 So Brad, you've been advocating for this for a long time. Is this actually going to be a catalyst toward a worldwide consensus on moving to market-based mechanisms to price carbon?
BC 11:03 Well, I think there's a good chance to do it now, for exactly the reasons that Peter was saying. One, the price of oil and gas is very low, so placing that tax on now would not be so visible to final consumers. And second, governments worldwide are going to need revenue. And I imagine that consumers might be more willing to accept a carbon tax than an added tax on income or personal consumption.
MW 11:26 And what's your view on what we were talking about earlier, in terms of the constraints being placed on the provision of capital to less-favored energy companies, particularly those that engage in carbon? Does the existence of a externality pricing mechanism remove some of that onus against providing capital for those sectors?
PK 11:48 Every one of the oil majors, so the CEOs of every one of the oil majors, has advocated a carbon tax, some sort of carbon pricing scheme for several years now. I think they recognize that, if you're a resource developer, you rely to a large extent on the social license to operate it. So I think they recognize that this is going to be seen as a cost of doing business. It will raise some prices. Absolutely. But again, if you're an economist, and you say you're internalizing externalities, you're not really raising system costs. You are simply allocating those costs to the users of the resource. So you can do it in a way that is not going to harm the economy, but that actually just makes sure we've got a more equitable distribution of costs.
BC 12:28 Ironically, this is one of the reasons that I'm opposed to this ESG movement. I really don't like the idea of executives making the decision of how socially responsible or how green they're going to be. I think those decisions have to be made by publicly-elected officials. But if that's the case, the publicly-elected officials have to step up and set the rules of the game. So if we get the right price signals in there, like a carbon tax, then everyone can go about their business of trying to maximize profits, and it won't be a problem. But if the price signals are all wrong, that's when you run into trouble.
MW 13:04 Fair enough, Brad. But let me offer a counterpoint. Is this not a response to market demand? My adult daughter was making her first future retirement investments with her first job. And she was very concerned about making sure that she was investing in companies that met environmental and social governance objectives. So could one take the opposite position and say that the supply side of capital is really just responding to the market, in terms of the demand of investors and shareholders to be more socially-conscious in their investments?
BC 13:38 Again, it depends on the rules of the game. We're going to need oil for all sorts of things, for agriculture, for industry, and so forth. There's nothing wrong with making oil. We're going to have to do it. What's wrong is making too much of it because the prices are wrong. And it's my view that if we get the price right, and we price the externality, then investing in a company that's producing oil is no less socially conscious than one that's producing solar power. The problem is getting the tradeoff right.
PK 14:06 The reality is, and we've seen this, energy poverty is a huge destructive force. And you look in third world countries that don't have access to energy, certainly access to clean energy, from a quality of life standpoint, from mortality-morbidity standpoint, it's a big deal. So the issue is to have a cleaner supply of energy, which we can do. And again, if we send the right market signals, that will happen sooner. We've basically known a lot of the costs related to fossil fuel burning for decades. And we've failed to deal with it. So there's a balance between allocating costs appropriately, yet also, making sure that people have access to energy, particularly in less developed countries. We talk about current emissions, and there's no question. You look at current emissions, we're the number two emitter. China is number one. And we all say China needs to clean up. But the reality is, China is cleaner at this stage of development than we were. The western countries, the developed countries, have used up most of the carbon budget. So there's a little bit of imperialism when we say that third-world countries shouldn't modernize, shouldn't have energy for the masses because we can't afford it from a carbon standpoint. We used up most of that carbon budget over the last century. So we need to work with others to get access to energy. And to Brad's point, even when we move towards greater electrification of transportation, and towards decarbonizing an awful lot of the economy, the reality is, there'll still huge demand for oil, petrochemical reasons, obviously, plastics and other uses, fertilizers, pharmaceuticals. So there'll be an ongoing need for some significant oil and gas production going into the future. The challenge will be to clean it up, to either remove carbon, to sequester carbon. But we're going to have an ongoing need for energy. And that energy is going to have a large component, which is fossil fuel.
MW 15:47 Well, in fairness, we may have used up the carbon budget, but I'm not sure everybody realized there was a budget at the time. Brad, let me ask you a question. I've worked with a lot of oil companies and traditional, conventional energy companies that have renewable energy project development activities. One conundrum that they're facing is that the returns in a lot of renewable energy investment, particularly when we think about conventional photovoltaic solar and onshore wind, the returns are quite challenging. They're a small fraction, in many cases, of the types of returns their investors expect them to achieve in exploring, producing, or processing hydrocarbon fuels. Is that a fundamental problem, in terms of promoting further investment into energy transition?
BC 16:32 Yes. The returns are a real issue. One thing I've been doing is talking to people that are attempting to build large solar and wind farms, and to other entities that are thinking of investing in those farms. And the fact is, if you want a return on, let's say, unleveraged equity capital of 7%, which is hardly some sort of private equity return, it's difficult to get in that space. And one of the solutions that I've been thinking about is we may need something similar to what the government has done in the real estate market through Ginnie Mae, where the government may want to offer guarantees to people who invest in these projects. So you would make the debt issue to finance them less risky and therefore attract capital. Now, I know that runs a little bit against my view that the government shouldn't be involved. But in something as large as the transition to renewable energy, it's probably going to have to play a role. And a role like the way Ginnie Mae did in the mortgage market might be something to consider.
PK 17:34 Well, I'd also argue that that was already played to some extent. So the states sort of adopted aggressive renewable portfolio standards. I lived in one of them, in New York. California certainly is one. There are a lot. The commissions in those states are generally allowing utilities to sign long-term PPAs well above market. And so that, in a way, is actually a sort of subsidization, when you've got a PUC that says, "We will approve as reasonable a long-term PPA at double--" I've been involved with some renewable financing where the PPA is worth more than double the then-current market. The issue is if 5% of your generation is double the market, you blend it in, and the markets work fine. And you don't have rate shock. When you get states like New York that are looking at 50% RPSs in totally 100% decarbonization at a certain point in time. If you try to roll in bulk generation at three times the market—Andrew Cuomo's attempts to add several gigawatts of offshore wind. It becomes a lot tougher. And so, commissions are responsive and receptive when you're talking about maybe a 1 gigawatt PPA. But when you're talking about needing 10 or 20 gigawatts at double or triple the market, that just moves the market. So there's some subsidy there, but there's a point when the rate shock becomes too extreme for the politicians or the ratepayers to absorb.
BC 18:49 And when you get to that level of renewables, then the storage and reliability questions become much more paramount. At 5%, you can run the gas peaker plants to make up any shortfalls, if it's not sunny or windy. But at 50% or 70%, you've got a big problem.
PK 19:06 And I would say, I've been in the utility sector for a long time. And I've long argued with EEI and others that we've done a terrible job of educating consumers. Most people don't understand the issue of intermittency. I have highly educated friends and neighbors in suburban New York who just say, "Why don't we go to 100% renewables?" They don't understand that the power business is the ultimate just-in-time business. And that if you were to go to all renewables, that you would simply have third-world quality power with rolling brownouts and blackouts. So until we get storage at scale at an affordable price, Brad's absolutely right. You're going to need a big fleet of gas-fired peakers to step in when the sun isn't shining or the wind isn't blowing. So there is a general lack of understanding about the dynamics of electric generation, which allows regulators and others to make bad policy decisions because the public doesn't understand the impacts of those decisions.
MW 19:56 So let me ask a question to both of you regarding what we've learned from past crises, and how it's been applied in COVID-19. One thing that has struck me in watching the capital markets after the crisis, and as we're recording, the equity markets have certainly roared back from their initial drop. But it does seem that we were very quick to apply the tools that were developed during the global financial crisis very quickly and without hesitation. What are your thoughts? I mean, has this worked out well, in terms of keeping the financial markets functioning properly? Or is it a portent of problems that we're going to deal with later, as we go through whatever pace of recovery?
PK 20:39 I think you hit the nail on the head with the last word. It's going to be pace related. We've had disruptions that were months in duration and the markets recovered pretty quickly. My guess is that this recovery is not going to be a [inaudible] or even a U. It may be an L recovery. And I think we may reset at a lower level of economic activity. That's going to create greater market challenges. Right now, there's an awful lot of liquidity in the market. That's true. And the debt capital markets are pretty open. But if you look at equities for oil and gas companies, their stocks have triggered off so dramatically, the market's generally been strong. But in the ENP sector and the oil field service sector, the drillers are all off over 90%. So the markets are effectively closed to them, just because there'd be so much dilution. Now, the debt markets, again, you can access them but at a higher cost. But it's hard to reconcile a higher cost of capital, if we've got a long-time, low oil price environment. So your revenues will be impacted negatively, and you're taking on debt at the higher coupon. So there will simply be some significant cutbacks in capital expenditures in the oil and gas sector. And this is what has created over the last century the boom and bust mentality. We will cut back cap-ex. Production will ultimately fall. And at some point, we'll dynamically balance the markets again, supply and demand. And then, if history is any guide, we'll find some shortages at some point. And prices won't stabilize and go up again. One of the advantages-- Michael mentioned shale earlier. Shale tends to be quicker response. So maybe we use shale producing as a balancer to bring supply in more quickly. I think it's going to have really, really long-term impacts on the high capital, long development cycle things, such as deepwater offshore. Because I think the likelihood that majors are going to want to deploy a lot of capital where you may have a 5 to 7 to 10-year delay from first investment to first revenue. That's going to be a tougher thing to bring back. So I think we'll be looking for production profiles that are quicker to bring on and perhaps quicker to deplete.
MW 22:34 Peter are the majors going to try and sweep in and be consolidators in that shale space? Or have they already spent their nickel and are licking their wounds?
PK 22:43 I'm not convinced that any of the global majors-- there will be some attractive opportunities to buy. But we're in a situation where I think we're going to end up leaving some resources in the ground. We're not going to deplete reservoirs, I think, because of carbon constraints. In the past cycles, we weren't really in a carbon-constrained environment. We are now. And so, do people want to double-down on shale? Or will they simply say, "We're going to leave more reserves in the ground than we originally envisioned"? Right now, the US oil and gas companies have cut their capital spending plans for this year and next by 40%. The internationals are down 20%. We're going to see some supply response to that level of cap-ex cuts.
BC 23:23 One thing that's going to affect the energy industry, it's going to affect everything, and I think it's fundamental to the financial markets in this recovery, it's what's going to happen to the millions and millions of small businesses that are sort of the heart and soul of the American economy. I mean, barbers, house cleaners, restaurants, small shop owners, personal service providers, all these people have to figure out a way—and we have to help them—that they can get back to work and run their businesses. And this crisis is unique because it's affecting the way they do everything. When can you go in and get a haircut again? And when you do, are you exposed to all of the people that had their hair cut earlier that day? How's a barber going to operate?
JK 24:05 And my fear is some of these sectors won't come back. Obviously, we've got people who we're not traditionally doing Internet-related shopping. They're going to find that, "Gee. It's pretty easy, convenient." I was talking to a friend who's a corporate attorney working on an airline stimulus package. And he was saying the airlines are looking and saying, "An awful lot of business travel, they may determine"-- I spent most my career as a banker and traveled a lot seeing clients. Well, maybe I still see clients on a quarterly basis but not a monthly basis. So I think long-term airline travel may face some headwinds. So yeah, the recovery, I think is going to reset at a lower level. Employment's going to reset at a lower level. So this, to me, is far more severe than anything I've seen in my career in this business.
MW 24:45 Luckily, we have an audio podcast, so nobody can see our uncut hair and shaggy faces. It was a pleasure. I appreciate your insights on the economy, the financial markets, and the energy sector. Thank you for joining the ThinkSet podcast.
PK 24:57 Thanks, Michael.
BC 24:58 Thank you.
MW 25:01 [music] This ThinkSet podcast is brought to you by BRG. You can subscribe to the podcast and access other content from ThinkSet magazine by going to thinksetmag.com. Don't forget to rate and review this show on iTunes, as well. I'm Michael Whalen. Thanks for listening. The views and opinions expressed in this podcast are those of the participants, and do not necessarily reflect the opinions, position, or policy at Berkeley Research Group, or its other employees and affiliates.