Matt Partridge, Wood Mackenzie, Edinburgh, Scotland
What began as a financial crisis has transformed into a global recession as businesses have been unable to access the capital necessary for growth and as consumers have put the brakes on spending amid recessionary fears. Since the onset of this crisis, there has been heated debate over how bad it will be compared to previous crises and how long it will last.
At present, the focus for many remains on the short-term imperative of surviving the storm, with considerably less thought devoted to what the future may hold. Considering both the severity of the global recession and the unprecedented and, in some cases, unorthodox actions being taken by governments to stabilize the situation, it is difficult to imagine that the post-recession world will mirror that prior to the recession.
Growth will indeed return. But how different will the world look when this does eventually happen?
In this article, we explore some of the potential repercussions of the global recession and related implications for the energy industry. We examine the actions being taken by governments to address the current situation and their potential macroeconomic and geopolitical ramifications, with a view to outlining what challenges may be in store for energy companies once the current crisis passes. Our analysis suggests that energy companies could face a variety of risks and challenges as the global economy enters a new phase.
The spectre of inflation
Governments the world over have pumped what has amounted to trillions of dollars into the global economy to stabilize banks, industry, and the wider economy as a means to encourage a return to economic growth. This unprecedented level of government intervention will have far-reaching consequences.
In the short term, deflation is a key concern for global economies mired in recession. However, inflationary pressures will likely emerge over the medium term as current policies of significant fiscal stimuli and ultra-loose monetary policy feed through to the real economy. Given the unprecedented level of sovereign debt issuance over the next couple of years, there is a real possibility that advanced economy governments will tolerate elevated inflation in order to reduce their nominal debt position.
Discussions surrounding government spending, particularly in the United States, have also raised concerns over a weakening US dollar and the potential impact of this on the global economy. So great have been the concerns over a potential weakening of the US dollar that in recent press coverage, several countries, notably China, have called for the replacement of the US dollar with an international reserve currency allied with an expansion in the use of IMF Special Drawing Rights.
The prospect of the US dollar being replaced by another currency or a global reserve currency in the near to medium term remains remote, as the dollar is favored by global investors, particularly in times of crisis, due to the US economy's position as the largest and, some would argue, the strongest in the world, backed by what many see as the most stable political system in the world. At present, the renminbi (China's currency) does not meet the most elemental criteria necessary for a global reserve currency but is nonetheless positioning itself to move towards this objective over the longer term.
However, concerns among large holders of US dollar-denominated debt have prompted calls, notably from China, to seek ways to limit exposure to US dollars. Indeed, China has recently negotiated currency swap arrangements with several countries whereby some trade between counterparties in those countries could be settled in renminbi and the respective counterparty's local currency.
A weakening US dollar could fuel increases in the prices of dollar-denominated commodities such as oil, as evidenced through mid-2008, when oil and other commodities reached historic highs, driven at least partially by the dollar's fall in value against other major currencies over the same period.
Apart from the impact on commodity prices, the biggest concern surrounding rising inflation and a weakening US dollar is what governments will need to do to curb it: pursue tighter monetary policy. It is likely that central banks around the world (especially inflation-targeting central banks, with the notable exception of the US Fed) will be forced to increase interest rates and slow economic growth to ground inflation expectations. This could force aggregate oil demand to slow, with households and corporations struggling to cope with higher debt costs. Under a worst-case scenario, this could trigger another recession.
Inflation and a weakening US dollar will drive higher commodity prices, a positive for energy companies – to a point. However, the high energy prices could eventually lead to erosion of demand as energy consumers feel the pinch and could potentially herald another recession. Higher inflation will also clearly have an impact on capital-intensive businesses such as those in the energy sector, drawing into question operators' contracting strategies as they look to lock in prices over the medium term.
Re-pricing of risk
Besides the medium-term risk of higher interest rates as a result of government moves to rein in inflation, lack of attention to risk in lending through the run-up to the current crisis has resulted in a full swing in the other direction. Credit markets have essentially been frozen for a number of months, with a slight thawing trend emerging only recently. The lending that has occurred has placed a high premium on risk, with large credit spreads between the highest-rated and lowest-rated companies.
The premiums being assigned to risk in the short term are being driven largely by the need among banks to repair and fortify their balance sheets as the value of assets has been severely eroded in the wake of the current crisis – a process that has scarcely begun. Driven to conserve cash and reluctant to lend, banks have been much more conservative in their lending practices, allowing them to charge handsome premiums for scarce credit.
On top of the risk aversion being displayed by banks, the spectre of tighter regulation of banks and the financial markets in general, manifesting itself in more detailed disclosure of the nature and quality of investments, will add an additional administrative burden and in turn an additional cost to finance. All these factors will combine to increase the cost of capital.
For energy companies, this re-pricing of risk will likely mean that highly indebted companies, especially those that employ a leveraged business model, could find it difficult (and at times impossible) to raise capital to fund ongoing operations. The more stable players appear so far to have weathered the storm, enjoying relatively low gearing and sufficient levels of cash. However, even some of the major oil companies are now having to borrow to maintain capital investment programs and pay dividends, clearly an unsustainable situation.
In an environment with potentially higher cost of capital and forecasted inflationary pressures, counterbalanced by higher commodity prices and driven by the weak US dollar, companies will be pressured to make tough choices regarding new investment projects.
The more capital-intensive, long-lead-time, commodity price-sensitive projects such as oil sands, gas liquefaction, and ultra-deepwater projects could become off-limits to all but the major players, which have a greater ability to access and secure relatively low-cost debt. For the smaller and medium-size players, access and the high cost of debt may freeze them out of these growth options, leaving them to pursue those that are less capital-intensive.
Are higher taxes on the way?
At the same time that governments are trying to deal with inflation and trying to instill confidence in their economies through tighter regulatory controls, they will also be struggling with how to pay for the massive waves of stimulus money spent just a few years earlier. Again, governments will need to act. This time action will most likely come in the form of higher taxes.
Higher taxation would squeeze consumer and corporate incomes, thereby stifling demand for goods, services, and energy commodities. There could also be changes in global and regional demand patterns, as countries not burdened with such high debt levels will avoid the need to raise taxes, potentially making them more attractive as lower-cost destinations for foreign investment.
This dichotomy of high-tax versus low-tax countries could drive a shift in migration patterns, with "highly mobile" people, companies, and entire industries migrating to lower-cost geographies. Indeed, Transocean Ltd., Weatherford International, Tyco, and Foster Wheeler have all moved headquarters to Switzerland, at least partially driven by a desire to take advantage of Switzerland's favorable corporate tax policies, which only tax domestic income. Could we be witnessing the beginning of a trend, with companies (along with associated jobs and related industries) moving operations away from the USA, the UK, and other countries that have growing tax risk to lower-tax locations?
In tandem, given the potential for inflation-fueled commodity price increases, is there the potential for governments to target bulging energy company profits by adopting "windfall profits" taxation as a source of revenue to balance budgets and pay down debt, providing yet another driver for a flight from developed countries with high levels of debt to emerging countries with correspondingly lower levels of debt? A shift to Asia, Africa, and South America could emerge, with countries previously viewed as economic backwaters emerging as vibrant, unencumbered growth engines.
For energy players, the prospect of such a dynamic would impact access and competition for human capital, and would also force a review of international strategies, particularly where there has been a focus on linking energy supply to high-value markets. Which markets will become the key demand engines under such a scenario?
Social unrest and political instability
The combined forces of high inflation, rising interest rates, an increased tax burden, high unemployment and migration of companies and jobs could ultimately lead to social unrest and political instability.
Governments will be under increased pressure to protect jobs and provide relief for burdened populations. In response, governments could adopt protectionist policies in an attempt to quell social unrest. Indeed, the recent US stimulus package has been criticized for being protectionist, favoring goods produced in the USA for use in stimulus-funded projects. Likewise, the EU has accused China of locking foreign suppliers out of its stimulus-funded projects.
Many worry that widespread protectionism could lead to breaks in global trade and indeed undermine globalization, the very force credited with facilitating the record levels of economic growth experienced through much of the 1990s and 2000s.
A rise in protectionism by some governments could spark retaliation from major resource-holding governments in the form of tighter access to natural resources. One potential consequence of this trend could be an increased focus on state-sponsored national champions, as energy is seen to be too important to leave to the market, particularly as nations perceive a need to fight to gain access to resources in a more polarized world.
In addition, as the pain of the current crisis and projected slow recovery further pinches, desperate governments may seek to redirect public ire to foreign companies, particularly energy companies, which are seen as making large profits at the expense of a struggling population. Governments could raise the stakes by increasing taxation on oil and gas production revenues or by nationalizing energy resources.
In a world of decreasing access and with the potential for increased government take, energy companies will struggle to grow portfolios and will need to explore new models to deliver growth, potentially ranging from developing alternative energy sources to offering major resource-holding countries services, to maximise the value of their resources (e.g. commercialization technologies, carbon trading).
What is the future model?
The current financial crisis has raised fresh questions about the credibility of the so-called Anglo-Saxon capitalist model, as rampant capitalism in the guise of "let the market decide" has become a scapegoat for the crisis.
As regulators sift through the debris of the financial crisis and try to determine both the causes and the appropriate legislative responses, many are advocating a softer, more European type of capitalism, while others marvel at the ability of centrally planned and controlled capitalist models to provide significant growth in parallel, enabling rapid response to crisis.
Rather than being a purely academic exercise, this debate raises far-ranging implications, in terms of both the future regulatory regime and how the multilateral lending institutions, notably the IMF and the World Bank, conduct their business. Many countries that have endured IMF- and World Bank-imposed austerity measures have called for a movement away from the Washington Consensus model of liberalization, free trade, and privatization.
Western energy companies have historically been able to exploit the opportunities arising from multilateral institutions as their mandated market liberalization and privatization of the energy sector have created new investment opportunities.
Take Argentina, for example. In the early 1990s, IMF loans were made to Argentina contingent upon its pegging the peso to the US dollar, privatization of industries from banking to oil fields, rolling back tariffs, and allowing the free flow of capital. The Argentinian economy subsequently collapsed in 2001. This collapse was brought about by a combination of factors, not least among which was the poor implementation of the IMF-backed reforms by the Argentinian leadership. Arguably, however, the conditions for such a collapse were partially created by the imposition on Argentina of an unfamiliar and austere economic regime.
More recently, China has been offering an alternative to the Western-dominated World Bank and IMF model. It has been making loans and building hospitals, schools, and infrastructure in exchange for access to natural resources, particularly in developing economies. China's apparent hands-off approach is welcomed by the host government, while the ultimate success of this approach for ongoing development in the country remains uncertain. However, past Western-sponsored initiatives have set a very low benchmark.
While significant challenges to the IMF and the World Bank as lenders of last resort remain remote, given their size and a lack of credible substitutes, the damage done to the Anglo-Saxon model may drive emerging economies, such as those of Brazil, India, and China, to demand a greater say in re-shaping the IMF and World Bank framework. However, one could foresee policies emerge under which loans are no longer contingent on large-scale market liberalisation, in turn severely limiting the investment opportunities across all sectors, particularly the energy sector.
What does this mean for energy companies?
Of the many things that could emerge after the current crisis has passed, one thing that will most certainly not occur is a return to business as usual. Companies hoping to be successful in the future will need to develop a view as to how the macro-drivers will combine to impact the energy industry, in the process developing robust strategic responses for delivering growth in an ever-changing world. To this end, company executive management should constantly review current business strategy to ensure that it is aligned with larger market forces and be prepared to make adjustments whenever required.
At the same time, company executive management should be evaluating potential growth opportunities. In a dynamic energy market place, the nature and type of opportunities change continually. Functioning effectively in this environment requires flexible decision-making capability, supported by timely and effective strategic and market insight.
Only the most agile and forward-thinking energy companies will be able to adjust effectively to the myriad changes that we anticipate affecting the global energy business environment. Consequently, energy companies of all sizes, as a matter of some urgency, should be looking to address challenges such as those below:
- Is your strategic planning process flexible and adaptable enough to handle what is expected to be a very uncertain future?
- What contingency plans have you made to address any sustained rise in the cost of capital, and when should you be looking to implement them?
- How prepared are you to deal with the possibility of a significantly weakened US dollar and associated potential outcomes?
- Do you have a clear strategy to cope with a potential rise in protectionism among oil- and gas-producing countries and consequent restrictions on access to natural resources? OGFJ
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