Informed Tip of the Week: Since this is a climate themed post, I thought this recent research was worth sharing. Dr. Klotzbach, who some of you will remember for his annual hurricane forecasts, looked at trailing 30 year hurricane activity and found a declining rate of storm frequency and severity.
This is in stark contrast to the many insurers and reinsurers who are raising prices for “increased climate risk” based on the last THREE years of data. There is a lot of inherent uncertainty so it’s unclear what the forward outcome may be, but it is interesting to see insurers and their actuaries cling to recency bias over the long run data.
There are a lot of allegations about oil companies or gas stations taking advantage of higher oil prices to drive “windfall profits”. We won’t get in to that too much today, other than to ask what the name was for the type of profits when oil was briefly below $0 two years ago?
Markets fluctuate, especially commodity markets. Markets for commodities like oil are very deep (meaning there is lots of trading – this isn’t nickel) and thus hard to manipulate or “corner”. Thus, price fluctuations are generally a reaction to a) changes in supply and demand b) psychology and/or c) technical factors like short squeezes or margin calls.
While armchair commentators (or politicians) like to attribute fluctuations to some Wizard behind the curtain pulling strings, neither oil traders or US based public corporations have the power to move such a vast market. OPEC can do so by changing supply but even their motives have changed.
While the proximate cause of higher oil prices is a combination of a more robust global economy (higher demand) and supply disruptions caused by the Russian invasion of Ukraine, there was a less discussed supply shock that emerged quietly over the last few years: the ESG supply shock.
ESG Is Winning But…
One of the big goals of ESG investors is to reduce the usage of fossil fuels, whether through reducing demand (through substitution), raising costs (for example, insurers who refuse to underwrite coal), or starving them of capital (by banning energy holdings in their portfolios).
Given the growth of ESG funds, the creation of Chief Sustainability Officers at many corporations, and activist investors forcing energy companies to shift production, there are large and significant forces making life more difficult for energy producers. Quite simply, the ESG crowd is winning.
Renewables are gaining share. Oil production is down. Stocks of energy producers are down and their cost of capital is up.
However, there is a consequence of winning. Because producers are less willing to drill due to the elevated uncertainty and higher capital costs, they will require a higher price to produce the same amount of oil. This is the aforementioned supply shock.
The Winner’s Curse
In a world where energy demand is stable and renewables are gaining share, this doesn’t matter. In fact, ESG supporters would say it’s desirable. After all, the higher the cost of coal and oil, the faster consumers will switch to renewables. Higher prices for oil aren’t a happy accident. They’re a feature.
But demand isn’t always stable. And, for that matter, neither is supply. One of the consequences of shutting down base capacity like coal is it takes less of a shock to tilt supply and demand out of balance.
Even before the pressure from Russia, Europe was struggling to generate enough renewable capacity to offset the dirty fuel it was shutting down. In the rush to transition, they increased their exposure to a supply shock.
ESG investors liked high prices when they encouraged substitution. But they didn’t understand that there was a danger zone beyond which substitution couldn’t meet demand fast enough. This is the calamity we are now facing. This is the Winner’s Curse.
ESG activists got what they wanted…and realized maybe it’s not actually what they really wanted.
Static vs. Dynamic Planning
This was a basic failure to plan beyond the base case. If you assume things are always near the mean, then encouraging high prices to shift demand to renewables made perfect sense.
However, if you modeled stochastically and assumed there would be multiple standard deviation shocks at some point in the future, you would quickly realize how disastrous driving up prices and lowering supply too quickly could turn out to be.
Now, you might say, well if prices get high enough, energy producers will crank up supply. In normal markets, yes. But energy markets are no longer normal. Because of activist pressures, producers are less responsive to short term price signals.
After all, why crank up capacity for a near term gain when you know as soon as the spike is over, you will be bullied to shut it down again? There are fixed start up costs that need to be accounted for.
The Tobacco Model
Oil and coal have largely moved to the tobacco industry model. Tobacco figured out twenty years ago they were always going to be a target and demand was in a long term decline. Thus, it made no sense to produce more. Rather, they focused on raising prices.
Yes, OPEC could act independently and pump on their own, but they understand these same dynamics. While they are harder to predict, they can do the same math and understand demand will decline so it is best to maximize price over volume.
So why are markets not able to respond to price signals? Because ESG pressures are interfering with the normal capacity to respond. In other words, the gouging at the pump is because of ESG pressuring oil producers to permanently cut capacity.
If renewables had won share in the market by having a better product at a better price, oil producers would still be able to respond to supply shocks. But because they have been shamed into submission, they no longer are willing to increase production almost regardless of price, so we have these shortfalls.
By the way, the new SEC pronouncement to require climate disclosures by public companies will only add to this dynamic. It will further raise energy costs in the base case and bring added systemic risk to the tail scenarios.
Therefore, if you’re looking for someone to blame for the price at the pump, it’s not the gas station’s fault. Their margins are thin. No, turn your anger to the ESG crowd who wanted to make energy more expensive to drive substitution without planning for the rainy day when there wouldn’t be enough supply to meet demand.