- Unknowable Energy Demand Challenges Oil Price Outlook
- The Possibility Energy’s Outlook Has Improved With Biden
- Should Mandates Or Economics Drive Renewables Switch?
- Is U.K. Green Energy Plan A Blueprint For U.S. Under Biden?
Musings From the Oil Patch
December 1, 2020
Allen Brooks
Managing Director
Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating oilfield service companies. The newsletter currently anticipates a semi-monthly publishing schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, I welcome your comments and observations. Allen Brooks
Unknowable Energy Demand Challenges Oil Price Outlook (Top)
Everyone wants to know when we are going to return to normal, especially as it relates to energy demand. The problem is that we have no idea what normal will look like. The Wall Street Journal’s Heard on the Street column recently had an article entitled: ‘Normal’ After Covid: More Suburban Sprawl, Fewer Business Trips.’ The headline was designed to capture two of the more noticeable trends of 2020 that came from dealing with the coronavirus outbreak. Those include people migrating from populated areas to less-populated ones offering larger homes that enable people in lockdowns more room to roam without having to go outside and encounter potential virus spreaders. The idea of fewer business trips encapsulates the dramatic changes underway within the business world as companies learn to operate with most, if not all, employees working remotely. Zoom or Teams calls are replacing the business trip and customer interactions that characterized the business world for centuries, such as why Marco Polo went to China. He went with his merchant father and uncle on their second trip to China both to learn about the country, its people, its religions and its leaders, but also about its commerce, as they wanted to do more business. It is all chronicled in The Travels of Marco Polo.
With the development of two Covid-19 vaccines and the possibility that enough Americans should be inoculated next spring and summer for normal life to return, the writer opines that “it won’t be quite the same as before.” The writer declares: “Our behavior will have changed, with profound effects on the economy.” That statement highlights the challenge facing every forecaster of social and economic trends – just how different will our lives and business activities be once government restraints are released? Assuming that how we live and work today will become the “new norm” is just as wrong as assuming we will return to the pre-Covid-19 world. What is unknown is which new behaviors will prevail and which ones will be rejected in favor of how we “used to do it.”
One thing we can count on is that every forecast will prove wrong – but just in what ways and by how much? Examining assumptions going into forecasts will actually become de rigueur. In the meantime, energy executives must begin planning for the future – which starts with 2021. The current surge in Covid-19 cases has the world on edge, as they will impact the foundation and context shaping forecasts. Countries, states and cities are resorting to greater restrictions on citizen activities, much to the consternation of the many who are tiring of being harnessed to their homes and told not to go to work or travel. With vaccines not arriving until December, and health workers and first responders receiving the initial doses, an economic downturn this winter due to uncontrolled virus outbreaks appears to be a given. The uncertainty over when a significant number of people will be vaccinated in 2021 makes predicting the pace of economic activity next year a guess. Understanding the semi-permanent behavioral changes, and guessing which ones will become permanent, will shape the long-term outlooks of oil forecasters.
As energy is the economy, i.e., nothing happens in our lives or businesses without the use of some form of energy, we need to start with an assessment of the activity outlook posited by economists. The current word being used to describe economic conditions this winter is “dark.” It is a term that conveys a future with increased fear and emotional stress, greater suffering, losses of jobs and incomes, heightened restrictions on mobility, and generally a miserable environment. That is not a positive outlook for the economy. In fact, JPMorgan economists have recently suggested that the U.S. economy will experience a 1% contraction in 2021’s first quarter. But, as they assume there will be meaningful stimulus spending injected into the economy in January by the new Biden administration and Congress, the economists expect a robust recovery in economic activity, as demonstrated by their projections of +4.5%, +6.5% and +3.8% quarterly increases in GDP for the balance of 2021.
Bill Gilmer, director of the Institute for Regional Forecasting at UH’s Bauer College of Business, recently forecast that Houston will remain in a moderate recession throughout next year. A reason why is due to his expectation that oil prices will only average $48.50 in 2021 and won’t return to an “activity-driving” $60 a barrel price until the second half of 2022. Here is a good example of understanding the assumptions going into the forecast.
The JPMorgan economists pointed out that “[b]y a wide margin, the course of the virus has been the most important factor shaping the outlook.” With increased headwinds from the current uptick in virus cases, they believe holiday spending will be hurt. They went on to say:
“We think the trends in the labor market should roughly follow what we expect for consumer spending – job growth should weaken noticeably around the turn of the year as the virus weighs on the economy, and then pick up again early next year once vaccine distribution eases virus concerns and fiscal support boosts growth.”
A different view on how economic activity might unfold in 2021 was presented in the following chart. Since the two vaccines that have been developed so far have efficacy rates in excess of 90%, one should be looking at healthy quarterly growth rates early in 2021, especially as the launch date for the vaccines is December.
Exhibit 1. How GDP Growth Is Impacted By The Vaccine
Source: John Mauldin
If the JPMorgan economists’ forecasts prove correct, energy demand should be looking at a healthy growth rate next year, after stumbling out of the gate in the first quarter. The weakest sector will be air transportation, as business travel and vacations will be slow to recover. Overall, however, we believe this outlook suggests 2021 oil demand slightly trailing its pre-Covid-19 level, despite a healthy increase in GDP. It is helpful to understand how the relationship between GDP growth and oil demand increases has weakened in recent times. We are not sure it is because of a structural change, but rather due to the aging demographics of the two largest oil consuming regions – the United States and Western Europe – and its impact on oil consumption. High oil prices may have also contributed to the slowdown in oil consumption, but that is rather a reflection of the move to more efficient use of energy.
Exhibit 2. Relationship Between GDP and Oil Demand
Source: EIA, World Bank, PPHB
When the economy was shut down in early 2020, oil demand and prices collapsed. Along with those declines went oil and gas industry capital spending. That means there have been substantially fewer new wells drilled and completed in 2020, leaving production to the vicissitudes of natural declines in the output of producing wells, which is not offset with new wells, as traditionally occurs.
To moderate and eventually reverse the decline in U.S. oil production will take a significant recovery in oil and gas spending and activity. Such a recovery will not happen quickly, as the response to the decimation of the industry in the spring, and the longer-term deterioration in demand that had become evident in 2019, forced companies to slash employment. The lack of revenues for service companies meant prioritizing spending away from equipment maintenance. Thus, it is safe to say that the oilfield services industry’s capacity to respond to higher activity levels has been impaired. How quickly it can be repaired is questionable.
As we think about future oil demand, we wonder what history may tell us about the relationship between oil consumption and economic activity during recessions and the months immediately after their endings. The current recession is not a typical one, as it was caused by government mandates shutting down activity to deal with a health emergency. Therefore, its recovery is also tied to government actions, the timing of which are uncertain, and often unpredictable.
In a recent article, investment advisor John Mauldin wrote about the challenge our economy had in returning to normal, a condition he has yet to fully describe. He presented a chart showing job losses and recoveries from recessions of the past 40 years. In making his point that the recovery will take time, he wrote the following:
“It is unrealistic to assume we will go back to some kind of “normal” in 2021. I think even 2022 will be a stretch. We have had a massive and severe blow to our economy. The chart below from the Center on Budget and Policy Priorities shows how it took four years to recover from the 2001 recession in terms of jobs and over six years for the Great Recession. The current recession is much worse than either of those.”
Exhibit 3. How Our Recent Recessions Developed
Source: John Mauldin
Jobs are a measure of the health of the economy. In April, when Covid-19 was raging in various regions of the U.S. and states were locking down their economies, American job losses exceeded 20 million that month, sending the unemployment rate skyrocketing to 14.7% and the U6 rate (unemployed plus underemployed workers) reached 22%. Since then, we have recovered more than half the jobs lost and the unemployment rate in October was down to 6.9%. With the rising virus cases, people are now worried that unemployment will begin climbing as governments institute a new round of economic lockdowns and curtailed activity. Weekly job losses are not declining, and often ticking up. The lockdowns and behavioral changes to the economy have people wondering what it means for employment, and, in turn, inflation. Spencer Hill, an economist at investment firm Goldman Sachs, in a recent report, said he doesn’t expect the labor market to recover until 2024, which he believes will hold down inflation. But that outlook doesn’t bode well for economic activity and energy consumption.
Using the chart from the Mauldin newsletter, we began examining this recession compared to the prior four recessions. All five recessions are displayed in Exhibit 4 that shows the percentage change by month from the start of the recession until it returned to 100%. In the legend accompanying the chart, we show the official dates for the recessions as determined by the National Bureau of Economic Research (NBER). For 2020, NBER has only announced the starting date for the recession, although many people have speculated that this might be one of the shortest U.S. recessions in history. What is of significance in this chart is the length of time each recession needed to return to the same employment level as when the recession started. For example, the December 2007 to June 2009 recession, actually didn’t see a return to the same employment level until May 2014, almost exactly five years later.
Exhibit 4. Recessions And Nonfarm Employment Recoveries
Source: St. Louis Federal Reserve Bank, PPHB
While everyone acknowledges that the 2020 recession is not like any prior recession, they are still using comparisons to those earlier ones in their discussions. One of the amazing economic stories of 2020, besides the destruction of the energy business, has been the strength of the housing sector. While some of its strength is assumed to be due to the virus – people wanting more room and homes outside of urban settings – analysts continue to marvel at the record-setting performance of new housing starts. Using that data series, we compared absolute monthly start data to the changes in nonfarm employment. Because the government didn’t begin to report housing starts until the latter 1980s, we don’t have a measure of how starts compared to employment changes during the 1981 recession.
Exhibit 5. How Employment And Housing Starts Tracked
Source: St. Louis Federal Reserve Bank, PPHB
What we see in the chart is that for every recession other than the 2007 recession, after an initial dip, there developed a steady upward trend in housing starts. The trend in housing starts in 2020 mirrors just as dramatically the decline and improvement in nonfarm employment. Only the 2007-2009 recession never saw housing starts recover to the level at the start of the recession. While some would suggest that this recession was caused by excesses within the housing industry – financing of homes – so it should not be a surprise that housing would suffer. With growth of population and employed people, besides the increase in the younger population just graduating from universities, it is hard to accept that housing starts would remain well below were they were at the start of the recession seven years earlier.
We struggled to find any other economic measures that offered much insight to overall economic activity. As a result, we turned our attention to the oil market. This produced some interesting results. The 1981 and 1990 recessions saw virtually no impact on oil prices – up or down! The 2001 recession did see oil prices rising as the economy was recovering, but one has to wonder how much of the price rise was due to the emergence of China as an oil consumer, especially as the country was revamping its infrastructure in preparation for the upcoming Olympic Games, and the emergence of the country on the world stage.
When we examined what happened to oil prices during the Great Recession of 2007-2009, we see that oil prices continued rising during the early months of the recession, but they then collapsed as the recession’s impact became clearer. The recession’s primary impact was a financial liquidity scare that froze global financial and currency markets. Without credit, global trade and economic activity slowed, but the bigger issue for energy companies was that the lack of assured access to capital caused producers to pull back their spending, which forced a significant reduction in oilfield activity. The fear of a global financial crisis and recession caused a sharp fall in oil prices. Despite the economic turmoil, oil prices quickly recovered once credit market conditions improved. The recovery was driven partly by the shale revolution and expectations that substantially more oil output was going to be required to satisfy global needs, especially with recurring fears of impending peak oil supply.
The current recession has seen oil prices collapse along with global oil demand. In fact, oil prices briefly traded at negative prices in reaction to market turmoil, which eventually proved to have been overblown. As economic activity rebounded once the lockdowns were eased, crude oil prices also rebounded. Once they reached the $40 a barrel level, the price advance essentially stopped, and prices became more volatile in a range of $37 to $43 per barrel. Prices appeared to move in direct response to daily news about the development of Covid-19 vaccines.
Exhibit 6. Nonfarm Employment And Oil Price Trends
Source: St. Louis Federal Reserve Bank, EIA, PPHB
The most telling analysis is the comparison of nonfarm employment and oil consumption. Excluding the 2020 recession, which is not over yet, only the 2007-2009 Great Recession did not see oil use, measured with a three-month average, rise above its starting point by the date of the full recovery of nonfarm employment. Was the failure of the Great Recession to reach a new high a function of oil’s extremely high price, or due to structural problems with the U.S. economy?
Exhibit 7. How Employment Changes Impacted Oil Use
Source: St. Louis Federal Reserve Bank, EIA, PPHB
While U.S. nonfarm employment has recovered slightly more than half of what it lost this spring when economic lockdowns began, oil use is 10% below where it was in February when the recession began. Although U.S. oil consumption is important for producers, price-setting is impacted by the overall health of the global oil market. Therefore, government responses to the virus are key drivers of demand.
Most oil forecasters by October had essentially fine-tuned their 2020 estimates, noting their cautiousness about predicting the impact of the new virus outbreaks on oil demand. About ten days ago, the members of the market monitoring committee of OPEC held a meeting at which they revised their 2020 demand forecast to reflect a decline of 9.8 million barrels per day (mmb/d). This was a further 300,000 barrels per day reduction from the organization’s October 2020 demand estimate. From OPEC’s original expectation for demand in 2020, the new estate suggests an 11 mmb/d cut. We compare that estimate with the September forecast from energy consultant Rystad Energy that shows a 10.2 mmb/d decline in oil use this year. The firm recently said that it does not expect global oil demand to return to pre-Covid-19 levels until sometime in 2023.
Moreover, the firm has just revised its long-term outlook for oil demand. It now suggests that peak oil consumption will be reached in 2028 when oil use reaches 102 mmb/d. That forecast is lower and sooner than its prior outlook, which saw the oil demand peak of 106 mmb/d not being reached until 2030.
Exhibit 8. How One Oil Forecaster Sees Oil Recovery
Source: Rystad Energy, PPHB
Another long-term forecast made earlier this year came from the Energy Information Administration (EIA) in their revisit to the agency’s Annual Forecast. Factoring in assumptions about how Covid-19 would impact behavioral patterns and the economy’s use of oil, the EIA expects demand will fall 2.3 mmb/d below where it would have been in 2025 without the virus. The EIA sees that shortfall from its prior forecast continuing and growing over time, such that by 2030 the shortfall is 2.9 mmb/d, and then lower by 6.1 mmb/d in 2040 and 12.8 mmb/d in 2050. What is interesting is if we compare the EIA and Rystad estimates, assuming the latter’s revised demand peak is for 2030. The difference between 4 and 3 mmb/d is, as they say, close enough for horseshoes, hand grenades and government forecasts.
Exhibit 9. How Covid-19 Virus May Hurt Oil Demand
Source: EIA, PPHB
A presentation by international energy policy expert Robert McNally, founder of The Rapidan Group, a Washington, D.C. energy consulting firm, at the recent energy conference sponsored by the Federal Reserve Banks of Dallas and Kansas City, suggests a vastly different future for energy markets and oil prices than assumed in the consensus view of forecasters. His outlook is supported by oil market news stories pointing out the dichotomy in global oil markets between the East and West regions of the globe. In fact, understanding this dichotomy may prove to be much more important in projecting energy’s long-term future than many people appreciate.
Mr. McNally’s presentation focused on three topics: Peak Oil Demand – realistic or wishful thinking; Geopolitical Disruption Risk; and Swing Producers – do we have them or need them? Rapidan’s view is that oil demand in Asia (the East) over the next few years will prove much stronger than forecasters are incorporating in their models, translating into a greater overall global demand increase, which will power a faster oil market recovery. Such a recovery will, in Mr. McNally’s opinion, quickly exhaust the industry’s current spare supply capacity, even after factoring in the return to the global oil market of the roughly 2 mmb/d of Iranian oil supply. The result will be oil prices rising substantially higher by the mid-2020s than oil companies and forecasters anticipate. He believes too many people are accepting of the conventional view, expounded by the International Energy Agency (IEA), that demand growth will be historically low, the world has plenty of spare oil production capacity and therefore oil prices will remain low. Shaping this view is the IEA’s belief in the success of countries shifting away from fossil fuels and embracing renewables. In his view, the scenario he outlined will lead to the next oil industry bust, which will speed the global switch to renewables, but not before.
The evidence for Mr. McNally’s scenario is Saudi Arabia raising oil prices for its Asian customers. In addition, The Wall Street Journal noted that Dubai crude oil is now selling at a premium to dated Brent (Atlantic basin oil) prices in contrast to having sold at meaningful discounts throughout 2018 and 2019. Tom Tom data shows multiple Asian cities showing year-over-year congestion increases.
As Amrita Sen, founder of Energy Aspects Ltd., a consulting firm, told the WSJ, “I can’t remember this level of disparity between the East and the West.” He went on to say, “Yes, the West is going to recover a bit, but I really don’t think Western demand is going to get back to pre-Covid levels ever, whereas the East already has.”
Mr. McNally recognizes that the future oil market will be different, and, importantly, driven by other considerations than what has propelled it throughout its history. The United States and Western Europe are mature oil markets, but they are large consumers. Without them, the global oil market would be a fraction of the size of what it currently is. Their contraction will impact global oil demand.
How will a U.S. oil industry unable to secure capital, and which is maligned by the incoming administration and the media, be able to sustain its economic importance? As a result, how much smaller will the industry become? Will the need for greater U.S. oil imports come at the same time Asian economies are sucking up the available supply? This will lead to much higher oil prices. But importantly, every time in the past, high oil prices sowed the seeds of industry’s destruction. Maybe we can enjoy higher oil prices, while figuring out how to avoid the industry’s destruction.
The Possibility Energy’s Outlook Has Improved With Biden (Top)
The stock market is a fascinating beast. It often confounds conventional wisdom. That is due to the stock market being a giant discounting machine. What we never know, however, is how far into the future it is willing to look and deliver a view – although not always right. Maybe what we are seeing in today’s stock market action is that the conventional view of those industries that win and those that lose with a new administration running the government is right.
For example, on November 3, election day, the price of West Texas Intermediate (WTI) closed trading at $37.66 per barrel. WTI closed trading last Wednesday night, before the Thanksgiving Day holiday, at $45.71, a 21% increase. Yes, there were reports that the OPEC-plus group of oil providers might extend their current output cuts into early next year, rather than restoring supply as has been anticipated. At the same time, the surge in coronavirus cases worldwide was pushing governments everywhere to clamp down on activity, which does little but undercut economic activity and oil demand. So, why would oil prices be rising, especially as fears grow about Cushing, Oklahoma’s oil storage tanks filling rapidly, recreating the psychology that briefly drove WTI into negative price territory. Quite possibly oil prices are reacting to revelations that OPEC countries are raising their export prices for those barrels moving into Asian markets.
Both the oil storage and Asian demand strengthening issues are fairly short-term in nature, but the overriding trend for oil is presumably negative, given President-elect Biden’s campaign promise of no role for oil in his plans to make the U.S. economy net carbon-free by 2050. While Mr. Biden waffled back and forth, when political-correctness demanded it, on the issue of banning hydraulic fracturing, he has been firm that the oil industry is not the energy future of this country.
Mr. Biden’s plan is only the latest in a growing list of countries and companies vowing to reach net-zero emissions in the 2030s, leading to forecasts about when global peak oil demand will be reached. But, as Robert McNally, founder of energy consulting firm The Rapidan Group, questioned during the Dallas and Kansas City Federal Reserve Banks’ energy conference, is peak oil demand reality or wishful thinking? In his view it is the latter. That is not the mainstream view, yet oil prices are going up and energy stocks are outperforming the overall stock market. What’s going on? We don’t have the definitive answer, but we think by looking at some history, we may divine an outlook.
Although we hate to dredge up bad memories, the performance of energy stocks compared to technology stocks since the last presidential election provides a sobering lesson. Exhibit 10 shows the performance of the leading tech (QQQ) stock index and the leading oil (XLE) and oilfield service (OSX) stock indices. We tracked the three indices from the beginning of November 2016, a few days before President Donald Trump’s surprising election victory until the night before Thanksgiving Day. The chart is not a pretty picture for energy investors, or anyone involved in the energy business.
Exhibit 10. The Sad History Of Energy Stock Investments
Source: Yahoo Finance, PPHB
As the chart shows, between November 1, 2016, and November 25, 2020, the QQQ was up an incredible 159%, while the XLE index lost 42% and the OSX was off an amazing 76%. During this time period, the weighting of energy stocks in the Standard & Poor’s 500 Stock Index (S&P 500) shrank from 7.5% to under 2%. Given that performance, it is not surprising that energy stock performance in the S&P 500 was either the second worst or the worst, including through the first half of 2020.
Exhibit 11. Energy Has Been Worst Performing Sector
Source: S&P, PPHB
Between Election Day 2016 and last Wednesday afternoon, oil prices were 2.3% higher, an increase of slightly more than a dollar a barrel. That is surprising because most of us remember oil prices being substantially higher, and actually negative during this time period. But what we find is that between the two election dates, oil prices fell 16%, or over $7 a barrel. This demonstrates how strong the oil price increase during November had been.
Exhibit 12. The Strange Journey Of Crude Oil Prices
Source: EIA, PPHB
No period in the stock market is ever exactly the same, especially since the market is always looking forward to a future it views either more or less favorable to current conditions. If we look at the performance of the three stock indices for the periods November 1, 2016, to January 31, 2017, and October 1, 2020, to November 25, 2020, we see interesting patterns. Keep in mind that heading into the November 2016 election, then-candidate Donald Trump’s prospects for defeating Hillary Clinton looked poor. He was battling the emergence of the Hollywood Tapes where Mr. Trump made disparaging remarks about females. Of course, Mrs. Clinton was attempting to weather the reopening of the investigation of her handling of her government emails. However, on the eve of the election, the pundits had Mrs. Clinton the overwhelming favorite.
Mrs. Clinton was supposed to represent the third Barack Obama term, which envisioned a continuation of the globalist thrust, coupled with increased regulation that ensured a continuation of the existing slow economic recovery. That scenario was thought to be challenging for energy, especially after world oil prices had crashed in late 2014. President Trump’s victory signaled an ‘America First’ approach to governing the country and the economy. That was seen to spark a rebirth for domestic manufacturing, fewer regulations on industries, especially oil and gas, and lower taxes that would lift energy demand. That scenario was greeted on Wall Street with unbounded enthusiasm, as American businesses and energy would benefit to the detriment of globally-oriented companies.
During the period November 1, 2016, to January 21, 2017, the S&P 500 rose 6.5%, while the Dow Jones Industrial Index (DJIA) climbed 8.4%. As shown in Exhibit 13, during that period the QQQ advanced 7.3%, as the XLE increased 6.2%, but the OSX soared 18.9%. The most volatile oil patch sector, and the one with the greatest earnings torque, demonstrated the strongest performance. That is what one would have expected, although the surge in market enthusiasm for the Trump victory propelled all stocks higher during the celebratory days following the election.
Exhibit 13. All Stocks Rose After 2016 Trump Election Victory
Source: Yahoo Finance, PPHB
In the most recent election period, October 1, 2020, to November 25, 2020, both the DJIA and the S&P 500 advanced by 7.4%. In contrast, tech stocks, as reflected by the QQQ, only rose 5%, while energy has soared, with the XLE up 35.6% and the OSX up an incredible 58.5%.
Exhibit 14. Energy Stocks Are Rocking After The Election
Source: Yahoo Finance, PPHB
It is impossible to make predictions about the next four years, but it seems ironic that the energy stocks have soared in the days following the election of the most anti-fossil-fuel-president in modern time, while the internationally-focused technology stocks (big supporters of President-elect Biden) are lagging the overall market. After the 2016 election, we saw all stock prices rise, but the tech stocks outperformed the broad oil index, while oilfield service stocks way outperformed both indices and the overall stock market. The subsequent four years turned into a nightmare for energy and energy stocks.
Don’t break out the champagne yet, but one could envision an anti-fossil-fuel-administration hurting the energy industry to the point that world oil prices have to rise, and rise substantially, to ensure sufficient energy to power the global economy as renewables performance, despite governments mandating them and throwing money at them, falls well short of forecasts. Welcome to the world of Humpty Dumpty, sometimes known as the stock market.
Should Mandates Or Economics Drive Renewables Switch? (Top)
If we are to decarbonize the world’s economy, policymakers will need to convince the public that they need to alter their living and working patterns, as well as either mandate steps or provide incentives to make the necessary changes happen. Incentives, along with stern lectures, appear to have been the preferred course to effect climate change policies in the past. That strategy seems to have changed in the past 12-24 months, as the language of environmentalists shifted from “climate change” to “climate emergency.” Climate advocates are now claiming the world must stop producing gas- and diesel-powered vehicles by 2030 in order to keep global warming to tolerable levels.
Changing the language to emphasize “emergency” has been coupled with the demand for more draconian steps to reduce carbon emissions if the world is to be saved. From cajoling people and providing incentives to act in certain ways, policymakers are now resorting to mandates to achieve their desired goals. From banning the sale of internal combustion engine (ICE) vehicles to requiring solar panels be installed on all new homes, governments are acting. Maybe not to the satisfaction of everyone. Moreover, policymakers appear to be in a race to shorten the timelines for mandate implementations.
If we look around the world, we see where the earlier policy approaches proved more successful in certain countries compared to others. That may have something to do with the size of a nation’s population, or it might have been that the changes were less intrusive to people’s lifestyles and working conditions. For example, non-cash incentives have been used extensively in Norway to accelerate its switch to electric vehicles (EV). Waving tolls, providing free parking in city centers, allowing EVs to access high occupancy vehicle (HOV) lanes, and installing free charging stations have worked to drive EV penetration in Norway’s fleet to record levels. Of course, Norway only has 5.5 million people, which is about the size of Houston.
Exhibit 15. EV Registrations Per Capita By Nations
Source: Wikipedia
In the United States, California has been leading the states in directing its citizens toward a net-zero carbon economy. The California Energy Efficiency Strategic Plan is an ambitious plan that targets development of zero net energy buildings. The goals include:
“All new residential construction will be zero net energy (ZNE) by 2020;
All new commercial construction will be ZNE by 2030;
50% of commercial buildings will be retrofit to ZNE by 2030; and
50% of new major renovations of state buildings will be ZNE by 2025.”
In September, California’s Governor Gavin Newsom signed an executive order that establishes a goal of ending the sale of new gasoline-powered cars in the state by 2035. It also orders the Air Resources Board to immediately begin drafting regulations to achieve the goal by 2035. During his signing ceremony, Gov. Newsom noted that California is home to 34 EV manufacturers and that just under 50% of all EV purchases in the U.S. are in the state. The state’s stature in the EV world is demonstrated in Exhibit 16 that shows California first, followed by Washington, Florida and Texas as the top ranked states for EVs.
Exhibit 16. A Few States Dominate The EV Industry
Source: DOE
California is also the leader in other zero-emission vehicles, as it is home to almost all the hydrogen-powered vehicles and all the hydrogen refueling stations. Besides EVs, which includes all versions of vehicles that plug-in to be fueled – battery electric vehicles (BEV) and plug-in hybrid electric vehicles (PHEV) ‒ and hydrogen fuel cell vehicles, there are ones powered by compressed natural gas (CNG) and ethanol, as well as hybrid electric battery/gasoline powered (HEV) units. The ethanol-powered vehicles are often designated as flexible fuel vehicles (FFV), as they can run on either a blend of 85% ethanol and gasoline, or 100% gasoline. The Energy Information Administration (EIA) reports the mix of alternative fuel vehicles (AFV), as of the end of 2018, as shown in Exhibit 17.
Exhibit 17. The Make-up Of Alternative Fuel Fleet
Source: EIA
According to National Renewable Energy Laboratory estimates, there were 22.2 million FFVs, 4.3 million HEV, and roughly 500,000 for each of the PHEV and EV categories in the U.S. vehicle fleet. The total AFV fleet represents about 10% of the estimated 278 million light-duty vehicles operating in the United States. Even though the U.S. sells roughly 17 million light-duty vehicles per year, it will be virtually impossible to dramatically alter the composition of the nation’s fleet in the near-term without mandates banning certain types of vehicles. Importantly, the California ban of ICE car sales does not eliminate their ownership or use, let alone the purchase and sale of used ICE cars. It also won’t ban the purchase of new ICE cars in neighboring states and registering them in California.
As California continues to advance its net-zero carbon emissions policies, one wonders how well it is doing in remaking its energy system. It is a very interesting question when one compares California’s energy sources against those of Texas, which has avoided mandates and subsidies for EVs and solar panels. Both California and Texas have renewable portfolio standards (RPS) that mandate a percentage of power or a megawatt total that is provided by carbon-free energy sources.
The Texas legislature established its RPS in 1999 that mandated 5,000 megawatts (MW) of new renewable energy be installed by 2015, or 5.4% of the state’s summer net generating capacity in 2012. It also established a target of 10,000 MW of renewable energy capacity by 2025. According to the Electric Reliability Council of Texas (ERCOT), the program administrator of the RPS, Texas surpassed the 2025 target in 2009 and had 26,045 MW of renewable energy capacity (24,381 MW of which was wind) in 2017.
Interestingly, California’s RPS program wasn’t established until 2002. It called for 20% of electricity retail sales be served by renewable resources by 2017. In 2015, the program was accelerated to mandate a 50% RPS by 2030, and was further increased to 60% by 2030, with a mandate that all the state’s electricity come from carbon-free resources by 2045. By the end of 2017, all of California’s retail electricity sellers either met or exceeded their interim 27% RPS target.
In a fact sheet published by the American Wind Energy Association (AWEA), it touted the history of California with regard to wind energy. It wrote: “California led the world in wind energy development throughout much of the 1980s and 1990s.” Those days are gone, however, as California only ranks fifth in the U.S. for wind power, has 12 wind-related manufacturing facilities and employed 6-7,000 direct wind industry jobs. Capital investment in wind projects through 2019 totaled $15.2 billion, and wind projects provided the state with tax payments of $86 million and $46 million in annual land lease payments.
In contrast, the AWEA headlined its fact sheet on Texas with the following: “Texas is the national leader in the U.S. wind energy industry.” It went on to point out that Texas ranks first in the country for both installed and under-construction wind generating capacity. The state embraced smart policies, such as creating Competitive Renewable Energy Zones (CREZ) that facilitated the construction of wind power transmission lines, enabling power to move from West Texas, with its sparce population, but strong winds, to the heavily populated Central and Eastern regions of the state. The Texas wind industry supports 25-26,000 wind-related jobs, with over 40 manufacturing facilities. The AWEA also noted that with over 30 gigawatts (GW) of wind capacity in Texas, only four countries have more wind power!
The wind energy industry in Texas has provided over $53 billion in capital investment through 2019. Importantly for Texas, the wind energy provides $285 million in state and local tax payments, while also supporting $192 million in land lease payments.
The AWEA noted that “Texas has a competitive electricity market where wind, solar, gas, nuclear and other energy sources compete in real time. Texas established modest renewable energy goals in 1999, and later fast-tracked well-placed transmission lines to resolve congestion and connect windy parts of the state to load centers. This combination of policy and infrastructure allows wind to compete in the market while unlocking economic opportunities for landowners and rural communities.” This philosophy has powered the Texas economy and its development of all forms of energy. That is why it is interesting to compare the evolution of the energy sources for California’s and Texas’ electricity industries, as well as what the development trends have meant for electricity customers.
If we focus on California’s electricity generation by fuel source between 1990 and 2010, we see that wind and solar barely contributed. Natural gas was the primary energy contributor, with nuclear and hydroelectric also significant suppliers. On the other hand, with mandates and subsidies, the state has driven dramatic growth in solar energy, rising from 0.4% in 2010 to 14.0% in 2019. Wind energy’s contribution more than doubled during that time, rising from 3.0% to 6.8%. What is most interesting is the significant role that natural gas continues to play in California’s energy picture. In fact, natural gas provided about the same percentage of the state’s electricity as it did in the 1990s, and it only had its share cut meaningfully in 2019 due to hydroelectric power’s share nearly tripling between 2015 and 2019. California also imports significant amounts of power from neighboring states, most if which is generated by burning natural gas.
The most damning data point is the price of electricity for California residential consumers. After remaining essentially flat during the 1990s, the price per kilowatt-hour (kWh) increased only a total of 2.5 cents between 1990 and 2005. In contrast, over the next 14 years, the price rose by 53%. Year-to-date, California’s residential electricity price has increased to 20.2-cents/kWh, making it the fourth most expensive power among the 48 contiguous states, trailing only Connecticut, Massachusetts and Rhode Island.
Exhibit 18. California Power Market Has Boosted Prices
Source: EIA, PPHB
marked reduction in coal-fired power and the marginal decline in nuclear power. Solar is barely a factor, accounting for only 0.1% of the state’s electricity generation last year. The growth of wind and natural gas power supply has helped reduce the state’s carbon emissions, while also helping to restrain power prices.
Exhibit 19. How Texas Power Market Has Evolved
Source: EIA, PPHB
The significance of this analysis is to point out that between 2000 and 2019 in California, the state cut its nuclear power supply in half, and reduced natural gas’ contribution by seven percentage points, while it added substantial amounts of wind and solar power. These changes have been accomplished via mandates and subsidies. The result for electricity consumers has been a 76% increase in their cost of electricity, and likely didn’t have much of an impact on carbon emissions as 2019 benefitted from a very strong contribution from hydroelectric power. On the other hand, Texas, while relying on market forces was able to cut its coal use in half, keep its nuclear contribution flat, build wind’s share of power to over 17% and only boost natural gas usage by three percentage points. This has contributed to cleaner air, but importantly, customers only experienced a 47% increase in their cost of electricity. Quite possibly, the large outmigration of California residents, many to Texas, is a reflection of their view of the impact of government mandates and subsidies for clean electricity on their financial health.
Is U.K. Green Energy Plan A Blueprint For U.S. Under Biden? (Top)
We now know President-elect Joseph R. Biden, Jr. plans to nominate former Senator and Secretary of State John Kerry as his Special Presidential Envoy for Climate. This post will allow Mr. Kerry to also sit on the National Security Council, reflecting the President-elect’s view that dealing with climate will be a central focus of his administration’s actions across all facets of the federal government. Appointing Mr. Kerry to this climate position is also a signal to other countries of the elevated importance of dealing with climate change and that the United States wants to resume its leadership role in directing global policies to reduce carbon emissions. It should be remembered that Mr. Kerry was instrumental in the Obama administration’s fight to secure the Paris Agreement dealing with climate change and America’s role in that Agreement.
Mr. Biden campaigned on returning the U.S. to the Paris Agreement, which the country had exited recently under President Donald J. Trump’s leadership. Returning to the Paris Agreement signals that on environmental matters, the Biden administration will be drawing much closer to the goals and policies of European countries who have been leading the climate change charge. Remember, the Paris Agreement is just that – an agreement and not a binding treaty. While the Obama administration would have loved to give the agreement a more permanent standing by having it ratified as a treaty, they knew it would be defeated in Congress. That was a replay of the Clinton decision in 1999 to not put the Kyoto Acord to a congressional vote because they knew it would fail.
Climate change remains a very polarized topic, but one that does not rank highly on lists of concerns of Americans. But it is of great concern among elites in this country, which includes John Kerry. The hypocrisy between the language and actions of climate change proponents is not lost on Americans. They hear people like Mr. Kerry and former President Obama lecture the public about the need to alter lifestyles and work patterns due to fear of having our coastlines overwhelmed by rising sea levels, only to learn that these two gentlemen own multi-million-dollar seaside homes on the island of Martha’s Vineyard.
As we prepare for an onslaught of climate change lectures and new mandates to fight carbon emissions, we thought the timely release of the United Kingdom’s Prime Minister Boris Johnson’s 10-point climate plan, or his ‘green plan’ or maybe his ‘green industrial revolution’ provides us a roadmap for future U.S. climate policies. Regardless of what one calls it, the plan is P.M. Johnson’s program for how the U.K. will shift from using fossil fuels to renewables to achieve a net-zero emissions economy.
His plan is an attempt to gain support from the liberal portion of the British electorate, but also to put the U.K. in step with (or maybe ahead of) the European Union, especially as Glasgow will be hosting COP-26, the next international gathering of environmental officials who will assess and recommend the course of action by nations to meet the Paris Agreement targets.
The EU has been struggling in getting its green energy plan in place, as various countries and industrial sectors within countries are fighting aspects of the plan. We need to be paying attention to these plans as they are being unveiled, and especially those parts receiving the greatest pushback, as we imagine core parts of these plans will form the Biden administration’s green energy plan.
The plan announced by P.M. Johnson included the following points, as summarized by the BBC:
- Offshore wind: Produce enough offshore wind to power every home in the U.K., quadrupling how much it produces to 40 gigawatts by 2030, and supporting up to 60,000 jobs.
- Hydrogen: Have five gigawatts of “low carbon” hydrogen production capacity by 2030 – for industry, transport, power and homes – and develop the first town heated by the gas by the end of the decade.
- Nuclear: Pushing nuclear power as a clean energy source and including provision for a large nuclear plant, as well as for advanced small nuclear reactors, which could support 10,000 jobs.
- Electric vehicles: Phasing out sales of new petrol and diesel cars and vans by 2030 to accelerate the transition to electric vehicles and investing in grants to help buy cars and charge point infrastructure.
- Public transport, cycling and walking: Making cycling and walking more attractive ways to travel and investing in zero-emission public transport for the future.
- Jet zero and greener maritime: Supporting research projects for zero-emission planes and ships.
- Homes and public buildings: Making homes, schools and hospitals greener, warmer and more energy efficient, including a target to install 600,000 heat pumps every year by 2028.
- Carbon capture: Developing world-leading technology to capture and store harmful emissions away from the atmosphere, with a target to remove 10 million tons of carbon dioxide by 2030 – equivalent to all emissions of the industrial Humber.
- Nature: Protecting and restoring the natural environment, with plans to include planting 30,000 hectares [74,100 acres] of trees a year.
- Innovation and finance: Developing cutting-edge technologies and making the City of London the global center of green finance.
There wasn’t much about energy or lifestyles left untouched by the plan. A story in The New York Times about the Johnson plan highlighted its key environmental points – “end the sale of new gas and diesel cars within a decade and change the way people heat their homes” – and why these details “were an early signal to President-elect Joseph R. Biden Jr. that Britain and the United States might find common cause despite the looming tumult of Brexit, which Mr. Biden opposed.”
According to one estimate, the cost of the 10-point plan will be $12 billion, of which reportedly $8 billion represents newly committed funds above the $4 billion that was the ticket price assigned to the government’s original green plan. The details of spending and timelines are to be spelled out in the government’s energy paper due next month. The problem with the current spending estimate, according to the critics, is it doesn’t provide sufficient money to undertake the massive scale of a green energy restructuring of the British economy. That reality, however, may be the undoing of the plan, as we are beginning to see researchers examining the costs of certain aspects of it. That is a critical development, as the realization of the costs of environmental actions are being recognized by the citizens of EU member countries, where the green energy movement is the strongest. The citizens are showing their displeasure at the policies and the costs, as they know their living standards will be severely impacted. Politicians have yet to fully comprehend this reaction, but it will likely dominate 2021 news.
If we look at research about the costs of Mr. Johnson’s 10-point plan, understanding that there are many details yet to be fully explained or their costs justified, we find analysts questioning the plan’s goals relative to its costs. As noted in the BBC summary, there is an emphasis on how the green energy revolution will create jobs – a key talking point of every green energy plan. P.M. Johnson emphasized that the plan will create 250,000 new jobs, which will be needed to offset the thousands of jobs in industries that will be shut down or severely damaged by the energy switch.
We noted the 10-point plan envisions building 30 gigawatts (GW) of new offshore wind power to supplement the 10 GW already in place. This effort will support 60,000 jobs. While Texas hasn’t built any offshore wind, nor are there plans to do so, it should be noted that the state has 30 GW of onshore wind that supports 25-26,000 jobs. Is offshore wind that much more labor intensive? If so, it supports the argument that offshore wind will be a very expensive source of electricity.
The plan’s target of installing 600,000 heat pumps in homes every year will also prove expensive, and questionable, when viewed from the impact on the power market and consumer electricity bills. According to a 2017 study of heat pumps, the annual cost of the 600,000 installations, based on 2016 prices, would range from $5.6 (£4.2) billion for hybrid heating pumps (HHP) to $7.2 (£5.4) billion for standalone heat pumps (HP) that also deliver hot water. These estimates compare to an annual cost of $1.3 billion (£942 million) to install a similar number of new gas boilers.
Exhibit 20. New Heat Pumps Are Very Expensive
Source: ElementEnergy
Based on a limited three-year test conducted in Manchester, England, the power needs for three types of heat pumps are shown in Exhibit 21 for each month of the year at the half-hour power demand measure. The figures at the right of the chart show the respective pump’s power needs on the coldest day of the year. Not surprisingly, the power needs are significantly higher than even during the coldest winter months. The hybrid systems rely on the home’s gas-fired boiler or electric units to provide hot water, rather than the standard heat pump.
Exhibit 21. The Amount Of Power Heat Pumps Need
Source: ElementEnergy
The power needs data assumes the pumps are powered for a constant heating. However, many British homeowners turn off their heat while they are gone from the home, such as for work, or at night when they sleep. That means homeowners will cycle their heat pumps twice a day, significantly adding to the electricity demand. The report showed the difference in demand between constant versus two heating cycles a day for the typical homes in England. The difference in energy demand was often five-times greater for the cycling operation.
Exhibit 22. Twice-A-Day Heating Is Very Power Hungry
Source: ElementEnergy
This analysis was done by Paul Homewood, who wrote two articles about the electricity demand impact of the heat pump strategy. It turned out that his first article overstated the demand impact, which he corrected after examining the ElementEnergy report on the Manchester test project. His calculations show that the installation of 19 million heat pumps (600,000 per year for 30 years) would lead to an increase in electricity demand by 2050 of 66 GW. To put that incremental demand into perspective, in 2019, the U.K.’s electricity generating capacity was 78 GW, which also requires imported power to satisfy the nation’s needs.
Exhibit 23. How U.K. Electricity Is Being Produced
Source: DUKES
When we turn to the mandate to ban the sale of gasoline- and diesel-powered by 2030, marking the second fastest ban behind Norway’s 2025 dictate, the question of how the electric vehicles (EV) will be charged becomes a key issue. According to last year’s “Net Zero” report from the Committee on Climate Change, the independent agency established under the Climate Act of 2008 and which advises Parliament on climate matters, the U.K. will need 76 terawatt-hours (TWh) of electricity annually by 2050 to recharge the nation’s EV fleet. Spread evenly over all the hours of the day, this requires an additional 9 GW of power. If most EVs are charged during early evening hours, peak electricity demand would be approximately 40 GW.
This power demand would be in addition to the incremental power needed due to installing heat pumps in all the homes in Britain. Combined, these two incremental power demands represent over 135% of the current generating capacity of the U.K. Another electricity demand consideration with this green energy plan is that the U.K. currently imports 3-10% of its power needs from countries on the continent. At the moment, the imported power helps National Grid balance the system’s supply needs when wind and solar power are unavailable. Will that surplus power be available when the major power exporters fully convert their economies to renewable power? Without this supply, the U.K. will need to add even more generating capacity to assure 100% domestic electricity reliability.
Another key point in promoting EVs is the government’s commitment to invest $1.7 (£1.3) billion in new charging stations. In addition, the government will provide $777 (£582) million in grants to buyers of EVs, continuing a program already in place to subsidize EVs. While banning fossil fuel-powered cars will harm the British automakers, by allowing the continued sale of hybrid cars becomes a sop to them and their workforces. The government also envisions subsidizing battery manufacture in the Midlands by providing $665 (£500) million of aid designed to boost employment in this region of the country.
Virtually every country encouraging its citizens to switch to EVs is investing in, or promoting private companies to invest in, public charging stations, since many people will not have access to garages where they could install their own charging station. The challenge is where to locate these public charging stations and what type of charging unit to build. Often times, the charging stations are located along major highways, leaving those that are installed locally to be installed in controlled locations such as garages, service stations and shopping centers, all controlled by private companies. Sometimes these “public” charging stations are located on the property or in the garages of private companies who prohibit public access.
The economics of charging stations has become an area of focus of environmentalist Paul Homewood. His attention to this topic was driven by his discovery of new charging stations in a neighborhood shopping center. He discovered that the charging station was installed by InstaVolt, a private company backed by private equity. When he examined the company’s financial statements, he found it to be generating substantial losses as it strives to build its business. He estimated that the average cost of a charging station was $24,000 (£18,000). These are 50-kilowatt (KW) units, which provide faster charging times than the lower capacity (7KW) home charging units that cost on average $1,300 (£1,000).
When Mr. Homewood examined the charging station, he discovered it cost the EV owner 46.7 cents (35 pence) (p) per kilowatt-hour (KWh) for the power. That compares with the current cost for domestic power of 18.7 cents (14p)/KWh, but as Mr. Homewood says, the owners of the charging stations are entitled to earn money to repay their investment and earn a return. He noted that according to Nissan, its 62 KW battery Leaf EV will go 239 miles on a single charge. That translates into 12.2 cents (9.1p)/mile for the InstaVolt charge compared to 4.8 cents (3.6p)/mile cost for a domestic charge. If the vehicle is driven 10,000 miles, the cost difference in power sources equates to an additional $734 (£550) annually in the cost of battery charges.
Mr. Homewood did another comparison. If an EV-owner were driving a comparable diesel car, such as the Ford Focus, which gets up to 55 miles per gallon, at current diesel prices, it would cost 13.1 cents (9.8p)/mile. If one excludes the nation’s fuel tax of 77.4 cents (57.95p) per liter, the true fuel cost drops to 6.7 cents (5.0p)/mile. As he concluded, for an EV owner who lacks access to his own charging station and must pay commercial rates for battery charges, his fuel cost is not much different from a comparable diesel car, especially when one considers the greater number of diesel refueling options, as opposed to the limited number of charging stations and potentially longer time required to charge compared to the time to refuel a diesel pump.
The economics of EVs remain controversial, although the initial cost to purchase them is the primary limitation. Attempts to overcome the cost differential through providing government tax subsidies is limited if EV buyers do not have tax liabilities that can utilize the subsidy. A study we prepared showed that average tax liabilities may become a restrictive force mitigating the ultimate number of EV buyers. Range anxiety also is a crucial issue that will only be overcome when charging stations are ubiquitous and charging times shorter. On that issue, a recent study claims that batteries can be harmed significantly even after as few as 25 charging cycles when using large capacity, rapid charging stations.
Although heat pumps are not likely to become a core component of a Biden administration green energy plan, there are numerous other mandate restrictions on our choice of fuels that will have similar impacts. The key conclusion from looking at the U.K. 10-point plan is that it will need to build significant new electricity generating capacity. As this new generating capacity will be renewable, managing the intermittency of the power flow either by employing batteries or other power storage systems will add to the cost and complexity of operating grid systems. The transition to a carbon-free, all electric energy system will take longer and be more costly than most green energy proponents predict, and P.M. Johnson’s plan is merely the latest to highlight those challenges and costs.
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Parks Paton Hoepfl & Brown is an independent investment banking firm providing financial advisory services, including merger and acquisition and capital raising assistance, exclusively to clients in the energy service industry.
