Bubble, bubble, is oil in trouble? The carbon bubble, Part 1

(2500 words)

“The value of oil, coal and gas reserves is the single biggest challenge to solving climate change.”

Mike Berners-Lee and Duncan Clark, The Burning Question

In reading the climate news we can sometimes lose heart. But, in an earlier post on Icarus, I argued in favor of cautious long-term optimism, based on my pig-headed hope that we may yet make progress addressing the climate crisis. In that post, I touched lightly on a variety of topics, aiming for an impressionistic sense of the range of activities underway that can feed our hope. Here I want to do a deeper dive into one particular issue that hasn’t received the attention it deserves: the notion that a “carbon bubble” might develop in the energy markets. This can be a source of hope, because it would imply a decline in the projected demand for fossil energy in coming decades, but it should also provoke some nervous jitters.

It’s best to avoid financial bubbles if at all possible. The old cliche says that markets can deal with anything — except uncertainty. The projections for fossil energy demand over the next two decades are currently quite uncertain, for reasons we’ll discuss in Part 2. If we sharply reduce our dependence on fossil energy in coming decades, and thereby ‘decarbonize’ the economy, navigating that transition will also require significant shifts in the financial markets, not only the ‘real economy’. As we know from the intergalactic financial crisis of 2008, the financial markets don’t always behave rationally, sentiments can change rapidly, and bad bets can lead to brutal consequences for those of us who live in the real world.

It might seem strange to readers who hope for real progress on climate to include reductions in fossil energy demand among a list of ‘risks.’ But here I am using the term in the sense of an investor looking for a wise place to put long-term money in a time of great change. Fossil energy companies have been viewed as solid investments for a very long time, and that opinion has been one of the anchors holding back our ability to make progress toward reducing dependence on their products. Is that opinion changing?

Broadly speaking, there are three possible causes for a shift in market sentiment: government policies to reduce fossil energy use; technological disruptions that reduce demand; and shifts in social behavior, not only among the environmentally minded, but also among those who allocate capital.

I’m not talking here about social movements urging divestment from fossil energy stocks for ethical reasons, a related but quite different social trend. When an institution like a university sells its holdings in fossil energy companies, by definition someone else buys those stocks, perhaps someone who cares less about climate issues. The divestment movement has received a lot of attention in the popular press. Instead, what I’ll focus on here are considerations that might cause even a hard-nosed investor to wonder whether the time has come when anyone caught holding fossil energy stocks will regret it, because a financial reckoning is coming. Perhaps those stock values are heading south in the coming decade. While I raise this question, I’m far from the first to do so. It’s not my area of specialization, and even for experts in the area, predicting the future of the energy market is notoriously difficult. I don’t claim to know what’s coming. Instead, this series of posts explores why some energy market analysts believe it’s the case that the fossil energy world is changing faster than most investors realize, that we are on the threshold of great changes unlike any we’ve seen in past decades, and why it’s vitally important that the markets not be found asleep at the switch.

This Icarus post comes in three parts: Part 1 answers the question ‘What is the carbon bubble?’ Part 2 summarizes why some analysts believe a bubble might be developing. Part 3 looks at the question of how big the bubble might be, and who would get hurt if it pops. The short answer is: it would be far larger than the housing bubble of 2008, and it would be painful for all of us.

Introduction: What is the ‘carbon bubble’?

In the two and half centuries since the start of the industrial revolution, there has been a steady increase in global CO2 levels in the atmosphere, and fully half that increase has occurred since 1988. CO2 levels are now higher than at any time in the history of our species. Emissions of methane, another major greenhouse gas, are also on the rise. The fact is, we don’t know what the long-term effects of these trends might be. The effects will take decades to fully manifest, and climate predictions are bedeviled by feedback loops and uncertainties we only dimly understand. I’ve written about the nature of climate knowledge in a related post here. The science is advancing rapidly, and in my opinion it is already more than good enough to craft sound risk management strategies based upon it.

The greatest gift we can give to future generations is to widen their options, not narrow them. Climate science and intergenerational ethics, therefore, point us toward the need to reduce greenhouse gas emissions. In addition, we have to allow for the possibility that future generations may conclude they will need to reduce greenhouse gas levels from those they inherit from us. Currently, they would have few options to work with, so research into what are called ‘negative emission technologies‘ is urgent. The crux of the matter is that if we are to stay within the 2015 Paris Agreement ‘carbon budget‘ for global emissions, most of the proven reserves of coal, oil, and natural gas will have to be left underground. Whether they will, in fact, be left underground is the largest source of uncertainty the energy markets have to deal with today.

The current market valuation of publicly-traded companies like Exxon, BP, and Shell suggests that investors believe those proven reserves will be brought to market and sold. Additionally, for many OPEC countries, those projected revenues form the backbone of national budgets. So, it’s important to keep in mind:

The stuff in the ground has value today only if investors believe it will be burned tomorrow.

The converse is:

If investors stop believing the stuff in the ground will be burned tomorrow, the value of it will drop today.

This critical point was first brought into sharp focus back in 2012 by the Carbon Tracker Initiative, a London-based non-profit that does deep dives into fossil energy financials and climate market risks. Carbon Tracker argued that if a decision is taken, either by the markets or through government policies, to leave most of the reserves of oil, coal and natural gas in the ground, they become stranded assets. How much would those reserves be worth then? No one knows. That is the ‘burning question’ of the day, highlighted in the 2013 book of that name by Mike Berners-Lee and Duncan Clarke.

This vital question about the future market value of reserves left in the ground is largely overlooked in much of the climate change conversation. The science around climate change is fascinating, the technological responses seductive, the geopolitics dramatic. In contrast, fossil energy financials seems wonky, down in the weeds, and it’s prone to put most of us to sleep. But, as the old saying goes: such things are well known, to those who know them well. These ideas should be known more widely, however, because if there is a carbon bubble — and if it bursts — it will affect all of us. So brew yourself a cup of coffee, roll up your sleeves, and put on the green eyeshades.

There are signs that the global markets are starting to factor in the costs of a transition to a low-carbon economy, and there are increasing demands for climate risk management strategies from companies. For example, a group of over 300 large institutional investors have formed the Climate Action 100+ group, which collectively manages over $33 trillion in assets and coordinates their approach to climate risk. The sovereign wealth fund of Norway recently announced intentions to divest itself of many fossil energy investments and then move to invest in renewable energy companies. These are good developments, because it uses the 800-pound gorilla of big money to push companies to address the question: What’s your climate plan?

But, some other investors might be caught unawares if the transition to a low-carbon world accelerates in the 2020s. As we’ll discuss in Part 2, some analysts think this is on the horizon. Such a shift is potentially due to countries adopting national policies in line with the Paris Agreement, but also the coming technological disruptions that will happen anyway. More conservative investors, those who assume that business-as-usual will continue in the energy markets for several more decades, might be in for a world of pain.

Projections like this are the heart of the matter:

The plot shows two different scenarios for world oil production, from a standard source used by planners: the International Energy Agency’s World Energy Outlook 2018. The New Policies Scenarios (NPS) assumes that current fossil energy development projects will in fact go into production, but no new major ones are started from this point forward. The upper trajectory overshoots the Paris Agreement emissions goals. The Sustainable Development Scenario (SDS) assumes more rapid transitions to renewable energy and electrified vehicles, with steady progress made toward meeting the Paris Agreement goals.

In both scenarios the world economy continues to grow, but in the lower curve it pursues a more aggressive path toward a low-carbon future. More details are given in Parts 2 & 3 of this post, where we’ll explore why some analysts believe the IEA is being too conservative, and that demand will drop even faster than the SDS projects, largely due to those technological disruptions in renewable energy and electrified transportation.

Past predictions that we have reached ‘peak oil’ have a terrible track record. What’s changed? In previous decades, those predictions concerned worries that we would run out of oil. With the fracking revolution, and other technological innovations in oil prospecting and drilling, the world now has enough oil to last fifty years at current rates of usage. The new projections of peak oil, like those in the IEA plots above, concern a possible coming drop in oil demand.

The wedge in the plot between now and 2040 represents a difference of over a hundred billion barrels of oil. The current market value of that oil is nearly ten trillion dollars. Even averaged over those two decades, such a drop in revenues would seriously impact oil company profits, and put a huge dent in their return on investment.

So, which will it be: the upper curve, or the lower one? That depends on a lot of factors, and only time will tell which proves closer to reality. But, the immediate question is: How should markets assess their risk exposure right now? The graceful shapes of the two curves are misleading. Suppose a bank bets the farm on the upper path, for example by lending a major oil company billions in long-term debt to bring a new field into production to meet those growing demand projections, with the debt paid for using revenue from selling that new oil. Suppose lots of banks make similar bets on other projects. But, what if the world demand curve follows the lower path, and the value of all that oil plunges because of a glut of overproduction? Those bets go bust. The recent history of GE stocks is salutary.

Science, like finance, works with probabilities, not certainties. Predicting the future outcome of current climate policy choices or new technologies is nothing like making an orbital calculation for sending a probe to Pluto. Instead it’s like counting cards at blackjack. In a game of chance, the goal must always be to shift the odds in our favor. So, assign probabilities to the two pathways in the plot above, and place your bets.

Part 2 examines why some energy market analysts believe the lower curve is the more likely one. There, I will discuss why those analysts believe that in the 2020s we will experience a cascading series of disruptions in how we produce and consume energy in the real economy. The real energy economy concerns mines and oil fields, drilling rigs and pipelines, ships, trucks, and trains, refineries, solar farms, wind turbines, battery gigafactories, and power distribution networks. The physical plant of the energy economy is always undergoing change and evolution, but that change is usually very sluggish, measured on a timescale of years and decades. Perhaps the timescale is compressing.

Part 3 concerns that more nimble and fickle character of the climate story: finance. Fossil energy projects, like bringing a new oil field into production, or a new coal field, requires massive investments, those bonds and bank loans to pay for it, and insurance to hedge risks. Should a portfolio manager continue to bet on those solidly-performing fossil energy investments, or shift now to those shiny new technologies? The shift to low-carbon technology is coming, the question is one of timing: When and how quickly? As we know from the financial crisis of 2008, the financial side of the economy can literally change overnight. Markets can panic. Capital can flee. In the current context, that flip might happen if and when institutional investors come to a new understanding of climate-related risk, or if they begin to believe the lower demand curve in the plot above is the more likely. If and when that flip happens, investors might quickly come to believe the returns on fossil energy investments are no longer worth the risk, and then act on it. If a bubble develops in the energy markets, that’s how it might go ‘pop’. How big would it be, and who would get hurt?

There are a lot of things in motion around the topic of climate risk, as even a casual reader of the financial news can find in the writings of those chroniclers of capitalism at the Financial Times, the Economist, or the Wall Street Journal. More recently, the US Commodity Futures Trading Commission (CFTC) issued a unanimous report on the importance of including climate change as part of risk analysis. The image that comes to mind is of standing on a hillside that’s begun to move underfoot. At first you think it’s a small earthquake, but then you realize to your alarm that you’ve been standing on a sleeping giant all along, one that’s now roused from its slumbers. That giant is the market, finally alive to the financial dangers of inaction on climate change.

Part 1: What is the carbon bubble? [current post]

Part 2: Why might a carbon bubble happen?

Part 3: How big might the bubble be? Who would get hurt if it pops?

Image: Oil refinery at Anacortes, Washington. Walter Siegmund [CC BY-SA 3.0 (http://creativecommons.org/licenses/by-sa/3.0/)]

The text is licensed under a Creative Commons Attribution-NoDerivatives 4.0 International License.