The way things are …
Capital is not scarce right now. Balance sheets are robust, bank debt is cheap and historic performance suggests energy is a mostly safe and reliable investment.
Most energy projects have long lives. They are favored by pension funds and other investors interested in long-term and stable returns. But ask which energy sources will be the main fuel source 30 years from now, and you will not get a definitive answer. How, then, can investors back energy projects and technologies that have uncertain returns and lifespans?
For energy companies to diversify into low-carbon and renewable technologies and spread the risks of their portfolios; for them to innovate and discover new energy sources; for them to transition from large and lumbering to lean and flexible, they need serious amounts of risk-friendly financing. And for that, investors need clarity.
… in power and utilities
Lack of certainty should point to dwindling investment. However, the low-interest-rate environment continues to be on the side of the power and utilities industry. Compared with other return-generating investments, network assets seem a low-risk punt. So, demand is growing, pushing up valuations, generating more demand. The grid, investment-wise, is also perceived as a safe place. It is a means by which new technologies will come to market. Or is it?
As soon as interest rates head north of 4-5%, prepare for network assets to take a backseat as investors seek higher returns elsewhere. Moreover, a drop in capital expenditure to support the network peak once new technologies come online, will see valuations fall. Lower valuations, on top of a higher interest-rate environment, will translate into reduced appetite for network assets and harder-to-come-by capital for investment.
… in oil and gas
Increased price volatility in the oil market and changing structures in the gas markets have reduced producers’ certainty when sanctioning projects. This increases reliance on balance sheet debt and public bonds to fund the industries’ extensive capital requirements.
It is not a problem in lower-risk projects and those where the sponsor has adequate balance sheet strength, but it is opening up a funding gap in higher-risk projects conducted by smaller market players. As most innovation happens at this end of the spectrum, we are facing a long-term challenge.
Even among larger players, the flight from risk is leading to smaller projects that minimize capital concentration. In turn, the move toward faster and less complex projects is compressing time between project approval and completion. These days, given a choice of spending US$15b and five years developing an asset that produces 300mbd or a choice of spending US$6b and three years developing one that produces 120mbd, most companies will opt for the latter.
As in power and utilities, there is extensive use of cheap debt. It is used to finance low-risk, low-volatility components of the value chain, such as midstream pipes and storage infrastructure. If, or when monetary policy tightens, it will present a real risk of a funding gap.