Advantage Oil and Gas

Federal Reserve squeezing of capital markets favors Big Oil

Corporate borrowing rates have risen to their highest level since the 1980s. That’s by design: The Federal Reserve is convinced raising benchmark interest rates at the fastest pace in 40 years is the way to quell post-pandemic inflation, and return to its long-term target of 2 percent. And judging from recent statements by voting governors, they’re willing to risk throwing much of the US economy into recession to get there.

The working theory is a familiar one: Raise interest rates enough and the central bank can slow down price pressures. In fact, in the 40 years or so since Paul Volcker was Fed Chairman, the belief that higher interest rates are the antidote for inflation is rarely questioned in economics classrooms. All the Fed need do to succeed, so the story goes, is just stay tough and stick to policy, regardless of pain.

Unfortunately, if the history of economy and investment markets teaches us one thing, it’s that pat theories may work for a while. But eventually, circumstances—mainly human behavior—change enough so they don’t.

That’s when flexible thinking is called for. And at this point, there doesn’t appear to be an abundance of it at the Federal Reserve where, like the US Supreme Court, those making key decisions now largely hail from the same educational and even economic worlds.

There’s no question the Volcker Fed’s draconian actions did crush inflation in the early 1980s. That was at the cost, however, of the worst US recession since the Great Depression. And the pain was far worse in the developing world, where the US dollar soared and made it literally impossible to import crashing whole industries overnight. It’s generally forgotten now that the pain of Volcker’s policies eventually became too great to bear and he was forced into a major reversal, which ultimately led to another inflation crisis in the late 1980s.

I’d like to posit another theory for what eventually defeated the inflation of the 1960s-1980s: A more favorable climate for investment.

Getting hyper inflation under control was a necessary first step. But after that, it was creating conditions for boosting supply versus underlying demand—especially in food, energy and housing—that brought prices under control. And there, it was arguably the consistent policies of Presidents Reagan, Bush and Clinton that created the confidence needed to elevate investment, including liberalizing trade with then rapidly developing China.

Admittedly, that’s a drastically simplified explanation of very complex phenomena, as anything to do with human behavior always entails. But it’s important now because encouraging investment doesn’t appear to be high on anyone’s priority list at the moment. In fact, statements from some of the Fed governors imply that crushing investment is indeed viewed as a necessary step for reducing inflation. And there’s growing evidence they’re succeeding, with the energy business a prime example.

In my post last week, I highlighted the emerging highly negative impact of rising interest rates on the renewable energy business—the latest example being leading US wind and solar energy producer NextEra Energy (NYSE: NEE) decision to indefinitely postpone the sale or “drop down” of renewable energy facilities to its affiliate NextEra Energy Partners (NYSE: NEP).

Over its 9 plus years of existence, NextEra Energy has funded a considerable portion of its growth cheaply with drop downs to Partners, taking the affiliate from zero to $23 billion plus of assets since mid-2014. And the parent has retained effective control with its 55 percent economic interest in that company.

Over that time, however, the pace of drop downs has varied greatly depending on capital market conditions. When the cost of debt and equity capital has been low enough relative to investment returns, the pace has been brisk. But when costs have risen as they have now, Partners has become all but useless to NextEra Energy as a fund-raising vehicle. And the parent has had to look for other sources of capital to fund growth, as it has by selling its Florida natural gas distribution utility unit to Chesapeake Utilities (NYSE: CPK).

NextEra Energy’s move is hardly the only example of higher interest rates affecting renewable energy investment to date. Avangrid Inc’s (NYSE: AGR) 800-megawatt Vineyard offshore wind facility is on track to enter service next year. And Orsted A/S (OTC: DNNGY) Ocean Wind facility is now under construction, with Dominion Energy’s (NYSE: D) rate based Coastal Virginia Offshore Wind set for final regulatory approval to begin later this year. But the rest of what was once envisioned as 30 gigawatts entering service by 2030 now looks like a pipe dream, with other projects shelved by higher funding costs and buyers unwillingness so far to shoulder them in rates.

But when the leader of a sector like NextEra—with a 20 percent US market share—has to pull in its horns, investors are going to assume other players will do the same. And the result has been a dramatic acceleration of the slide in renewable energy stocks that began in early 2021, shortly after Biden entered the White House.

It’s hard to argue the president hasn’t exceeded expectations when it comes to financial help for renewable energy, with the Inflation Reduction Act providing massive tax credits and a real multiplier effect on investment. And despite the lack of bipartisan energy permitting reform so far, the administration has eased regulatory approvals considerably, particularly in offshore wind where the Trump administration had all but blocked new projects with a mountain of red tape.

All of that, however, has been more than offset by the impact of rapidly rising borrowing costs. And the longer the Fed keeps at it, the more difficult it will be to build anything in renewable energy, other than in regulator-approved utility rate base. Shares of rooftop solar leaders SunPower (NSDQ: SPWR) and SunRun (NSDQ: RUN), for example, are now down more than -90 percent since early 2021, with much of the losses coming in the past year as high borrowing costs have undermined economics for would be customers.

Oil and gas companies too have seen borrowing costs rise. In fact, Kinder Morgan Inc (NYSE: KMI) this year has seen the positive impact of several major new assets entering service in Texas completely offset by the cost of eliminating its floating rate debt. I think that will prove a good move for the company in the long run.

But conventional energy companies in general have not seen their cash flow, CAPEX, balance sheets or dividends significantly impacted by rising interest rates for one major reason: Since the previous decade, they’ve been largely shut out of capital markets on economic terms, the residual impact of the unwinding of the previous energy up-cycle combined with unpopularity as the alleged culprits behind climate change.

Instead, sector companies including Kinder have been funding their CAPEX, dividends/stock buybacks and even maturing debt with operating cash flow. And they’ve kept doing it consistently, even as oil and gas prices shot higher last year, producers holding down CAPEX for new drilling and exploration and midstream/downstream companies for anything other than incremental capacity additions mostly to facilitate exports.

There are exceptions where capital is flowing, Permian Basin oil production and the apparently nearing completion Mountain Valley Pipeline in Appalachia as two examples. But for the most part, conventional energy companies have kept things conservative—and they’re being rewarded for it now by not having to access now very expensive debt and equity capital.

In the real world, of course, energy is energy. And whether it’s from solar, wind, storage, geothermal, nuclear or fossil fuels, the world is going to need a lot more of it in coming decades.

That means renewable energy’s capital raising problem is not necessarily to the benefit of oil and gas companies. Equally, what many would call irrational restrictions on fossil fuels haven’t always accrued to the benefit of renewable energy deployers, a good example being soaring natural gas prices passed through to utility customers that have in some states undermined companies’ ability to invest wind and solar into rate base the past couple years. And don’t forget some of the world’s biggest investors in renewable energy are oil companies, TotalEnergies (Paris: TTE, NYSE: TTE) being a good example.

But a Federal Reserve pushing interest rates and therefore the cost of debt ever-higher is clearly pushing energy sector investment to a much lower point than where it would be under normal conditions. And the longer it continues, the more likely renewable energy companies—even leaders like NextEra and TotalEnergies—will invest only what they can without relying heavily on outside capital.

It’s the constraint oil and gas companies have been operating under for almost a decade now. As has been the case in that sector, the conditions will favor large, diversified renewable energy developers and deployers with low costs and strong balance sheets. And ultimately, it will mean less supply relative to underlying demand, higher energy prices and faster resulting inflation—along with much fatter profits and higher stock prices for the companies able to adapt now.