Stranded: Why some of the largest oil producing countries face an unstable future

Up until now investor attention has focused on the downside risks to the publicly traded oil industry resulting from a transition to a low carbon future. Specifically the risk that companies will have to write down ‘stranded’ assets and face declining demand for their products. Yet there is a much bigger potential problem that investors may need to face: sovereign credit risk of state owned oil producers and escalating geopolitical conflict.

A new paper (Stranded Assets And Sovereign States) by the Council on Foreign Relations (CFR) and published in the National Institute of Economic and Social Research looks at the potential impact of stranded oil and gas assets. It argues that in most cases, it will be sovereigns, not private investors, who will bear the brunt of stranded oil and gas assets.

To put the exposure of sovereigns in perspective, the largest traded private oil companies, which include ExxonMobil, Royal Dutch Shell, Chevron, Total, BP, Equinor, ENI, and ConocoPhillips, hold total oil reserves of 49 billion barrels (Energy Intelligence, 2018). This represents only about 3 per cent of total proven world oil reserves of 1.7 trillion barrels. In comparison, the share of world oil reserves by nations that are members of the Organization of Petroleum Exporting Countries (OPEC) is 79 per cent, with Venezuela controlling 25 per cent, Saudi Arabia 22 per cent, Iran 13 per cent, Iraq 12 per cent, and Kuwait and United Arab Emirates roughly 8 per cent each (OPEC, 2018).

The CFR argues that state owned oil companies have had little incentive to accelerate that transition.

Petro-states were willing to hold back production and delay investment for exploiting undeveloped reserves because they believed that the value of those assets would rise over time, as oil output from older oil fields in North America, Europe, and Australia began to decline from natural physical geological limitations.

It’s also worth reflecting that autocratic regimes have used the wealth generated from oil to quell unrest from the poor and to keep the elite on side. According to the International Monetary Fund (IMF), approximately $550 billion a year is spent on energy subsidies. Half is spent by governments in the Middle East and North Africa, where on average it is worth approximately 20% of government revenues.

What has changed now is that oil seems to be in greater abundance, just at the time when uncertainty about future demand is emerging. Some oil dependent nations are ahead of the curve though in reducing their carbon impact.

The national oil companies of the Persian Gulf, notably Saudi Arabia, the United Arab Emirates, and Kuwait are among the NOCs taking the most ambitious measures to reduce energy consumption and emissions in oil production processes and facilities and to pivot to investment in renewable energy.

Still, not all national oil companies have developed strategies to address the question of stranded assets. Those with little access to credit, either because of mismanagement or sanctions are poorly positioned.

For example, Venezuela is highly exposed to stranded asset risk not only because it holds the largest oil reserves in the world but also because of the current dire situation of its national industry. The country’s internal problems have led to gross mismanagement of the sector, in addition to looting and other damage to most major facilities, that has all but crippled state firm PDVSA’s ability to operate…Before bureaucratic mismanagement, massive state economic decline, and then US sanctions hit the firm, PDVSA used to spend upwards of $3 billion to $4 billion a year just to arrest wellhead declines in its mature oil basins. Capacity expansions at the country’s extra heavy oil Orinoco Belt region would take tens of billions of dollars.

Access to capital isn’t likely to improve in a world in which investment institutions are seeking to divest from carbon intensive energy sources. Where it is available, it will come at a price.

Availability of this capital to finance a restoration of Venezuela’s oil sector remains unclear. The country is deep in debt, including over $20 billion owed to China alone, and it will take any government, including a new government, years to stabilise finances. Moreover, since many international oil companies will be less interested in amassing large reserves in the coming years, and the poor state of Venezuela’s fields and the country’s political instability weigh against foreign investment, Caracas will have more difficulty finding parties who will be willing to invest large sums into its oil sector. The longer Venezuela’s current internal political crisis continues, the harder it will be for the country to tap its oil reserves as a means to pay for its future.

Elevated oil revenues have historically supported government budgets. If these dry up over time national institutions will be destabilised even further.

In the International Monetary Fund’s October 2019 Global Financial Stability Report entitled “Lower for Longer” it notes that state-owned enterprise debt represents a “significant portion” of total emerging market debt securities. The IMF report notes that emerging market oil and gas state enterprise (SOE) leverage has nearly doubled over the past fifteen years at the same time these same firms are experiencing a decline in profitability. The IMF report also states: “IMF staff analysis indicates a widening in spreads in major SOEs can spill over to sovereign spreads and these spillovers have been rising in recent years, in contrast to the spillovers from sovereigns to SOEs” (IMF, 2019). For countries that already suffer from high debt levels, a worsening credit position in light of stranded asset risk for oil and gas national flagships could result in a worsening fiscal position for sovereigns.

But for countries that fail to prepare their populations may find a harsher reality. CFR argues that in some cases, governments may resort to increased internal repression as existing patronage systems become less sustainable in co-opting disparate political interests, while the nature of regional geopolitics is also likely to be affected.

As they come under increased pressure, the intensity of regional conflicts could subside as parties to disputes are constrained by loss of oil revenues (Gause, 2015). But there is also the possibility that petro-states will seek a substitute for the waning influence previously established by their vast oil and gas reserves. It is unlikely that threats of oil cutoffs can serve as a diplomatic coercive lever over time as consuming states become less worried about energy supplies and more reliant on domestically produced renewables and energy saving digital technologies. One option petro-states will be tempted to take is to assert their geopolitical interests more directly with brute military power rather than suffer a decline in influence. Viewed through this lens, recent military buildups in the Middle East by Russia, and Iran’s recent attacks on shipping and oil installations in the Persian Gulf, may take on deeper implications.

The paper concludes that:

“many resource-dependent economies could come under stress in the coming decades, just as climate change increases the burden on governments to respond. Moreover, as the oil intensity of the global economy lessens, the opportunity for petro-states to amass fiscal surpluses will shrink over time, requiring economic reforms and restructuring that will be politically unpopular at home.”

Those left behind will not do so quietly. The irony of this story is that those countries with some of the greatest energy resources (Venezuela, Iran and Russia) will be in no position to respond should the transition to a low carbon future be slower than consensus opinion imagines. If they get left behind stranded societies risk becoming unstable ones.

Related article: Up in smoke: Why investors in oil companies may reap a climate rebellion dividend

The futures curve is not a price forecast

Futures prices are often used in the macroeconomic models built by central banks and other official agencies, and it is tempting to view them as a commodity price forecast. In the Bank of England’s latest monetary policy report (January 2020) it shows a chart of the crude oil and futures curve out through 2020. The BoE interpret the change in the oil futures curve as being slightly more inflationary in January 2020 than three months earlier, while the gas futures curve as being significantly less inflationary.

Uncertainty over the future price of energy is thought to be one of the main causes of uncertainty in inflation projections – complicating decisions over future monetary and fiscal policy. Work by the European Central Bank found that a 20% change in the oil price can affect inflation by approximately 0.4–0.8 percentage points (depending on the initial level of the oil price). Indeed, the chart on the left shows how important a driver energy prices have been to falling inflation in the UK.

This reliance on energy market futures curve to direct monetary policy is a mistake as its likely to underestimate inflationary pressures. To see why it’s important to understand what a commodity futures price actually represents.

To recap, futures markets provide a means for trading the price of a commodity for delivery at some point in the future. The shape of this series of prices is known as the futures curve. The notion that the futures price is the best forecast of the spot price comes from a belief in the so-called “Efficient Market Hypothesis”. In an efficient market, new information is instantly reflected in commodity prices.

The two terms “futures” and “forecast” both sound like they should represent the same thing. They are anything but. A cursory review of the futures curve’s behaviour in recent years shows that it has been a very poor predictor of realised spot commodity prices. The futures curve shows the price at which it is possible to buy or sell contracts for a date in the future at a price agreed on today. It is not a forecast of future spot prices.

A futures curve is described as being “in contango” when it is upward sloping and so prices in six months’ time are higher than the spot price. This is also known as a normal curve or a normal market. Traders will pay a premium to avoid the costs associated with transporting, storing and insuring a commodity (known as the cost to carry); so, the furthest-out contracts are typically higher in price. In contrast, when the shape of the futures price curve is downward sloping, then the market is said to be in backwardation. This is also called an inverted curve or an inverted market.

Forecasters may view a rising futures curve (a market in contango) as a sign that the market expects higher prices, and vice versa for a downward sloping futures curve. This is based on the perception that futures prices should incorporate all the available information to market participants, and that they also act as signals of what the “market” expects to happen.

There are several factors that affect the futures curve, not just market expectations of where the price of a commodity will be:

  • First, the physical characteristic of the commodity – whether it is easy to store and whether there are ample inventories, etc.
  • Second, longer dated contracts are illiquid, raising doubts of whether they are an effective aggregator of information. Given that monetary policy acts with a lag in excess of a year that raises doubts.
  • Third, the futures curve fails to account for inflation.
  • The fourth and final factor is that futures prices will always be discounted to the market’s expected future spot price in order to give investors a “risk premium” to take on risk from producer hedgers (known as the “normal backwardation” theory). This means that even if the spot price is estimated correctly, the traded futures price will tend to understate the market’s current real price expectations.

Despite all its faults forecasts by government institutions are likely to continue to use the futures curve. Why? It is because it is a simple and transparent market-based measure and so it is preferable to more opaque model-based forecasts.

My worst investment ever

My story of investment woe dates back to late 2013 / early 2014. The gold price was just under the $1500 per oz mark, similar to where it is now as I write this answer. Gold had dropped from $1900 per oz three years earlier, and for very good reasons. Strong dis-inflationary tendencies, rising real interest rates and the increasing opportunity cost of being invested in a shiny pet rock as the stock market soared conspired to pull the rug out from beneath the gold market.

In the depths of the market I spied an opportunity. Sentiment towards gold and gold miners in particular was very poor. Fears over the long term impact of low interest rates and quantitative easing were beginning to surface. There was also some evidence that this was just a mid-cycle correction in gold prices similar to the mid-1970’s.

I decided that the gold market was pretty close to the bottom, and that there were compelling reasons why the gold price could have quite a bit of upside potential. I was excited to be taking a contrarian position in the market.

But here’s where things started to go wrong. I wanted a way to gain leveraged exposure to gold but also provide some limited downside in the case that gold fell further. I had read about a particular company in the press and on social media. It appeared to have one of the lowest cost structures of all the major gold mines. The low cost base would offer some protection in case the price of gold fell further.

Problem was that the country in which it was situated was looking to take back control over its resource sector. It was a monster mistake. The miner fell 30–40% before I could even bring myself to close out my position, and even then liquidity was so poor it took me days to finally exit.

I was tempted to hold onto it in the hope that gold prices would rebound, and I would be able to recuperate my investment. If I had waited for gold prices to rebound it would have been even worse. The share price remains 70% below levels at the start of 2014, despite a rebound in the gold price to similar levels.

The lessons I learnt from this particular painful episode include:

  1. Social media bombards you. Lots you can learn, but you must try and avoid being pushed into action by the noise.
  2. Importance of being clear about your own time frame
  3. Risk management approach is key – before you enter an investment or trade.
  4. Proxies for gaining exposure. Be careful about being too clever.
  5. Sentiment, and price can always get worse before it gets better.
  6. Not cutting my losses meant I wasted time, emotional energy and money. So there was an opportunity cost which meant I couldn’t look at other opportunities.
  7. I knew I made a mistake, but I didn’t admit it to myself.

If you would like to hear more, I was recently interviewed by Andrew Stotz, host of My Worst Investment Ever podcast. I have to say it felt good, if difficult to talk about. None of us likes admitting that we’re fallible. But by sharing our mistakes we can learn from each other, and hopefully avoid making the same mistakes.

Ep179: Peter Sainsbury – Use a Journal to Stay Self-aware When Making a Contrarian Investment – My Worst Investment Ever