"I'm from the government and I'm here to help"

A risk assessment for surviving Western government energy policy risk

For much of the past 20+ years, the popular quote from President Ronald Reagan seemed like it was from a bygone era of government over reach that we surely weren't going to repeat. Capitalism beat communism. The TikTok generation hasn't even heard of the Soviet Union! No one likes dealing with the DMV, TSA check points, the MTA, or just about any other example of government "services". But hey, those that don't study history are doomed to repeat it or something to that effect.

At a recent industry event I attended, a former senior government official offered this sobering perspective on the nature of government policy at a time of energy crisis conditions (paraphrasing): when you reach the point of crisis, tactics to politically survive the crisis are all anyone thinks about; there is almost no chance you will see thoughtful, pragmatic long-term policy prescriptions being contemplated. I appreciated the person's sentiments. It's time to stop wishing for what should be and instead do a risk assessment of what we might actually need to endure from our elected leaders in western countries.

If I translate the above to investor and corporate strategy: worst case is really bad policy happens from flailing efforts by politicians to minimize the pain of the here and now; best case is status quo gridlock keeps the worst case from happening. In the event we do not get the "do nothing best case" public policy scenario, the question becomes the degree to which various governmental policy prescriptions can impact short - and long-term supply/demand fundamentals, the outlook for sector profitability, and how investor and energy companies might consider navigating various policy responses.

Here is an unfortunately incomplete but top of mind list of various policy ideas or rhetoric being bandied about in the US, UK, and EU ranked from most to least harmful:

• Price caps (UK, EU)

• Export bans (US)

• Windfall profits tax (UK, EU)

• NOPEC legislation (US)

• Price gouging rhetoric (US)

I would define "good" energy policy as driving a combination of higher energy supply and lower energy demand per unit of GDP with a prioritization of affordability, security, and reliability; there is also a need to take into account negative climate and environmental externalties that arise from energy supply needed for economic growth. We are not on-track for good energy policy. The only question is how much worse will the energy crisis be due to the actions of politicians and policymakers and how should investors and corporations think through assessing risk and taking mitigating actions.

The biggest risk I see is that in trying to shelter consumers from spiking energy prices the odds of having actual energy shortages rise. Without price induced demand destruction, the only way to keep physical supply/demand in balance is actual shortages. Some of us remember gas lines and odd/even license plate filling days last seen in America during the Carter Administration. While I do not expect such conditions to return to the US, the same cannot be said for Europe (for home/business heating and electricity generation). Without energy there cannot be economic growth, which raises the probability of a deep recession materializing. Recession is bad for everyone—consumers, energy suppliers, and investors.

A partial list of government "solutions" to the energy crisis

Note: As I think most of you will appreciate, there is far more complexity and nuance to the below topics than I will write about in this summary post.

Price caps

Efforts to artificially cap energy prices all but guarantee physical shortages in the absence of a supply response, be it this coming winter or in future years. Recession risk increases meaningfully. The impact is harmful to the extent it does not motivate new supply and mutes the desire for energy users to implement efficiency solutions. In the 1970s, I believe President Richard Nixon gets the award for first implementing disastrous energy price controls. Hopefully this serves as a reminder that bad American energy policy is a decidedly bi-partisan affair. Of course it is the UK and EU that is going down the price cap road this go round. I understand the allure for politicians; I am unaware of any prior situation where price caps (or price controls) ended well.

Export bans

Energy protectionism instincts among US politicians likely raises the risk of energy shortages developing in various countries/regions in the rest of the world, while having an uncertain benefit to US consumers (i.e., the degree to which domestic energy prices possibly ease is far from certain; Rory Johnston recently addressed this in his Commodities Context newsletter (here)). This has the potential to be a long-term risk to energy suppliers in the US to the extent export ban restrictions are continued by future administrations. Similar to the price cap discussion, rest of world recession risk grows.

Windfall profits taxes

The analytical horse power of many politicians is obviously poor. Oil and gas is a sector that at best earns a through-cycle return that about equals its cost-of-capital; along the way there are peaks and troughs. Labeling only the peaks as "windfall" is a cynical mis-direct on the part of politicians to skirt responsibility for their own policy failures and missteps. The risk of windfall taxes is a driver for companies to be cautious on raising capital spending when prices (and returns) rise. In the US, I am not expecting a windfall profits tax at the Federal level (there is some talk in California) to materialize, which does assume split government post the November mid terms. Clearly this is a risk being realized in Europe.

NOPEC legislation

It is hard to understand what the enforcement mechanism would be if legislation that would declare OPEC an illegal cartel and subject to anti-trust laws were passed by US Congress, where there is apparently bi-partisan support. Relations between the Biden Administration and key Middle East producers like Saudi Arabia is already openly hostile; the degree to which that is relevant is subject to debate usually centered around its geopolitical and security implications more so than oil supply/demand in a post-shale revolution world. From the perspective of energy markets, at this moment I put this in the more bark than bite category; I suspect the relevance to energy suppliers or investors is how retaliatory action from either side (i.e., the US and key OPEC countries) materializes.

Price gouging rhetoric

This is perhaps the ultimate symbol of the complete abdication of duty by US and EU politicians. I think most readers of Super-Spiked understand the ridiculousness of the accusation. With that said, yelling at oil and gas companies is probably the least harmful of the policy options being pursued by politicians. I would categorize price gouging rhetoric as the most annoying but least harmful government endeavor.

How should investors navigate these policy prescriptions?

• Does the policy raise the risk of energy shortages? If yes, one needs to be concerned about deeper recession risk which is bad for both energy companies, energy investors, and the broader market. Of the above list, I would put UK/EU price caps in the category of most likely to lead to recession. A US export ban might indirectly drive recession risk as suffering increases in other countries that depend on American energy supply.

• Does the policy disincentivize a supply response? One might argue that some of these policies are net bullish for energy suppliers. For example, if a policy disincentivizes a supply response, one might expect energy prices to remain higher than would otherwise be the case. However, in a world of inadequate energy supply growth, demand destruction pricing becomes the balancing driver, after which recession risks increase.

• Does the policy increase the risk of geopolitical turmoil? While geopolitical risk is already high, the impact of a "war of words" is perhaps the most unpredictable driver of prices. I think few were anticipating a 2 million b/d headline cut out of OPEC a month ago, which has sparked a rally in both oil prices and energy equities. This may prove to be short-term trading noise as OPEC cuts early in a deep recessionary downturn have historically not helped avoid trading pain for energy investors. But OPEC cuts in a mild recession or "soft landing" scenario might suggest a higher profitability floor could exist, especially when below-ground spare capacity, above-ground inventories, and industry CAPEX are all at low levels.

How should traditional energy companies navigate policy risks?

• Super Vol Mindset. The short-term inelasticity of energy demand and supply points to global oil and natural gas prices reaching demand destruction levels. But when you flip from one barrel (or Mcf) of more demand than supply to one barrel (or Mcf) of surplus supply, prices can fall rapidly and sharply. This is the kind of market we seemed to destined to be in for the foreseeable future (i.e., the 2020s)

• Fortress Balance Sheet. The goal is to not only survive but thrive in a Super Vol commodity macro backdrop. How do CAPEX and cash return strategies hold up on the inevitable sharp pullbacks?

• M&A Inevitability. Are you prepared to take advantage of opportunities that may arise from market dislocations? It could be via M&A, bolt-on property deals, or selective investment opportunities.

Arjun, this post doesn't seem very balanced...is there really nothing good about Western government energy policy?

Balance for the sake of balance is not the point of Super-Spiked. The only ideology publicly espoused is that I am pro-capitalism, anti-socialism. With that said, I am going to dig deep and find some nice things to say about Western government energy policy!

There are aspects of the mis-named Inflation Reduction Act that I support. Carbon capture, for example, is a technology that will be needed if the goal is to have available, affordable, reliable, and secure energy with as small of a climate and environmental footprint as possible.

I support efforts to move US oil and gas operations to "near zero" methane, which ultimately will ensure that US (and Canadian) barrels and Mcfs are part of the long-term energy supply solution.

Permitting reform in the US has long been discussed and on the surface has bi-partisan support. I am not an expert on the specific steps that should be taken. But for advocates of both traditional and newer energy technologies, there is a clear opportunity for alignment on this important issue.

US state initiatives to promote electric vehicle (EV) charging infrastructure along highways is something I support. Broader EV subsidies and incentives I don't believe are needed. As the EV market naturally expands, I believe businesses like hotels, shopping centers, and office parks will be self-motivated to add charging infrastructure. It can and will happen organically, in my opinion, and does not require government support. But accelerating the process by which highway rest stops add EV charging infrastructure could prove beneficial to EV adoption.

I do not support banning internal combustion engine (ICE) vehicles. I would support banning all consumer vehicles that do not achieve a minimum (real world) 30 mpg by 2030, 40 mpg by 2040, and 50 mpg by 2050 (or something like that). Why are SUVs exempt from the same strict fuel economy standards of sedans? Why don't we have in the US the kind of hybrid vehicles that exist in the UK and Europe that achieve well over 50 mpg? Forcing EVs on all consumers I don't believe will ultimately work. EVs are sufficiently attractive in their own right that I believe consumers will naturally gravitate toward them as consumer choice, performance, and relative costs all improve. Ban low mpg vehicles rather than forcing EVs on everyone.

I support efforts to re-shore manufacturing and mining to the United States. At a minimum, domestic manufacturers should not be at a disadvantage from weaker labor and environmental standards in other parts of the world. I am not an expert on the best way to level the playing field other than to observe it is not level today (an obvious example is solar panel manufacturing in China).

This is not meant to be an exhaustive list of government policies that I support (and in some cases don't support). As I have noted in prior posts, while I favor as small of a government involvement in our lives as possible, I do not support anarchy and there is a clear need for some amount of laws, rules, and regulations in order to meet societal goals.

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⚡️On a personal note…

If you haven't been, I would highly recommend visiting the Ronald Reagan Presidential Library & Museum in Simi Valley, California. Admittedly, its only the presidential library I have visited. Its been a while but I recall my favorite part being the opportunity to walk through Air Force One.

I am too young to have had the opportunity to vote for President Reagan, but am grateful for everyone that did. I would sign up in a heartbeat for a future equivalent Reagan-H.W. Bush-Clinton run of presidents. Growing up in the pre-Reagan 1970s, I don't think anyone saw the end of the Cold War and collapse of the Soviet Union coming within a decade as it did. I also don't think anyone saw 1970s energy crisis conditions ending in the 1980s either. There is hope for the 2030s!

Super-Spiked publisher visiting the Ronald Reagan Presidential Library & Museum in 2016

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⚖️ Disclaimer

I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue.

Regards,

Arjun