Peter Jones: North Sea oil is a risky business

Mark Carney has warned about the risks to financial stability of stranded reserves. Picture: WPA/Getty Images

Scotland got hit by the financial crisis, are we now about to get hit again by a carbon crisis? The phrase “carbon crisis” may not mean much to many people, but if it unfolds as some people think it may, the impact on the Scottish economy may be as bad, perhaps even worse, than was the case with the financial crisis. Even Mark Carney, governor of the Bank of England, is concerned about it.

The path to this crisis began with the question of climate change and the need to reduce the amount of carbon dioxide being pumped into the atmosphere. That entails cutting our consumption of fossil fuels. This will bring change to economies and financial markets, particularly those markets aiming to direct investment into the most productive parts of the economy to earn the best return.

Unfortunately, sometimes overly large sums get invested in a part of the economy which then turns to dust instead of the anticipated gold – a bubble followed by a burst.

This is what happened in the financial crisis. Ingeniously designed mortgages enabled people previously unable to buy houses to get into the property market, driving house prices up. Then when the ingenious bit ended – usually a low-payment period of two years – lots of poorer people could not meet the higher payments and they defaulted on their loans.

The lenders, rather stupidly, assumed that ever-rising house prices would enable them to get their money back after repossession. But as the house price bubble had burst, much of their money was lost. Banks went bust as a result, including our own dear Royal Bank of Scotland and HBOS.

Now the same economic fundamentals are operating in the oil and gas sector. Rising demand for the industry’s products (in fast-growing China and India, for example) coupled with supply disruptions (such as the Arab Spring) to push prices up five years ago.

Investment seeking to cash in on high prices poured in, eventually increasing supply – and then growth in China slowed, suppressing demand, causing the oil price bubble to burst from inflated $100+ per barrel levels to less than $50 per barrel.

This, however, is not the carbon bubble that environmentalists have been talking about. They are talking about the analysis that limiting global warming increases to 2C means burning only a limited quantity of the world’s known fossil fuels reserves.

Since fossil fuel companies’ value has some relationship to their exploitable reserves, it follows that if they cannot extract everything, they may be over-valued and due to take a tumble. This is the carbon bubble they argue is due to burst.

And now it is not just environmentalists. In a speech to insurers Lloyd’s of London – and preferring the term “carbon budget” to “carbon bubble” – Mark Carney said: “Take, for example, the International Panel on Climate Change’s estimate of a carbon budget that would likely limit global temperature rises to 2C above pre-industrial levels. That budget amounts to between one-fifth and one-third of the world’s proven reserves of oil, gas and coal.

“If that estimate is even approximately correct it would render the vast majority of reserves ‘stranded’ – oil, gas and coal that will be literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics.”

Mr Carney’s speech was about risks to financial stability and no central bank governor, especially not Mr Carney, refers to things as being risks without being pretty sure the danger is real.

And, as I have said, there are signs that recent investment in oil and gas is following the path of a classic bubble. Accountants Deloitte reckon oil and gas firms raised $850 billion in new capital between 2009-13, a stonking 27 per cent of all non-financial firms’ capital raising.

But ominously, their free cashflow over the period was about $150bn less, and that was in the high price years. And this spending is only a fraction of total fossil fuel capital expenditure, estimated by the International Energy Agency to have been $950bn in 2013 alone.

This is a risk to financial stability, because much of this spending is borrowed money. Now not just low prices, but also investor worries about increasing climate change regulation and rising public antipathy towards fossil fuels mean there may not be the earnings to meet repayment schedules.

Up to mid-September, 19 small independent US oil and gas producers had filed for bankruptcy this year and as many again look to be close to the edge. While the big oil majors are a long way from that, investor fright is signalled by, for example, BP and Shell losing a quarter of their market value over the past year. Big coal producers have lost even more – mining giant Glencore has lost nearly four-fifths of its value since it was formed by merger in 2013.

That may be just caused by worries about deeply depressed prices, but from what I read, several hundred investment funds, worried about climate change and carbon budgets, have pulled out of fossil fuel investment.

Bankruptcies and lost share values mean banks, insurers, and pension funds losing money, and that risks causing financial instability in the same way they lost money when sub-prime mortgages went sour.

For Scotland, the risk is that investment stays away from oil and gas, pushing the North Sea industry downhill faster than anyone has expected, causing the loss of tens of thousands more highly-paid jobs – something the economy can ill afford.

Of course, it may not happen, Russia’s intervention in Syria may de-stabilise the Middle East even further, causing oil prices to rise. Or it may not. And if there is a price rise, investors may forget their misgivings and return to the sector. Or they may not. And the international climate change conference starting in Paris in a few weeks’ time may result in stiff regulatory action to curb fossil fuel consumption. Or it may not.

Whatever way things go, running an oil and gas company currently is clearly a high-risk business. That in itself is not good news for Scotland, for what investors crave is certainty, low risks, and decent returns. None of that looks likely to be had from the North Sea in the near future.