electricity and natural gas provide a strong incentive to switch away from oil. This process is already happening and faster than many people think. And, just like coal, the impact will be more global and more permanent than what the large majority believes today.
Yet another example is how solar has impacted the electricity market and taken over peak capacity in countries like Germany. See Chapter 14 for more details.
The effect of these forces and competition ultimately results in winners and losers. And along the process, perhaps the major beneficiary of the flatter energy world is the consumer. Just like the internet revolution.
As discussed before, the bubble played an important role in the development of new technologies, the overcapacity, and the availability at cheap prices. But bubbles are complex processes. When do they accelerate, when do they peak, what triggers the burst?
“We are fine. We do not need to be bailed out”16 said the Finance Minister of Portugal in 2009. And it may have well been true, when, at that time, Portuguese credit spreads were at 2 % and they could finance themselves. Under those market conditions, Portugal was solvent.
But not everyone believed it, and investors in Portuguese debt started demanding higher and higher returns for the risk they were taking. Downgrades by rating agencies such as Standard & Poor's, Moody's, and Fitch compounded the problem. The cost of borrowing increased, and servicing the debt started to become a problem. Portugal was still solvent, but the pricing dynamics were quickly deteriorating the “fundamentals” of the country. The process started to accelerate into a “vicious cycle” that fed on itself. Higher credit spreads resulted in higher servicing costs, which in turn would push credit spreads higher, until, eventually, the yield of the 10-year bond reached 8 %, a level regarded by many as the “tipping point” when a country's finances become unsustainable. The price of the bonds collapsed as the yield exploded above 15 % within just a few weeks.17 Prices had impacted fundamentals. Portugal was no longer solvent.
“We have agreed to a bailout package”, said the same Finance Minister. Was he lying a few months before when he said the country did not need a bailout? Well, not necessarily. Portugal was solvent, but vulnerable to higher rates and refinancing needs. Should the price path had been different, Portugal might have not needed to be rescued. But the reality was different.
And the “domino effect” that had “knocked out” Iceland, Greece, Ireland, and then Portugal, repeated itself once again and brought Spain and Italy to the brink of collapse. It took decisive action by Mario Draghi, President of the European Central Bank (ECB) to support the euro “by all means possible” and the introduction of the LTRO (Long Term Repurchase Obligation) programme to contain the negative spiral.
Once under control, the process reversed and through a virtuous cycle, the 10-year Spanish bond, having been at 7.5 % in the summer of 2012, reached historical low levels in December 2014. Enough to swing a government from solvency to insolvency.
These reflexive relationships also exist in the energy markets.
The “quiet revolution” in North America, the Fukushima nuclear crisis, ongoing geopolitical tensions in North Africa and the Middle East, and monetary easing have all contributed to the large price divergences that act as the catalyst for change and impact fundamentals.
Look at the super-spike in oil prices in 2007. In previous times when oil prices have risen dramatically, panic takes over. Even if the disruptions are expected to be short-lived, the mindset impacts governments, consumers, and of course, the media. People dust off Hubbert's peak oil theories (even if they have been debunked many times over) and subsidies and incentives are provided to guarantee the security of supply. To respond to the situation, the investment machine takes over. In Europe, between 2007 and 2010 around 3 % of the Eurozone GDP was devoted to large infrastructure and energy projects based on “security of supply”. In parallel, oil-producing countries devoted another 2 % of their GDP to new sources of generation.18 Combined, the expansion results in overcapacity and excess power generation to meet expected growth and needs until well over 2020.
How much capacity will be built this time? Where? How fast? The answers will shape the future of energy prices, not only from a cyclical point of view, but also on a more structural and permanent basis. Just like the 1970s resulted in the displacement of crude oil from power generation forever.
In the early stages of the subprime crisis in North America, as Alan Greenspan and others were dismissing the potential impact of the crisis, I came across a very interesting poll that asked mutual and hedge fund managers “Which inning are we in?”, a baseball analogy in reference to “are we closer to the beginning, middle, or end, of the crisis?” The answers were very polarized. Some believed we were at the eighth inning (closer to the end), while many others thought we were at the second inning (closer to the beginning).
Yet, the crisis went on to unfold into one of the global recessions in modern history, much further than many had anticipated, showing how market participants and industry experts can disagree on basic issues as “which inning are we in?” With the benefit of 20/20 hindsight, everyone today is familiar with the magnitude and main reasons for the crisis. But back then it was not so obvious.
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