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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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Are Low Interest Rates Bad For Energy?

Yellen

Money today costs practically nothing. A recent study out of the Federal Reserve Bank of San Francisco set the “natural“ rate of interest at about 0.5 percent, down from about 3.5 percent in 2000. The natural in-terest rate is economic jargon for a real rate of interest that does not interfere with stable operation of the economy.

In the United Kingdom, the natural rate is closer to 1.5 percent and in the Eurozone around -0.5 percent. Several European countries now issue bonds carrying a negative interest rate (the lender pays the borrow-er to take their money). In the old days we would have thought this was some type of reversal of the natural order.

Pundits blame the present ultra-low interest rate regime on the Federal Reserve or the European Central Bank. But we can also see low interest rates in classic supply and demand terms, too much supply of sav-ings (cheap money) and too little demand for it (potential investments). Unless either the private sector or government try to pick up this "slack" thereby increasing demand for funds, interest rates could stay lower for longer.

A low interest rate environment is also a tremendous advantage to builders of large infrastructure projects, like utilities. For an electric power generating station cost of capital is a significant part of the cost of producing energy, maybe 15-20 percent on average.

Related: Oil Prices Rebound On Falling Gasoline Futures

But for power generation not relying on fossil fuel (nuclear units, windmills, residential solar) capital costs make up almost half of total power costs. As a result, low cost of capital makes new non-fossil facilities more competitive with new fossil-fueled plant. The current low interest rate environment favors non-fossil power generation. Carbon emissions reductions that result can also be seen as an unexpected conse-quence of low interest rates.

We don't envy today's utility managers. They face an unfortunate truth. If interest rates are low, so is the return on new equity capital, typically several percentage points over Treasury bond yields. Investors will accept low (by past standards) returns because they have no alternatives of comparable quality.

A potential 6 percent equity return to shareholders (4.5 percent over the U.S. ten year), should find eager interest on the part of pension fund investors now receiving 0.1 percent interest on short term loans. Some banks in Europe charge you to keep your money and one firm considered storing cash rather than leaving it in the bank.

Related: Oil Under Fire As OPEC Head Sees No Deal

In other words, the expected return threshold for new investment should have crashed as well. Companies not investing due to “poor” return potential may be missing out on opportunities that would benefit share-holders and society. Minimizing new investment and concentrating activities on the old investments that earn higher returns may not work for long, though. New firms, willing to accept lower returns will move in and compete for business.

Low natural rates of interest favor renewables, nuclear power and other capital intensive businesses that benefit disproportionately from low cost money. Legacy investments made in a higher interest rate envi-ronment for the moment still offer relatively high potential returns to equity capital. The future rate is probably lower.

By Leonard Hyman and William Tilles

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  • JHM on September 21 2016 said:
    The authors fail to point out that low interest rates also support the price of oil. Low interest rates reduce the cost to carry oil in storage. So the incredibly large oil stock is held in place off market with low interest rates. When rates go back up, more of this oil will come out of storage and drive the price of oil down. Low interest rates both finance oversupply and the carry of that surplus. Unwinding low rates could be treacherous for oil.

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