Three years ago, interest rates hit an 800 year low, if you believe the interest rate mavens after having declined steadily for 42 years. Just recently, interest rates hit a 16 year high. Something of interest to bankers, investors and financiers? Yes, but also of importance to the energy industries. Here is how.
1. The rise in interest rates changes the investment horizon of oil and gas companies— During the long period when borrowed money cost almost nothing, energy companies could commit themselves to long-duration projects that would not produce revenues for many years. Borrowing money to fund the projects cost next to nothing. Now, having money tied up in non-producing properties hurts because the borrowed money has a real cost. So, forget about that multi-billion dollar project to build a drilling platform and pipeline from the North Pole to open in 2040. Instead, buy oil companies that have just opened oil fields or have ready-to-drill properties. That might help to explain the recent mergers announced by Chevron and ExxonMobil. Long-term costs money.
2. Cost of equity capital goes up—Cost of capital consists of a risk free return (bond yield) plus a return for risk (the equity risk premium). In three years, the cost of equity capital (what stockholders demand) has risen roughly five percentage points, we calculate. Projects can raise money if their prospective return exceeds a hurdle rate (usually at least the cost of capital). Now that the hurdle rate has risen, many formerly attractive projects no longer look so good.
3. Cost of regulated and renewable assets will rise — Regulated assets (power and gas lines), nuclear and renewables (windmills and solar) require big investments of capital compared to facilities that burn fossil fuels. Thus higher cost of capital disproportionately affects costs for those assets. Take note of the cost problems of some wind projects and the rate increases requested by utilities. Related: Top German Court Voids $65 Billion of Government Climate Funding
4. Price of securities declines—Utility and infrastructure company common stocks serve as substitutes for bonds because investors demand yields on those stocks that are in line with what they could earn on bonds. From September 2022 to October 2023, the yield on short term Treasuries rose from 3.9% to 5.1% (31%) and the price of utility stocks fell 25% in the same period. Thus, utilities that need to raise money to expand or update facilities will have to sell more shares when raising money, which diminishes the attractiveness of existing shares.
5. Technology startups and private equity deals look less attractive— For years, tech companies with no products could raise money almost indefinitely from investors, but now these investors can earn a good interest rate on funds, so they will be more reluctant to wait forever for returns. Private equity funds borrow at a low-interest rate in order to buy assets (for which they often overpaid). Now they cannot borrow at next to zero rates, so deals look less attractive. For the energy sector, it probably means fewer energy tech start-ups and fewer acquisition deals for energy infrastructure.
Overall, higher interest rates mean that energy companies will pay more to borrow money, which means that consumers will pay more for those companies’ services, and the companies will focus more on the short term. Not the end of the world, except, maybe for those who made extra low-interest rates the key to their business strategies.
By Leonard Hyman and William Tilles for Oilprice.com
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