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Financial meltdown -- the implications for energy


The latest chapter in the US financial crisis has started to claim victims in the energy world. US investment banks were/are active in many energy markets around the world, from European power and gas to crude oil derivatives and the physical delivery of jet oil and gasoline.


But Bear Stearns has been consigned to history, Lehman Brothers is bankrupt and Merrill Lynch taken over. Even the stronger of the US investment banks, Goldman Sachs and Morgan Stanley, have suffered a crisis of confidence.


Traders are naturally wary of doing business even with those institutions that have survived. There are now fewer counter parties to trade with and ample evidence that trades with the survivors are being closely monitored or unwound.


A decline in liquidity in the energy markets where these banks were active appears certain; there are simply fewer counter parties today than at the beginning of September and there is less appetite for risk.


US utility Constellation Energy has also run into problems, although this appears to be collateral rather than systemic damage. Constellation already had financial problems, but the recent bout of turbulence undermined its recovery plans, forcing it into talks with potential buyers.


It seems likely that energy companies with existing weaknesses in their financing strategies, particularly those dependent on credit lines to investment banks, will encounter problems.


The broader question is where the US financial crisis will leave commodities as an asset class. Commodities might still benefit; they may be volatile but they are not 'toxic', in the way that collateralized mortgage bonds are.


Yields on government bonds are likely to stay low, while the likelihood of a bear market in stocks and shares means commodities may still look attractive as an asset class.


But how free will trade be? Energy trading was already under fire in the US as many blamed 'speculators' for the rise in pump prices. While this issue has taken a back-seat, the war between 'Main Street America' and 'Wall Street America' has only just begun.


A crisis of such proportions cannot but lead to a swathe of banking reforms, but how deep will the regulatory broom sweep? 'Light touch regulation' is certainly out of fashion.


Then there are the wider macroeconomic implications. Part of commodities' allure was fundamental long-term demand growth, but that outlook too has been shaken.


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The argument prevalent only a month ago that the US economy would prove resilient to the economic downturn has taken a battering. And the argument that non-OECD growth has its own independent dynamic has been shaken.


The economic outlook in the US does not look bright; falling home values, a weak stock market, rising unemployment, combined with inflationary pressures, is eroding consumer confidence.


The government's own rescue package will create a huge burden on the state finances, suggesting tax rises rather than fiscal expansion. The outlook for the US economy has deteriorated, and with it the OECD more generally.


Less economic growth means less demand for energy. A more pronounced recession will mean projections for energy demand growth will contract. It also suggests expectations for future prices will fall, which is a major element in sanctioning projects.


For the last five years, rising material costs have been balanced by a buoyant price outlook. Materials costs are still rising, but the demand and price outlook are now much more uncertain.


The deteriorating economic outlook will add to a much tougher lending environment. If the cost of finance rises, and requirements for lending become more stringent, then the energy industry is likely to suffer. The scale of investment required to meet growing world energy demand already runs into trillions of dollars, according to the International Energy Agency.


Tougher financial conditions make a shortfall more likely. Lower energy prices will hit companies ability to finance projects from their own balance sheets. Oil majors' current capex is possible not because they have expanded production -- they haven't -- but because prices are high.


Projects more dependent on capital costs will suffer disproportionately. It is harder today to ask for money for a new nuclear plant than it was at the start of September. Moreover, the cost of power sector decarbonization is already a major issue and one that now looks harder to resolve. Emergent low-carbon technologies like carbon capture and storage are highly capital intensive and still unproven.


At the other end of the market, small companies researching low carbon technologies such as hydrogen and solar may well find their funding sources squeezed. More conservative, risk-averse lending strategies are likely to create more of a bias towards market favorites such as gas-fired generation plant and wind.


Meanwhile, revisions to future price expectations will hit a range of marginally economic technologies first, such as second generation biofuels, wave power, or oil projects at the high end of the price spectrum, like Arctic or pre-salt drilling.


The possibility of lower energy prices has always carried risks; a short-term and short-sighted decline in investment, a reversal of the focus on energy conservation and efficiency, and delays or even the abandonment of bringing new low-carbon technologies to commerciality.


However, the impetus behind climate change policies is unlikely to abate, so while heavy demands will still be made on the energy industry, its financial ability to respond will be weaker. In terms of mitigating climate change, it will make an already hard task even harder.


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