Will oil cause the next global recession?

Could changes in energy use and geopolitics make fossil fuels a dangerous bet for banks? 

Sign Up

Get the New Statesman's Morning Call email.

In February, David King travelled to Dallas, Texas, to address a group of oil barons on the future of energy. During his trip, the scientist was concerned to observe temperatures drop to well below zero, something that very rarely happens. He was further concerned to hear that the temperature in the North Pole was hovering around the zero degrees mark – warmer than Texas.

In 2004, during his tenure as chief scientific adviser to the government, King famously declared climate change to be the greatest threat facing the world, greater even than terrorism. Fast forward 14 years, as the Northern Hemisphere reels from one of the strangest summers in living memory, and that statement no longer seems dramatic at all, and – evidently – King has not stopped worrying.

“I believe, just to put my position clearly,” he tells Spotlight, “that globally we have about ten years to make all the right decisions on emissions, and in that ten years we will be taking decisions for the future of civilisation over the next 10,000 years.”

Luckily, King is an optimist – “I have to be, in this game” – and he believes that a transition from fossil to renewable fuel is already underway, and will quickly escalate. But this necessary energy transition, he warns, poses a different global risk: recession. “The big risk for the global economy,” he explains, “is all the continued investment by the fossil fuel industry in new fossil fuel industry infrastructure, because they’re borrowing from banks to do it, and the debt won’t be repaid because those industries will not be able to function in that way.”

Historically, King explains, banks have always loaned great sums of money to oil companies because they tend to be very good at paying it back, due to the sheer size of the industry: “they have such an enormous marketplace.” King believes that when the world inevitably switches completely to green energy and cuts out dangerous sources such as oil, the industry will be hit with a shock unlike ever before, default on its enormous debts, and bring down a number of banks. When it comes to bank loans, he claims, energy companies are the greatest corporate borrowers. “There is no global industry that matches up to the oil industry … clearly companies like Google and so on are pretty big, but they are not engaged in borrowing money in this way.”

In 2014, the price of oil did crash. It plummeted from $100 a barrel, to just $27 by 2016. Between 2004 and 2014, when the price was rising steadily, the amount of debt owed by junk-rated energy producers grew by 11 times, to $112.5bn. In 2016, oil and gas loans accounted for 2.4 per cent of Bank of America’s total lending, at $21.3bn, and Morgan Stanley was the most exposed of the big banks, at five per cent of its red book. As a result of the crash, energy companies defaulted on over $13.1bn of debt. It was caused by a sudden drop in demand, but the crisis King is predicting is of a far greater scale; one he believes has the potential to tank the global economy. “I’m not talking about oil price volatility. I am talking about the end of the road for the oil industry.”

Bob McNally has a different take on things. The former energy adviser to President George W. Bush – an administration King once accused of “failing” to tackle climate change – and former adviser to Republican hopefuls Mitt Romney and Mark Rubio “in no way” sees a transition to fossil fuels taking place in his area of expertise, transport, in the coming decades.

Transport, McNally points out, has always considered electricity. “The first vehicles that graduated from horse and buggy were electric, and in 1900 or so I think data shows about a third of cars were electric.” But oil rose to the top because it was cheaper, easier to store, and it’s not as high in demand in other sectors: “oil won out for largely commercial reasons.” In the UK, the government is budgeted to spend £124m on electric vehicle grants from 2018-19, and in the US, the government hands out $2,500 – $7,500 in tax credits on each EV bought, part of what McNally calls “a rich history of wasting a lot of money in unsuccessful attempts to make electricity commercially viable”. But if someone can find out how to make the electric car battery compete with the internal combustion engine – not just commercially viable, but profitable – then that, he says, would be a “goldmine”.

In McNally’s view, if/when a meaningful transition from fossil to renewables takes place, it will be the private sector leading the way, and it will be doing so because it makes commercial sense. In the US and the UK, when it comes to major investment decisions, “the oil industry does not take orders from policy officials”.

So, bank exposure in the context of an abrupt switch to green energy is not something that keeps McNally up at night – “I don’t think it’s a big problem” – but that’s not to say he isn’t concerned about bank exposure in general. “Were there to be a shock to the oil industry of the type [King] is describing, absolutely the banks that are exposed through contagion could easily cause a global financial crisis and economic slowdown.” It’s for the precise reason that the banks are so vulnerable to oil downturn, he says, that “governments will not induce that shock” by imposing a wholesale transition. “They will not forcibly bankrupt the oil industry.”

McNally describes how, for the last 15 years, the world has been living through an era of boom-bust oil prices, in which supply and demand has been peaking and plummeting in far shorter cycles, creating shocks like the one seen in 2014. He views the recent return of “authentic” boom-bust oil cycles as “a much bigger risk to the bank balance sheets” than any transition to green energy, and to the global economy in general. King calls oil price volatility “infamous” because “it has so many ramifications”. A glance at the news will tell you that we are living in through an age of geopolitical flux, which presents a serious risk to oil stability.

In Venezuela, which in 2016 was the tenth-largest producer of oil, the economy has crumbled. The country faces 1,000,000 per cent inflation. Iran, the fifth-largest producer of oil, has just been hit with a fresh round of economic sanctions by Donald Trump’s administration. These and other developments caused alarm in oil markets and sharply increased demand. Until a few weeks ago, the price of oil had risen by over 25 per cent in 2018, creating the possibility of hitting $100 a barrel before the end of the year. This run-up in the price of oil sent jitters through the market that the price could once again tumble.

Compounding this, the journalist Jamal Khashoggi was murdered in the Saudi consulate in Istanbul on 2 October, triggering an international diplomatic crisis. “There’s no question,” says McNally, “that the Khashoggi affair poses a grave threat to the US-Saudi relationship, and everyone ought to be concerned about that … It’s a big problem.” Saudi Arabia, until it was recently overtaken by America, was the biggest producer of oil in the world, and has been acting as “swing producer” – cutting or increasing its oil production to stabilise oil prices.

Recently, observers have become concerned by the ruling House of Saud’s reluctance to play this role, but McNally thinks that both Saudi Arabia and Russia – another oil-producing giant – have now been “scared straight” by the events of 2014-16. During the crash, the Saudis declined to cut production until OPEC (the Organization of the Petroleum Exporting Countries) was eventually forced to do so, and Saudi Arabia had to take a “big hit”, according to its oil minister, to prevent a full-blown crisis. “They have been burned by experience; we’ve all been reminded about how extremely volatile oil prices can be when supply and demand is unbalanced and there’s no swing producer,” McNally concludes. As a result, he is predicting that the Saudis and Russia will unite to become joint swing producers, and bear the responsibility together. “I think the Saudis are still determined not to be the only swing producer … they want to build on this temporary relationship they’ve had with Russia, and say: ‘Look – we’re back to balancing the market. We’re going to ensure stability; we’re working with Russia this time.’”

In recent weeks, the price of oil has dropped considerably – Brent crude has dropped by $20 a barrel since the start of October – partly due to the US issuing waivers to its sanctions against Iran, meaning less oil is being removed from the market than expected. McNally wonders whether, in the face of this price drop, Saudi Arabia might avoid implementing “big, high-profile production cuts” in order to drive the price up once again “for fear of angering the United States” over the Khashoggi affair; the US wants the price of oil to come down so as to please American motorists. But despite Khashoggi, the Saudis have pledged to cut production in 2019, and the announcement has sent prices rising once again. The power of oil to define international events is evident. “Oil is the livelihood of modern civilisation,” says McNally. “It is the tail that wagged the dog of the global economy and global geopolitics, and when that is volatile, it threatens to destabilise everything else – including the banks that are exposed to it.”

Some banks have taken steps to cut ties with the industry. HSBC has committed to ending its funding of new oil sands projects, the World Bank – 1-2 per cent of whose $280bn lending portfolio was allocated to oil and gas projects – will end its support for extraction within the next two years, and BNP Paribas made a similar pledge last year. And this time around, McNally thinks the banks that do invest are being more careful when it comes to committing money. “Oil prices recently rose to $80 a barrel, and oil companies haven’t done as well, because investors and banks are like, ‘wait a minute, we’ve seen this movie before!’ You’re starting to see some caution and discipline.”

A report entitled Banking on Climate Change, produced by a group of six American climate pressure groups, found that of the top lenders to non-renewable producers, 21 banks reduced (often marginally) their lending to producers in 2017, but 14 increased their support. According to the report, the Royal Bank of Canada (the second-largest lender) increased its lending from $4.173bn in 2016, to $13.011bn in 2017, and JPMorgan Chase (the third-largest lender) from $7.598bn to $11.645bn. In fact, bank support overall for the “largest extreme fossil fuel companies” in 2017 came to $115bn, which was 11 per cent higher than in 2016, fuelled largely by a huge increase in bank lending to tar sands oil extraction projects.

The report found that in 2017, “financing levels went in the wrong direction”, making it a year of “backsliding for banks”. Bloomberg reported at the start of 2018 that “speculative-grade debt” from junk-rated energy companies was experiencing a rapid increase in value due to the rise in the price of oil; bonds from companies nearly wiped out by the 2014 crash were reporting returns of nearly 50 per cent.

The road to a fossil-free future seems long, but as hard as it may be to envisage a switch to green energy, King’s confidence is understandable; will governments really stand back and watch as the world descends into climate chaos, and their citizens die? “What’s happening to the global weather systems is a big wake-up call,” he asserts. “Fossil fuels have actually been very bad for our health over all these years – I certainly remember smogs in London … the drive towards clean energy is also a health-driven issue.” Nevertheless, he admits that “the demand for oil and gas around the world is increasing all the time … we’re now approaching two billion cars on the planet” and producers are still heavily investing in new extraction infrastructure. The recent green light for fracking to take place in the UK is just one example.

As for the next recession, if he doesn’t think it will be caused by energy transition, would McNally care to throw his hat in the ring? His is the “unified theory”, which is the theory that the next recession is not far away because “the usual suspects at the scene of a recession are starting to show up.” By the “usual suspects”, McNally is referring to interest rate hikes by the Federal Reserve – “the rise in short-term rates or tightening of monetary policy; that’s the first suspect” – large trade disputes, especially the one currently raging between America and China, “a rapid fall” in emerging market currencies such as the drop recently experienced by Turkey, and last but not least: a big run-up in oil prices.

Over-exposure of the banks to such an unreliable and fluctuating – not to mention environmentally damaging – commodity can only serve to produce yet more insecurity in the global financial system, as it prepares itself for the next inevitable beating, whenever it arrives. “The stars are aligning,” warns McNally. “In a bad way.”

Augusta Riddy is a Special Projects Writer at the New Statesman.