Energy Musings - November 10, 2023

We have left the world of zero inflation and zero interest rates and entered the world of higher inflation and high interest rates. Business models and investment strategies will need to change.

Summary

Offshore wind’s financial troubles reflect the wrong business model for the new world marked by higher inflation and high interest rates.  Younger investors and company executives, and those with short memories, believe current interest rates and inflation are the aberration of history.  The reality is that 2008-2020’s era of zero inflation and zero interest rates was THE aberration.  That environment encouraged using large doses of debt to ramp up equity returns, especially for traditionally low-return businesses such as offshore wind.  To understand this new economic and financial world one must understand how much of the economic growth, large investment returns, and benign business conditions environment of the past 40 years was attributed to the four decades of declining interest rates.  There is no hope for another 2,000 basis point interest rate decline to propel outsized returns.  Using debt to magnify equity returns will prove a disastrous business strategy. 

Interest Rate Sea Change Explains Offshore Wind’s Problems

Everyone is talking about returning to “normal.”  What is normal?  It depends on the speaker’s financial interests.  Equity investors think normal is lower interest rates, reduced inflation, and growth stocks back in vogue.  Credit analysts see it as stable monetary and fiscal policy, stable inflation, and stable interest rates.  Corporate America thinks normal is a growing economy with low interest rates and inflation, and healthy consumers to buy their goods and services. 

We think their views of normal are based on an aberration in our economic and financial history.  These worlds are experiencing an economic sea change.  We have left a multi-decade era of declining interest rates, solid global GDP growth, and soaring stock markets.  The new era will be marked by higher interest rates, greater inflation, and slower GDP growth. 

Such a sea change means investors must invest differently.  Politicians need to rethink their policies.  Corporate executives need different business models with different balance sheets, growth strategies, and risk management.  Until all parties understand this sea change, watch for repeatable financial disasters.  The financial turmoil of offshore wind developers is merely the tip of the iceberg that will sink many more businesses and industries that fail to grasp the economic sea change. 

A year ago, we found our thinking about a different economic world in sync with a prior boss, Howard Marks, co-founder and co-chairman of Oaktree Capital Management, the largest investor in distressed securities worldwide. 

In December 2022, Marks released a memo he had sent to Oaktree clients titled “Sea Change.”  It began with a Grammarist’s definition: “sea change (idiom): a complete transformation, a radical change in direction in attitude, goals…”  

Sea Changes In History

In his 53-year investment career, Marks said he has experienced two sea changes.  Today’s evolving economy would mark his third.  The first sea change occurred about five years after Marks started in the investment industry.  It was the end of the fade of investing in the “Nifty Fifty” stocks, or the 50 companies considered America’s best and the fastest growing companies.  They were considered so good that nothing bad could ever happen to them.  Thus, investors believed there was “no price too high” to pay for their shares.  However, as Marks pointed out, if you bought the Nifty Fifty when he started at Citibank in 1969 and held them until 1974, you would have lost more than 90% of your money despite owning pieces of the best companies in America.  As he put it: “Perceived quality, it turned out, wasn’t synonymous with safety or with successful investment.” 

Another aspect of that sea change involved the bond market.  Historically, non-investment grade bonds (those rated double-B and below) were off-limits to fiduciaries.  But Michael Milken and his Drexel Burnham collaborators conceived of how to make them attractive: offer enough interest to compensate for the risk of default.  The result, according to Marks, was that “investment managers could now prudently buy bonds of almost any quality as long as they were adequately compensated for the attendant risk.”  In 1979, the U.S. high-yield bond market amounted to about $2 billion.  By 2022, it had grown to roughly $1.2 trillion in size. 

The development of the high-yield bond market, often referred to as junk bonds, ushered in a dramatic change in financial markets.  Companies could be acquired by others who did not have cash equal to the purchase price.  Buyers could turn to the high-yield debt market for the money necessary to acquire companies.  This change permitted the growth of leveraged buyouts and what is now called the private equity market. 

Marks summed up the significance of the evolution of the high-yield market for financial markets and investing in general in the following paragraph. 

However, the most important aspect of this change didn’t relate to high-yield bonds, or to private equity, but rather to the adoption of a new investor mentality.  Now risk wasn’t necessarily avoided, but rather considered relative to return and hopefully borne intelligently.  This new risk/return mindset was critical in the development of many new types of investment, such as distressed debt, mortgage-backed securities, structured credit, and private lending.  It’s no exaggeration to say today’s investment world bears almost no resemblance to that of 50 years ago.  Young people joining the industry today would likely be shocked to learn that, back then, investors didn’t think in risk/return terms.  Now that’s all we do.  Ergo, a sea change.  (Emphasis in the original.) 

At the same time investment industry changes were occurring, the macroeconomic world was changing.  For Marks, they began with the 1973-74 OPEC oil embargo, which caused the price of U.S. crude oil to jump from $4.08 per barrel in 1973 to a high of $15.04 in 1975!  That price explosion ignited rapid inflation.  The heavily unionized American workforce had contracts possessing automatic cost-of-living adjustment clauses.  They spurred wage increases, which exacerbated inflation and led to even more wage increases.  The price/wage spiral spurred strong inflationary expectations among consumers that soon became self-fulfilling.  Other people suggest the inflation era began with President Richard Nixon’s closing of the U.S. government’s gold exchange window which angered Middle East oil producers who led the oil embargo. 

The annual Consumer Price Index rose from 3.2% in 1972 to 11.0% by 1974.  It then retreated to 6-9% for four years before rebounding to 11.4% in 1979 and 13.5% in 1980.  The tools to fight inflation ranged from WIN (Whip Inflation Now) buttons to price controls to a federal funds rate that reached 13% in 1974.  President Ronald Reagan’s appointment of Paul Volcker as Fed chairman in 1979 and his determination to kill inflation by shocking the financial system led to a fed funds rate of 20% in 1980.  By the end of 1983, the inflation rate was back to 3.2%. 

WIN buttons were popular during Gerry Ford’s presidency but ineffective.

Volcker’s aggressiveness in fighting inflation later allowed the Fed to reduce the fed funds rate to the high single digits and maintain it there through the rest of the 1980s.  It then fell to the mid-single digits in the 1990s.  In Marks’ view, Volcker’s “actions ushered in a declining-interest-rate environment that prevailed for four decades…  I consider this the second sea change I’ve seen in my career.”  (Emphasis in the original.)