Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

It is a reasonable bet that the $24 billion Hinkley Point C nuclear power project in the U.K., due online in 2025, will neither be ready by 2025 nor cost just $24 billion. Indeed, it's so reasonable that, as fellow Gadfly Chris Bryant lays out here, the stock market appears to be making that very same bet.

Leave aside the also reasonable conspiracy theories about London buttering up Paris and Beijing by approving the project and focus on the ostensible reason for doing it: maintaining security of energy supply.

That's been a big theme this week. On Wednesday, the International Energy Agency released a hefty tome concluding, among other things, that "the scale and speed of cuts" in upstream oil and gas investment mean we could be caught out by price spikes again, despite $583 billion in spending last year. As I've discussed here and here, it's curious that, despite this apparent need for investment, oil majors continue to pull back.

Hinkley Point actually helps explain why. Added bonus: The oil and gas industry's experience reveals one more insidious risk facing the nuclear project.

There's a reason EDF demanded the U.K. government guarantee an electricity price for Hinkley Point's output at double the current wholesale price. Financing a $24 billion project that won't produce a cent of revenue for a decade is really tough -- especially in an industry carrying as much historical baggage on busted budgets and timescales as nuclear power does. Subsidies and guarantees help bridge the risk gap.

Nuclear power isn't alone in this regard. Big Oil is undergoing a similarly painful lesson with liquefied natural gas, or LNG. On the whole, the oil majors have been completely wrong-footed when it comes to gas. They started out expecting the U.S. to run short of the fuel and joined a race to build terminals on the coast to import LNG from the Middle East. In the process, they missed the fracking boom that rendered such investments mostly moribund.

Exxon Mobil's case is illustrative. It was part of a project, Golden Pass, to build one of those import terminals, and then compounded the mistake by buying into the fracking boom just before gas prices collapsed entirely:

Let's Talk Timing
Exxon's major steps in U.S. LNG and shale gas have been repeatedly undercut by the market
Source: Bloomberg
Note: Generic 1st-month natural gas futures price.

This isn't to pick on Exxon; the energy business, with its inherent cycles and penchant for geopolitical drama, is replete with such examples. Chevron and Royal Dutch Shell have also been burned in LNG. The point is that the initial assumptions underpinning these endeavors can prove wrong -- and pretty quickly.

An interesting academic paper titled "Big is Fragile" lays out some of the risks facing large, complex investment projects. It focuses on dams, but its breakdown of the typical business case for these could apply equally to any pitch for a giant new power station or LNG project:

First, the business case outlines the massive electricity or water shortfall a country faces;

Second, the business case argues that the country possesses large untapped hydropower resources;

Third, the business case proposes that a big dam should be built on a site deemed to be particularly advantageous by experts. The business case goes on to argue that the proposed big dam will be a big increment in solving the electricity or water scarcity of the country;

Fourth, the business case cites technical studies which show that the big dam will be capable of quickly filling the gap between current market need and market supply and offer slack to meet surging future demand.

It goes on, but the main point is that mega-projects can prove vulnerable not despite their scale but because of it. They might extract savings on, say, procurement, but their inherent complexity makes it hard to apply lessons from previous examples to gain efficiency. That's one reason why, as this chart from the IEA report shows, unit costs for many LNG projects went up rather than down as capacity expanded:

Capture

And once a company is several years into building a new power plant or LNG terminal, the compulsion to complete it is enormous, due to the already huge sunk costs (and need to save face), even if budgets and schedules have been blown through or -- as was the case with fracking -- another technology has disrupted the market.

So, yes, U.K. ministers fret about how to keep the lights on if electricity consumption rises 20 percent over the next couple of decades. But if you want to see how long-range energy forecasts can pan out, look at expectations for U.S. electricity consumption in 2006 compared to what happened:

We Lost California (and Florida and Nevada)
The gap between prior and current forecasts of U.S. electricity consumption in 2017 is equal to the entire annual retail sales of power in California, Florida and Nevada combined
Source: Energy Information Administration

The most salient point in "Big is Fragile" -- and one highlighted to me by oil industry veteran Harry Benham of Carbury Consulting -- is that "fragility arises when big is forced into doing what was best left to the scalable."

In other words, if your concern is making sure the lights come on (or the gas burner or whatever) when and where you need it, then the best solution may not be a one-shot big fix but a series of small ones.

For the oil majors, the outsize impact and apparent efficiency gains of smaller, quicker shale projects stands in marked contrast to the problems associated with LNG and other mega-projects. That's one reason why investors' tolerance for the latter has dried up and why Chevron, for example, places more emphasis on its considerable shale assets these days.

The same applies to Hinkley Point, which, at 3.2 gigawatts, is big even for a nuclear plant. There are valid arguments for building new nuclear plants to produce electricity with zero carbon emissions. But even Third Way, a think tank that advocates strongly for new nuclear plants, has suggested smaller, modular ones could be key to any renaissance for the industry.

With energy technology in such flux right now, ranging from renewable power to batteries to energy efficiency, is there a high risk that a giant plant a decade or more away from completion becomes stranded? You bet.

There's one more lesson from the global gas business to consider here. Don't forget that most LNG projects and even major pipeline projects, such as Gazprom's trunklines to western Europe, were built with their own guarantees in place, be it oil-linked prices, minimum volume commitments or both. Yet, when the U.S. shale gas glut and changing demand patterns intervened, buyers' remorse, as well as leverage, took hold and many of those contracts were renegotiated -- even Gazprom's.

In Hinkley Point's case, of course, any future U.K. government wouldn't dare try to wriggle out of those high, guaranteed power prices for fear of enraging the French. Because that's never happened.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net