Sovereign Funds Should Sell Off Oil Assets
It's easy to see the oil and gas asset sell-off proposed by Norges Bank Investment Management, the entity that runs Norway's $1 trillion sovereign wealth fund, as a bet on the hydrocarbon industry's long-term decline. Indeed, Siv Jensen, Norway's finance minister and the proposal's addressee, predicted such a decline in a conference speech on Friday. But there's a better reason for oil-based sovereign funds to change their thinking.
Economist Sony Kapoor, whose think tank, Re-Define, has long campaigned for the Norwegian Government Pension Fund's oil and gas divestment, laid it out in a report published in 2013:
Because the Fund gets new money from the sale of oil and gas every year, its final value (when the oil runs out) is very highly dependent on the price at which it is able to sell this oil. This means that the Fund has a large negative exposure to policy actions that need to be taken to tackle climate change. Any increase in the rise of the price of carbon emissions or restriction in their quantity will have a negative impact on the final value of the Fund. Despite this large exposure to carbon, the GPF continues to invest heavily in oil and gas majors, which account for three out of its ten largest investments.
Four years later, the fund's managers accepted the argument. In their letter to the finance ministry, they write that regardless of how hydrocarbon assets will perform in the future, the double exposure -- through the revenues that flow into the fund and through its investments -- increases the risk that the rainy-day fund is supposed to mitigate. They point out that, at 4 percent of the fund's value, its investments in oil and gas stocks are twice as high as an index-based approach would have allowed -- but these equities are far more sensitive to oil prices than the stock index.
The double exposure to oil fluctuations isn't limited to Norway. Of the world's 20 biggest sovereign-wealth funds, 11 are oil and gas-based. Their portfolios are generally not transparent, but research has shown that they've tended to overinvest in hydrocarbon-related stocks. A 2013 paper by Bernardo Bortolotti of Bocconi University in Milan and his collaborators put the share of total sovereign fund investment in oil and gas at 7.1 percent -- twice as much as financial investors from the same countries generally put in these industries. That share is roughly consistent with a 2010 paper by University of Michigan's Surendranath Jory and collaborators.
In 2008, University of Miami's Vidhi Chhaochharia and the International Monetary Fund's Luc Laeven wrote of an oil bias that was "particularly strong for SWFs from oil producing countries." "The fact that the home countries of some of the largest SWFs are major oil exporters could explain the relatively high share of investments in oil and related industries," the researchers wrote, suggesting that sovereign fund managers tend to invest in they understand best.
It doesn't really matter if one believes that oil is going out of fashion, as salt once did as a valuable commodity. The members of the Organization of the Petroleum Exporting Countries -- the United Arab Emirates, Kuwait, Saudi Arabia, Qatar, Iran, Libya -- have built up some of the biggest sovereign funds, don't think so. In its long-term outlook, published earlier this month, the organization predicts that by 2040, global oil demand will increase by 15.8 million barrels a day, implying an average growth of 0.7 percent a year. Though all the growth is predicted in the developing world -- demand is expected to fall in the rich nations -- that alone shouldn't be a reason to divest hydrocarbon assets. But investing in the industry that feeds the fund is not a good approach from a risk management point of view.
It's also a bad idea from a development standpoint. The sovereign funds have different stated goals -- from macroeconomic stabilization to funding pensions once oil runs out -- but it's always useful to see them also as vehicles for expanding a nation's horizons. Even if a fund invests overseas to prevent the Dutch disease, it's wise and forward-looking for it to invest in industries a country would like to develop at home. With investment comes access to technology and exposure to promising markets. Kapoor of Re-Define advised the Norwegian GPF to go overweight on sustainable energy to align the fund's activity to the Norwegian government's climate goals. Middle Eastern nations don't have to take this advice, but their efforts to diversify their economies could only benefit from diversifying their sovereign funds away from oil and gas.
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Mike Nizza at email@example.com