Economy:

McGuireWoods' Schewel discusses impacts of financial downturn on energy project lending

What will the economic crisis and financial bailout mean for the future of energy projects? Do certain industries have more to lose? How will cleantech projects, oil and gas development, and carbon capture-and-storage research fare as a result of the economic downturn? During today's OnPoint, Michael Schewel, a partner at law firm McGuireWoods and an energy project financing expert, gives his take on the effects of the financial downturn on investments in the energy sector.

Transcript

Monica Trauzzi: Welcome to the show. I'm Monica Trauzzi. With us today is Michael Schewel, a partner at McGuire Woods. In his practice, Michael focuses on the development and financing of energy projects. Michael, nice to have you here.

Michael Schewel: Nice to be here.

Monica Trauzzi: Michael, with the financial crisis in full focus, there's a lot of uncertainty relating to energy project investments. Which energy sector do you see as the most vulnerable heading into the next few years, in terms of investments and capital?

Michael Schewel: Monica, I'm not sure that I would categorize them so much as sectors as sort of maybe sub-sectors. For example, I think projects that have merchant risk associated with them, so that there's not a strong off-taker from a project, I think, those kinds of projects are going to have a hard time. I think projects that need a lot of debt financing, by definition, could have a hard time depending on who the credit is, because there's just fewer banks lending and they obviously have plenty of problems in terms of their own lending issues. I also think that there's a risk that projects that are depending on federal money, either in the form of subsidies or grants, could also be at risk given the huge federal cost of the current bailout. Now, that's something we don't know yet how that will play through all of the various other types of projects that the feds now fund. But I think that's worrisome.

Monica Trauzzi: OK, we're going to walk through all of the industries that we cover here at E&E and we're going to get your take on it now.

Michael Schewel: OK.

Monica Trauzzi: Renewable energy projects, that's something that's been in full focus this year. The tax incentives were finally passed at the end of this session of Congress and one would think that the renewable energy industry would be celebrating; a lot of people are concerned though about what this economic downturn could mean.

Michael Schewel: Well, there's still a lot of interest in renewable energy projects. There's a lot of equity chasing in those projects, but, unfortunately, there's not a lot of debt available. And so what you see are projects that can be funded with higher levels of equity getting done, projects that require more debt having a harder time getting done, and projects that require lots of tax equity. There's not much of a market for tax equity out there these days, so projects that are very tax equity dependent are going to have more trouble. But, overall, it seems to me that renewable energy is likely to do OK, particularly for projects that have a strong off-taker. So, for example, if a developer of a wind project or a developer of a geothermal or solar project, that has contracted to sell that power to a strong utility, I think those kind of projects are going to get done with relative ease compared to the market in general. That doesn't mean they'll be easy, but projects that really are selling just into the market, have a merchant risk associated with them, I think they'll have a lot of difficulty.

Monica Trauzzi: Let's talk about gas prices, because as a surprise to many, they've actually gone down in recent days. Many people believe though that once the dust settles oil and gas prices are going to continue to climb. What do you see as the short-term and long-term prospects for oil and gas prices and how might this tie into offshore drilling projects that are being pushed by many in Congress?

Michael Schewel: Well, it seems to me that my ability to predict oil and gas prices is probably as good as everybody else's, which means not very good. But it does seem to me that with the economy of the U.S. and other countries being very slowed down these days, that's going to put downward pressure on the prices of oil and gas until those economies start to perk again. So, I think, in the short term those prices will be down relatively flat, certainly compared to where they were last year. On the other hand, I believe that the inevitable trend will be up simply because those are resources with who knows whether the oil has peaked or not, but certainly oil is getting more expensive to get. Natural gas trades a distinct discount oil in terms of Btu value, so you would have to expect that natural gas will rise. Natural gas seems to be the natural intermediate fuel to meeting the U.S.'s electricity needs. It seems to me there's going to be general upward pressure on prices over time.

Monica Trauzzi: Yeah and we've seen some trouble in the natural gas sector in recent days with Chesapeake Energy, which is the nation's largest natural gas producer. They announced that they're going to be making cuts this year and next year. In addition, one of their major shareholders sold off a bunch of shares, 94% I think of his shares. So what are you expecting in terms of the future of natural gas? And it's sort of being touted as this interim fuel, is it going to really be able to live up to that if prices continue to climb?

Michael Schewel: I think it will, but I think one of the things that happens with Chesapeake and some others is that when prices were high they bought reserves which are relatively expensive compared to where prices are today. So then the question is how long will it be before they can actually realize an economic return from those resources? But, to me, it seems that certainly in the intermediate and long-term, that the story for natural gas remains strong for the very reason you mentioned, which is as an interim fuel to get the United States and perhaps other countries from a fossil fuel based electricity production to clean coal or renewable based electricity production, nuclear or whatever the outcome is, down the road. And so how do we get there? Well, natural gas would seem to be one of the ways to bridge that intermediate-term gap and it seems to me that over time the price of natural gas will rise as a result.

Monica Trauzzi: With DOE restructuring its FutureGen project there were already many questions about the future of carbon capture and storage technology. There's also a lot of regulatory uncertainty dealing with that technology. Does the financial crisis further complicate things for investors in that area and for final deployment of this technology?

Michael Schewel: I think it does for a couple of reasons. First of all, to get from where we are in carbon capture and sequestration to where we need to be it seems to me it inevitably will require a substantial investment of federal funds. We simply don't have the technology perfected by any means yet, so one of the key things is the federal funding for that. Well, as I said at the beginning, I think it's unclear what the future is for federal funding of many types of energy resources when we now have these competing claims for federal dollars through the bailout and for other projects related to a faltering economy and tax cuts associated with that. So, I think that's sort of the big question in terms of the deployment and the development of that technology. But the other thing is, you know, one of the good drivers, one of the economic values associated with carbon sequestration is enhanced oil recovery. Well, when the price of oil is at $140 a barrel then it's worth it to spend extra money to get every drop out of your oil wells. However, if the price falls, I think today it's $75 a barrel, well, every drop of oil is exactly half as valuable. So, what you're willing to do to the value of that enhance recovery is commensurately reduced. So I think that the financial and economic crisis that we're in now has a detrimental impact on the prospects for at least the immediate deployment of carbon capture and sequestration. Over time, of course, just as gas prices, I think, will rise, oil prices will rise. That should work its way through the system and, hopefully, the feds will realize that this is something that you have to spend money on now so that when the time comes to really deploy it that we have the technology really buttoned down.

Monica Trauzzi: But does this mean that a project, that maybe a technology that would have been available say 20 years from now, before the financial crisis, might need 30 now?

Michael Schewel: Well, I hope it's not 30 because we can't wait for 30 years. But I think it could slow it down. I think that's certainly possible.

Monica Trauzzi: OK, let's talk about biofuels. There was a lot of concern earlier in the year that investment in second-generation biofuels would take a hit because of all that we were hearing about the food-to-fuel issue and all the issues with corn ethanol. Are R&D projects and commercially-sized pilot plants at risk because of the financial crisis, in terms of biofuels?

Michael Schewel: Well, I think they have a couple issues. First of all, to the extent that the viability of biofuels depends on federal subsidies, as I was mentioning before, I think all issues like that at least have an element of doubt to them at the moment. And, of course, in the case of biofuels there's the whole, as you mentioned, food-to-fuel issue, which I think isn't an additional subsidy issue. The two other problems for biofuels are that, of course, they're selling as a substitute for either gasoline or diesel. As the price of gasoline and diesel fall, then those commodities really determine the price of biofuels to a large degree. So suddenly biofuel makers are faced with falling prices for the product they make. Now, if the price of corn falls in the price of soy falls at the same rate, then that's not the end of the world. But if they are selling product at a lower price, but having to buy fuel and their feedstock, then it could be a real problem for them. I think the other thing is that oftentimes biofuel plants, at least often, not always, they don't have a committed off-taker for all their output. Sometimes they do, but not always. Sometimes they're selling into a market in which they're selling it at essentially market prices and buying corn or soy oil at market prices. As I was saying before, I think merchant risk is one of the things that is going to create problems for owners. I think that lenders are going to be less comfortable with merchant risk. I think that will be true on the biofuels side, just as I think it is on the electricity side.

Monica Trauzzi: What's your take on how the financial crisis will impact the prospects for climate change legislation in the U.S.?

Michael Schewel: I've been pondering that question, and I think there's sort of two countervailing factors in play. I think the question is which one is going to predominate? The first factor in favor of -- that I think will help the prospects for carbon legislation is that when the price of energy is very high and carbon legislation is seen as an additional cost to energy, then I think that is a detriment to the likelihood of passage. Now, energy prices have fallen substantially. I think in some ways that makes it easier to pass carbon legislation because it won't create such an additional charge on the cost of energy that people will go, wow, it's even higher than it was before! I think the countervailing factor and maybe even the stronger factor, and this is what you're seeing starting to happen in Europe and also in the United States, is that as the economy falls, anything that's seen as an additional cost on the economy, as an additional burden on the economy, suddenly starts looking less politically attractive. So, for example, Governor Patterson in New York has recently made a number of statements that would suggest that New York is considering its participation in the RGGI initiative in New England. In Europe, the Germans, the Pols, a number of other countries have started to question the degree to which they're going to participate or what exceptions they want in the next round of carbon caps over there. So, you're starting to see the impact of the bad economy on this kind of legislation, both here and overseas.

Monica Trauzzi: OK, and talking about overseas, in terms of all the industries that we just discussed, are they feeling the heat overseas as well or are we feeling it more here in the U.S.?

Michael Schewel: Well, I think that on the financial side it's not that different. It's not particularly different in Europe than it will be here. On some of the things like natural gas, I think it's a little bit different because we tend to produce more natural gas here than maybe they do in Europe example. So, in terms of in general though, at least in Europe, and I'm not speaking so much for the Middle East or for Asia, in Europe it seems to be fairly similar to what's going on in the U.S.

Monica Trauzzi: OK, we're going to end it right there. Thanks for coming on the show.

Michael Schewel: OK, thank you for having me.

Monica Trauzzi: And thanks for watching. We'll see you back here tomorrow.

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