Joseph Schumpeter, the Austrian Finance Minister and Harvard professor coined the term ‘creative destruction’ in the 1940s to describe a ‘process of industrial mutation that incessantly revolutionises the economic structure from within, incessantly destroying the old one, incessantly creating the new one.’[i]
This process is now widely recognised as an essential and valuable feature of capitalism, recognisable across the economy as new technologies and business models displace older versions. The shift from mainframe to personal computers, from photographic film to digital and from CDs to MiniDiscs to MP3 players are all contemporary examples of creative destruction in action.
Creative destruction in hyper-drive
The process of creative destruction though is arguably in hyper-drive at the moment as whole swathes of industry are disrupted by novel technologies. A substantial proportion of this is driven by digitisation which is undermining business models in advertising, the media and education to name but a few. This story is well-known and understood. But there is an equally profound dislocation happening in the power and energy sectors driven by the arrival of low carbon and high-efficiency technologies.
This is perhaps most visible in the electric utility industry in Germany which, over the last few years, has seen a rapid shift in its structure. Traditional large-scale fossil fuel generators are being displaced by renewable generation capacity, principally solar and wind. This new generation capacity, particularly solar, has destabilised the utility business model by undermining midday power demand and pricing, cutting hard into the excess returns that utilities had previously earned at this time of day. The impact is clear in the share prices of these businesses with Eon and RWE, Germany’s two dominant electric utilities, having endured share price declines of 50% and 70% respectively over a five year period while the wider German index has risen by nearly 40%.[ii]
The process of creative destruction is also visible at a sectoral level as value migrates across different parts of the global economy. Figure 1 shows just how markedly the composition of the MSCI World has changed over only a seven year period from 2009 to 2016. Energy in particular has fallen precipitously from 11% of the index to just 6.4%. Materials too has fallen from 6.6% to just over 4%.
Figure 1: Composition of the MSCI 2009-2016[iii]
On the other side of the ledger, consumer discretionary stocks have increased significantly from 9% to over 13% as has healthcare (up from 9.7% to 13%) and information technology (11.4% to 14.3%). Interestingly financials have hardly moved at all – 2009 was a low year for financials but the sector has recovered only marginally – though is still the largest sector at 20% of the index.
As thematic investors these changes are important reflections of broader change taking place in the economy. Some of this clearly has the fingerprints of digitisation on it such as the extraordinary growth in ‘Internet retail’ which has been the fastest growing sub-sector in consumer discretionary as consumers have shifted their purchasing on-line.
Changes are structural not cyclical
The collapse in the value of the energy and materials sectors are clearly related to the fall in oil and wider commodity prices.[iv] But the question of whether this is cyclical or structural is still hotly debated. Most financial analysts see it as cyclical with higher oil prices inevitable in the medium-term. Maybe – but there is more than an outside chance that the price declines, particularly in oil, are driven by structurally softening demand. According to analysis from the Bank of England, ‘around two thirds of the fall in oil prices over the last 6 months can be accounted for by demand-led factors’.[v] This includes weaker demand in China but also weak demand in the OECD. US oil demand has rebounded somewhat from a trough of 18.4 million barrels of oil per day (million b/d) in 2012 to about 19 million b/d in 2014-15. But even at these levels, it is only back to levels from the late 1990s having reached a peak in 2005 at over 20m b/d. And meanwhile the economy has grown by 50%. According to the World Economic Forum, the vast majority of the avoided oil consumption in 2014-15 has come from more efficient transport with the remainder coming from a reduction in miles travelled.[vi]
Meanwhile the fall in the coal price, initially driven by declining demand for metallurgical coal in Chinese steel-making, has more recently been further exacerbated by weakening demand for coal in power generation in large part due to fuel switching from steam coal to cleaner natural gas and renewables.[vii]
It may seem outlandish to suggest that the fossil fuel markets are in structural decline, and certainly this is the view of the industry itself. ExxonMobil’s recent long-term outlook on energy markets still sees oil as the world’s most important energy source in 2040.[viii] But we have been here before. In 1900 it would have been difficult to find a car on the streets of New York City, but by 1913 you would have been hard-pressed to find a horse.[xi] Change can sometimes happen very quickly. It already has in the German utility industry… and the global coal industry. As Mark Twain put it, “History doesn’t repeat itself, but it does rhyme”. We might just look back on 2016 not as another cyclical trough in the ongoing saga of oil and gas but as the beginning of the end.
[i] Joseph Schumpeter, ‘Capitalism, Socialism and Democracy’, Harper & Brothers (1942)
[iv] It is worth noting that even in 2009 the average spot price was around $60/bbl.