In the nexus of climate change and financial markets, disclosure is the flavour of the day.
Carbon Tracker recently analysed the volumes of disclosure produced by the oil and gas majors. There are several counter-arguments to the view that the low-carbon transition might be disruptive for an industry whose raison d’être is to extract and sell carbon. But amid those, some red herrings keep resurfacing.
1. “Our reserves will be produced within the next 15 years, during which there will be plenty of demand for oil and gas.”
This criticism of the “carbon bubble” thesis first emerged in 2014 and still persists. It generally follows: a) the largest oil and gas companies, at least, are valued principally (85-90%) on the cash that will flow from their proved reserves; b) their “proved reserves life” (proved reserves divided by current production) is only 10-15 years; and c) there will be sufficient demand for oil and gas over that period to need this supply. First, having 10-15% of your business exposed to long-term falling demand is not to be dismissed casually. Second, debates about fossil fuel demand are far from settled. Third, and most importantly, the argument distracts from two fundamental points.
Oil and gas companies strive to remain stable or grow; not decline. To do this, they must develop new sources to replace current production by continually reinvesting to find new “resources” – oil and gas prospects that have yet to be sanctioned but still hold value for shareholders. Today’s resources are explored and appraised to become tomorrow’s proved reserves. We estimate that, on average, the oil and gas majors have reinvested about 80% of their cash over the last five years. The key question for investors is will these investments produce economic returns? The value of proven reserves is only “safe” if companies pay out that the resulting cash to investors rather than recycling it.
Moreover, the counterargument looks simply at the volume of reserves, rather than the impact of short- and medium-term price volatility or the timing of production. A 10-year reserves life does not mean that all proven reserves will be produced in the next 10 years. A portion will be produced on a longer time horizon, exposing them to a decline in price that could be expected to accompany a decline in demand.
Recycling cash to reinvest in fossil fuels will lead companies into an environment of weakening demand and expose their assets to economic stranding. Confidence in proved reserves should not distract from the uncertainty for future resources.
2. “Using an internal carbon price ensures that our investments are resilient to the low-carbon transition.”
When it comes to company assessments of the potential business risks of the low-carbon transition, a favoured tool is the internal carbon price. This isn’t unreasonable, since carbon pricing is a preferred policy for disincentivising the consumption of carbon and it appears to be a simple proxy for the unpredictable impacts of the energy transition.
As ever, the devil is the detail. For oil and gas companies, 90% of their associated emissions come from consumers’ use of their products (or Scope 3); a minority come from the production of the oil and gas (or Scopes 1 and 2). Yet companies, generally, prefer to apply the carbon price only to the latter. This doesn’t make much sense. For companies that are in the business of selling carbon-based products, a carbon price would, theoretically, lower demand for such products, perhaps significantly so (and hence lower revenue received by the producer, due to both lower netbacks and lower volumes). It is this effect that oil and gas companies should be modelling.
We estimate that a US$40/tCO2 price – applied only to Scope 1 and 2 emissions – adds roughly $2 per barrel, assuming the company absorbs the entire cost. Carbon prices as they are currently applied provide undue comfort and no sense of the “stress” that the low-carbon transition might present.
3. “Our portfolio is resilient even to the IEA’s 2°C scenario.”
Companies are increasingly leaning on the IEA (International Energy Agency) for the stamp of approval on statements to reassure investors that a 2°C scenario doesn’t signal the end. However, look deeper and it’s clear that they are focusing on the wrong thing.
An oil and gas company’s capital expenditure will ebb and flow with the oil price. Risk lies in the possibility that oil and gas demand will significantly underperform the company’s expectation and depress prices below those for which the company has planned, providing insufficient returns on investments. One needs to look no further than the recent impairments that companies took based on downward revisions to future price expectations (see Shell and ConocoPhillips).
Whatever a company believes about future prices, it is nearly universally acknowledged that lower demand would lead to lower price expectations. Therefore, a company planning for greater than 2°C demand should not test against prices in a 2°C scenario that are higher than its planning assumptions.
The problem has already led to counterintuitive conclusions for some companies planning for oil demand to increase, where the value of their assets performs better under the IEA’s 2°C scenario (in which demand falls) than their base case simply because the IEA’s price assumptions are higher.
Don’t judge a book by its cover
Many oil and gas companies are trumpeting their long-term resilience. But the same red herrings continue to surface, and they distract from the simple logic that if your business model is centred around fossil fuels, you’re going to struggle to thrive in a low-carbon world.
Tom Drew – Regulatory and Policy Associate
Aurore le Galiot – Intern