Summary
- Occidental neglects demand fundamentals in its 2°C analysis and opts for the foregone conclusion of a test against oil and gas prices higher than today’s, undermining the request outlined by shareholders last year.
- Occidental only models the impact on proven reserves. However, it is the lower confidence reserves and non-reserve resources that carry the greatest risk.
- The company uses an internal carbon price, but it is likely to have a limited impact on upstream sanctioning activity and shouldn’t be seen as a panacea.
Last year, shareholders in Occidental Petroleum (“Occidental”) voted for the company to test and disclose how it would fare in 2°C world. On Friday 2 March, Occidental aimed to relieve investor concerns with its inaugural climate report titled ‘Climate-Related Risks and Opportunities: Positioning for a Lower-Carbon Economy’. However, its lax approach and scant detail present cause for concern.
Recognised reference
Occidental has provided an assessment using the decarbonisation scenarios published by the International Energy Agency (IEA): 2017’s Sustainable Development Scenario (SDS) and the preceding 450 Scenario (450)[1]. These third-party scenarios provide users with a reasonable and sufficiently detailed framework for comparability, and are commonly-used reference points[2].
However, the approach adopted by Occidental falls short on two main counts: reliance on the commodity prices provided with those scenarios instead of demand fundamentals, and limiting the scope of its assessment to proven reserves.
Scenario prices – a poor substitute for demand fundamentals
Occidental are not the first company to pass off a comparison with the IEA’s modelled prices as a serious test. However, given the impossibility of reliably modelling future oil prices, we do not think that using these prices alone represents a defensible proxy for falling demand.
While the IEA derives these prices using internal reference points for supply and demand, in practice these long-term price assumptions to 2040 have a tendency to lag the current spot price. Moreover, there is no way of knowing whether the underlying assumptions are the same as in Occidental’s analysis and hence whether using the two together is an “apples with apples” comparison. For example, the IEA might be using higher supply costs than Occidental, which would result in an inconsistent outcome with a price that was relatively too high.
One may also note that the prices prevailing in the IEA scenarios are higher than those that have prevailed in recent history or longer-term averages. If prices in a scenario where oil demand is falling at c.1 mmbbl/d per year are higher and less volatile than the present when oil demand is growing at c.1.5 mmbbl/d per year, that does not seem like a particularly stringent or realistic test[3].
The significance of performing downside stress tests is not to argue over whether the price assumptions are correct or not, but for management to demonstrate that they are giving appropriate consideration to possible downside risks. Occidental’s management have shown a lack of seriousness in this regard.
Narrowing the scope – testing proven reserves only
Occidental thus concludes that the 2°C scenario has minimal impact. However, it limits the scope to its proven reserves, which generally tend to relate to near term or already producing projects. We would broadly agree that the volume risk to proven reserves is limited (although they remain subject to price risk); the greater risks are likely to be with future projects. These longer-term options are therefore of much greater interest for such a test, but Occidental is silent on this. How can investors satisfy themselves that Occidental won’t invest money in potentially stranded assets if it doesn’t include them in its analysis?
By definition, proven reserves are recoverable with reasonable certainty at existing prices[4], which are rather lower than the IEA scenario prices that Occidental use as a test.
Figure 1 – Delta Between Product Prices for Portfolio Analysis
Source: Occidental: Climate-Related Risks and Opportunities: Positioning for a Lower-Carbon Economy
That higher prices don’t represent a huge threat to already economic reserves is not exactly a revelation. If this is the extent of Occidental’s willingness to challenge its thinking – frankly, what was the point?
Limited impact of internal carbon pricing
Occidental’s current assets are not subject to a cost of carbon in their countries of location. In its report, Occidental state that from 2018 onwards an internal carbon price of $40 per tonne of CO2 will be assumed in its capital allocation process and for sensitivity testing. Occidental itself notes that this translates to only a $1.50 cost of carbon per barrel for its larger projects. Given the context of general commodity price volatility, this internal price alone doesn’t give confidence that climate risks are well covered. As we have mentioned in other publications[5], there is a risk that internal carbon prices may be misused as a proxy while ignoring other fundamentals.
Conclusion
The recent spate of climate-related disclosures from oil and gas companies has proven their usefulness in giving a window into managements’ thinking and the seriousness with which they treat downside risks; implications either way are instructive. Occidental’s report is similarly welcome on this basis. Occidental has taken some steps in the right direction by referencing the voluntary TCFD guidelines, and committing to regular assessments of its portfolio to climate-related risk.
But it is disappointing to see that Occidental has not attempted a genuine exploration of the questions raised by shareholders, and given limited indication that its capital planning and business strategy incorporates such long-term risks. If it is confident that its business is resilient, why not show this properly rather than palming shareholders off with the weakest of tick-box exercises?
We hope that management will address these fundamental issues in the next iteration.
Sebastian Ljungwaldh – Energy Analyst
Andrew Grant – Senior Analyst
Robert Schuwerk – Executive-Director (North America)
[1] The SDS replaces the previous 450 scenario in the 2017 World Energy Outlook. Both scenarios demonstrate a decarbonisation scenario of limiting global temperature rise to 2°C with a 50% probability, and the SDS further incorporates objectives relating to air pollution and energy access although they result in similar demand outcomes.
[2] Such as Chevron, see blog – https://carbontransfer.wpengine.com/chevron-takes-tentative-steps/
[3] See for example Exxon’s recent comment that declines in demand may sharply impact prices https://www.bloomberg.com/news/articles/2018-03-07/exxon-says-watch-for-oil-shocks-as-demand-becomes-market-driver
[4] In accordance with current U.S. Securities and Exchange Commission (SEC) rules, Occidental determined year-end proved reserves using arithmetic average of the first-day-of-the-month price for each month within the year for oil and natural gas.
[5] See https://carbontransfer.wpengine.com/time-machine-climate-risk-bringing-future-forward-2%CB%9Ac-scenario-analysis/
