"The Financial Case for Fossil Fuel Divestment," The Institute for Energy Economics and Financial Analysis
The world economy is shifting toward less energy intensive models of growth; fracking has driven down commodity and energy costs and prices; renewable energy and electric vehicles are taking market share; litigation on climate change and other environmental issues is expanding; and campaigns in opposition to fossil fuels have matured and are a material risk to the fossil fuel sector. Taken together, the risks suggest that the investment thesis advanced by the coal, oil and gas sector that worked for decades has lost its validity. If the industry continues with aggressive acquisition and drilling activities going forward it likely lead to more losses for investors, but to pull back and acknowledge lower future returns and more modest growth patterns only confirms the problems the industry confronts. How the industry will resolve this is uncertain, but for individual and institutional investors it is time to reconsider investments in the fossil fuel sector.
Investors who are seeking to understand climate risk need first to understand that the fossil fuel sector is no longer a “blue chip” investment in which investors can expect steady, powerful growth in cash and value. The value portion of the stocks, as reflected in the reserve portfolios, is no longer a guarantor of future profitability. The cash flow of the companies is now key, and is tied to an increasingly volatile sector with downward pressure on price and, more importantly, profits.
Like any business, the oil and gas sector’s fundamental financial health hinges on three critical variables: the total volume of products the industry sells; the cost of producing those products; and the prices it receives for its products.
Yet for years, global investors believed that a fourth factor was just as critical for an oil or gas company’s long-term financial prospects: the size of its hydrocarbon reserves. According to this investment thesis, global oil and gas production was the fuel for and synonymous with economic. Growth would inexorably lift prices, revenues, and profits for the oil and gas sector. Price spikes and price troughs and the trajectories of rising and declining prices had a specific financial function, with spikes providing capital to support more growth. As the global economy grew, demand for oil and gas would periodically collide with supply constraints creating periods of price volatility. The industry, when challenged by conditions to innovate scientifically and technologically, would make improvements and navigate any political conflict.
Companies had to be prepared to deliver returns in any investment climate. The key was to maintain an abundant portfolio of oil and gas reserves. Investors supported large acquisition budgets as part of the long-term bet they made on the industry, and they treated reserves as a key metric of long-term value.
This investment thesis succeeded for decades, and many investors simply assumed that new reserves, even those acquired at great cost, would ultimately yield handsome rewards. Driven by this factor, oil and gas executives placed a high priority on steadily restocking reserves through a combination of exploration, acquisitions and creative accounting. And they bet big on high-cost oil projects tar sands, arctic drilling, and deepwater extractionthat required decades of high prices to recover the initial capital costs.
During the early years of the shale boom, the oil and gas sector doubled down on the reserve growth thesis. Small and midsized E&P companies entered bidding wars for shale oil fields and paid high costs to drill and prepare new wells for production. Pipeline companies piled up debt to build (and often overbuild) new oil and gas transportation networks to service the vast amounts of oil and gas that the industry was preparing to produce. The industry quickly gained experience and confidence in coaxing oil out of basins that had previously been dismissed. And Wall Street long accustomed to viewing oil reserves as a key metric of financial value flocked to the sector.
But even as the oil and gas industry and investors poured money into the shale revolution, the production boom it had unleashed was steadily upending the investment thesis that equated oil and gas reserves with long-term value.
Fracking undermined the old reserve-based investment thesis in two ways. First, it eroded the assumption that global oil and gas supplies inevitably would be subject to periods of constraint. Burgeoning oil and gas output in the U.S along with hints that fracking technology could spread globally rendered old estimates of total global reserves meaningless. And if oil and gas were not in short supply (at least on a time frame that mattered to Wall Street) investors could not rely on reserves as a gauge of long-term value.
Second, the price collapse caused by the new abundance of oil and gas actuallydestroyed the economic value of many reserves. Accounting rules define proved reserves in both geologic and economic terms: a reserve represents the amount of oil and gas that could be profitably extracted at expected future prices. But as expectations for future prices fell, many so-called reserves became unprofitable. This forced the industry to “de-book” many reserves and write off many investments as worthless. The result was a seeming paradox: oil and gas production was soaring even as whole segments of high-priced reserves were rendered valueless.
As the old, reserve-focused investment thesis withered, the oil and gas sector was gradually becoming just another commodity, subject to the same short-term financial concerns about prices, profits, cash flows, debt, dividends, and asset quality as the rest of the global market.
Yet by the metrics of financial success that apply to other mature industries, much of the sector had been chalking up dismal results for years. Even when prices were high in the early part of the shale boom, many companies spent more to acquire and develop new reserves than they were earning from production. To sustain their capital spending while maintaining robust dividend pay-outs, the sector borrowed heavily from the debt markets. For any other mature industry, this sort of debt-fuelled spending spree would have set off warning bells. But the old reserve-focused investment thesis fuelled investors’ belief that profligate capital spending would ultimately yield handsome profits, letting the sector off the hook, at least for a while.
The elevation of cash flow, rather than reserves, as the key metric of value in the oil and gas industry is forcing a comprehensive re-evaluation of the sector’s financial health. Investors increasingly view oil and gas companies even the supermajors such Chevron as speculative investments whose fortunes are intimately tied to the ups and downs of commodity markets.
And now that cash flow matters to investors, oil and gas prices matter. The direction of oil prices, and the specific effects of prices on revenue and profit, increasingly determine how investors evaluate oil and gas companies. And unfortunately for the oil and gas sector, there are financial and political risks at both ends of the spectrum.
The results of the low-price environment have been on display for the past several years: a sharp decline in revenue, reserve write-offs, poor stock market performance, numerous bankruptcies and defaults, and a general decline in public and investor confidence. Expectations of a prolonged low-price environment also have forced companies to move aggressively to cut costs and curtail capital spending.
At the other end, high prices could offer a reprieve of sorts for oil and gas companies through higher revenue. But higher prices tend to tamp down overall demand and run the risk of strengthening competing resources. Prices for clean renewable energy resources already are falling fast, and any increase in oil and gas prices simply improves the economic competitiveness of the alternatives.
In addition to price risk, oil and gas executives now face a confluence of forces some continuations of past trends and others newly emerging that will continue to pressure the industry’s finances in the years ahead.
As mentioned above, investors once had a clear (if not necessarily accurate) idea of how oil and gas companies would generate profits: prices would steadily rise, and even expensive projects would eventually yield handsome returns. The shale boom, and the accompanying price collapse, has undercut that idea, but no new investment narrative has emerged to take the place of the old one.
A broader backdrop is creating both policy and market challenges for the coal, oil, and gas sector. The nature of economic growth is shifting from energy intensive manufacturing and industrial models to more service oriented, higher technology models with lower energy intensity. This is a global phenomenon. Mature economies are growing, most having already made significant investments in lower energy sectors. High growth, emerging markets now have significant incentives and opportunities to reduce energy costs to facilitate growth rates.
ExxonMobil’s most recent Energy Outlook estimates that the fastest growing countries by GDP through 2040 will be China and India. They also will be the countries with the most rapid declines in energy intensity. More broadly, non-OECD nations will grow faster than OECD nations and will do so with declining energy intensity. Older economies, like the U.S. and Europe, already have lower energy intensity, which will continue to improve even as their economies grow, albeit at slower rates. The trend toward lower energy costs and more energy innovation tilts away from fossil fuel investment that is largely inflationary, volatile, and disruptive to national economic growth strategies.
The absence of a coherent, industry-wide value thesis that incorporates these broader trends places investors at a true disadvantage. Successful oil and gas investing now requires expertise, judgment, an appetite for risk, and a strong understanding of how individual companies are positioned with respect to their competitors both inside and outside the industry. Passive investors could once choose from a basket of oil and gas industry securities with little reason to fear they would lose money. Today, that is no longer the case, pushing passive investors into other blue-chip stocks with stable returns.
Fossil fuel companies depend on rising demand to keep supplies tight and prices rising. In this context, even small losses in market share to renewables or electric vehicles could have outsized impacts on both oil prices and profits. Renewables offer key advantages over coal and gas, including both climate benefits and freedom from energy price fluctuations. A growing renewables sector is poised to steal market share from gas, keeping energy prices in check and diverting capital investments away from fossil fuels. In the U.S., wind and solar already have begun to put downward pressure on natural gas prices and demand in the electricity sector.
Globally, wind and solar energy have grown at levels that far exceed expectations. For example, BP’s chief economist recently apologized for a mistaken forecast, underestimating the speed of the energy transition, particularly in India and China. In the U.S., wind and solar energy growth is running about 40 years ahead of the Energy Information Administration’s market growth estimates.
The growth of wind and solar is based on its highly competitive pricing structure. Record-low auction prices for solar and wind, as low as 3 cents per kilowatt-hour (kWh), make headlines regularly, and are reported across the globe, from India to Chile. At these prices, solar and wind are lower than generation costs of newly built gas and coal power plants. Based at least partly on competitive prices, new solar PV capacity around the world grew by 50% in 2017, with solar PV additions growing faster than any other fuel. China accounted for almost half of this expansion.
Meanwhile, the auto industry a key driver of oil demand increasingly sees its future in electric vehicles. GM, for example, plans to launch up to 20 new all electric vehicles by 2023, and a top executive stated that the company “believes in an all electric future.” Ford announced a pivot toward becoming a “mobility company” rather than a car company, saying that its future is now in “smart, connected vehicles, including…electric vehicles.” Last fall, Volkswagen announced that it would invest $84 billion in electric cars, including massive new battery factories. Nissan, Toyota, Daimler, Teslathe list of major global car companies that have made big bets on EVs goes on and on. And perhaps most important, electric vehicles have made major inroads in the Chinese market. The growing technological successes of autonomous vehicles also could speed the transition to EVs, further crimping petroleum demand.
The risks to fossil fuels from electric vehicles have grown relatively slowly, and so market share capture has been easily dismissed by the fossil fuel industry. Bloomberg New Energy Finance has presented the chart below showing the quickening rate of market absorption of electric vehicles. The rise of electric vehicles creates significant market share and other business risks for fossil fuel sales.
Although the pace of change is quickening, there remains substantial debate within the business community about the rate and trajectory of electric car displacement of fossil fuels. Market indicators during this period of transition produce results that point to growth in the electric vehicle sector and general weaknesses in the fossil fuel sector. The storyline is not a straight or smooth one, as the two industries vie for market share.
Figure 1: Electric vehicle sales are accelerating
The growing global climate protection movement has emerged as a material financial risk to the oil and gas industry. In addition to traditional lobbying and direct-action campaigns, climate activists have joined with an increasingly diverse set of allies particularly the indigenous rights movement to put financial pressure on oil and gas companies through divestment campaigns, corporate accountability efforts, and targeting of banks and financial institutions. These campaigns threaten not only to undercut financing for particular projects, but also to raise financing costs for oil and gas companies across the board.
Although U.S. federal climate policy is in a period of retrenchment, climate and fossil fuel activism continues to score major policy victories around the globe, creating profound and growing policy challenges for the oil and gas industry. Recent victories by activists opposing Kinder Morgan’s Trans Mountain pipeline reflect the impact organized opposition can have on projects, even projects that have already incurred expenses of hundreds of millions of shareholder dollars. Despite Kinder Morgan dropping its ownership of the project, and the government of Canada agreeing to purchase it, the controversy is likely to be protracted.
Great Britain, France, Norway, Scotland, and China have all proposed phase-outs of conventional gasoline and diesel vehicles. Jurisdictions as varied as India, California, Germany, and the Netherlands may follow suit. At the same time, many nations and subnational jurisdictions have enacted carbon prices that could dampen demand for carbon intensive fuels.
The fossil fuel industry faces huge litigation risks, including class action suits that seek to quantify investor losses. These lawsuits are the result of company and industry-wide mismanagement of climate change and other social and environmental issues. The current approach being taken by fossil fuel companies does not contribute to the climate problem, nor does it make the issue go away from a narrow company perspective. As the citizen efforts noted above grow, so too will calls for litigation.
Fossil fuel company management has dug in deep when confronted with litigation. The strategy exemplifies management’s ultimate recalcitrance to address climate risk and profitability in a transitioning energy future. The industry, led by the U.S based oil majors, has a contentious relationship with law enforcement as illustrated by its aggressive tactics in responding to lawsuits filed against it. For example, a standard industry defense has been to claim it is a victim of a political vendetta, which should not be settled in court but should be settled through public policy initiatives. Another tactic is to counter-sue opponents. Still another tactic involves denouncing and impugning the motives of public officials, including those who are responsible for issuing municipal bonds.
Litigation efforts span a range of issues that directly relate to climate in some instances, and to broader corporate financial problems that have a more indirect linkage to climate. State attorneys general have focused on oil company disclosures regarding carbon emissions and on how companies value their reserves, and cities are organizing lawsuits to make damage claims against oil companies, similar to those made against the tobacco industry. Class action efforts are looking at investor damages, with others looking at investor suits targeted at the efficacy of any fossil fuel investments. In addition, individual country suits have been filed against oil companies for false claims, and indigenous people’s suits asserting tribal rights.
Combined capital expenditures (capex) for the oil and gas industry are expected to approach $500 billion in 2018an increase over the last three years, which featured capex freezes and cutbacks. Some companies are placing caps on these expenditures, even though the levels have increased, while others see rising prices and a reduced production cost environment as reasons to move forward with more acquisitions. This suggests a cautious optimism in word, and a potential new wave of investment in practice. As many companies have expressed the need to improve dividends and payments to shareholders in the current environment, the increase in capex spending may intensify overall pressures on company financial performance.
Looking forward, some companies may very well chooseunwiselyto put more dollars into upstream projects for the oil side of their businesses. Companies will expose themselves to further risk if they pursue such a traditional “oil is growth” scenario. Natural gas investments look more sustainable because of the growth in that market. However, selling natural gas at such low margins decreases industry and company profitability. Many petrochemical companies are searching for some sort of balance in the volatile world of oil and gas prices and the related pressures in the markets for specialized refined products.
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