Oil and gas companies: the carbon risk
We take a look at how investors can assess a company's overall exposure to carbon risk.
Fossil resources in a carbon constrained world
The stranded asset argument has raised new awareness of the carbon risk in the energy sector.
It lies in the idea that as carbon regulations strengthen and economies shift to low carbon models in order to limit global warming to 2°C, energy companies are likely to see a proportion of their fossil fuel assets remain in the ground, as illustrated by the Carbon Tracker Initiative in the figure below.
Research suggests that “a third of oil reserves, half of gas reserves and over 80% of current coal reserves should remain unused from 2010 to 2050 in order to meet the target of 2°C”1.
Coal, oil and gas reserves are likely to be impacted in various proportions.
Regulatory and technology push for a new energy system
The focus on reducing carbon emissions has led to the introduction of carbon pricing mechanisms in some countries and regions.
Consultancy firm Ecofys estimates that 12% of global emissions are covered by carbon pricing mechanisms2 – a threefold increase over the past decade.
In most of the world though, there is no cost to emitting carbon. We believe this is about to change.
Carbon cost mechanisms are likely to develop over time at local and national levels impacting more and more sectors.
Alongside carbon pricing, other headwinds to the fossil fuel sector include environmental regulation, technological advances or community opposition.
These factors will have direct or indirect impact on energy companies’ business models all throughout their value chain.
It is therefore becoming increasingly important that investors start factoring the cost of carbon emissions into their financial models.
Our aim in this sector analysis has been to assess the carbon risk companies face by building an indicator that reflects their overall exposure.
Cost and carbon pressures - economically or carbon stranded?
The oil and gas industry has been under cost pressure since the beginning of the oil price crash in 2014.
Firms have been forced to cut spending in less economical projects, reduce production costs, delay and lower the cost of exploration programmes and focus only on the most economical fields.
In the current oil price environment, and given the potential development of carbon pricing mechanisms, carbon intensive assets could come under even more economic pressure.
Citi believes that 40% of the current investment in oil would be stranded at oil prices below $75 barrel3.
The oil production cost curve in Figure 2 shows the variability of extraction costs per type of resources.
Goldman Sachs found that deepwater, heavy oil, oil sands and liquefied natural gas (LNG) projects were the most likely to be stranded in a low oil price environment because they are so costly to extract4.
On top of this, some research has also shown that the most environmentally sensitive projects such as Arctic drilling and oil sands are also the ones most at risk of remaining unexplored due to their high extraction cost profile.
According to the UCL study cited earlier, this has negative implications for projects in Alaska and Canada. Therefore companies exposed to these regions have a greater risk profile.
In this context, we think the industry needs to reconcile carbon- and cost-optimal drilling strategies.
Indeed, not only do fossil resources face environmental and regulatory issues, but portfolio high carbon content could become a competitive disadvantage to energy companies.
Low carbon resilience and the gas shift
The response from companies to the shift to a low carbon world has been to claim that natural gas should address most climate change issues given that gas is far less carbon intensive than oil.
Figure 3 shows how most oil majors have been moving towards gas extraction in the last 15 years.
However, we question how proactive companies really are in shifting their reserves towards future gas production.
Figure 3 shows some trend in the gas shift but production estimates for some of these majors in the next five years do not seem to indicate an obvious change (Figure 4).
Rather surprisingly the chart suggests a decrease of the share of gas in companies’ production mix. We believe there are a number of issues with these production forecasts:
- There may be mismatch between project pipelines (most are focused on oil) and global energy demand (which is shifting towards gas).
- Energy companies may be conservative when planning their share of gas in the production mix, or not proactive enough in promoting this resource as they aim for better return and profitability in the current market assumptions.
- Energy analysts may be misinterpreting companies’ strategies and future production mix.
- In our view, this means that the industry is not positioning itself to address the challenges of the low carbon shift.
Beyond gas: a carbon intensity portfolio view gives a carbon risk factor
The taxing of carbon emissions can have a direct, but more importantly an indirect, impact throughout an energy company’s value chain – from the cost of operating to the demand for, and value of, fossil resources.
Analysis of the carbon content of a company’s upstream production mix should enable a better assessment of their exposure to carbon risk.
We have developed a carbon indicator to measure this risk: we have aggregated the carbon emissions from the three main stages of fossil fuels’ lifecycle - the extraction and refining stages plus the emissions from the burning of fossil fuels.
We have used these estimates to analyse our investee companies’ portfolios. We can use this life cycle carbon factor as an overall indicator of energy companies’ risk exposure to the carbon shift.
We acknowledge the analysis is done on estimates. Indeed there is a distinct lack of available data both in terms of a company’s exact production mix by type of fuel (oil sands, heavy oil, tight oil, shale gas, liquefied natural gas (LNG), gas natural liquids (GNL) etc.) and actual lifecycle carbon emissions.
We strongly believe that more granular data will be needed for financial research to become more accurate in assessing the carbon risk of energy companies’ assets.
The estimates we have used are a good start however, and a helpful risk-mapping exercise.
From an investor’s perspective, we believe low-carbon portfolios should provide energy companies with better resilience to the shift of energy systems.
In the meantime, and in anticipation of this long-term trend, we suggest that a carbon risk analysis should be run against a capital spending efficiency analysis.
A two dimension analysis (capex per barrel produced vs. carbon content per barrel produced) should provide a better understanding of a company’s exposure to carbon risk.
1. The geographical distribution of fossil fuels unused when limiting global warming to 2⁰C, Christophe McGlade & Paul Ekins, Nature, January 2015, doi:10.1038/nature14016↩
2. Carbon pricing watch 2015, World Bank & Ecofys↩
3. Global perspectives & Solutions, Citigroup, August 2015↩
4. 420 projects to change the world, Goldman Sachs, 19 May 2015↩