Is there a carbon bubble?


Climate change is for real. The well documented increase in global temperature levels, the link with greenhouse gases and the again well documented rise in atmospheric CO2 levels (the main greenhouse gas) should, for all practical purposes, no longer leave any room for doubt. The vast majority of earth scientists and engineers working for oil companies do not doubt and have not done so for a long time. What has changed is the perception. From one of many problems that the world faced in the 1980’s (famine, nuclear weapons, overpopulation, “waldsterben”) this one struck us a difficult problem but one that was far away, for our children and technological progress to solve. These days we have seen that the last decade was the warmest decade on earth recorded so far. The decade before that was the second warmest. The decade before that was the third warmest. We are all to blame. Or at least the two billion people or so responsible for most of the CO2 emissions.

IOC’s (international oil companies) accept that climate change is for real. Furthermore they do not close their eyes for technological breakthroughs such as the dramatic decrease in price for solar panels (hopefully followed by a similar development in energy storage). If oil companies have been reluctant to participate in wind power or solar power it is not that they underestimate these technologies, but rather that they do not want to be dependent on subsidies or feel that solar panel fabrication is not something they can become competitive in. If you are dependent on subsidies it greatly helps to be sexy and popular. Oil companies are not; something that is unlikely to change.

IOC’s see their strength in finding, producing and refining hydrocarbons. They expect that fossil fuel demand, for oil and gas in particular, is there to stay for several tens of years. Population and economic growth will add to demand. Increasing efficiencies, higher taxes or carbon pricing and the rise of alternatives (more easy in electricity generation, more difficult in transport) will reduce demand. The OPEC cartel of low cost oil producers and its key member Saudi Arabia have a long term policy of keeping oil prices high, a strategy that is unlikely to change. In a true free market we would only produce low cost oil. OPEC market share would be higher but OPEC revenues would be lower, given that oil prices would be dramatically lower (even compared to the $ 40 per barrel or so that we are currently seeing in late 2015). IOC’s accept that the oil and gas industry will become a sunset industry (perhaps later rather than sooner, but still). They would welcome a functioning global carbon tax system. In their view it would reduce uncertainties and create a more level playing field (more so than for a system of unpredictable government subsidies and other measures to promote renewables) from which gas, the cleanest fossil fuel, could profit.

Fossil fuels demand

Fossil fuels market share will in likelihood decrease. To what extent is quite uncertain, fossil fuels market share in 2035 ranges from about 63 to 80 % for different IEA scenarios (from current 81 %). The lower end member number is the approximate fossil fuel share for a scenario that (likely) limits global warming to 2 degrees (450 scenario). In this scenario the 2050 market share further reduces to about 50 %. The higher end member basically reflects business as usual (noting that fossil fuels market share over the last 40 years has hardly changed).

The high fossil fuels market share in 2035 for the IEA 450 scenario is a sobering thought and illustrates the magnitude of the challenge we are facing to limit global warming to acceptable levels. Even with a dramatic decrease of solar power cost and a concerted effort in at least some OECD countries (e.g. Germany’s Energiewende) we have only just started to materially reduce fossil fuels market share. Most inroads are being made in electricity generation – yet electricity currently only accounts for approximately 20 % of the total final energy consumption on a global basis.

fig 31

Stranded Assets

Many NGO’s state that stranded fossil fuel deposits imply a “carbon bubble” for stock market valuations of oil and gas companies (e.g. the Carbon Tracker Initiative).

Are there fossil fuel deposits that are stranded? When lumped together (coal, oil, gas; proved, probable, possible) that is a no brainer. Off course we do not want to burn them all. The resulting temperature rise will be significantly larger than what is deemed acceptable. Even a large, unexpected breakthrough in CCS (making it both cost effective and socially acceptable) would probably only reduce the amount of stranded assets.

But are we talking about coal, oil or gas? In this paper I want to focus on oil and gas and on the valuation of IOC’s. Are we looking at proved reserves, probable or possible reserves? Developed or undeveloped reserves (note that developed and proved reserves for a company are not the same, although it is expected that the numbers are similar given that most companies will not book proved reserves before FID has been taken)? Are we looking at low cost OPEC oil or high cost non OPEC oil (with a much lower reserve life)? The more meaningful question is: are IOC’s overvalued because their value estimation is based on assets that cannot be fully produced. If some existing assets cannot be fully produced, or if new assets can hardly be developed, and if investors would not be aware of this and attach value to these assets late production life, or to the ability of oil companies to find and develop new assets, then there could truly be a bubble.

So how about the risk that developed oil and gas assets are stranded? The figure below ilustrates that at least the developed oil and gas reserves of IOC’s are unlikely to be stranded – even for a 450 scenario that likely limits global warming to two degrees. The reason is simply the limited reserves that oil companies tend to have. Proved reserves vs production ratios of 10 – 15 are common. That in itself is a big problem for oil companies but is does imply that at least their developed assets can be produced. Different studies exist (one can vary the amount of oil, gas and coal that can be burned under a 450 scenario, the depletion rates of existing assets, etc) but the chance that a large part of existing oil and gas assets cannot be produced seems very low. Developed coal assets run a much greater risk. So do undeveloped oil and gas assets.

The question is not whether IOC’s developed / proved reserves can be produced. They can and will be. Future demand is a much greater question mark. Will developing countries really be ready to walk away from wealth generation by a phase of energy intensive growth fueled by low cost coal (thus not following the path that China has taken for the last 20 years). Will they feel adequately compensated by the developed world?

fig 32

Oil Company valuation

Proved, probable and possible reserves all have a bearing the valuation of an oil company. Proved reserves typically only account for 15 – 30 % of the total resource base of a company but also typically account for 80 – 90 % of the value of a company (a detailed overview can be found in a recent IHS report). That is not surprising, given that proved reserves are either developed or in the process of being developed (most companies require FID to have been taken). In other words: these are the assets were large investments have taken place in the past or are currently taking place. In general, the investments related to developing a field are much (typically 1 or 2 orders of magnitude) larger than the finding costs. Much less value is attributed to undeveloped, possible reserves and probably rightly so. For a long time the market has had doubts on the long term sustainability of IOC business models. That has been primarily based on the lack of access to cheap oil provinces and the difficulties that IOC’s have to replace reserves, even when spending vast amounts of money. More recently the advance of shale oil and climate concerns have started to play a role as well.

The value attributed to possible oil and gas reserves is at risk in a 450 scenario world. Long term lower than initially expected demand may result in more limited new developments. The ability of IOC’s to find and develop new oil may have less value. Given the limited value attributed to these reserves this seems unlikely to have resulted in a major bubble, however.

A carbon bubble being unlikely does not mean that the future for IOC’s looks that good. As I put it in a previous blog, IOC’s have been facing a number of issues for a long time:
– They have lost their edge in technical knowledge to smaller companies, service companies and, to a lesser degree, to NOC’s
– They have trouble replacing reserves given their lack of access regions with low cost, easy to find oil
– They are gradually becoming gas producers rather than oil producers, given the much greater geographic spread of gas reserves. Gas is likely to be systematically less profitable.
– They are not well suited (company culture, strengths) to profit from the US shale oil / gas boom.
– Many of the big oil and gas discoveries in other parts of the world have been made by smaller niche exploration companies

In addition we are now seeing that lower than expected demand (implying a downward pressure on prices) is there to stay:
– Lower growth of less energy intensive economies
– Carbon tax and other measures to reduce CO2 emissions
– Increased competitiveness of renewables, in particular solar, for power generation. Potentially further aided by developements in energy storage and fully electric vehicles

The relatively low IOC valuations suggest that many of these risks are already incorporated in the stock price. Until the recent oil price drop P/E ratios for IOC’s have been about 8 – 12. Over the last 15 years IOC stock values have been trading at an increasing discount compared to their assessed Net Asset Value (see figure below). In any case the IOC risks and issues as listed above are well known in the industry. This is hardly something that is below the radar for investors and fund managers (making a bubble less likely). That does not mean that IOC shares cannot drop significantly over the coming years. Should this happen, however, this will much more likely be caused by low demand (and resulting low prices) than by stranded assets. And of course the reverse may happen in case of high demand vs supply.

fig 33

Concluding remarks

A part of fossil fuel assets will not be produced for sure. More so for possible reserves and more so for OPEC reserves (and more so for coal in general). Less so for proved reserves and less so for non OPEC reserves. IOC valuations are primarily based on proved reserves and these are unlikely to be stranded (basically because there are so little of them, with typical IOC reserves production ratios of 10 – 15). A carbon bubble because of stranded assets thus seems unlikely.

To gradually shift to sunset mode may be the best option for IOC’s: accept a long term gradual decline of production and remain profitable by being very disciplined in spending capital (especially for exploration). Shareholder and NGO pressure as well as the current low oil prices currently enforced by OPEC will all be contributing to the capital discipline that the oil industry is not capable of when left to itself. High oil prices may be back within a few years. Consumers beware; all these stakeholders welcome high oil prices!




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