For the last few years NGOs have been warning of the investment risks of climate policy for fossil fuel producers. The warnings have largely fallen on deaf ears amongst mainstream investment managers. As one oil analyst put it: “Aggressive carbon regulation may well cause stranded assets, but you don’t seriously think that’s likely to happen any time soon.” Investor ears should be deaf no more. Coal mining share prices have fallen by two thirds in two years. Several oil majors are seeing their lowest rating against the market for a decade. A wave of new broker research from Bernstein, Citi, Deutsche Bank, Goldman Sachs, HSBC and Morgan Stanley (listed at the foot of the article), takes a markedly bearish view of the prospects for these sectors, pointing to serious difficulties with their economics, and even, in some cases, suggesting they could be about to go into ‘terminal decline’. An Economist front cover (Aug 3rd) summed it up, showing a dinosaur at a gasoline pump headlined ‘Yesterday’s fuel.’ This bearish turn in investor sentiment dramatically changes the debate about stranded assets, and could offer the most important ESG integration and engagement opportunity for a long time.
Carbon Tracker, an NGO, has been extraordinarily successful in winning press coverage for its ‘unburnable carbon’ thesis. Its argument rests on a simple equation: the amount of carbon embedded in the reserves of the listed oil and coal mining companies is bigger than the amount we can safely emit to avoid dangerous climate change (a 2°C rise in temperatures). So, if governments were to regulate carbon emissions to put us on track for2°C some reserves will become ‘unburnable’, creating the risk of stranded assets and wasted capital expenditure (cap ex). Carbon Tracker claims that these companies share prices may therefore be overvalued, creating a ‘carbon bubble’ whose bursting would hurt investors exposed to oil, gas and mining companies. The Carbon Tracker work has also been used in the US by Bill McKibben and the Fossil Free campaign to justify divestment from these companies.
The struggle for share price relevance
While I struggle to find industry analysts who buy Carbon Tracker’s more sensational claims (e.g. a carbon bubble may create systemic risks for the UK economy), there is widespread agreement about the basic stranded assets logic. Carbon regulation is a big risk for fossil fuel companies. But, as I’ve discussed on RI previously in practice it is hard to persuade oil analysts to factor these risks into their company valuations and investment decisions. The first problem is that the unburnable carbon argument is hypothetical. Only if carbon emissions regulation looks likely to move to a 2°C path will stranded assets become a material risk. Given the ongoing failure of governments to make substantial progress towards a global deal (and the climate scepticism of the entrenched Republican majority in the US House of Representatives), the probability of a 2°C path seems depressingly low and stranded assets remain a hypothetical issue. The second problem is timing.
Using standard discount rates, impacts that are 10 or 20 years ahead shrink dramatically in analyst forecasts. If
we don’t look likely to switch to a 2°C path till 2025 or 2030, then even a big subsequent impact on earnings is largely discounted away. It shrinks further still if you adjust for its low perceived probability. As a result, the financial risk of unburnable carbon has failed to make it into the premier league of share-price relevant issues.
‘Yesterday’s fuel’, today’s investment risk.
The new investment bank research changes this picture dramatically. Recent reports from Bernstein and Citi, suggest that demand for coal and oil may soon go into decline globally as a result of new trends, without any need for a global climate deal and a step change in climate policies. Citi argues that existing fuel efficiency standards and growing oil-to-gas switching will mean global oil demand could peak by 2020. Bernstein argues that coal demand is falling nearly everywhere except China, but that it will fall there too by 2017. If these bearish views turn out to be right, this marks a dramatic upgrade in the perceived probability of stranded asset risk, and brings its timing into the current decade. (As well as raising the welcome possibility that global carbon emissions might peak much sooner than previously feared). And it is not only a matter of possible falling demand. Analysts at Goldman Sachs and Morgan Stanley are also raising the alarm about rising costs and declining return on equity among the oil majors, and questioning the sustainability of their cap ex programmes. While equities in general have been enjoying a bull run, share prices for most of the majors have been flat for several years, and this despite sustained $100/barrel oil prices. Morgan Stanley arguesthat this results from escalating costs and unsustainably high levels of cap ex. Goldman suggests some oil majors would see higher share prices if they delayed or cancelled new projects and returned the money to shareholders instead. The mining sector is already well beyond this point. The share prices of pure play coal companies have already fallen by two thirds or more since. Disappointing demand plus the huge investment in new mining capacity in the last decade means that the market is chronically oversupplied. Thermal coal prices have fallen by a third in two years as a result. Companies have cancelled expansion plans and are selling assets. One significant US coal miner has filed for bankruptcy. The prospects for future growth look uncertain at best, and if Bernstein is right, grim indeed. While the gloomiest investment bank predictions may turn out to be overdone, their existence underlines profound new uncertainty about future demand. This uncertainty makes stranded assets a risk that today’s investors would be unwise to ignore in their company valuations and investment decisions. Crucially, this uncertainty is not contingent on some desirable but depressingly out of reach global climate deal (though a deal would only make matters even worse for producers).
The cost-curve decides unburnability
As well as increased investment-relevance, the new analysis gives sharper focus to the mechanism that will, sooner or later, strand assets. Counter-intuitively, perhaps, risk exposure is not a function of the amount of carbon embedded in company reserves. Risk arises instead from the position of the company on
the industry cost curve. This is basic economics. When demand falls, the marginal producers at the expensive end of the cost curve become unprofitable and mothball or close capacity, while the producers at the cheap end remain profitable. The PDF link in the downloads section – see left hand column is an oil industry project cost curve sourced from Citi Research. It shows that marginal oil projects require US$90/bbl to make a return (Breakevens reflect NPV zero using a 10% discount rate). The cost curve is what, in practice, will drive the ‘unburnability’ of carbon and potential asset stranding. As demand falls, expensive carbon will become unburnable first, cheap carbon later. Up to a point, an oil company can have as much carbon in its reserves as it likes, as long as it is cheap to extract. Carbon Tracker’s point is not that no more carbon can be burned, but that only some of it can. The question is what will get burned and what will be left in the ground? The cost curve provides the answer. Companies like Petrobras have large amounts of carbon embedded in their reserves, but its production is at the cheap end of the cost curve: their exposure to falling-demand risks are low. Canadian oil sands, also with large amounts of carbon, lie at the opposite end of the cost curve and face greater stranded assets risk. Reserves do have some relevance to risk: their nature and location roughly predicts a company’s future position on the cost curve, but they are only a long-term indicator. Over the time horizons that drive share prices, the position on the cost curve of a company’s current and development projects is what matters. The break-even costs and rates of return of these wells will determine a company’s ability to generate cash over the next decade, and this drives share prices.Investor action
Campaigners will argue that these bearish analyst views justify blanket divestment from the oil, gas and mining sectors. But analyst pessimism changes little for trustees. Blanket exclusions remain legally questionable. If the bears turn out to be wrong, a hydrocarbon-free pension fund could severely underperform the market. While divesting from pure-play coal miners probably would not impact portfolios much either way – they are just too small – a blanket divestment from large cap oil, gas and mining companies would be a huge risk. The right strategy for fiduciary investors is to effectively integrate cost curve risks into investment decisions and to engage to reduce the risk of stranded assets and wasted capital. What might integration and engagement look like? The most interesting opportunities relate to oil and gas rather than coal. This is surprising, perhaps, given that the vast majority of unburnable carbon reserves are in the coal sector. The reality is falling coal prices and overcapacity mean that most companies have already stopped investing in new capacity. Carbon Tracker was right to flag the potential for ‘wasted cap ex’ in its recent report, but as far as coal mining is concerned this is no longer a problem. No capital is being wasted if no capital expenditure is happening. Similarly, from an ESG integration perspective, share price falls over the last two years have already priced in a great deal of bad news for the coal sector. SWIP, like many investors, has reduced its active exposure to pure play coal miners to zero in both equity and fixed income. There is still exposure to the big integrated miners, but coal is a small and declining share of their revenues. Of course, if
you are still investing in pure play coal mining, you have a much more interesting question to answer. Is the current downturn a cyclical low, or is Bernstein right that the sector is now in terminal decline?
The story is very different in the oil and gas sector. Capital expenditure is proceeding apace, with an eyewatering $2 trillion planned for deployment in the 300 biggest projects in development up to 2020. And, unlike coal, most investors have very substantial exposures to the sector. If Citi is right that share prices do not reflect the risks falling demand might pose for some companies, then there is a significant potential ESG integration opportunity. Investors could usefully seek to develop a much clearer sense of companies’ aggregate cost curve position and what would happen to their cash flows in the event of lower oil prices or less gas demand due to competition from cheap solar or wind. Some companies are much better positioned for demand uncertainty than others, but this may not be reflected in their share prices. There is also an interesting engagement angle. The fact that many companies have delivered poor share price performance and historically low and falling returns on equity is making mainstream investors unhappy. They want to see more cost control and capital discipline. If companies fail to exert this discipline they may have to cut their dividends. This unusually acute shareholder focus on cap ex levels presents a rare window of opportunity to challenge oil company strategy and test whether it adequately takes account of downside demand risks. Particular scrutiny is needed for the bottom quartile projects at the right hand end of the cost curve that will not breakeven if demand contracts. If Goldman Sachs is right about theshare price benefits, investors would see better returns if companies returned capital to them via share buybacks rather than investing in these projects. The message is already getting through. My oil analyst raised some of these questions at a recent meeting with the CEO of one oil major. The CEO responded that he’s been hearing this message “loud and clear” from investors: greater capital discipline is a top priority. We’ve also seen activist hedge funds mount proxy battles partly targeting this issue. The proxy initiative at Hess earlier this year met with success both in terms of both the company response and subsequent share price improvements. There are also questions to ask about company remuneration policy. Are directors’ incentives sufficiently focused on driving capital discipline (via metrics like return on capital employed or return on equity) or is there too much emphasis on delivering growth irrespective of its quality? Now that shareholders are increasingly willing to back their say on pay with votes, this may offer a concrete place to focus discussion with some companies.
One final point merits emphasis. Unlike the majority of ESG issues, the cap ex problem described above is a genuine top rank investment issue for mainstream fund managers. Enhanced analysis offers the real prospect of portfolio impact. This also means that failure of companies to respond to engagement may credibly affect investment decisions. But this lever can only be pulled if ESG investors have the buy-in of their mainstream equity colleagues. At company meetings, it is they, not the ESG specialists who need to be pushing the CEO on on capital discipline. The ESG community
certainly has an important part to play in this debate, but only if it learns to speak the language of cost curves, IRRs and free cash flows. The intricacies of oil sector economics are new to many ESG specialists, which creates a challenge. To move us along the learning curve, the Institutional Investors Group on Climate Change (IIGCC) is developing material on this topic to enable its members to better discuss these issues with their energy analysts and companies.
For more information contact Morgan LaManna
*Craig Mackenzie is Head of Sustainability at Scottish Widows Investment Partnership and chairs the Corporate Programme at IIGCC.*h5. Investment bank research referred to in the article
- Parker, M and Ho, P (2013) “Asian Coal & Power: Less, Less, Less…The Beginning of the End of Coal” Bernstein Research;
- Kleinman, S et. al (2013) “Global Oil Demand Growth – The End Is Nigh” Citi Research;
- Syme, A et al. (2013) “Global Oil Vision: Investing for Commodity Uncertainty” Citi Research;
- Hsueh, M and Lewis, M (2013) “Thermal Coal: Coal at a Crossroads” Deutsche Bank Markets Research;
- Della Vigna, et al (2012) “Death and Rebirth of an Industry”. Goldman Sachs;
- Della Vigna et al. (2013) No light at the end of the tunnel Goldman Sachs;
- Rats, Martijn et al. (2013) “Why ‘Big Oil’ has Underperformed So Much” Morgan Stanley Research;
- Robins et al. 2012 “Coal and Carbon” HSBC Global Research.