The conundrum of responsible hydrocarbon investing

Can investors chart a path around risky drilling and CO2 emissions?

Socially responsible investing ideals of competitive financial results and a commitment to social change are especially hard to juggle when investing in extractive hydrocarbon companies. As the fight for reserves becomes more desperate, oil companies are pushing into unconventional, deeper, colder and more dangerous frontiers. Over the last 10 years, oil company profiles have shifted dramatically towards these more challenging projects. Deep water, liquefied natural gas, unconventional oil and unconventional gas now comprise half of the estimated future profits of the major oil companies. There are huge technological challenges of drilling at considerable depths and managing extreme weather conditions such as those in the Arctic. Working in these areas is a huge risk that has not been met with equivalent safety advances, so we feel very uncomfortable investing in companies who do it. The Arctic is one of the most ecologically sensitive environments on the planet. It would also be one of the hardest to clean up if something went wrong as there are no proven technologies that exist to clean up the Arctic after a spill. Both governments and industry have a tendency to underestimate the risks involved in operating in these harsh new environments and to overstate their ability to respond to spills. As one of the last unexploited areas on earth, the Arctic is no place for misplaced bravado. Another hot area of oil production is the pre-salt areas off Brazil and West Africa where companies have get through a few km of water and then drill through another few miles of shifting salt and sand to reach the oil. Governments in these areas have a huge stake in their local oil industry and are rubbing their hands in anticipation, waiting to spend the windfalls. This has led to concerns that regulators are allowing companies to rush into areas without knowing how to drill safely and without any contingency plans in these very demanding frontier areas.This kind of collusional overconfidence, together with more difficult wells in more extreme terrain has led to increased accidents and near misses around the world.
Another trend that has emerged over the last decade of diminishing new reserves is that in exchange to access to resources, multinational oil companies are being forced to work with local oil companies. Multinational oil companies that look like they have decent systems in place to mange safety, environmental or social risks, have to partner with these government owned companies for their local knowledge or for political reasons. These companies often have a cavalier attitude towards safety and the multinational oil companies do not have the ability to exert much control over their practices, even if they wanted to, for fear of losing out on valuable projects. It is also notoriously difficult to get contractors to participate in safety and environmental initiatives when profitability trumps everything. In theory, land based drilling should be safer as companies are more experienced, there are usually less complications, and emergency deployment can be faster. However, land based extractive companies are also coming up against resource constraints and their reaction has been to push into virgin areas. In many cases, this means coming up against indigenous peoples who are unhappy at these government sanctioned incursions into their lives but are often powerless to stop it.
Most oil companies now have a substantial portion of their operations that are subject to these large potential risks, never mind the more obvious human rights or environmental infractions that happen in more conventional hydrocarbon operations with disappointing regularity. And these arguments don’t even take climate change into account. Bill McKibbon’s recent article in Rolling Stone advocates for divestment from fossil fuel. His argument is that if fossil fuel companies produce all

of their reserves and we burn it, this will produce five times the “safe” amount of carbon dioxide that would theoretically allow us to stay below 2 degrees C of warming. While he makes a good point, oil companies aren’t going to stop producing oil voluntarily just because we want them to. The best way to decrease the value of their reserves and thus make them rethink some of their production is to increase energy efficiency and to make alternatives more competitive. Natural gas is sometimes thought of as a bridging fuel to more sustainable renewable power sources because of the lower greenhouse gas emissions that are produced when it is burned. It is difficult to compare the greenhouse gases produced over the lifecycle of a fuel but very roughly, gas produces about 40% less CO2 than coal and 30% less than oil during both production and combustion. The low price of natural gas in North America caused by the glut in supply has meant electricity generators have been favoring gas over coal as a fuel source and this looks likely to continue. However the low price also means that a large amount of gas is flared when it is produced with oil because companies don’t find it worthwhile to connect their fields to gas pipelines. Flaring releases large amounts of carbon dioxide with absolutely no benefits. Cheap gas also means that the producers are not careful about leakage of methane during the drilling process. While it is theoretically possible for companies tocontain the vented gas, it is seldom done because of the increased cost. This adds to the controversy about viewing natural gas as a better substitute in terms of greenhouse gas emissions than other fossil fuels. Most gas at least in the US is produced using some sort of fracking technology. Most of the concerns stem not from the fracking process itself but from the way the wells are cased, the disruptive mining of sand used to keep the fractures open, the large amounts of water used, as well as water contamination from poor fracking techniques. The devastating social and health impacts on communities compound these problems. While research has shown that natural gas development theoretically can be done safely, most companies choose to operate to the lowest common denominator because the regulators allow it.
Despite these large challenges, we believe there are some opportunities in hydrocarbons that will allow us to fulfill our financial and social mandates. Instead of investing in classic “best in class” oil and gas companies, we are more imaginative, thinking about which types of companies are going to benefit from higher energy prices either directly or indirectly. Through this thought process we discover some interesting companies doing creative things. While they might not have a perfect correlation to traditional fossil fuel energy stocks, we feel much more sanguine about including them in client portfolios.
Sonia Kowal is Director of Socially Responsible Investing at Zevin Asset Management.