Stranding oil and gas

June 24, 2019

Familiar in the propaganda of climate politics is the fait accompli. Arguments for extreme precaution against global warming work backwards. They start with the political goal: to make humanity quit burning hydrocarbons. Then they snap arguments into place to support the objective: Dangerous warming attributable to hydrocarbon combustion promises certain disaster if people don’t sacrificially change behavior, and all that. The arguments are treated as indisputable. Anyone questioning them is treated as wrong, morally or intellectually or both.

From this reasoning emerges the systematic opposition that nowadays greets new oil and gas projects, especially pipelines. Because people must quit burning hydrocarbons, the thinking goes, affiliated projects must be disallowed. From this reasoning, too, flow efforts to divert capital away from oil and gas by worrying investors about assets “stranded” by growth in renewable energy and climate regulation. While trying to strangle hydrocarbon energy with regulation and obstructionism, extremists also hope to starve it of capital. In this political environment, a level-headed assessment of stranded oil and gas is welcome indeed.

The financial risk

Commentary published on June 10 by Fitch Solutions Macro Research takes that approach. Its message: Although efforts to decarbonize the energy mix raise the risk of oil and gas asset-stranding, the financial risk for most companies is low.

Fitch points out that stranded-asset analyses make assumptions about hydrocarbon resources, the carbon content of those resources, and the global carbon “budget.” The budget is the total of carbon-dioxide emissions beyond which temperature targets for Industrial Age warming cannot be met under further assumptions about climate sensitivity. To whatever extent regulation keeps emissions within the carbon budget, resources representing potential emissions exceeding the budget will not be developed.

Most assets exposed to that risk are possible or probable resources, Fitch notes. Yet assets on oil and gas company balance sheets relate to proved reserves, economic lives of which are, on average, relatively short. Among about 70 companies tracked by Fitch, the average oil reserves-to-production (R/P) ratio is 13 years. And oil demand continues to grow. “Given the latency between policy, technological and consumer shifts, and shifts in the overall energy mix, it does not seem reasonable to expect any significant increase in asset stranding over a 10-15-year horizon,” the firm says.

Companies with above-average R/P ratios face elevated risk of asset-stranding, Fitch acknowledges. And the R/P ratio mixes producing assets near the ends of their economic lives with reserves earlier in development with lives well beyond 15 years. But cost-recovery mechanisms and the time value of money push most of a project’s economic value to its early years.

Still, the risks of asset-stranding “will inevitably rise with time,” Fitch says. The transition to a low-carbon economy is nonlinear, subject to large policy shifts and disruptive technological breakthroughs that create large uncertainties about the timing of peak oil demand and subsequent demand declines. And the firm says environmental risks, physical and transitional, are broader than those of stranded assets and threaten to permanently lower revenues, erode profitability, and weaken balance sheets. Transitional risks include exposure to toughened environmental policies, shrinking demand and lower commodity prices, reputational challenges, and litigation related to climate.

‘Policy discontinuities’

The financial risk of asset-stranding, while lower than activists want investors to believe, is nevertheless rising, as Fitch notes. The possibility looms of drastic, global policy reactions to current failures to meet national goals for emission cuts pledged in the 2015 Paris Climate Agreement. And stated targets for global average temperature require cuts greater than those. The likelihood thus grows, Fitch says, for “future policy discontinuities and large and sudden shifts in legal, regulatory, and fiscal landscapes.”

Politics, including reactions Fitch doesn’t mention by energy consumers resisting imposed cost, will shape those outcomes. Investors will adapt to whatever risks emerge, as they always do. And capital will flow as needed to oil and gas projects because, to the great peril of backward-thinking extremism, people will continue to need affordable energy.