A survey of institutional investors by the Oxford Institute for Energy Studies (OIES) was conducted in July-October 2018. There were 26 participants, including investors based in the US and Europe, from “long only” asset managers and hedge funds to private equity investors. Each interview focused on the hurdle rates seen as desirable for different types of energy investment.
Specifically, the question was: “What base-case internal rates of return (IRR), or hurdle rate, must a new energy project generate, for you to prefer reinvestment in that project, rather than further growth in dividends and buybacks?”
The hurdle rates stated were, on average, 10-11% for solar and wind, 14% for LNG, 15% for shale oil, 18% for deepwater oil, 21% for large projects outside of the safest geographies, and 40% for new coal mines.
However, according to information collected from the public domains, completed projects in the last few years, on average, have had a hurdle rate of 9-11% for wind and solar, 12% for LNG, 10% for shale oil, 15% for deepwater oil, 13% for megaprojects, and 16% for coal mines.
The hurdle rates for wind, solar, and LNG projects have remained relatively stable (wind and solar are widely shielded from market uncertainties through government support schemes). However, the minimum required returns for other fossil fuel projects, especially deepwater oil, long-cycle megaoil projects, and new coal have increased markedly.
Although there might have been imperfections in the survey, the comparison revealed a change in risk preferences around energy projects over the last few years. OIES attributed this change in risk preferences to uncertainties associated with energy transition and climate-emission policies.
As cited by OIES, California democrats recently said they want to “ban all fossil fuels from the electrical grid” at some point after 2030 (Wall Street Journal, 2018). In third-quarter 2018, New York regulators denied an air permit for a newly built gas-fired power plant, as climate activists criticized its carbon dioxide emissions and gas use from hydraulic fracturing (APPA, 2018).
“While such a change in risk environment due to energy transition may not be surprising, the implications of said change are highly significant. This is because, to date, transition has been seen as only possibly having long-term effects. This, along with the uncertainty about climate change and emissions abatement policies, may lead to an underestimation of the problem and its effect on growth prospects, firms’ cash flows, and asset payoffs.”
Implications
Change in risk preferences and consequently discount factors will lead to reassessment of the value of firms and their future profits.
“This could have a huge impact on their market capitalization, demand, creditworthiness, and the value of their assets. This is especially problematic because oil and gas companies are heavily debt financed and asset revaluation has implications for financial stability,” OIES said.
A consequence of risk-aversion is overconcentration of listed oil and gas companies’ activities in the “harvesting phases” and away from the “exploration and appraisal” and “development” phases. One junior E&P company noted its frustration to OIES: “We cannot partner with majors. Many have moved to a zero-risk model. They would rather pay $500 million to back in once you’ve derisked an opportunity than pay $50 million to back in early.”
In a similar manner, private equity-backed companies are better positioned to unlock value from short-term projects such as shale formations, and they inherently discourage long-cycle investments.
When turning to national oil companies, however, it is unlikely that NOCs on their own would be able to meet the investment and financing gap.
The possibility of a supply gap due to lack of investment would lead to higher-than-expected long-term oil prices. Thus, shale projects are well positioned to take advantage of the strong environment. However, whether shale can fill any possible supply gap is uncertain.
In the end, the energy transition process could be accelerated as higher long-term oil prices improve the economics of alternative resources, OIES noted.
