The Fuse

Oil Majors Face Risky Future

by Nick Cunningham | September 11, 2019

Battered by low share prices, stubborn oil prices, public scrutiny and investor pressure, the global integrated oil majors find themselves at a crossroads.

The growing call for a rapid transition away from fossil fuels presents the majors with a crisis. They have not responded to this particular moment in a uniform fashion, but even as they adapt and pivot in different ways, several new reports suggest that the industry could face a reckoning in the years ahead.

Sector-wide downgrade
The world is falling short of the Paris Climate Agreement, which was a modest and otherwise voluntary deal that may not achieve climate targets even if adhered to. But at the very least it laid down a marker, and it put the oil industry on notice. Whether 1.5 degrees Celsius, 2 degrees C or some other metric, emissions from fossil fuels need to decline dramatically, which ultimately means that painful regulation on the industry is inevitable in some form.

But the gap between where we need to go and where we are today is extraordinarily large. It is against that backdrop that the oil majors continue to spend heavily on developing new reserves, assuring investors that demand will continue to grow for years to come.

However, the danger for oil companies and their shareholders is that billions of dollars’ worth of investments are tied up in projects that may ultimately be abruptly cut off or otherwise rendered uneconomical

However, the danger for oil companies and their shareholders is that billions of dollars’ worth of investments are tied up in projects that may ultimately be abruptly cut off or otherwise rendered uneconomical. The precise mechanism – production restrictions, carbon taxes, subsidies for renewables, etc. – is not all that important, but the direction is. In other words, there are decent odds that governments around the world will crack down on fossil fuels while simultaneously pouring money into competing technologies that will undercut the economics of oil and gas.

This isn’t a novel theory or new news. But the warnings are proliferating. For example, the number of institutional investors that have committed to divest from fossil fuels has climbed from 180 in 2014 to more than 1,100 now, according to the Financial Times. Royal Dutch Shell admitted in its annual report that the trend presents a material risk to the company.

Meanwhile, a new report from Redburn, a research firm, laid out the risks that lie ahead. In the medium- to long-term, global oil demand will either begin to decline, or governments fail to act and the climate crisis grows worse. “Faced with this uncertainty, the Majors are continuing to grow oil output whilst making limited investments in renewables. Their exposure to so-called ‘transition risk’ is therefore rising,” Redburn’s authors wrote.

The firm essentially issued a downgrade for the entire class of integrated oil majors. “We argue that the sector derating that began 18 months ago will continue, and we double-downgrade Exxon to Sell; Eni, BP and OMV from Buy to Neutral; and Shell and Repsol from Neutral to Sell,” Redburn analysts wrote.

Redburn said that while there are multiple scenarios that achieve the 2C target, all of them essentially lead to peak oil demand by the mid-2020s, and decline thereafter. That obviously presents an existential crisis to the oil industry.

“We are not starry-eyed idealists. We recognise that the current political environment makes a concerted global push to reduce GHG emissions unlikely and that oil demand could therefore continue to grow for many years,” the Redburn authors wrote. “But each year it does, the risk of greater disruption at some point in the future rises. This has inescapable implications for the sector today.”

A bet against climate restrictions
To date, governments have not done enough to head off dangerous levels of warming, and oil and gas demand continues to rise. But Redburn argues that blowing past climate targets could result in “adverse climate effects,” which will “ultimately pose severe downside risks to demand.” Every year that passes with inaction increases the odds of a more draconian response. Thus, in “either scenario, 2040 demand is likely to be significantly lower than current forecasts.” Redburn even pointed to comments earlier this year from OPEC Secretary-General Mohammed Barkindo, who said that the “growing mass mobilization of world opinion” had become “the greatest threat to our industry going forward.”

The report finds that the oil industry has invested or committed to spending $50 billion – just since last year – on projects that are not compatible with the Paris Climate Agreement

Meanwhile, a separate report from Carbon Tracker quantifies and catalogues some of the specific projects at risk. The report finds that the oil industry has invested or committed to spending $50 billion – just since last year – on projects that are not compatible with the Paris Climate Agreement. A few of the projects included Shell’s $13 billion LNG Canada project, or Imperial Oil’s $2.6 billion Aspen oil sands project (which has since been delayed). Even U.S. shale is at risk, despite its image as a safer investment because of its short-cycle nature. However, because shale is higher cost and requires constant investment to maintain production, it would likely fall out of favor in a world of falling demand and low prices.

For now, the majors continue to spend heavily on projects that are completely incompatible with a scenario in which climate targets are achieved. In that sense, they are making a risky bet that governments fail to act.