The Fuse

SEC Investigation of ExxonMobil a Watershed Moment

by Nick Cunningham | September 23, 2016

News reports surfaced in recent days that the U.S. Securities and Exchange Commission (SEC) has opened an investigation into ExxonMobil over its accounting practices, which largely involve how the oil major discloses its risk to climate change and future restrictions on oil and gas production.

Instead of focusing on what Exxon knew about climate science in the past, the formal investigations on behalf of the New York Attorney General and now the SEC are looking more at how Exxon is valuing the company today and into the future.

At issue is whether ExxonMobil will be able to produce all of the oil and gas that it says it will, and at what price.

At issue is whether ExxonMobil will be able to produce all of the oil and gas that it says it will, and at what price. In that sense, it is a straightforward question of accounting practices. But the uncertainty lies in whether oil demand will inexorably rise decades into the future, as it has for much of the last century. The threat of increasingly tighter restrictions on oil and gas production—which may occur if the international community wants to achieve its climate goals—could cut into Exxon’s ability to realize all of its potential value, much of which is currently underground. In addition to the threat to Exxon’s supply, the penetration of electric vehicles could put a dent in oil demand. The result would be the same: Exxon would not be able to produce all of its oil and gas reserves because they would either be off limits or unprofitable.

Exxon has dismissed the probes as unwarranted and politically motivated, but they could mark a watershed moment for the oil and gas industry.

Exxon in the hot seat

The the origins of the probe of ExxonMobil began with a 2015 investigation published by the news organization Inside Climate News, which revealed the company has had a sophisticated understanding of the role that burning fossil fuels played in driving global climate change since at least the 1970s. On the heels of that report, New York Attorney General Eric Schneiderman initiated an investigation into the oil major, a campaign that has since been joined by about a half dozen Attorneys Generals from other U.S. states.

The inquiry has shifted to a focus on Exxon’s accounting practices, or more specifically, why ExxonMobil has not written down any assets over the past two years even while its peers have taken more than $200 billion in impairment charges.

But the inquiry has seemingly shifted to a focus on Exxon’s accounting practices, or more specifically, why ExxonMobil has not written down any assets over the past two years even while its peers have taken more than $200 billion in impairment charges. In other words, will ExxonMobil be able to produce all of its oil and gas reserves, even though oil prices are less than half of what they were two years ago? Are those reserves still worth what Exxon says they are worth? “It is impossible to believe that no assets have been impaired,” Paul Sankey, an oil analyst at Wolfe Research, wrote in August, according to The Wall Street Journal.

There are no easy answers to those questions, and the details are often left open to subjective interpretation. Exxon says it is conservative in booking new reserves, so it has less of a reason to write them down when oil prices fall. Moreover, the company argues that its oil and gas reserves will rise in value when oil prices rebound.

The AGs and federal regulators are not so sure, and have looked at whether the oil major is defrauding its shareholders.

Governments lock away oil and gas

The international community pledged late last year to cap global temperature rise at 2 degrees Celsius, a commitment that would require much more aggressive carbon reductions than the current trendline. One could rightly question the seriousness of the climate pledges, but assuming major emitters follow through on their promises, the oil and gas industry would expect a steadily tightening noose around its neck.

The signs of a crackdown are clearly visible today. The Obama administration recently scrapped plans to auction off acreage in the Arctic and Atlantic Oceans, no doubt with an eye on pressure from climate activists. A moratorium on fracking is already in place in New York, and multiple municipal bans on fracking have passed around the U.S. It is safe to assume more restrictions could be in the offing.

Canada has struggled to export its oil sands because of the inability to build pipelines. The Keystone XL pipeline was rejected, and other major projects have suffered delays. North Dakota’s Bakken recently took a hit with the temporary blocking of the Dakota Access Pipeline. Norway is under pressure to scale back drilling plans in the Arctic.

The fossil fuel divestment campaign has mushroomed from a small effort on behalf of some committed environmentalists into a global phenomenon, spreading significantly in just a few years.

The fossil fuel divestment campaign has mushroomed from a small effort on behalf of some committed environmentalists into a global phenomenon, spreading significantly in just a few years. The campaign itself will do little to hurt the share prices of oil companies, or prevent them from producing. But it undercuts the industry, thereby giving credibility and momentum to regulation, taxation, or outright bans on the extraction of fossil fuels. A parallel effort to “keep it in the ground” has emerged as well. While most oil and gas producing regions do not fear outright restrictions right now, access to some fossil fuel reserves, such as on U.S. federal lands, has come under intense pressure from environmental groups.

Oil companies argue that they are merely providing a product that the world demands, fueling economic growth and prosperity. Restricting oil and gas production will simply drive up prices, companies argue, to the detriment of consumers around the world.

EVs lead to permanently low oil prices

But that is only true if there are no alternatives, a fact that is looking more tenuous over time. Although few oil market analysts believe oil prices will stay permanently low, the possibility that the oil market is in the midst of structural change on the demand side is starting to gain credence.

The sales of electric vehicles are now surging. Costs are declining and the technology continues to improve. Batteries are becoming cheaper, range is growing, charging infrastructure is proliferating, and more EV models are starting to hit the showrooms. Chevy is about to come out with its Bolt, a fully electric car with a 238-mile range and a sticker price of around $30,000 after federal tax credits. The much more hyped Tesla Model 3 will be released next year, and many more models will be introduced to the market in the coming years. Costs will continue to fall with time.

Bloomberg New Energy Finance envisions a scenario in which EVs make up more than one-third of all vehicle sales by 2040. If that projection is accurate, it would eat into oil demand by some 13 million barrels per day. That is more than 12 percent of what the International Energy Agency (IEA) expects global demand to be in 2040, and needless to say, it would likely keep prices much lower than the expected $130 per barrel or so the IEA expects in its business-as-usual scenario. It would also mean that the oil industry would be unable to produce a large portion of the oil and gas reserves currently on their books, and what they do produce will be sold at dramatically lower prices.

Exxon argues that nobody knows what the future will hold, so if its prediction about its ability to dig up all of its oil and gas is wrong, it can be chalked up to the inevitable pitfalls of forecasting.

If this is what the future looks like, ExxonMobil may not be as valuable a company as the market currently thinks it is. The AG investigation might have a difficult time proving that ExxonMobil is knowingly misleading shareholders, and while statements and presentations from the company could be key, a smoking gun will be difficult to prove. Exxon argues that nobody knows what the future will hold, so if its prediction about its ability to dig up all of its oil and gas is wrong, it can be chalked up to the inevitable pitfalls of forecasting. Exxon dismisses claims that it is defrauding its shareholders.

Supply going up

Given the importance of oil and gas production to so many countries—roughly 75 percent of global oil and gas reserves are under state control—the largest oil-producing countries will likely be reluctant to limit output. Publicly traded oil companies like Exxon might run into regulatory trouble, but if anything, national oil companies (NOCs) might accelerate output to monetize their assets while they can. Saudi Aramco’s IPO, along with Saudi Arabia’s move to ramp up output to record levels, is but one sign that the effort to “keep it in the ground” will prove to be difficult.

The oil major can only hope for a business-as-usual trajectory, fighting measures to restrict supply or cut into demand. A rebound in oil prices will improve its bottom line and rescue the company from charges that it is overvaluing its assets.

In the meantime, low oil prices will act as the largest deterrent for Exxon and other oil companies in producing more oil. But on top of poor market conditions, there will be an ongoing assault on its ability to produce, whether that comes from carbon taxes, drilling restrictions, or other regulatory measures. The oil major can only hope for a business-as-usual trajectory, fighting measures to restrict supply or cut into demand. A rebound in oil prices will improve its bottom line and rescue the company from charges that it is overvaluing its assets. That will give the company the best shot at producing all of the oil and gas reserves on its books. But the investigations led by the SEC and several state Attorneys General demonstrate that the oil industry’s long-term viability is up in the air.

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