Financial Market

Investors Need to Look Carefully at Stranded Asset Risks – BRINK – Conversations and Insights on Global Business

The shift away from a carbon-based economy risks stranding a large number of assets, particularly in sectors with high financial market exposure, such as oil and gas. 

The nonprofit financial think tank Carbon Tracker Initiative is tracking the assets most likely to be impacted. In the second of two articles, Mark Campanale, founder and executive chair of Carbon Tracker, explains that many companies are not reflecting these risks properly in financial statements. Read part one here.

CAMPANALE: Oil and gas reserves are not balance sheet items for fossil fuel companies. But under SEC rules, a reserve is only a reserve if it’s extractable at the current market price. So for example, when oil prices fell in 2020, you had a lot of de-booking. 

For the balance sheet, the question is whether assets are impaired. In other words, whether they are likely to generate revenues sufficient to cover the capital invested. Here, companies look to not just current prices, but what they reasonably expect the prices to be in the future.  Even here, we’ve seen companies like BP write down asset values because they expect prices to be lower. 

The Retirement Costs of Oil Wells

When you write down assets under U.S. GAAP, that’s forever, but in Europe, you can impair them when you see prices going down, and then write them up if your oil price expectation goes up. Then, there are the retirement costs of retiring oil and gas wells. They present the costs of retirement on the balance sheet on a risk-adjusted discounted basis.  

There’s going to be an awful lot of oil refinery capacity the world doesn’t need in a 1.5 degrees world, that’s going to have to be written down. We’re not seeing the discussion we’d expect to see by companies as an audit risk item.

Many of the companies are pushing out retirement of wells to 50 or 70 years. Because of that, the costs seem really small at first glance. But what happens if they have to retire those assets, like offshore oil rigs, early? Those costs will be incurred much earlier and be much larger than the discounted numbers we see today.  

There’s going to be an awful lot of oil refinery capacity the world doesn’t need in a 1.5 degrees world, that’s going to have to be written down. We’re not seeing the discussion we’d expect to see by companies as an audit risk item.

The Cost of Cleanup

In the U.S., companies are saying it’s going to cost $10,000 for each well — these nodding donkeys — to be closed and cleaned up. But actually, the real market cost of each well could be as much as $300,000 — more if there’s contamination to clean up. So what the companies are doing, and this is well written up in places like Colorado and elsewhere, is they’re moving their abandoned assets into defunct companies, which they then allow to go bust. And the state, the taxpayers, will pick up the decommissioning costs.

We think that companies should place a bond on the real cost of the cleanup and retirement of the wells. For each well, they should be putting a couple hundred thousand dollars or up to $300,000. But if they do that, it makes the whole company uneconomic, because if you have to make a provision for the cleanup costs, these projects wouldn’t be viable.

They certainly wouldn’t be generating the return on capital, which they are now, if you had to fully incorporate their cleanup costs. So, there are costs that the market knows about, regulators know about, the companies know about, investors know about, except they’re not transparently on the balance sheet of companies because there’s no legal requirement today for companies to actually price the full cost of cleanup on their balance sheets.

The Rest of the Value Chain Is Also Exposed

BRINK: What about the rest of the value chain of oil and gas companies? Is there risk to others in the value chain?

CAMPANALE: In Carbon Tracker’s analysis, we did a report where we calculate there’s around $30 trillion of fixed assets in the fossil fuel system. Pipeline, refineries, oil rigs, offshore engineering facilities. You’ve got LNG tankers. You’ve got coal mines. You’ve got railroads that carry coal. You’ve got the port that takes the coal out on ships to China. 

We’re going to have to lose at least half of that in the next decade. Around a quarter of equity markets are linked to the fossil fuel system. So cement, steel, aviation, shipping, obviously transportation and power, and about half of the corporate bond market. Look at all the bonds linked to funding fracking in the U.S., these high yield junk bonds. All of that essentially gets turned over in the next decade, in the low-carbon scenario.

Regulatory Risk Is Looming

If we get extreme weather events at 1.5 [degrees warmer], the policymakers could turn around and say, “Right, everything closes. Nobody drives a car today. Coal-fired power stations are off. Oil production stops.” 

It could be that governments suddenly reach a holy-moly moment, and you’ll get a rapid intervention, not too dissimilar to us coming off of Russian gas. Use of gas in some European countries, because of Russia, is down 20% this last year. And you could see something like what happened in the crisis of ’07, ’08, when the risk ratings were all wrong. But when it comes to the fossil fuel system, the write-downs would be four or five times bigger than the size of the financial crisis of ’07, ’08.

What we’re asking investment managers to do and pension fund trustees to do is to stress test their assumptions and their climate scenarios: What happens to asset valuations if fossil fuel use drops by half? Can you model this? Does the share price of Exxon go up, or does it go down? If half of gas and all coal-fired power goes, stress test the downside risks to, say a company like Glencore, which is hugely dependent on coal revenues as part of its profits.

That’s the rational thing to do. But unfortunately, talking to a lot of fund managers and pension fund trustees, they tend not to be doing those kinds of valuation stress tests.

How Will This Risk Play Out?

BRINK: So how do you think this is likely to play out in the next couple of years?

CAMPANALE: Well, the energy transition is happening rapidly. Clean technologies are on S-curves of rapid, exponential growth, displacing fossil fuel demand. The two things to look for, and we’ve seen it in coal, is firstly when demand peaks for a core fossil fuel product. The key one is obviously oil and gas because that’s where the most capital is tied up.

When you see millions of barrels of oil demand destruction a day, then you’ll see a very strong negative sentiment in the investment community toward oil and gas. If you remember what happened the year before last, oil prices entered into a period of being in the low twenties, and actually, at one point reached a negative value briefly, because there was a mismatch.

And when oil prices get down that low, the return on capital is killed. If you’re producing at 20 and selling at 20, the return on capital is zero. And that is the biggest threat to the industry — falling demand leads to soft prices, which in turn reduces margins significantly.  

When that happens, the market will punish you by de-rating you. But at this point, with electrification happening all the way through the energy and transportation systems, it will be permanent and structural, not cyclical and temporary. 

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