Why investors should think more seriously about oil prices

It is risky business to be an oil and gas company these days, if only for the simple reason that the transition to a net-zero economy poses an existential threat to their business model.

A world that is less dependent on oil means less demand for oil and consistently lower prices. And lower prices could mean significant losses for oil companies and their investors.

Yet instead of winding down operations and investing the lion’s share of their capital in, say, renewable energies or low carbon technologies, the world’s largest oil companies continue to pour vast sums of money into new oil and gas projects, even as they commit to net zero on paper.

What they are planning for is a delayed transition in which oil prices and demand stay higher for longer.

The gamble seems extraordinarily risky: the average break-even oil price across the upcoming planned oil fields of the five biggest oil and gas companies is significantly higher than the projected $35 per barrel by 2030 under the International Energy Agency’s (IEA) net zero scenario, according to data from Global Data.

The capital costs of the upcoming projects are also very large. For each company, the average capex of a new project to first production is more than $2 billion; for ExxonMobil, it is more than $6 billion.

In short, there’s a lot to lose if the transition isn’t delayed.

“When oil prices fall lower than the break-even price of production costs, markets will downgrade and de-rate oil companies just as they did during the Covid crisis,” said Mark Campanale, founder at Carbon Tracker. “Yet many asset owners aren’t thinking carefully, if at all, about these transition risks. Their fund managers tell them an oil company is a buy and that’s it.”

A 5% drop in global oil demand during the COVID crisis caused the price of US crude oil to turn negative for the first time in history, forcing producers to pay buyers to take the barrels that they could not store due to oversupply.

Campanale described that time as a kind of “trial run” for the net zero transition.

The term transition risks relates to the risks associated to transitioning to a lower-carbon economy, especially the economic impact of policy, legal, technology, and market changes.

Flawed models

One reason for the likely underestimation of oil price risk and other transition risks is that asset owners still rely on flawed models sold to them by investment consultants.

"It’s the investment consultant's role to advise pension fund finance officers on risk management, but also asset-liability modelling," Campanale said. "It's this actuarial role, when it bashes up against climate risk, that makes getting the energy transition right so important."

Last year, Carbon Tracker published a report highlighting the extent of the finance industry’s dependency on these “flawed models”.

In addition to assuming that oil prices will remain higher for longer – the only financial justification for new projects - the models fail to account for the decommissioning costs of fossil fuel assets.

“I recently asked a large pension fund whether it was confident that its external managers were pricing in and managing the transition risk effectively,” Campanale said. “They didn’t know. It was a typical response.”

Carbon Tracker has identified $200 billion of unfunded liabilities and decommissioning costs in the US alone.

“Reaching ‘net zero’ suggests that the energy system including oil and gas companies stand to lose about half of their fossil fuel infrastructure in the next decade,” he added. 

Along with Rocky Mountain Institute, Carbon Tracker estimates the whole system is about $50 trillion of fixed assets, including reserves, pipelines, oil rigs, shipping, transports, LNG, and coal mines.

Yet asset managers "continue to ignore" the risks of assets being written down and stranded. One way they do this is by "putting positive terminal values in their DCF [discounted cash flow] valuations for fossil assets that do not have any future".

Meanwhile, climate risk assessments tend to focus on “emissions data” even though that information “doesn’t say anything about how an oil price drop, falling demand due to electrification or decommissioning costs will impact a company’s valuation”.

“These asset managers are basically saying there will be no decommissioning cost or drop in oil prices because decarbonisation won’t happen and demand for oil will continue to grow,” he said.

The IEA has predicted that oil demand will peak by 2030 as the world shifts to cleaner energy, in sharp contrast to the OPEC [Organisations of the Petroleum Exporting Countries], which expects oil demand to keep rising until at least 2045 and calls for $14 trillion in new oil sector investment, or around $610 billion annually, to 2045.

Delayed transition scenario

The “delayed transition” or “higher oil prices for longer” scenario lacks sufficiently compelling evidence, argued Reclaim Finance’s Lara Cuvelier.

“Various reports, such as those from Carbon Tracker, suggest that the transition is happening by itself on economic grounds and that companies that keep investing in new oil and gas fields are oversupplying the market and are not prepared for when demand for oil will weaken,” she said.

Even though the financial statements of most oil and gas companies “clearly don’t reflect the true picture”, “most investors continue to vote for the approval of financial accounts at the AGM, for the renewal of auditors and for the re-election of directors”, Cuvelier added.

“Given that these financial statements are likely based on incorrect scenarios, we believe that investors should question the responsible parties, not reward them,” she said.

NGO ClientEarth recently wrote to the twelve biggest UK pension schemes and warned them that their failure to use bond investments as a lever in engagement with fossil fuel companies opens the door to legal risk.

Only a short term hold

Investors also justify investing in oil and gas by arguing that they can benefit from the dividends in the short term but divest before the valuation goes bad.

ClientEarth lawyer Catrionia Glascott voiced serious concerns with this approach.

“We know from the last financial crisis that many investors playing first-to-the-door don’t make it out in time,” she said. “When systemic, economic risks crystalise, the impact can be swift and brutal. If I were a pension fund, I wouldn’t count on my ability for a sufficiently rapid divestment.”

Asset managers tend to be the ones advocating this “short-term hold” approach to oil and gas companies, an anonymous climate-focused legal source noted,

“One would hope that asset owners would take a longer-term view in their investments,” the source added. “It is also worth mentioning that pension funds aren’t climate scientists or oil price experts and therefore may lack the necessary in-house expertise to continue with their short-term hold approach.”

Cuvelier said certain asset owners are “beginning to realise that if they want to be universal owners, they can’t depend on the advice of asset managers”.

There are signs of progress on this front, she added.

For example, the UK Asset Owner Roundtable recently commissioned academic research to investigate whether asset owners and asset managers are aligned in their proxy voting in the oil and gas sector.

The research confirmed that a gap had developed between asset owners’ expectations and asset managers’ voting activity.

Positive tipping points

Another chink in the armour of the “higher oil prices for longer” scenario is a potential underestimation of the speed of the uptake of renewables and EVs, what Campanale called a “positive tipping point”.

“We estimate that for every 14 million EVs on the road, demand for oil reduces by a million barrels of oil per day,” said Campanale. “A sudden switch to EVs would therefore have a dramatic impact on oil prices.”

The UK is a particularly interesting jurisdiction to watch, given the prevalence of the lease-holding model of car ownership.

Lease-holders are typically given the option to change cars every three years. If they start opting for EVs, the car market would change rapidly, Campanale argued.

“We don't know what will happen or how the UK government will incentivise EV adoption,” said Campanale. “But we do know that asset owners should be thinking very carefully about oil prices. The inevitable drop could happen sooner than they expect and catch them unawares.”