$1.1 trillion of oil investment over next decade needs to be challenged by investors

CTI carbon supply cost curve enables investors to understand the relationship between capex plans and carbon

London, 8th May 2014 — New research by the Carbon Tracker Initiative today reveals how many oil projects make neither economic nor climate sense.

The risk analysis identifies that many higher cost oil projects are too far up the cost curve to fit within low demand, low price scenarios that would also limit oil-related emissions to within a carbon budget. The research identifies $1.1 trillion of potential capital expenditure (capex) up to 2025 in key locations by province requires a market price over $95/bbl. CTI recommends that investors now engage with companies to discuss the risk of capital being wasted on carbon intensive projects that are not certain to generate value, and are not consistent with the coming carbon constrained world.

This report urges investors to challenge the demand and price assumptions underlying the capital expenditure plans of oil companies. Gambling on a $95/bbl oil price on behalf of shareholders is risky given that oil prices have dropped to $40 per barrel twice in the last decade. Demand could be impacted by a range of future issues, such as the increasing constraints on emissions, efficiency gains, improvements in technology, and slowdown in the Chinese economy.

James Leaton, Research Director, Carbon Tracker, said:  “This risk analysis shows that many oil companies are betting on a high demand and price scenario. Investors need get ahead of the carbon supply cost curve to ensure capital is not being wasted.”

Mark Fulton, adviser to Carbon Tracker Initiative, (and a former Head of Research at Deutsche Bank Climate Advisors), said: “For the first time, this report bridges the worlds of oil project economics – in terms of both the marginal cost of supply  – and carbon, allowing investors to gauge where risk lies, given a range of demand scenarios.  It makes it clear that investors have reason to engage companies on many high cost and high carbon content projects.”

Looking further forward to 2050, the analysis found that around $21 trillion of capex would need to be invested by the private sector in  high risk projects; investment which would not pay for itself in a world where demand is lower and that continues to take climate change and air quality seriously. The CTI research shows that oil production requiring a market price above $75 per barrel would take the world beyond 2°C of warming, based on a reference scenario of continued business as usual consumption of the main fossil fuels -coal, oil and gas.

Investors have already started engaging with listed oil companies regarding concerns over carbon asset risk. The CTI analysis shows that the private sector is the major player in funding high cost oil production, where national oil firms have limited interests. The answer for investors to help mitigate these risks is to demand capital discipline from oil majors. This requires a refocus on shareholder value, instead of a pursuit of production volume. Practically, that could see returns to investors through buy-backs and dividends, rather than investments in high-cost oil exploration.

Paul Spedding, a former-HSBC Oil & Gas Sector Analyst, said: “Many investors are concerned about the growing amount of capital that the oil companies have thrown at low return, carbon heavy projects. The majors’ strategies need to be challenged. As this report shows, returns are falling and costs are rising. To reverse this, a greater focus is needed on higher return, lower cost assets. If this means lower capital investment and higher dividends or buybacks, so much the better. This analysis is important as it provides the data investors need to challenge proposed investments on the basis of returns as well as carbon content.”

For the smaller independents, a large number of such companies have exposed more than half their potential capex to 2025 to high cost projects requiring over a $95 oil price. A low demand/price scenario challenges the business model of these companies. Focusing on some of the more specialist deepwater or oil sands players may represent a new target group for engagement by investors.

The report enables comparison of which companies have the highest levels of potential capex over the next decade in Arctic, Oilsands and Deepwater provinces. And the analysis indicates the largest companies with the majority of their capex at the high end of the cost curve.

CEO of Carbon Tracker, Anthony Hobley said: “CTI’s research has created a new debate around climate change and investment. Numbers are the bedrock of financial markets and it is the numbers that allow you to move from the general to the specific in the investment world. This analysis is another critical tool from CTI to help financial experts identify carbon investment risk in the capital markets today.”

Technical summary of analysis

1) A 2°C carbon budget context

As Carbon Tracker has pointed out in its previous research, staying within a 2°C global “carbon budget” will require a significant reduction in future oil demand.1 Measures necessary to achieve this reduction include stronger climate policies, heightened energy efficiency, and broader deployment of renewable energy sources. In this new study we examine the supply and demand for oil at the global level through 2050.  As a reference point, we find that the oil-related portion of a 2°C carbon budget (360 billion tons of carbon dioxide, or GTCO2 which is 40% of the global 900 GTC02 CTI has calculated) can be exhausted entirely through potential production with a break-even oil price (BEOP) below $60/bbl (i.e. production that, after adding a $15/bbl contingency, requires a minimum market oil price of $75/bbl). The focus of our document is a risk analysis of oil project economics in this context.

2) Through 2050 the private sector will play a pivotal role in developing new oil resources

In our analysis of Rystad Energy’s UCube Upstream database, we find over over half of potential production in total is set to come from the private sector (as opposed to entities with any state ownership). As a result, economic or policy constraints on future oil production will have major implications for investors.

3) Stress-testing the logic of rising upstream oil capital expenditure

Over 2014-50, private oil companies would need to invest $25.5 trillion in upstream oil production with a BEOP above the $60 threshold to unlock their full supply; an average of $0.7 trillion per year. In this study we provide information for investors to evaluate capital expenditures of oil companies under different demand scenarios that include constraints on carbon-dioxide (CO2) emissions, varying rates of economic growth, and other key drivers.  The goal of this is to stress-test the demand and oil price assumptions that drive corporate decision-making on future reserve and production growth.  Investors can use such analysis as a starting point to engage with companies on capital allocation, i.e. how much should be devoted to new capital expenditures or returned to shareholders via buybacks and dividends.

4) Introducing the Carbon Supply Cost Curve

We have previously emphasized the importance of a 2°C “global carbon budget”. We analyze how this budget interacts with the economics of oil production via Carbon Supply Cost Curves; these curves show potential oil supply in terms of cumulative oil production (million barrels per day) and lifecycle CO2 emissions (billion tons of CO2, or GTCO2). This bridges the gap between decisions on capital and climate change. We analyze the economics of oil projects using the break-even oil price (BEOP), the price at which an asset yields a net present value of zero (assuming a 10% internal rate of return).On top of that we add a $15 contingency to arrive at a market price.

5) Projects needing an above $95/bbl market price are most vulnerable in a low-carbon demand scenario

Through 2050, 22 MBPD of oil production (20% of total potential production and CO2 emissions) will  potentially come from private-sector projects with BEOPs over $80/bbl (i.e. that require a market price above  $95/bbl); financing such projects will require $21 trillion of new investment.  Many such projects involve significant technical challenges (ultra-deepwater, oil sands, Arctic), or are in geo-politically sensitive locations (Russia, East Africa, Nigeria, Venezuela) or both.  To help investors understand their exposure to these risks we examine in detail the technological/categories and location break-down of high-cost projects.

6) Significant exposure for private companies, including Majors

Though the bulk of potential production from the seven global “majors”3 is projected to have a BEOP below $80/bbl, these companies also have notable exposure to higher-priced locations/oil types.  Avoiding expenditure at the high end of the cost curve in order to return cash to shareholders is a valid capital management strategy. Engaging with the Majors over these higher priced projects within their overall portfolio could catalyze an industry-wide pullback on new capital expenditures.   Note that many independent smaller companies have significant exposure to high-cost projects that is not compensated for by a strong position in lower-cost resources.