The steep fall in the price of oil since the middle of last year has brought volatility back to the market with a vengeance, after three years of generally range-bound trading where the Brent price hovered around the $110/bbl level.

Following this period of relative price stability, investors and oil companies alike have been sharply reminded that they are trading commodities where pricing cannot be taken for granted; volatility and hence risk are inherent. For Carbon Tracker, the key lies in how this risk is factored into decision -making.

At Carbon Tracker, we have focused our approach on company capex, and in particular the breakeven price of projects on which capex is spent. At the risk of stating a truism, projects that break even at lower prices have better downside protection, and hence greater resilience to volatility, and generate better returns.[i]

But what hurdle rate of return should companies accept when they are deciding whether to sanction a project for development? This depends on the perceived risk of investing in fossil fuel projects compared to other lower risk opportunities. We call this the ‘fossil fuel risk premium’.

Looking only at oil markets for the moment, it’s clear that there are a number of significant risk factors that directly affect pricing: Saudi production policy and slowing Asian economic growth, to name a couple.

We see clouds continuing to gather long-term. For example, increasing energy efficiencies and climate-related regulation that are here to stay in our view. We believe that demand will tend to disappoint industry expectations, and it is clear that Saudi Arabia is not just going to sit there and watch every new source of supply eat into its market share. This potent mix spells continued uncertainty and periods of volatility.

We do not believe that risks such as these are always adequately factored in when companies press ahead with high-cost projects. As we have seen recently, as well as in past crashes, small percentage changes in the supply-demand balance can lead to dramatic price falls.

Various commentators see further volatility on the horizon, including the International Energy Agency (IEA) (saying that the oil price was a “precarious balance”) and Wall Street Journal (in an article entitled “Oil’s Big Swings Are the New Normal”).

Although in this post we have concentrated on the oil price, given recent events, the issue is just as pertinent in coal. Coal export markets continue to head south, with Australian prices at a five-year low. The collapse has been such that investors are having to consider a fundamental question; do you think the seaborne thermal coal market is in structural decline? Or, is it just experiencing the bottom of a supercycle?

Much of this rides on China, where again demand may surprise to the downside. If a company is investing capital in anticipation of an upturn in the coal export market, this leaves them exposed to the gap between demand trajectories.

We recently published a paper on this topic focusing on the U.S. thermal coal market, concluding that a combination of factors including competition from other energy sources and increasing regulations to combat pollution meant that it was unlikely that the sector would ever recover.

Regardless of whether current low prices in oil and coal persist or vanish, investors and corporates must all learn the lessons and translate them into lasting changes in the way they look at fossil fuel investment practice.

Companies should be disciplined with capital and demanding of the returns they require from their developments, focusing their efforts on low-cost projects and cancelling high-cost ones. We would also recommend that companies disclose the hurdle return rates/break even prices that they require, to reassure shareholders that the dangers have been recognised and are being managed.

The fossil fuel risk premium needs to be raised.

By Andrew Grant and Mark Fulton

Andrew Grant is a financial analyst at the Carbon Tracker Initiative (CTI).

Mark Fulton is Research Advisor at CTI, and Former Head of Research DB Climate Change Advisors.

[i] The breakeven price of a project is the price needed to give a Net Present Value of 0 using a set Internal Rate of Return (IRR)/discount rate (typically 10-15%). Accordingly, a lower breakeven project gives a higher IRR in a given price scenario.