Stranded Assets a Response: Myth or Reality?

Late last year respected British economist Dieter Helm dismissed the concept of “stranded assets” as a hollow theory – Now Carbon Tracker’s Paul Spedding explains why the risk of ‘stranding’ may indeed be right on the money

Dieter Helm’s paper Stranded Assets – a deceptively simple and flawed idea (Energy Futures Network Paper No. 15, Oct 2015) itself relies on two simple and therefore highly questionable assumptions:

1) Action on climate change can’t affect demand in the short or medium-term so it can’t affect prices. Therefore, it can’t strand assets.

2) Even if such action could affect demand and prices, the effect is so far in the future investors can safely ignore or ‘discount’ it.

At Carbon Tracker we don’t believe either of these to be true. In this article we address the issues raised by Helm and argue that that they risk leaving investors (and corporates) blind-sided by the risk action on climate change poses to shareholder value. We will attempt to respond to each of the specific concerns Helm’s report raises with the stranded asset hypothesis in turn:

1. “…the lack of a serious carbon price now [means] climate change … is more hot air than serious action.”

Carbon pricing isn’t the only way climate change can be tackled. Action on the demand side via improved efficiency has been ongoing in most of the OECD for some time – rising fuel economy vehicle standards, rising fuel duties, mandated efficiencies (LED bulbs, condensing boilers etc.). This perhaps explains why OECD carbon emissions for 2014 were back to 1998’s level. Europe’s are back to 1970’s, hardly supportive of the comment that climate change is only “hot air”.

Efficiency is likely to play a key role going forward but fuel substitution will also be important as more and more regions implement ambitious renewable energy targets. For example, climate change legislation passed in California requires 50 per cent of the state’s electricity to come from renewable energy sources by 2030. The EU’s 2030 climate & energy framework sets a binding target to boost the share of renewables to at least 27 per cent of EU energy consumption by 2030. Action by governments, both co-ordinated and country-based, is likely to include efficiency mandates and continued fuel substitution, especially renewables. Fossil fuel demand in the OECD has fallen by five per cent over the past decade: EU demand has fallen by 18 per cent, equivalent to two per cent annually suggesting that the IEA’s 450 scenario is not “hot air.”

Any industry seeing falling demand for its products, however caused, faces potential trouble. A very good example of how assets can be stranded even in the absence of carbon pricing is the European refining industry. Since the late 1990s, gasoline demand has been trending down at around 2.5 per cent annually. This was the result of high taxation at the pump and efficiency mandates (including switching to diesel). Over that period, 11 European refineries closed and a further three were mothballed with only the slightest hint of a carbon price.

A more recent example of how action on climate change can affect valuations is the European power industry. Increasing renewable energy deployment has been linked to the loss of over half the market capitalisation (over €500bn) of the top 20 energy utilities in Europe from peak value in 2008 to October 2013.

2. “The stranded asset argument in its simple form is all about quantities, and silent on price.”

Just because the “simple” form of stranding is quiet on price doesn’t mean all forms are. From a top-down perspective, the simple form does focus on volumes because it aims to assess the volume of reserves (and resources) that are not needed in the context of a 2C carbon budget. But it is not true that all those interested in stranded assets look solely at volume, especially those interested in investments. For example, Carbon Tracker uses carbon budgets together with cost curves to identify high-cost projects that would be unnecessary in a 450-style demand scenario. It is these projects that would be at risk of destroying shareholder value.

Carbon Tracker called these projects “financially stranded” as they risk failing to earn a return above a company’s cost of capital. Price is a key metric in this analysis. Projects with breakeven prices above the marginal cost of supply needed to meet a 450 scenario risk destroying shareholder value. This concept is highly relevant to investors and corporates as it provides an early warning signal of full blown stranding. Investors in those closed and mothballed European refineries might have welcomed a study that showed that proposed efficiency measures would mean supply (refining capacity) was set to exceed demand. They would have been able to bail out well before the assets had to be written off.

3. “…the threat of price changes has very little to do with climate change in the short to medium term”

This is a risky assertion but the paper’s conclusion relies on the concept that climate change cannot affect prices and so cannot strand assets. Most economists would accept that in a perfect world, prices are determined by the relationship between supply and demand. Falling demand tends to cause falling prices. Claiming that climate change measures can’t affect prices in the short-to-medium term is therefore risky – as those European refinery owners would probably agree.

The history of the oil market shows that even small changes in the supply demand balance can cause very large movements in oil prices. For example, the collapse in Brent from $120 in 2014 to under $35 today was caused by a two per cent move in the supply demand balance caused by Saudi Arabia putting an additional 2mb/d on to the market. That was not caused by “climate change”. However, it is certainly possible that moves to address climate change could cause a similar change in future. Mandated efficiency measures, gas substitution and increased duty on fuel helped European Union oil demand (gasoline, diesel and heavy fuel oil) fall by one per cent annually over the past two decades. This might seem modest but is slightly shy of the long term trend for global oil demand under the IEA’s 450 scenario.

A similar demand scenario has already played out in the US coal market over the past five years. Substitution combined with tightening emission standards has seen US coal demand fall by around two per cent annually. Over that five years, the US quoted coal index has fallen by over a third in absolute terms and by nearly two-thirds relative to the S&P 500 index. With China taking action on coal owing to air pollution, it is likely that thermal coal is in structural decline with seaborne prices remaining depressed due to oversupply. A potential lesson from history for the oil industry perhaps?

4. “… until recently, climate campaigners [argued] that these prices will go ever higher as peak oil (and peak gas) kick in.”

And

5. “Now note the implications. If this were true and prices were going ever upwards, the assets on the balance sheets of the oil and gas companies would be ever more valuable.”

Not all “activists” believe in ever-higher prices. Carbon Tracker’s report in May 2014 – when the oil price was still $100 plus – described a transition scenario that would deliver Brent prices in the $75 area. Recent research from UCL (January 2015) showed that there is sufficient oil to meet demand well beyond 2050 (even under the IEA’s current policies scenario) at prices under $70. Neither constitutes an “ever higher” price scenario in our view. An assertion that might have more validity is that “activists” see ever-rising costs rather than prices. Assuming an efficient world, rising costs would imply rising prices as projects would be developed in order of cost. But this does not result in rising margins. And margin is a far more important driver of value than price is.

Sadly, the oil market is far from efficient because of the presence of OPEC. The world has spent much of the past 40 years developing high cost non-OPEC oil whilst leaving most of OPEC’s low cost oil in the ground. It may be that the current low level of oil prices will not endure. But what is far clearer is that the $100 plus world that formed the basis of oil industry planning over the five years running up to 2014 was far from sustainable. It assumed that OPEC, Saudi Arabia especially, was willing to lose market share in order to support prices. Events of 2014 suggest that willingness is not written in stone. The oil industry should have cast an eye over the events that led to the 1985/86 oil price crash – similar in magnitude to that of 2014. They would have seen identical behaviour by Saudi Arabia.

Philosopher George Santayana’s quote, “those who cannot remember the past are condemned to repeat it”, seems appropriate.

6. “The implications of discounting are obvious and profound: at any reasonable number, investors are not much interested in returns in even 10 years’ time, let alone in 2050”.

Analysts taking the top-down approach to stranded assets don’t need to invoke discount rates as they are interested in the volumes at risk of becoming stranded not value at risk. But there are many reports that analyse the financial risk. Carbon Tracker has looked at the financial risk for all three fossil fuels. And Goldman Sachs and Sanford Bernstein have issued similar reports looking at market risks. These reports all use discount rates – and they used discount rates close to the industry’s cost of capital (10-15 per cent). It is true that some observers have called for relatively low discount rates to illuminate the costs that future generations will have to fund in order to repair the damage caused by climate change. But the studies that focus on investment risk – such as CTI’s – are very much aligned with the metrics used by the financial and energy industries.

But there is also a flaw in the report’s claim that discount rates mean investors are not interested in returns “in even 10 years’ time”. Of course, it is obvious that an investor will be more interested in $100 today rather than $100 in 10 years’ time. After all, the $100 in 2025 is only worth less than $40 in terms of today’s money, assuming a 10 per cent discount rate. But the report’s argument relies on a static view of a company – it assumes today’s $100 is not reinvested but returned to investors. But oil companies do re-invest and most of them re-invest far more than they return to shareholders (In 2014, ExxonMobil’s capital expenditure was around 60 per cent higher than its shareholder distributions). Oil companies invest because it adds value – as long as returns beat their cost of capital. So, for example, investing today’s $100 at a 15 per cent IRR (internal rate of return) would deliver value of around $155 in 10 years’ time (in today’s money). So $100 invested for 10 years is far more valuable than $100 in the pocket.

It is obvious that the effect of discounting does not mean investors should not be interested in events a decade ahead. As long as the oil industry keeps investing, they should be very interested in the cash flows that will result from today’s investment.

One reason for this is that the oil industry’s best laid plans often go awry. Cost overruns, project delays, fiscal changes, and unanticipated changes in commodity prices are common occurrences. Indeed, many of the projects sanctioned for development by oil companies in 2013 are unlikely to deliver the returns the industry originally projected due to the fall in the oil price. We suspect many will now destroy value unless oil prices recover. If, for example, our “15 per cent” project delivered only five per cent, the $100 invested today would be turned in to $60, not $155. Such financial risks are another very good reason to keep a very close eye on cash flows 10 years hence.

Of course, if companies chose to move to a ‘harvest’ strategy rather than reinvesting, Dieter Helm’s conclusion that investors have little interest in “10 years’ time” is valid. An oil company in harvest mode has less to fear from the effect of climate change as it is not rolling the risk forward by re-investing. The same is true for its shareholders as the dividends would have already been safely banked.

7. “More than 90% of oil reserves are in state not private hands.” (So it’s not a problem for quoted oil anyway)

There are two problems with this statement. First, many so-called private companies are partially quoted – including Petrobras, Statoil, many Chinese producers and most Russian producers – so the quoted universe is much larger than the 10 per cent cited. Second, quoted companies make up a far greater percentage of potential production over the next 20 years. Most quoted oil companies have proven reserve lives of 10-15 years whereas OPEC’s are in excess of 50 years.

Carbon Tracker estimates that the major oil companies and quoted Exploration & Production companies will make up around 30 per cent of production over the next 20 years leaving them more exposed to climate change than the 10 per cent reserve comment implies. Another key issue highlighted by Carbon Tracker in its 2014 report was that private companies’ production is on average far higher cost than that of state oil companies. Another is that much of the high cost production likely to start in the next 20 years is in private hands. Around 70 per cent of production in state hands had break-even prices below $60: for private companies, the comparable figure was a little under 40 per cent. This means that private companies have more operational gearing to oil prices and so have more to lose should the oil market follow the coal industry.

8. “If nevertheless demand for oil slowly dries up as the carbon constraint bites, then these countries [State controlled companies] will conclude that oil today is worth more than oil tomorrow. They will then have every incentive to pump more and faster.”

So the paper accepts that it is possible that carbon constraints could cause lower demand possibly leading to the big reserve holders initiating a price war to protect market share. The emergence of such a price war – similar to that initiated by Saudi Arabia in 2014 and 1985/86 – is probably one of the greatest threats facing quoted oil. This is because if demand is under pressure from action on climate change, it implies a growing mismatch – rising supply and falling demand which would likely force prices lower. In extremis, prices would be pushed back to cash operating costs which could be even lower than spot prices today.

9. “…investors will find it more profitable to concentrate on the price of oil, and they can profitably ignore the stranded asset argument.”

The price of oil is an important driver of shareholder value and certainly should be concentrated on – although margin is probably more important. But that does not mean the risk of stranded assets should be ignored. Time and time again, the commodity market has shown that falling (or lower than expected) demand can cause price pressure. Such pressure can financially strand assets remarkably quickly. We could invoke the fate of Europe’s refineries again but the collapse in the US coal sector due to weak demand is a more recent and more financially painful example.

Anticipating how demand might change in response to future action on climate change might well give early warning of price trouble ahead, potentially leading to financial stranding. Ignoring stranding on the grounds that climate policy can’t affect price and hence can’t strand assets seems a rather blinkered view. In any case, stranded assets are normally the result of weak pricing so arguing that one should ignore stranding and focus on prices is disconnected thinking. One is a function of the other.

More importantly, worrying about stranding gives you an indication of the scale of the potential risk that weak pricing could pose to your portfolio. Investors should continuously be looking for the early signs of “financial stranding”, the definition Carbon Tracker uses. Dieter Helm is correct that prices (or more importantly margins) are important but it is demand that sets prices. Investors need to monitor issues – such as action on climate – that can change the demand outlook. Assuming stranding is irrelevant because it can’t occur except in the long term is dangerous. It risks investors ending up in the same position as the last shareholders in Kodak, Polaroid, Peabody Coal and various Canadian oil sand producers.

Interestingly, Kodak re-emerged from bankruptcy in 2012 and is manufacturing specialist film. Peabody and many Canadian oil sand producers are still operating, so technically they are not stranded under Dieter Helm’s narrow definition. But we doubt that is of much comfort to their shareholders or bond holders.

Paul Spedding is an advisor to Carbon Tracker and an ex-HSBC head of oil & gas

This article was first published in Business Green