The $2 trillion stranded assets danger zone: How excessive fossil fuel capex risks eroding investor returns
How many industries are on the hook for $2.2 trillion that risks damaging both the planet and their shareholders?
Over the next decade fossil fuel companies plan to invest trillions of dollars to expand production of coal, oil, and natural gas. Most of these companies, however, assume growth trajectories for fossil fuel demand that are incompatible with international efforts to limit climate change to two degrees Celsius above pre-industrial levels (2°C). By diminishing future fossil fuel demand, progress toward the 2°C goal reduces the need for fossil-fuel capital expenditures (capex) today. The question is, in a 2°C world, what portion of planned fossil-fuel capex becomes unneeded?
In a recently-published report, my colleagues at the Carbon Tracker Initiative and I estimate at least $2.2 trillion in potential 2015-2025 fossil-fuel capex that is unneeded if the world is to adhere to a 2°C climate target. Proceeding with such investments risks exposing shareholders to higher-cost projects that will be unable to generate satisfactory financial returns in a carbon-constrained world.
A 2°C climate trajectory spells the most trouble for coal. A 2°C world eliminates the need for new thermal coal mines through at least 2035, as production from existing mines is sufficient to meet new sources of demand. Declining demand for thermal coal will further pressure already embattled U.S. coal producers such as Peabody Energy (NYSE:BTU), Murray Energy and Foresight Energy (NYSE:FELP); it will also negatively impact diversified miners such as Glencore (LON:GLEN) that have been increasing their exposure to thermal coal. Conversely, our analysis confirms the sound rationale for the recent decisions by BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) to sell or spin-off thermal coal assets in Australia and South Africa.
Though in a 2°C world most of the unneeded potential fossil fuel supply relates to coal, 90 percent of unneeded potential fossil fuel capex relates to oil and gas. In a 2°C scenario global oil demand peaks around 2020 and then declines by 1.5 percent per year through 2035; this demand trajectory eliminates the need for one-third of potential supply from new projects (with associated investment of $1.3 trillion). Particular risks exist for shale oil in the U.S., oil sands in Canada, deepwater and ultra-deep water projects in the U.S. and Mexico, heavy oil in Venezuela, and Arctic production in the U.S., Russia, and Norway.
Natural gas is the fossil fuel that fares best in a 2°C world, with global demand projected to grow at 0.8 percent per year through 2035 (or half the rate as is projected to occur under a business-as-usual scenario). Slower growth in global demand eliminates the need for one-fourth of potential production from new projects (with associated investment of $459 billion). Across the gas markets we analyze (North America, Europe, and the LNG export market), we identify risks to two-thirds of new coal bed methane and Arctic projects and half of new LNG projects (including nearly all new LNG projects in the U.S. and Canada, as well as some in Australia, Qatar, and Indonesia).
The fossil fuel producers most at risk in a 2°C world are those that are entirely leveraged to higher-cost, long-life projects. Prime examples include oil sands producers Suncor (NYSE:SU) and Canadian Natural Resources Ltd.(TSE:CNQ); should global oil demand follow a 2°C trajectory, roughly 40 percent of 2015-2025 potential capex from these companies become unneeded. Somewhat better positioned to withstand the transition to a 2°C world are the oil majors, with unneeded capex amounting to 20-25 percent of total potential oil and gas capex over the next decade.
Among the Majors, ConocoPhillips (NYSE:COP) has the least exposure to unneeded capex in both absolute and relative terms (with $21 billion in unneeded capex amounting to 16 percent of Conoco’s total 2015-2025 capex); most exposed are Shell (NYSE:RDS.A) and ExxonMobil (NYSE:XOM), with $73-77 billion in unneeded capex amounting to 28-29 percent of total 2015-2025 capex. Among the 20 largest oil and gas companies in the world, only three – Petrobras (NYSE:PBR), Statoil (NYSE:STO), and Saudi Aramco – see 90 percent or more of total 2015-2025 potential capex remain needed to meet projected demand in a 2°C scenario.
Our analysis highlights the importance of stress-testing planned fossil fuel investments against demand and price scenarios consistent with a 2°C world. Companies should cancel projects that fail such stress tests; as capex needs diminish over time, companies should return greater amounts of capital to investors via share repurchases and dividends. For certain companies, increased investments in low-carbon energy sources may also be a viable strategy (note that CEOs of several large European oil companies, including Eni (NYSE:E) and Statoil, have announced aspirations for more deployment of low-carbon solutions).
In addition to greater capital discipline, fossil fuel producers serious about navigating the transition to a lower-carbon economy should also emphasize strong balance sheets (to withstand periods of lower-than-expected prices without resorting to distressed asset sales), flexible capital budgets (with limited exposure to long lead-time, long pay-out projects), and performance metrics for executive compensation that prioritize medium and long-term shareholder returns over increases in production and operating cash flows.
From Kodak (NYSE:KODK) to IBM (NYSE:IBM), business history abounds with examples of incumbents who have failed to prepare adequately for industry transitions. Smart fossil-fuel producers will begin adapting now to a world where demand for fossil fuels is declining rather than increasing. Our report offers these companies a $2.2 trillion wake-up call that can inform strategies for protecting and enhancing, rather than destroying, shareholder value.
Reid Capalino is a Senior Energy Analyst with the Carbon Tracker Initiative, a financial think thank that advises investors and policymakers on the low-carbon transition of the world’s energy system.